DERIVATIVES MARKET

Workbook

NSE Certified Capital Market Professional

(NCCMP)
(A joint certificate course from _______________________________ and
The National Stock Exchange of India Limited)

CHAPTER 1.....................................................................................................................................5
INTRODUCTION TO DERIVATIVES.........................................................................................5
DERIVATIVES DEFINED............................................................................................................6
FACTORS DRIVING THE GROWTH OF DERIVATIVES........................................................7
DERIVATIVE PRODUCTS...........................................................................................................7
PARTICIPANTS IN THE DERIVATIVES MARKETS................................................................8
ECONOMIC FUNCTION OF THE DERIVATIVE MARKET....................................................8
EXCHANGE-TRADED VS. OTC DERIVATIVES MARKETS................................................10
NSE'S DERIVATIVES MARKET...............................................................................................11
Participants and functions.......................................................................................................12
Trading mechanism..................................................................................................................13
CHAPTER 2...................................................................................................................................19
INTRODUCTION TO FUTURES & OPTIONS AND SWAPS................................................19
FORWARD CONTRACTS..........................................................................................................19
LIMITATIONS OF FORWARD MARKETS...........................................................................................20
INTRODUCTION TO FUTURES...............................................................................................20
DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS.............................22
FUTURES TERMINOLOGY...............................................................................................................22
INTRODUCTION TO OPTIONS...............................................................................................23
OPTION TERMINOLOGY.........................................................................................................23
FUTURES AND OPTIONS.................................................................................................................26
INDEX DERIVATIVES......................................................................................................................27
Interest Rate Swap...................................................................................................................29
Basis Swap...............................................................................................................................32
CHAPTER 3...................................................................................................................................34
APPLICATIONS OF FUTURES AND OPTIONS.....................................................................34
TRADING UNDERLYING VERSUS TRADING SINGLE STOCK FUTURES.............................................34
FUTURES PAYOFFS.........................................................................................................................35
Payoff for buyer of futures: Long futures.................................................................................35
Payoff for seller of futures: Short futures................................................................................36
PRICING FUTURES.........................................................................................................................37
Pricing equity index futures.....................................................................................................38
Pricing index futures given expected dividend amount...........................................................38
Pricing index futures given expected dividend yield................................................................39
PRICING STOCK FUTURES..............................................................................................................41
Pricing stock futures when no dividend expected....................................................................41
Pricing stock futures when dividends are expected.................................................................42
APPLICATION OF FUTURES............................................................................................................42
Hedging: Long security, sell futures........................................................................................43
Speculation: Bullish security, buy futures................................................................................44
Speculation: Bearish security, sell futures...............................................................................44
1

Arbitrage: Overpriced futures: buy spot, sell futures....................................................................45

Arbitrage: Underpriced futures: buy futures, sell spot............................................................46
OPTIONS PAYOFFS.........................................................................................................................46
Payoff profile of buyer of asset: Long asset............................................................................47
Payoff profile for seller of asset: Short asset...............................................................................47
Payoff profile for buyer of call options: Long call........................................................................47
Payoff profile for writer of call options: Short call.................................................................49
Payoff profile for buyer of put options: Long put....................................................................50
Payoff profile for writer of put options: Short put...................................................................50
PRICING OPTIONS..........................................................................................................................51
APPLICATION OF OPTIONS.............................................................................................................52
Hedging: Have underlying buy puts........................................................................................52
Speculation: Bullish security, buy calls or sell puts................................................................53
Speculation: Bearish security, sell calls or buy puts...............................................................55
Bull spreads - Buy a call and sell another...............................................................................59
Bear spreads - sell a call and buy another..............................................................................61
THE GREEKS.................................................................................................................................64
Delta ( )................................................................................................................................64
Gamma ( ).............................................................................................................................64
Theta ( )...............................................................................................................................64
Vega .....................................................................................................................................65
Rho( )...................................................................................................................................65
CHAPTER 4...................................................................................................................................66
TRADING.......................................................................................................................................66
FUTURES AND OPTIONS TRADING SYSTEM....................................................................................66
Entities in the trading system...................................................................................................66
Basis of trading........................................................................................................................67
Corporate hierarchy................................................................................................................68
Client Broker Relationship in Derivative Segment..................................................................69
Order types and conditions......................................................................................................70
THE TRADER WORKSTATION.........................................................................................................72
The market watch window.......................................................................................................72
Inquiry window........................................................................................................................73
Placing orders on the trading system...........................................................................................74
Market spread/combination order entry......................................................................................74
Basket trading..........................................................................................................................74
FUTURES AND OPTIONS MARKET INSTRUMENTS...........................................................................75
Contract specifications for index futures.................................................................................76
Contract specification for index options..................................................................................77
Contract specifications for stock futures.................................................................................80
Contract specifications for stock options................................................................................81
CRITERIA FOR STOCKS AND INDEX ELIGIBILITY FOR TRADING.....................................................83
Eligibility criteria of stocks.....................................................................................................83
Eligibility criteria of indices....................................................................................................83
Eligibility criteria of stocks for derivatives trading................................................................84
especially on account of corporate restructuring....................................................................84
2

CHARGES......................................................................................................................................85
CHAPTER 5...................................................................................................................................86
CLEARING AND SETTLEMENT..............................................................................................86
CLEARING ENTITIES......................................................................................................................86
Clearing members.....................................................................................................................86
Clearing banks.........................................................................................................................86
CLEARING MECHANISM................................................................................................................87
SETTLEMENT MECHANISM............................................................................................................89
Settlement of futures contracts.................................................................................................90
Settlement of options contracts................................................................................................92
ADJUSTMENTS FOR CORPORATE ACTIONS.....................................................................................95
RISK MANAGEMENT......................................................................................................................96
NSCCL-SPAN.............................................................................................................................97
Types of margins............................................................................................................................97
MARGINING SYSTEM..............................................................................................................98
SPAN approach of computing initial margins..........................................................................99
Mechanics of SPAN..................................................................................................................99
Overall portfolio margin requirement...................................................................................104
Forms of collaterals acceptable at NSCCL..........................................................................104
Requirements to become F&O segment member...................................................................104
Requirements to become authorized / approved user............................................................105
Position limits........................................................................................................................106
Reporting of client margin.....................................................................................................110
ADJUSTMENTS FOR CORPORATE ACTIONS...................................................................................110
CHAPTER

6.................................................................................................................................113

ACCOUNTING FOR DERIVATIVES..................................................................................................113

Accounting for futures............................................................................................................113
Accounting for options...........................................................................................................117
TAXATION OF DERIVATIVE TRANSACTION IN SECURITIES...........................................................119
Taxation of Profit/Loss on derivative transaction in securities.............................................119
Securities transaction tax on derivatives transactions..........................................................120

Copyright 2009 by National Stock Exchange of India Ltd. (NSE)

Exchange Plaza, Bandra Kurla Complex,
Bandra (East), Mumbai 400 051 INDIA
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compilation etc. are the property of NSE. This book or any part thereof should
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electronic, mechanical, photocopying, recording or otherwise.
3

INTRODUCTION
The derivatives trading at NSE commenced on June 12, 2000 with futures
trading on S&P CNX Nifty Index. Subsequently, the product base has been
increased to include trading in options on S&P CNX Nifty Index, futures and
options on CNX IT Index, Bank Nifty Index and Nifty Midcap 50 Indices and
more than 150 single stock futures and options.
The trading volume in the futures and options segment has risen from
Rs.2,365 crore in 2000-01 to Rs.17,663,665 core in 2009-10. Average daily
trading volumes have jumped from Rs. 12 crore in 2000-01 when NSE started
its derivative market segment to Rs. 72,392 crore in 2009-10.
In the year 2009, NSE ranked as the seventh largest derivatives exchange in
the world. Worldwide, NSE ranks second in terms of number of contracts
traded in single stock futures and stock index options and third in terms of
number of contracts traded in stock index futures.
This book endeavours to explain various aspects related to the Derivatives
market such as trading mechanism, product features, trading strategies and
clearing and settlement of Derivatives.

CHAPTER 1
INTRODUCTION TO DERIVATIVES
The emergence of the market for derivative products, most notably forwards,
futures and options, can be traced back to the willingness of risk-averse
economic agents to guard themselves against uncertainties arising out of
fluctuations in asset prices. By their very nature, the financial markets are
marked by a very high degree of volatility. Through the use of derivative
products, it is possible to partially or fully transfer price risks by locking-in
asset prices. As instruments of risk management, these generally do not
influence the fluctuations in the underlying asset prices. However, by lockingin asset prices, derivative products minimize the impact of fluctuations in
asset prices on the profitability and cash flow situation of risk-averse
investors.
Derivatives have probably been around for as long as people have been
trading with one another. Forward contracting dates back at least to the 12th
century, and may well have been around before then. Merchants entered into
contracts with one another for future delivery of specified amount of
commodities at specified price. A primary motivation for pre-arranging a
buyer or seller for a stock of commodities in early forward contracts was to
lessen the possibility that large swings would inhibit marketing the commodity
after a harvest.
The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws(Amendment) Ordinance, 1995, which
withdrew the prohibition on options in securities. The market for derivatives,
however, did not take off, as there was no regulatory framework to govern
trading of derivatives. SEBI set up a 24member committee under the
Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate
regulatory framework for derivatives trading in India. The committee
submitted its report on March 17, 1998 prescribing necessary preconditions
for introduction of derivatives trading in India. The committee recommended
that derivatives should be declared as securities so that regulatory
framework applicable to trading of securities could also govern trading of
securities. SEBI also set up a group in June 1998 under the Chairmanship of
Prof.J.R.Varma, to recommend measures for risk containment in derivatives
market in India. The report, which was submitted in October 1998, worked
out the operational details of margining system, methodology for charging
initial margins, broker net worth, deposit requirement and realtime
monitoring requirements.

The Securities Contract Regulation Act (SCRA) was amended in December

1999 to include derivatives within the ambit of securities and the regulatory
framework was developed for governing derivatives trading. The act also
made it clear that derivatives shall be legal and valid only if such contracts
are traded on a recognized stock exchange, thus precluding OTC derivatives.
The government also rescinded in March 2000, the three decade old
notification, which prohibited forward trading in securities.

DERIVATIVES DEFINED
Derivative is a product whose value is derived from the value of one or more
basic variables, called bases (underlying asset, index, or reference rate), in a
contractual manner. The underlying asset can be equity, forex, commodity or
any other asset. For example, wheat farmers may wish to sell their harvest at
a future date to eliminate the risk of a change in prices by that date. Such a
transaction is an example of a derivative. The price of this derivative is driven
by the spot price of wheat which is the "underlying".
In the Indian context the Securities Contracts (Regulation) Act, 1956
(SC(R)A) defines "derivative" to include1.

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.
Derivative products initially emerged as hedging devices against
fluctuations in commodity prices, and commodity-linked derivatives
remained the sole form of such products for almost three hundred years.
Financial derivatives came into spotlight in the post-1970 period due to
growing instability in the financial markets. However, since their
emergence, these products have become very popular and by 1990s, they
accounted for about two-thirds of total transactions in derivative
products. In recent years, the market for financial derivatives has grown
tremendously in terms of variety of instruments available, their
complexity and also turnover. In the class of equity derivatives the world
over, futures and options on stock indices have gained more popularity
than on individual stocks, especially among institutional investors, who are
major users of index-linked derivatives. Even small investors find these
useful due to high correlation of the popular indexes with various
portfolios and ease of use.
Box 1.1: Emergence of financial derivative products
6

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.

DERIVATIVE PRODUCTS
Derivative contracts have several variants. The most common variants are
forwards, futures, options and swaps. We take a brief look at various
derivatives contracts that have come to be used.
Forwards: A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today's pre-agreed
price.
Futures: A futures contract is an agreement between two parties to buy or sell an
asset at a certain time in the future at a certain price. Futures contracts are special
types of forward contracts in the sense that the former are standardized
exchange-traded contracts.
Options: Options are of two types - calls and puts. Calls give the buyer the
right but not the obligation to buy a given quantity of the underlying asset, at
a given price on or before a given future date. Puts give the buyer the right,
but not the obligation to sell a given quantity of the underlying asset at a given
price on or before a given date.
Warrants: Options generally have lives of upto one year, the majority of
options traded on options exchanges having a maximum maturity of nine
months. Longer-dated options are called warrants and are generally traded
over-the-counter.
7

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities.

These are options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The
underlying asset is usually a moving average of a basket of assets. Equity
index options are a form of basket options.
Swaps: Swaps are private agreements between two parties to exchange cash flows
in the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are:

Interest rate swaps: These entail swapping only the interest related cash
flows between the parties in the same currency.

Currency swaps: These entail swapping both principal and interest

between the parties, with the cash flows in one direction being in a
different currency than those in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become
operative at the expiry of the options. Thus a swaption is an option on a forward
swap. Rather than have calls and puts, the swaptions market has receiver
swaptions and payer swaptions. A receiver swaption is an option to receive fixed and
pay floating. A payer swaption is an option to pay fixed and receive floating.

PARTICIPANTS IN THE DERIVATIVES MARKETS

The following three broad categories of participants - hedgers, speculators,
and arbitrageurs trade in the derivatives market. Hedgers face risk associated
with the price of an asset. They use futures or options markets to reduce or
eliminate this risk. Speculators wish to bet on future movements in the price
of an asset. Futures and options contracts can give them an extra leverage;
that is, they can increase both the potential gains and potential losses in a
speculative venture. Arbitrageurs are in business to take advantage of a
discrepancy between prices in two different markets. If, for example, they
see the futures price of an asset getting out of line with the cash price, they
will take offsetting positions in the two markets to lock in a profit.

ECONOMIC FUNCTION OF THE DERIVATIVE MARKET

Inspite of the fear and criticism with which the derivative markets are
commonly looked at, these markets perform a number of economic functions.
1. Prices in an organized derivatives market reflect the perception of market
8

participants about the future and lead the prices of underlying to the
perceived future level. The prices of derivatives converge with the prices of
the underlying at the expiration of the derivative contract. Thus derivatives
help in discovery of future as well as current prices.
2. The derivatives market helps to transfer risks from those who have them
but may not like them to those who have an appetite for them.
3. Derivatives, due to their inherent nature, are linked to the underlying cash
markets. With the introduction of derivatives, the underlying market
witnesses higher trading volumes because of participation by more players
who would not otherwise participate for lack of an arrangement to transfer
risk.
4. Speculative trades shift to a more controlled environment of derivatives
market. In the absence of an organized derivatives market, speculators
trade in the underlying cash markets. Margining, monitoring and
surveillance of the activities of various participants become extremely
difficult in these kind of mixed markets.
Early forward contracts in the US addressed merchants' concerns about
ensuring that there were buyers and sellers for commodities. However 'credit
risk" remained a serious problem. To deal with this problem, a group of
Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The
primary intention of the CBOT was to provide a centralized location known in
advance for buyers and sellers to negotiate forward contracts. In 1865, the
CBOT went one step further and listed the first 'exchange traded" derivatives
contract in the US, these contracts were called 'futures contracts". In 1919,
Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow
futures trading. Its name was changed to Chicago Mercantile Exchange
(CME). The CBOT and the CME remain the two largest organized futures
exchanges, indeed the two largest "financial" exchanges of any kind in the
world today.
The first stock index futures contract was traded at Kansas City Board of
Trade. Currently the most popular stock index futures contract in the world is
based on S&P 500 index, traded on Chicago Mercantile Exchange. During the
mid eighties, financial futures became the most active derivative instruments
generating volumes many times more than the commodity futures. Index
futures, futures on T-bills and Euro-Dollar futures are the three most popular
futures contracts traded today. Other popular international exchanges that
trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore,
TIFFE in Japan, MATIF in France, Eurex etc.
Box 1.2: History of derivatives markets

5. An important incidental benefit that flows from derivatives trading is that it

acts as a catalyst for new entrepreneurial activity. The derivatives have a
history of attracting many bright, creative, well-educated people with an
entrepreneurial attitude. They often energize others to create new
businesses, new products and new employment opportunities, the benefit
of which are immense.
In a nut shell, derivatives markets help increase savings and investment in
the long run. Transfer of risk enables market participants to expand their
volume of activity.

EXCHANGE-TRADED vs. OTC DERIVATIVES MARKETS

Derivatives have probably been around for as long as people have been trading with
one another. Forward contracting dates back at least to the 12th century, and may
well have been around before then. Merchants entered into contracts with one
another for future delivery of specified amount of commodities at specified price. A
primary motivation for pre-arranging a buyer or seller for a stock of commodities
in early forward contracts was to lessen the possibility that large swings would
inhibit marketing the commodity after a harvest.
As the word suggests, derivatives that trade on an exchange are called exchange
traded derivatives, whereas privately negotiated derivative contracts are called OTC
contracts.
The OTC derivatives markets have witnessed rather sharp growth over the
last few years, which has accompanied the modernization of commercial and
investment banking and globalisation of financial activities. The recent
developments in information technology have contributed to a great extent to
these developments. While both exchange-traded and OTC derivative contracts
offer many benefits, the former have rigid structures compared to the latter. It has
been widely discussed that the highly leveraged institutions and their OTC
derivative positions were the main cause of turbulence in financial markets in
1998. These episodes of turbulence revealed the risks posed to market stability
originating in features of OTC derivative instruments and markets.
The OTC derivatives markets have the following features compared to exchangetraded derivatives:
1. The management of counter-party (credit) risk is decentralized and located
within individual institutions,
2. There are no formal centralized limits on individual positions, leverage, or
margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and
10

integrity, and for safeguarding the collective interests of market

participants, and
5. The OTC contracts are generally not regulated by a regulatory authority
and the exchange's self-regulatory organization, although they are
affected indirectly by national legal systems, banking supervision and
market surveillance.
Some of the features of OTC derivatives markets embody risks to financial market
stability. The following features of OTC derivatives markets can give rise to
instability in institutions, markets, and the international financial system: (i) the
dynamic nature of gross credit exposures; (ii) information asymmetries; (iii) the
effects of OTC derivative activities on available aggregate credit; (iv) the high
concentration of OTC derivative activities in major institutions; and (v) the central
role of OTC derivatives markets in the global financial system. Instability arises
when shocks, such as counter-party credit events and sharp movements in asset
prices that underlie derivative contracts occur, which significantly alter the
perceptions of current and potential future credit exposures. When asset prices
change rapidly, the size and configuration of counter-party exposures can become
unsustainably large and provoke a rapid unwinding of positions.
There has been some progress in addressing these risks and perceptions.
However, the progress has been limited in implementing reforms in risk
management, including counter-party, liquidity and operational risks, and OTC
derivatives markets continue to pose a threat to international financial
stability. The problem is more acute as heavy reliance on OTC derivatives
creates the possibility of systemic financial events, which fall outside the
more formal clearing house structures. Moreover, those who provide OTC
derivative products, hedge their risks through the use of exchange traded
derivatives. In view of the inherent risks associated with OTC derivatives, and
their dependence on exchange traded derivatives, Indian law considers them
illegal.

NSE's DERIVATIVES MARKET

The derivatives trading on the NSE commenced with S&P CNX Nifty Index
futures on June 12, 2000. The trading in index options commenced on June
4, 2001 and trading in options on individual securities commenced on July 2,
2001. Single stock futures were launched on November 9, 2001. Today, both
in terms of volume and turnover, NSE is the largest derivatives exchange in
India. Currently, the derivatives contracts have a maximum of 3-month
expiration cycles. Three contracts are available for trading, with 1 month, 2
months and 3 months expiry. A new contract is introduced on the next
trading day following the expiry of the near month contract.

11

Participants and functions

NSE admits members on its derivatives segment in accordance with the rules
and regulations of the exchange and the norms specified by SEBI. NSE
follows 2-tier membership structure stipulated by SEBI to enable wider
participation. Those interested in taking membership on F&O segment are
required to take membership of CM and F&O segment or CM, WDM and F&O
segment. Trading and clearing members are admitted separately. Essentially,
a clearing member (CM) does clearing for all his trading members (TMs),
undertakes risk management and performs actual settlement. There are
three types of CMs:
Self Clearing Member: A SCM clears and settles trades executed by him only
either on his own account or on account of his clients.
Trading Member Clearing Member: TM-CM is a CM who is also a TM. TM-CM may
clear and settle his own proprietary trades and client's trades as well as clear
and settle for other TMs.
Professional Clearing Member PCM is a CM who is not a TM. Typically, banks or
custodians could become a PCM and clear and settle for TMs.
Details of the eligibility criteria for membership on the F&O segment are
provided in Tables 7.1 and 7.2 (Chapter 7). The TM-CM and the PCM are
required to bring in additional security deposit in respect of every TM whose
trades they undertake to clear and settle. Besides this, trading members are
required to have qualified users and sales persons, who have passed a
certification programme approved by SEBI.
Table 1.1 Business growth of futures and options market:Turnover (Rs.crore)
Month Index futures
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06

35
590
2,123
9,348
64,017
77,218
243,572

Jun-07

Index
options

Stock options

Stock futures

195
389
1,942
8,473
16,133
57,969

4,642
15,042
7,424
14,799
11,306

16,178
46,505
78,392
163,096
243,950

240,797

92,503

21,928

451,314

Jun-08

377,939

308,709

21,430

375,987

Jun-09

346,934

545,643

49,745

589,657

12

Trading mechanism
The futures and options trading system of NSE, called NEAT-F&O trading
system, provides a fully automated screen-based trading for Index futures &
options and Stock futures & options on a nationwide basis and an online
monitoring and surveillance mechanism. It supports an anonymous order
driven market which provides complete transparency of trading operations
and operates on strict price-time priority. It is similar to that of trading of
equities in the Cash Market (CM) segment. The NEAT-F&O trading system is
accessed by two types of users. The Trading Members (TM) have access to
functions such as order entry, order matching, order and trade management.
It provides tremendous flexibility to users in terms of kinds of orders that can
be placed on the system. Various conditions like Immediate or Cancel,
Limit/Market price, Stop loss, etc. can be built into an order. The Clearing
Members (CM) use the trader workstation for the purpose of monitoring the
trading member(s) for whom they clear the trades. Additionally, they can
enter and set limits to positions, which a trading member can take.

OVERVIEW OF GLOBAL AND INDIAN MARKETS

Global Derivatives Market
The global derivative markets can also be divided into two, i.e for Exchange
traded derivatives and Over-the-Counter derivatives. There are various types
of innovative derivative products that are traded across the globe. These
include, weather derivatives, Volume futures/options, Energy derivatives,
Credit derivatives etc.

13

Derivative products are available in both the Exchange Traded and OTC
Markets.
Exchange Traded Products
1) Stock Index Futures
2) Stock Index Options
3) Interest Rate Futures
4) Interest Rate Options
5) Currency Futures
6) Currency Options

Over the Counter

1) Interest Rate Swaps
2) Currency Swaps
3) Caps
4) Collars
5) Floors
6) Swaptions

Other types of derivatives products are derivatives on agriculture products,

energy, precious metals and non-precious metals.
Global Listed Derivatives Volume
Jan-Dec 2008
Futures
8,317,699,090
Options
9,361,078,113
Total Volume
17,678,777,203

Jan-Dec 2009
8,179,106,145
9,520,925,954
17,700,032,099

Global Listed Derivatives Volume by Category

Category
Jan-Dec 2008
Jan-Dec 2009
Equity Index
6,488,621,284
6,381,989,182
Individual Equity
5,511,194,380
5,554,015,554

% Change
-1.7%
1.7%
0.1%

% Change
-1.6%
0.8%
14

Interest Rates
Currency
Agricultural
Energy
Non-Precious Metals
Precious Metals
Other
Total

3,204,838,617
597,481,714
894,633,132
580,952,996
198,715,383
157,443,026
444,896,671
17,678,777,203

2,467,763,942
984,484,525
927,609,111
655,931,442
462,541,406
151,260,666
114,436,271
17,700,032,099

-23.0%
64.8%
3.7%
12.9%
132.8%
-3.9 %
154.9%
0.1%

Global Listed Derivatives Volume by Region

Jan-Dec 2008
Jan-Dec 2007 % Change
Asia-Pacific
5,000,857,132
6,206,052,917
24.10%
Europe
4,167,116,664
3,802,208,645
-8.76%
North America
6,995,436,928
6,353,455,998
-9.18%
Latin America
854,405,219
1,020,822,690
19.48%
Other *
660,961,260
317,491,849
-51.97%
Global Total
17,678,777,203 17,700,032,099 0.1%
* Other consists of exchanges in South Africa, Turkey, Israel and
Dubai.
Source: FIA

Indian Derivatives Markets

Derivatives trading in India commenced in June 2000 after SEBI approval on
the NSE and BSE. Trading first commenced in Index Futures contracts,
followed by Index options in June 2001, options in individual stocks in July
2001 and futures in single stock derivatives in November 2000. Indias
experience with the launch of equity derivatives market has been extremely
15

positive. In India, there are two derivative exchanges- NSE & BSE and NSE
accounts for 98% of the market in Indian derivatives market.
Market share of NSE in Equity Derivatives
Segment (2009-10)

Products available in the Equity Derivative Market Segment in India

In India, equity based futures & Options contracts available on Indices and
Stocks. The various products available on the National Stock Exchange for
futures and options trading are shown below.
Products available for trading on Derivatives Segment
Products on Derivative Segment

Date of Launch

S&P CNX Nifty Futures

June 12, 2000

S&P CNX Nifty Options

June 4, 2001

Single Stock Options

July 2, 2001

Single Stock Futures

November 9, 2001

CNX IT Futures & Options

August 29, 2003

Nifty Midcap 50 Futures & Options

October 5, 2007

Mini Nifty Futures & Options on S&P CNX Nifty

January 1, 2008

Long term Options on S&P CNX Nifty

March 3, 2008

The equity derivatives trading (F&O Segment) at NSE has witnessed a

phenomenal growth in past few years.
Year
June 2000- March 2001
2001-02
2002-03
2003-04
2004-05

Total Turnover
in F&O Segment
(Rs. Crore)
2,356
101,925
439,855
2,130,649
2,547,053
16

Year

Total Turnover
in F&O Segment
(Rs. Crore)
4,824,250
7,356,271
13,090,478
11,010,482
17,663,665

2005-06
2006-07
2007-08
2008-09
2009-10

The growth of equity derivative trading at NSE is depicted in the graph below:

NSE s Ranking in the Global Derivatives Markets:

NSE ranks as the seventh largest derivative exchange in the world.
%
Change

Rank Exchange

Jan-Dec 2008 Jan-Dec 2009

1
2

2,865,482,319
3,172,704,773

3,102,891,777 8.3%
2,647,406,849 -16.6

3,277,630,030

2,589,551,487 -21.0%

1,675,791,242

1,729,965,293 3.2%

1,194,516,467

1,729,965,293 3.2%

741,889,113

920,377,678

-24.1%

601,599,920

918,507,122

52.7%

3
4
5
6
7

Korea Exchange
Eurex (includes ISE)
CME Group (includes
CBOT and Nymex)
NYSE Euronext (includes
all EU and US markets)
Chicago Board Options
Exchange (includes CFE)
BM&F Bovespa
National Stock Exchange
of India

17

8
9
10
11
12
13
14
15
16
17
18
19
20

Nasdaq OMX Group

(includes all EU and US 722,107,905
markets)
Russian Trading Systems
238,220,708
Stock Exchange
Shanghai Futures
140,263,185
Exchange
Dalian Commodity
319,519,693
Exchange
Multi Commodity
Exchange of India
103,409,912
(includes MCX SX)
IntercontinentalExchange
(includes US, UK and
234,414,538
Canada markets)
Zhengzhou Commodity
222,557,134
Exchange
JSE South Africa
513,584,004
Osaka Securities
163,689,348
Exchange
Boston Options
178,650,541
Exchange
Taiwan Futures
136,719,777
Exchange
London Metal Exchange 113,215,299
Hong Kong Exchanges &
105,006,736
Clearing

814,639,771

12.8%

474,440,043

99.2 %

434,864,068

210.0%

416,782,261

30.67%

384,730,330

273.3%

257,118,644

9.7%

227,112,521

2.0%

166,592,373

-67.6%

166,085,409

1.5%

137,784,626

-22.9%

135,125,695

-1.2%

111,930,828

-1.1%

98,538,258

-6.2%

Source: FIA

18

CHAPTER 2
INTRODUCTION TO FUTURES &
OPTIONS AND SWAPS
In recent years, derivatives have become increasingly important in the field of
finance. While futures and options are now actively traded on many
exchanges, forward contracts are popular on the OTC market. In this chapter
we shall study in detail these three derivative contracts.

FORWARD CONTRACTS
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.

However forward contracts in certain markets have become very

standardized, as in the case of foreign exchange, thereby reducing transaction
costs and increasing transactions volume. This process of standardization
reaches its limit in the organized futures market.
19

Forward contracts are very useful in hedging and speculation. The classic
hedging application would be that of an exporter who expects to receive
payment in dollars three months later. He is exposed to the risk of exchange
rate fluctuations. By using the currency forward market to sell dollars forward,
he can lock on to a rate today and reduce his uncertainty. Similarly an importer
who is required to make a payment in dollars two months hence can reduce his
exposure to exchange rate fluctuations by buying dollars forward.
If a speculator has information or analysis, which forecasts an upturn in a price,
then he can go long on the forward market instead of the cash market. The
speculator would go long on the forward, wait for the price to rise, and then take
a reversing transaction to book profits. Speculators may well be required to
deposit a margin upfront. However, this is generally a relatively small proportion of
the value of the assets underlying the forward contract. The use of forward
markets here supplies leverage to the speculator.

LIMITATIONS OF FORWARD MARKETS

Forward markets world-wide are afflicted by several problems:

Lack of centralization of trading,

Illiquidity, and

Counterparty risk

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.

INTRODUCTION TO FUTURES
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
20

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

Merton Miller, the 1990 Nobel laureate had said that 'financial futures
represent the most significant financial innovation of the last twenty
years." The first exchange that traded financial derivatives was
launched in Chicago in the year 1972. A division of the Chicago
Mercantile Exchange, it was called the International Monetary Market
(IMM) and traded currency futures. The brain behind this was a man
called Leo Melamed, acknowledged as the 'father of financial futures"
who was then the Chairman of the Chicago Mercantile Exchange. Before
IMM opened in 1972, the Chicago Mercantile Exchange sold contracts
whose value was counted in millions. By 1990, the underlying value of
all contracts traded at the Chicago Mercantile Exchange totaled 50
trillion dollars.
These currency futures paved the way for the successful marketing of a
dizzying array of similar products at the Chicago Mercantile Exchange,
the Chicago Board of Trade, and the Chicago Board Options Exchange.
By the 1990s, these exchanges were trading futures and options on
everything from Asian and American stock indexes to interest-rate
swaps, and their success transformed Chicago almost overnight into
the risk-transfer capital of the world.
Box 2.1: The first financial futures market

21

Table 2.1 Distinction between futures and forwards

Futures

Forwards

Trade on an organized exchange

Standardized contract terms
hence more liquid
Requires margin payments
Follows daily settlement

OTC in nature
Customised contract terms
hence less liquid
No margin payment
Settlement happens at end of period

DISTINCTION BETWEEN FUTURES AND FORWARDS

CONTRACTS
Forward contracts are often confused with futures contracts. The confusion is
primarily because both serve essentially the same economic functions of
allocating risk in the presence of future price uncertainty. However futures are
a significant improvement over the forward contracts as they eliminate
counterparty risk and offer more liquidity. Table 2.1 lists the distinction
between the two.

FUTURES 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-months and threemonths 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 under

one contract. Also called as lot size.
22

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.

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.

INTRODUCTION TO OPTIONS
In this section, we look at the next derivative product to be traded on the
NSE, namely options. Options are fundamentally different from forward and
futures contracts. An option gives the holder of the option the right to do
something. The holder does not have to exercise this right. In contrast, in a
forward or futures contract, the two parties have committed themselves to
doing something. Whereas it costs nothing (except margin requirements) to
enter into a futures contract, the purchase of an option requires an up-front
payment.

OPTION TERMINOLOGY

Index options: These options have the index as the underlying.

23

Some options are European while others are American. Like index
futures contracts, index options contracts are also cash settled.

Stock options: Stock options are options on individual stocks. 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.

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.

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.

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 cashflow 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
24

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 cashflow if it were exercised immediately. An option on
the index is at-the-money 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 cashflow 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 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.

Although options have existed for a long time, they were traded OTC, without
much knowledge of valuation. The first trading in options began in Europe and the
US as early as the seventeenth century. It was only in the early 1900s that a group
of firms set up what was known as the put and call Brokers and Dealers Association
with the aim of providing a mechanism for bringing buyers and sellers together. If
someone wanted to buy an option, he or she would contact one of the member
firms. The firm would then attempt to find a seller or writer of the option either
from its own clients or those of other member firms. If no seller could be found,
the firm would undertake to write the option itself in return for a price.
This market however suffered from two deficiencies. First, there was no secondary
market and second, there was no mechanism to guarantee that the writer of the
option would honor the contract. In 1973, Black, Merton and Scholes invented the
famed Black-Scholes formula. In April 1973, CBOE was set up specifically for the
purpose of trading options. The market for options developed so rapidly that by
early '80s, the number of shares underlying the option contract sold each day
exceeded the daily volume of shares traded on the NYSE. Since then, there has

25

been no looking back.

Box 2.2: History of options

FUTURES AND OPTIONS

An interesting question to ask at this stage is - when would one use options
instead of futures? Options are different from futures in several interesting
senses. At a practical level, the option buyer faces an interesting situation. He
pays for the option in full at the time it is purchased. After this, he only has
an upside. There is no possibility of the options position generating any
further losses to him (other than the funds already paid for the option). This
is different from futures, which is free to enter into, but can generate very
large losses. This characteristic makes options attractive to many occasional
market participants, who cannot put in the time to closely monitor their
futures positions.
Buying put options is buying insurance. To buy a put option on Nifty is to buy
insurance which reimburses the full extent to which Nifty drops below the
strike price of the put option. This is attractive to many people, and to mutual
funds creating "guaranteed return products".

Options made their first major mark in financial history during the tulipbulb mania in seventeenth-century Holland. It was one of the most
spectacular get rich quick binges in history. The first tulip was
brought into Holland by a botany professor from Vienna. Over a
decade, the tulip became the most popular and expensive item in Dutch
gardens. The more popular they became, the more Tulip bulb prices
began rising. That was when options came into the picture. They were
initially used for hedging. By purchasing a call option on tulip bulbs, a
dealer who was committed to a sales contract could be assured of
obtaining a fixed number of bulbs for a set price. Similarly, tulip-bulb
growers could assure themselves of selling their bulbs at a set price by
purchasing put options. Later, however, options were increasingly used
by speculators who found that call options were an effective vehicle for
obtaining maximum possible gains on investment. As long as tulip prices
continued to skyrocket, a call buyer would realize returns far in excess
of those that could be obtained by purchasing tulip bulbs themselves.
The writers of the put options also prospered as bulb prices spiralled
since writers were able to keep the premiums and the options were
never exercised. The tulip-bulb market collapsed in 1636 and a lot of
speculators lost huge sums of money. Hardest hit were put writers who
were unable to meet their commitments to purchase Tulip bulbs.
Box 2.3: Use of options in the seventeenth-century
26

Table 2.2 Distinction between futures and options

Futures

Options

Exchange traded, with novation

Same as futures.

Exchange defines the product

Price is zero, strike price moves
Price is zero
Linear payoff
Both long and short at risk

Same as futures.
Strike price is fixed, price moves.
Price is always positive.
Nonlinear payoff.
Only short at risk.

The Nifty index fund industry will find it very useful to make a bundle of a
Nifty index fund and a Nifty put option to create a new kind of a Nifty index
fund, which gives the investor protection against extreme drops in Nifty.
Selling put options is selling insurance, so anyone who feels like earning
revenues by selling insurance can set himself up to do so on the index options
market.
More generally, options offer "nonlinear payoffs" whereas futures only have
"linear payoffs". By combining futures and options, a wide variety of
innovative and useful payoff structures can be created.

INDEX DERIVATIVES
Index derivatives are derivative contracts which derive their value from an
underlying index. The two most popular index derivatives are index futures
and index options. Index derivatives have become very popular worldwide.
Index derivatives offer various advantages and hence have become very
popular.

Institutional and large equity-holders need portfolio-hedging facility.

Index-derivatives are more suited to them and more cost-effective
than derivatives based on individual stocks. Pension funds in the US are
known to use stock index futures for risk hedging purposes.

Index derivatives offer ease of use

irrespective of its composition.

for

hedging

any portfolio

27

Stock index is difficult to manipulate as compared to individual stock

prices, more so in India, and the possibility of cornering is reduced.
This is partly because an individual stock has a limited supply, which can
be cornered.
Stock index, being an average, is much less volatile than individual
stock prices. This implies much lower capital adequacy and margin
requirements.
Index derivatives are cash settled, and hence do not suffer from
settlement delays and problems related to bad delivery, forged/fake
certificates.

SWAPS
A swap is an agreement to exchange cashflows at specified future times
according to certain specified rules. A swap can also be described as a custom
tailored product in which two counterparties agree to exchange a stream of
cash flows over an agreed period of time. The agreed amount which
determines the cash flow may be exchanged upfront or may not be so
exchanged. When it is not exchanged it is referred to as Notional principle.

Characteristics of Swaps:

Exchange of interest payments on some agreed-upon notional amount.

No exchange of principal amount
Converts the interest rate on an asset or liability from:
fixed to floating
floating to fixed
floating to floating
A swap is a powerful tool which allows the user to align risk
characteristics of assets and liabilities
A swap transaction, is a custom-tailored bilateral agreement
two counter-parties agree to exchange specified cash flows at periodic
intervals
over a pre-determined life of the swap
on a notional amount
Swaps originated mainly from the need to exploit the comparative advantage
that different players have in different markets such as difference in
perception of lenders in different markets or differences in fixed and floating
interest rates in each markets. The initial need for a swap was felt due to the
restriction on exchange control prevalent particularly in England after World
War II. The exchange control restrictions made borrowing needlessly costly
for some borrowers who were looking for some method of working around the
restrictions. The landmark in the development of the swap market was the
28

IBM- World Bank swap in 1981. Thereafter the market started growing very
rapidly.

Interest Rate Swap

The most commonly used interest rate swap is called a generic or plain
vanilla swap. The plain vanilla swap involves an agreement between parties
to exchange periodic payments calculated on the basis of a specified coupon
rate and a mutually agreed notional principal amount. In other words, plain
vanilla swaps are typically an exchange of floating rate interest obligations for
fixed rate interest obligations.
Features:

Exchange of fixed rate of interest for floating rate and vice versa.
Denominated in the same currency, on a notional amount.
Principals Are Not Exchanged.
Based On Comparative Advantage.
Liability Swap For Payables.
Asset Swap For Interest Receivable.
Interest Rates Are Benchmarked
Used to hedge against adverse movements in interest rates

Example
The Principal is Rs.100 crore, the life of the swap is 5 years. In this example ,
counter party A is the fixed rate payer and counterparty A borrows floating
rate funds but wants to pay interest at a fixed rate. Counterparty B borrows
fixed rate funds but sees interest rates declining and decides to swap some of
this fixed rate borrowings for floating rate. Here, n interest rate swap can thus
be used to transform one type of interest rate obligation into another enabling
the participants to adjust their interest rate obligations to meet their needs in
a particular rate environment and hedge against futures changes in rates or
lock in a profit margin.
The only exchange that is made is interest payments on the principal,
whereas payments corresponding to the principal amounts are not involved in
this transaction. In fact, the principal could already have been invested for
instance in plant and machinery.

29

Interest Rate Terminology:

The Fixed Rate Payer

Receives floating
Has bought a swap
Is long a swap
Is taking a swap

The Floating Rate Payer

Receives Fixed
Has sold a swap
Is short a swap
Is giving a swap

Risk Profile for Fixed Rate Payer

Long term liability

Floating rate asset

Risk Profile for floating Rate Payer

Longer term asset

Floating rate liability

30

Floating Rate

Counterparty B

Counterparty A
Fixed Rate

Fixed
Rate
Funds

Floating
Rate
Funds

A Generic/Plain Vanilla swap: Rs.100 crore 5 years

31

Numerical
A bank enters into an interest rate swap with coporate on following terms:

Nominal Principal Amt.

Corporate to pay
Corporate to receive
Start Date of the swap
Tenor of the swap
Termination of the swap
Interest Payment Dates
First Fixing

: Rs. 25 cr.
: INR 6.55 % Fixed
: 3 Month NSE MIBOR
: 19th Sep 06
: 6 months
: 19th Mar 07
: 19th Dec & 19th Mar
: 6. 20%

Cash Flow On the 19th Dec 06 :

3 Month NSE MIBOR
: 6.20 %
(This was the 3M NSE MIBOR on 19th Sep 06)
Corporate to pay
: Rs. 0.40 cr.
( Rs. 25 cr. X 6.55% X 90 days / 365 days)
Bank to pay
: Rs. 0.38 cr.
(Rs. 25 cr. X 6.20% X 90 days / 365 days)
Cash Flow On the 19th Mar 07 :
3 Month NSE MIBOR
: 6.30 %
(This was the 3M NSE MIBOR on 19th Dec 06)
Corporate to pay
: Rs. 0.41 cr.
( Rs. 25 cr. X 6.55% X 92 days / 365 days)
Bank to pay
: Rs. 0.39 cr.
(Rs. 25 cr. X 6.30% X 92 days / 365 days)
Net Result
Corporate to pay

: Rs. 0.81 cr.

32

Bank to pay

: Rs. 0.77 cr.

Basis Swap
A basis swap is an interest rate swap which involves the exchange of two
floating rate financial instruments. A floating-floating interest rate swap under
which the floating rate payments is referenced to different bases.
Features :
contractual agreement
exchange a series of cash flows
over a pre-defined period of time
each swap leg is referenced to a floating rate index

Currency Swaps
A financial contract for exchange of principal & fixed rate of interest payments
on a loan in one currency for another currency. currencies are exchanged
during the life of the swap at spot rate prevailing on the date of the contract
Features of Currency Swaps:

A contract between two counterparties.

Commitment to an exchange of cashflows over an agreed period
One counterparty pays a fixed or floating rate on a principal amount,
denominated in one currency
The other counterparty pays a fixed or floating rate on a (different)
principal amount, denominated in another currency
At the end of the period, the corresponding principal amounts are
exchanged at a pre-determined FX rate (usually spot FX rate)
Synergy Of Comparative Advantage.
Exchange Of Principal Takes Place At The Beginning & End Whereas
Interest Payments Takes Place During The Life Of The Swap.
33

Banks Act As Intermediaries To Eliminate Counterparty Risk. Product

Available In India
Each leg is in a different currency.
Each leg can be floating or fixed
The swap value is sensitive to Forex rates

Example:
An agreement to pay 4.71% on GBP notional 100MM and receive 3.39% on a
USD notional of 190 MM At the end of 5Y, the principal amounts are
exchanged

In a currency swap the principal is exchanged at the end of the swap, and
often also at the beginning. This compares with an interest rate swap, in
which the principal is not exchanged
The major difference between a generic interest rate swap and a generic
currency swap is that the latter includes not only the exchange of interest rate
payments but also the exchange of principal amounts both initially and on
termination. Since the payments made by the two parties are in different
currencies, the payments need not netted

34

CHAPTER 3
APPLICATIONS OF FUTURES AND
OPTIONS
The phenomenal growth of financial derivatives across the world is attributed
the fulfilment of needs of hedgers, speculators and arbitrageurs by these
products. In this chapter we first look at how trading futures differs from
trading the underlying spot. We then look at the payoff of these contracts,
and finally at how these contracts can be used by various entities in the
economy.
A payoff is the likely profit/loss that would accrue to a market participant with
change in the price of the underlying asset. This is generally depicted in the
form of payoff diagrams which show the price of the underlying asset on the
X-axis and the profits/losses on the Y-axis.

TRADING UNDERLYING VERSUS TRADING SINGLE

STOCK FUTURES
The single stock futures market in India has been a great success story across the
world. NSE ranks first in the world in terms of number of contracts traded in single
stock futures. One of the reasons for the success could be the ease of trading and
settling these contracts.
To trade securities, a customer must open a security trading account with a
securities broker and a demat account with a securities depository. Buying
security involves putting up all the money upfront. With the purchase of shares of
a company, the holder becomes a part owner of the company. The shareholder
typically receives the rights and privileges associated with the security, which
may include the receipt of dividends, invitation to the annual shareholders
meeting and the power to vote.
Selling securities involves buying the security before selling it. Even in cases
where short selling is permitted, it is assumed that the securities broker owns the
security and then "lends" it to the trader so that he can sell it. Besides, even if
35

permitted, short sales on security can only be executed on an up-tick.

To trade futures, a customer must open a futures trading account with a

derivatives broker. Buying futures simply involves putting in the margin money.
They enable the futures traders to take a position in the underlying security
without having to open an account with a securities broker. With the purchase of
futures on a security, the holder essentially makes a legally binding promise or
obligation to buy the underlying security at some point in the future (the expiration
date of the contract). Security futures do not represent ownership in a corporation
and the holder is therefore not regarded as a shareholder.
A futures contract represents a promise to transact at some point in the
future. In this light, a promise to sell security is just as easy to make as a
promise to buy security. Selling security futures without previously owning
them simply obligates the trader to selling a certain amount of the underlying
security at some point in the future. It can be done just as easily as buying
futures, which obligates the trader to buying a certain amount of the underlying
security at some point in the future. In the following sections we shall look at some
uses of security future.

FUTURES PAYOFFS
Futures contracts have linear payoffs. In simple words, it means that the
losses as well as profits for the buyer and the seller of a futures contract are
unlimited. These linear payoffs are fascinating as they can be combined with
options and the underlying to generate various complex payoffs.

Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for a
person who holds an asset. He has a potentially unlimited upside as well as a
potentially unlimited downside. Take the case of a speculator who buys a twomonth Nifty index futures contract when the Nifty stands at 2220.
The underlying asset in this case is the Nifty portfolio. When the index moves up, the
long futures position starts making profits, and when the index moves down it
starts making losses. Figure 3.1 shows the payoff diagram for the buyer of a
futures contract.

36

Figure 3.1 Payoff for a buyer of Nifty futures

The figure shows the profits/losses for a long futures position. The investor bought futures
when the index was at 2220. If the index goes up, his futures position starts making profit. If
the index falls, his futures position starts showing losses.

Payoff for seller of futures: Short futures

The payoff for a person who sells a futures contract is similar to the payoff for
a person who shorts an asset. He has a potentially unlimited upside as well as a
potentially unlimited downside. Take the case of a speculator who sells a two-month
Nifty index futures contract when the Nifty stands at 2220. The underlying asset in
this case is the Nifty portfolio. When the index moves down, the short futures
position starts making profits, and when the index moves up, it starts making
losses. Figure 3.2 shows the payoff diagram for the seller of a futures contract.

37

Figure 3.2 Payoff for a seller of Nifty futures

The figure shows the profits/losses for a short futures position. The investor sold futures when the
index was at 2220. If the index goes down, his futures position starts making profit. If the index
rises, his futures position starts showing losses.

PRICING FUTURES
Pricing of futures contract is very simple. Using the cost-of-carry logic, we
calculate the fair value of a futures contract. Everytime the observed price
deviates from the fair value, arbitragers would enter into trades to capture the
arbitrage profit. This in turn would push the futures price back to its fair value.
The cost of carry model used for pricing futures is given below:

where:
r Cost of financing (using continuously compounded interest rate)
T Time till expiration in years
e 2.71828
Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be
38

invested at 11% p.a. The fair value of a one-month futures contract on XYZ is
calculated as follows:

Pricing equity index futures

A futures contract on the stock market index gives its owner the right and
obligation to buy or sell the portfolio of stocks characterized by the index.
Stock index futures are cash settled; there is no delivery of the underlying
stocks.
In their short history of trading, index futures have had a great impact on the
world's securities markets. Its existence has revolutionized the art and
science of institutional equity portfolio management.
The main differences between commodity and equity index futures are that:
There are no costs of storage involved in holding equity.
Equity comes with a dividend stream, which is a negative cost if you are
long the stock and a positive cost if you are short the stock.
Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial aspect
of dealing with equity futures as opposed to commodity futures is an accurate
forecasting of dividends. The better the forecast of dividend offered by a
security, the better is the estimate of the futures price.

Pricing index futures given expected dividend amount

The pricing of index futures is also based on the cost-of-carry model, where
the carrying cost is the cost of financing the purchase of the portfolio
underlying the index, minus the present value of dividends obtained from the
stocks in the index portfolio.
Example
Nifty futures trade on NSE as one, two and three-month contracts. Money can
be borrowed at a rate of 10% per annum. What will be the price of a new
two-month futures contract on Nifty?
39

1. Let us assume that ABC Ltd. will be declaring a dividend of Rs.20 per share
after 15 days of purchasing the contract.
1. Current value of Nifty is 4000 and Nifty trades with a multiplier of 100.
2. Since Nifty is traded in multiples of 100, value of the contract is 100*4000 =
Rs.400,000.
3. If ABC Ltd. Has a weight of 7% in Nifty, its value in Nifty is Rs.28,000 i.e.
(400,000 * 0.07).
2. If the market price of ABC Ltd. Is Rs.140, then a traded unit of Nifty involves
200 shares of ABC Ltd. i.e. (28,000/140).
3. To calculate the futures price, we need to reduce the cost-of-carry to the
extent of dividend received. The amount of dividend received is Rs.4000
i.e. (200*20). The dividend is received 15 days later and hence
compounded only for the remainder of 45 days. To calculate the futures
price we need to compute the amount of dividend received per unit of
Nifty. Hence we divide the compounded dividend figure by 100.
7.

Thus, futures price

Pricing index futures given expected dividend yield

If the dividend flow throughout the year is generally uniform, i.e. if there are
few historical cases of clustering of dividends in any particular month, it is
useful to calculate the annual dividend yield.
(rq)T

F = Se
where:
F futures price
S spot index value
r cost of financing
q expected dividend yield
T holding period
Example

A two-month futures contract trades on the NSE. The cost of financing is 10%
40

and the dividend yield on Nifty is 2% annualized. The spot value of Nifty
4000. What is the fair value of the futures contract?
(0.10.02) (60 / 365)

Fair value = 4000e

= Rs.4052.95
The cost-of-carry model explicitly defines the relationship between the futures
price and the related spot price. As we know, the difference between the spot
price and the futures price is called the basis.
Nuances

As the date of expiration comes near, the basis reduces - there is a

convergence of the futures price towards the spot price. On the date of
expiration, the basis is zero. If it is not, then there is an arbitrage
opportunity. Arbitrage opportunities can also arise when the basis
(difference between spot and futures price) or the spreads (difference
between prices of two futures contracts) during the life of a contract are
incorrect. At a later stage we shall look at how these arbitrage
opportunities can be exploited.

There is nothing but cost-of-carry related arbitrage that drives the

behavior of the futures price.

Transactions costs are very important in the business of arbitrage.

Figure 3.3 Variation of basis over time

The figure shows how basis changes over time. As the time to expiration of a contract reduces, the basis
reduces. Towards the close of trading on the day of settlement, the futures price and the spot price
converge. The closing price for the June 28 futures contract is the closing value of Nifty on that day.

41

PRICING STOCK FUTURES

A futures contract on a stock gives its owner the right and obligation to buy or
sell the stocks. Like index futures, stock futures are also cash settled; there is
no delivery of the underlying stocks. Just as in the case of index futures, the
main differences between commodity and stock futures are that:

There are no costs of storage involved in holding stock.

Stocks come with a dividend stream, which is a negative cost if you are
long the stock and a positive cost if you are short the stock.

Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial aspect

of dealing with stock futures as opposed to commodity futures is an accurate
forecasting of dividends. The better the forecast of dividend offered by a
security, the better is the estimate of the futures price.

Pricing stock futures when no dividend expected

The pricing of stock futures is also based on the cost-of-carry model, where
the carrying cost is the cost of financing the purchase of the stock, minus the
present value of dividends obtained from the stock. If no dividends are
expected during the life of the contract, pricing futures on that stock is very
simple. It simply involves multiplying the spot price by the cost of carry.
Example
XYZ futures trade on NSE as one, two and three-month contracts. Money can
be borrowed at 10% per annum. What will be the price of a unit of new twomonth futures contract on SBI if no dividends are expected during the twomonth period?
42

1. Assume that the spot price of XYZ is Rs.228.

0.10 (60/365)

2.

Thus, futures price F = 228e

= Rs.231.90

43

Pricing stock futures when dividends are expected

When dividends are expected during the life of the futures contract, pricing
involves reducing the cost of carry to the extent of the dividends. The net
carrying cost is the cost of financing the purchase of the stock, minus the
present value of dividends obtained from the stock.
Example
XYZ futures trade on NSE as one, two and three-month contracts. What will
be the price of a unit of new two-month futures contract on XYZ if dividends
are expected during the two-month period?
1. Let us assume that XYZ will be declaring a dividend of Rs. 10 per share after
15 days of purchasing the contract.
2. Assume that the market price of XYZ is Rs. 140.
3. To calculate the futures price, we need to reduce the cost-of-carry to the
extent of dividend received. The amount of dividend received is Rs.10.
The dividend is received 15 days later and hence compounded only for
the remainder of 45 days.
4. Thus, futures price =
F = 140e

0.1 (60/365)

10e

0.1 (45/365)

= Rs.132.20

APPLICATION OF FUTURES
Understanding beta
The index model suggested by William Sharpe offers insights into portfolio
diversification. It express the excess return on a security or a portfolio as a
function of market factors and non market factors. Market factors are those
factors that affect all stocks and portfolios. These would include factors such
as inflation, interest rates, business cycles etc. Non-market factors would be
those factors which are specific to a company, and do not affect the entire
market. For example, a fire breakout in a factory, a new invention, the death
of a key employee, a strike in the factory, etc. The market factors affect all
firms. The unexpected change in these factors cause unexpected changes in
44

the rates of returns on the entire stock market. Each stock however responds
to these factors to different extents. Beta of a stock measures the sensitivity
of the stocks responsiveness to these market factors. Similarly, Beta of a
portfolio, measures the portfolios responsiveness to these market
movements. Given stock betas, calculating portfolio beta is simple. It is
nothing but the weighted average of the stock betas.
The index has a beta of 1. Hence the movements of returns on a portfolio
with a beta of one will be like the index. If the index moves up by ten
percent, my portfolio value will increase by ten percent. Similarly if the index
drops by five percent, my portfolio value will drop by five percent. A portfolio
with a beta of two, responds more sharply to index movements. If the index
moves up by ten percent, the value of a portfolio with a beta of two will move
up by twenty percent. If the index drops by ten percent, the value of a
portfolio with a beta of two, will fall by twenty percent. Similarly, if a portfolio
has a beta of 0.75, a ten percent movement in the index will cause a 7.5
percent movement in the value of the portfolio. In short, beta is a measure of
the systematic risk or market risk of a portfolio. Using index futures contracts,
it is possible to hedge the systematic risk. With this basic understanding, we
look at some applications of index futures.
We look here at some applications of futures contracts. We refer to single stock
futures. However since the index is nothing but a security whose price or level is a
weighted average of securities constituting an index, all strategies that can be
implemented using stock futures can also be implemented using index futures.

Hedging: Long security, sell futures

Futures can be used as an effective risk-management tool. Take the case of an
investor who holds the shares of a company and gets uncomfortable with market
movements in the short run. He sees the value of his security falling from Rs.450
to Rs.390. In the absence of stock futures, he would either suffer the discomfort of
a price fall or sell the security in anticipation of a market upheaval. With security
futures he can minimize his price risk. All he need do is enter into an offsetting
stock futures position, in this case, take on a short futures position. Assume that
the spot price of the security he holds is Rs.390. Two-month futures cost him
Rs.402. For this he pays an initial margin. Now if the price of the security falls
any further, he will suffer losses on the security he holds. However, the losses he
suffers on the security, will be offset by the profits he makes on his short futures
position. Take for instance that the price of his security falls to Rs.350. The fall in
the price of the security will result in a fall in the price of futures. Futures will now
trade at a price lower than the price at which he entered into a short futures
position. Hence his short futures position will start making profits. The loss of
Rs.40 incurred on the security he holds, will be made up by the profits made on
his short futures position.
45

Index futures in particular can be very effectively used to get rid of the market
risk of a portfolio. Every portfolio contains a hidden index exposure or a market
exposure. This statement is true for all portfolios, whether a portfolio is composed
of index securities or not. In the case of portfolios, most of the portfolio risk is
accounted for by index fluctuations (unlike individual securities, where only 3060% of the securities risk is accounted for by index fluctuations). Hence a position
LONG PORTFOLIO + SHORT NIFTY can often become one-tenth as risky as the LONG
PORTFOLIO position!
Suppose we have a portfolio of Rs. 1 million which has a beta of 1.25. Then a
complete hedge is obtained by selling Rs.1.25 million of Nifty futures.
Warning: Hedging does not always make money. The best that can be achieved
using hedging is the removal of unwanted exposure, i.e. unnecessary risk. The
hedged position will make less profits than the unhedged position, half the time.
One should not enter into a hedging strategy hoping to make excess profits for
sure; all that can come out of hedging is reduced risk.

Speculation: Bullish security, buy futures

Take the case of a speculator who has a view on the direction of the market. He would
like to trade based on this view. He believes that a particular security that trades at
Rs.1000 is undervalued and expect its price to go up in the next two-three
months. How can he trade based on this belief? In the absence of a deferral
product, he would have to buy the security and hold on to it. Assume he buys a 100
shares which cost him one lakh rupees. His hunch proves correct and two months
later the security closes at Rs.1010. He makes a profit of Rs.1000 on an
investment of Rs. 1,00,000 for a period of two months. This works out to an annual
return of 6 percent.
Today a speculator can take exactly the same position on the security by using
futures contracts. Let us see how this works. The security trades at Rs.1000 and
the two-month futures trades at 1006. Just for the sake of comparison, assume
that the minimum contract value is 1,00,000. He buys 100 security futures for
which he pays a margin of Rs.20,000. Two months later the security closes at
1010. On the day of expiration, the futures price converges to the spot price and he
makes a profit of Rs.400 on an investment of Rs.20,000. This works out to an annual
return of 12 percent. Because of the leverage they provide, security futures form
an attractive option for speculators.

Speculation: Bearish security, sell futures

Stock futures can be used by a speculator who believes that a particular security is
over-valued and is likely to see a fall in price. How can he trade based on his
opinion? In the absence of a deferral product, there wasn't much he could do to
46

profit from his opinion. Today all he needs to do is sell stock futures.
Let us understand how this works. Simple arbitrage ensures that futures on an
individual securities move correspondingly with the underlying security, as long as
there is sufficient liquidity in the market for the security. If the security price
rises, so will the futures price. If the security price falls, so will the futures price.
Now take the case of the trader who expects to see a fall in the price of ABC Ltd.
He sells one two-month contract of futures on ABC at Rs.240 (each contact for
100 underlying shares). He pays a small margin on the same. Two months later,
when the futures contract expires, ABC closes at 220. On the day of expiration, the
spot and the futures price converges. He has made a clean profit of Rs.20 per
share. For the one contract that he bought, this works out to be Rs.2000.

Arbitrage: Overpriced futures: buy spot, sell futures

As we discussed earlier, the cost-of-carry ensures that the futures price stay
in tune with the spot price. Whenever the futures price deviates substantially
from its fair value, arbitrage opportunities arise.
If you notice that futures on a security that you have been observing seem
overpriced, how can you cash in on this opportunity to earn riskless profits?
Say for instance, ABC Ltd. trades at Rs.1000. One-month ABC futures trade
at Rs.1025 and seem overpriced. As an arbitrageur, you can make riskless
profit by entering into the following set of transactions.
1. On day one, borrow funds, buy the security on the cash/spot market at 1000.
2. Simultaneously, sell the futures on the security at 1025.
3. Take delivery of the security purchased and hold the security for a month.
4. On the futures expiration date, the spot and the futures price converge. Now
unwind the position.
5. Say the security closes at Rs.1015. Sell the security.
6. Futures position expires with profit of Rs.10.
7. The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the
futures position.
8. Return the borrowed funds.
When does it make sense to enter into this arbitrage? If your cost of
borrowing funds to buy the security is less than the arbitrage profit possible,
it makes sense for you to arbitrage. This is termed as cash-and-carry
arbitrage. Remember however, that exploiting an arbitrage opportunity
involves trading on the spot and futures market. In the real world, one has to
build in the transactions costs into the arbitrage strategy.
47

Arbitrage: Underpriced futures: buy futures, sell spot

Whenever the futures price deviates substantially from its fair value, arbitrage
opportunities arise. It could be the case that you notice the futures on a
security you hold seem underpriced. How can you cash in on this opportunity
to earn riskless profits? Say for instance, ABC Ltd. trades at Rs.1000. Onemonth ABC futures trade at Rs. 965 and seem underpriced. As an arbitrageur,
you can make riskless profit by entering into the following set of transactions.
1.
2.
3.
4.
5.
6.
7.

On day one, sell the security in the cash/spot market at 1000.

Make delivery of the security.
Simultaneously, buy the futures on the security at 965.
On the futures expiration date, the spot and the futures price
converge. Now unwind the position.
Say the security closes at Rs.975. Buy back the security.
The futures position expires with a profit of Rs.10.
The result is a riskless profit of Rs.25 on the spot position and Rs.10
on the futures position.

If the returns you get by investing in riskless instruments is more than the
return from the arbitrage trades, it makes sense for you to arbitrage. This is
termed as reverse-cash-and-carry arbitrage. It is this arbitrage activity that
ensures that the spot and futures prices stay in line with the cost-of-carry. As
we can see, exploiting arbitrage involves trading on the spot market. As more
and more players in the market develop the knowledge and skills to do cashand-carry and reverse cash-and-carry, we will see increased volumes and
lower spreads in both the cash as well as the derivatives market.

OPTIONS PAYOFFS
The optionality characteristic of options results in a non-linear payoff for
options. In simple words, it means that the losses for the buyer of an option
are limited, however the profits are potentially unlimited. For a writer, the
payoff is exactly the opposite. His profits are limited to the option premium,
however his losses are potentially unlimited. These non-linear payoffs are
fascinating as they lend themselves to be used to generate various payoffs by
using combinations of options and the underlying. We look here at the six
basic payoffs.

48

Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, Nifty for
instance, for 2220, and sells it at a future date at an unknown price, St. Once
it is purchased, the investor is said to be "long" the asset. Figure 3.4 shows
the payoff for a long position on the Nifty.

Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, Nifty for
instance, for 2220, and buys it back at a future date at an unknown price, St.
Once it is sold, the investor is said to be "short" the asset. Figure 3.5 shows
the payoff for a short position on the Nifty.

Payoff profile for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the
strike price specified in the option. The profit/loss that the buyer makes on
the option depends on the spot price of the underlying. If upon expiration, the
spot price exceeds the strike price, he makes a profit. Higher the spot price,
more is the profit he makes. If the spot price of the underlying is less than
the strike price, he lets his option expire un-exercised. His loss in this case is
the premium he paid for buying the option. Figure 3.6 gives the payoff for
the buyer of a three month call option (often referred to as long call) with a
strike of 2250 bought at a premium of 86.60.
Figure 3.4 Payoff for investor who went Long Nifty at 2220
The figure shows the profits/losses from a long position on the index. The investor bought the index at
2220. If the index goes up, he profits. If the index falls he looses.

49

Figure 3.5 Payoff for investor who went Short Nifty at 2220
The figure shows the profits/losses from a short position on the index. The investor sold the index at
2220. If the index falls, he profits. If the index rises, he looses.

Figure 3.6 Payoff for buyer of call option

The figure shows the profits/losses for the buyer of a three-month Nifty 2250 call option. As can be
seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the
strike of 2250, the buyer would exercise his option and profit to the extent of the difference between the
Nifty-close and the strike price. The profits possible on this option are potentially unlimited. However if
Nifty falls below the strike of 2250, he lets the option expire. His losses are limited to the extent of the
premium he paid for buying the option.

50

Payoff profile for writer of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the
strike price specified in the option. For selling the option, the writer of the
option charges a premium. The profit/loss that the buyer makes on the option
depends on the spot price of the underlying. Whatever is the buyer's profit is
the seller's loss. If upon expiration, the spot price exceeds the strike price,
the buyer will exercise the option on the writer. Hence as the spot price
increases the writer of the option starts making losses. Higher the spot price,
more is the loss he makes. If upon expiration the spot price of the underlying
is less than the strike price, the buyer lets his option expire un-exercised and
the writer gets to keep the premium. Figure 3.7 gives the payoff for the writer
of a three month call option (often referred to as short call) with a strike of
2250 sold at a premium of 86.60.
Figure 3.7 Payoff for writer of call option
The figure shows the profits/losses for the seller of a three-month Nifty 2250 call option. As the spot
Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty
closes above the strike of 2250, the buyer would exercise his option on the writer who would suffer a
loss to the extent of the difference between the Nifty-close and the strike price. The loss that can be
incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the
extent of the up-front option premium of Rs.86.60 charged by him.

51

Payoff profile for buyer of put options: Long put

A put option gives the buyer the right to sell the underlying asset at the strike price
specified in the option. The profit/loss that the buyer makes on the option depends
on the spot price of the underlying. If upon expiration, the spot price is below the
strike price, he makes a profit. Lower the spot price, more is the profit he makes. If
the spot price of the underlying is higher than the strike price, he lets his option
expire un-exercised. His loss in this case is the premium he paid for buying the
option. Figure 3.8 gives the payoff for the buyer of a three month put option (often
referred to as long put) with a strike of 2250 bought at a premium of 61.70.
Figure 3.8 Payoff for buyer of put option
The figure shows the profits/losses for the buyer of a three-month Nifty 2250 put option. As can be seen,
as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of
2250, the buyer would exercise his option and profit to the extent of the difference between the strike
price and Nifty-close. The profits possible on this option can be as high as the strike price. However if
Nifty rises above the strike of 2250, he lets the option expire. His losses are limited to the extent of the
premium he paid for buying the option.

Payoff profile for writer of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike
price specified in the option. For selling the option, the writer of the option
charges a premium. The profit/loss that the buyer makes on the option
depends on the spot price of the underlying. Whatever is the buyer's profit is
the seller's loss. If upon expiration, the spot price happens to be below the strike
52

price, the buyer will exercise the option on the writer. If upon expiration the spot
price of the underlying is more than the strike price, the buyer lets his option unexercised and the writer gets to keep the premium. Figure 3.9 gives the payoff
for the writer of a three month put option (often referred to as short put) with a
strike of 2250 sold at a premium of 61.70.
Figure 3.9 Payoff for writer of put option
The figure shows the profits/losses for the seller of a three-month Nifty 2250 put option. As the spot
Nifty falls, the put option is in-the-money and the writer starts making losses. If upon expiration, Nifty
closes below the strike of 2250, the buyer would exercise his option on the writer who would suffer a
loss to the extent of the difference between the strike price and Nifty-close. The loss that can be
incurred by the writer of the option is a maximum extent of the strike price (Since the worst that can
happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of
the up-front option premium of Rs.61.70 charged by him.

PRICING OPTIONS
An option buyer has the right but not the obligation to exercise on the seller. The
worst that can happen to a buyer is the loss of the premium paid by him. His
downside is limited to this premium, but his upside is potentially unlimited. This
optionality is precious and has a value, which is expressed in terms of the option
price. Just like in other free markets, it is the supply and demand in the
secondary market that drives the price of an option.
There are various models which help us get close to the true price of an option. Most
of these are variants of the celebrated Black-Scholes model for pricing European
options. Today most calculators and spread-sheets come with a built-in BlackScholes options pricing formula so to price options we don't really need to memorize
the formula. All we need to know is the variables that go into the model.
53

The Black-Scholes formulas for the prices of European calls and puts on a
non-dividend paying stock are:

The Black/Scholes equation is done in continuous time. This requires

continuous compounding. The r that figures in this is ln(l + r).
Example: if the interest rate per annum is 12%, you need to use ln
1.12 or 0.1133, which is the continuously compounded equivalent of
12% per annum.

N() is the cumulative normal distribution. N(d1) is called the delta of

the option which is a measure of change in option price with respect to
change in the price of the underlying asset.

a measure of volatility, is the annualized standard deviation of

continuously compounded returns on the underlying. When daily
sigma are given, they need to be converted into annualized sigma.

APPLICATION OF OPTIONS
We look here at some applications of options contracts. We refer to single stock
options here. However since the index is nothing but a security whose price or
level is a weighted average of securities constituting the index, all strategies that
can be implemented using stock futures can also be implemented using index
options.

Hedging: Have underlying buy puts

Owners of stocks or equity portfolios often experience discomfort about the
overall stock market movement. As an owner of stocks or an equity portfolio,
sometimes you may have a view that stock prices will fall in the near future. At
other times you may see that the market is in for a few days or weeks of
54

massive volatility, and you do not have an appetite for this kind of volatility. The
union budget is a common and reliable source of such volatility: market volatility
is always enhanced for one week before and two weeks after a budget. Many
investors simply do not want the fluctuations of these three weeks. One way to
protect your portfolio from potential downside due to a market drop is to buy
insurance using put options.
Index and stock options are a cheap and easily implementable way of seeking
this insurance. The idea is simple. To protect the value of your portfolio from
falling below a particular level, buy the right number of put options with the
right strike price. If you are only concerned about the value of a particular stock
that you hold, buy put options on that stock. If you are concerned about the
overall portfolio, buy put options on the index. When the stock price falls your
stock will lose value and the put options bought by you will gain, effectively
ensuring that the total value of your stock plus put does not fall below a
particular level. This level depends on the strike price of the stock options
chosen by you. Similarly when the index falls, your portfolio will lose value and
the put options bought by you will gain, effectively ensuring that the value of your
portfolio does not fall below a particular level. This level depends on the strike
price of the index options chosen by you.
Portfolio insurance using put options is of particular interest to mutual funds
who already own well-diversified portfolios. By buying puts, the fund can limit
its downside in case of a market fall.

Speculation: Bullish security, buy calls or sell puts

There are times when investors believe that security prices are going to rise.
For instance, after a good budget, or good corporate results, or the onset of a
stable government. How does one implement a trading strategy to benefit from
an upward movement in the underlying security? Using options there are two
ways one can do this:
1. Buy call options; or
2. Sell put options
We have already seen the payoff of a call option. The downside to the buyer of the
call option is limited to the option premium he pays for buying the option. His
upside however is potentially unlimited. Suppose you have a hunch that the price
of a particular security is going to rise in a months time. Your hunch proves
correct and the price does indeed rise, it is this upside that you cash in on.
However, if your hunch proves to be wrong and the security price plunges down,
what you lose is only the option premium.
Having decided to buy a call, which one should you buy? Table 3.1 gives the
premia for one month calls and puts with different strikes. Given that there are a
55

number of one-month calls trading, each with a different strike price, the obvious
question is: which strike should you choose? Let us take a look at call options with
different strike prices. Assume that the current price level is 1250, risk-free rate is
12% per year and volatility of the underlying security is 30%. The following
options are available:
1. A one month call with a strike of 1200.
2. A one month call with a strike of 1225.
3. A one month call with a strike of 1250.
4. A one month call with a strike of 1275.
5. A one month call with a strike of 1300.
Which of these options you choose largely depends on how strongly you feel about
the likelihood of the upward movement in the price, and how much you are willing
to lose should this upward movement not come about. There are five one-month
calls and five one-month puts trading in the market. The call with a strike of
1200 is deep in-the-money and hence trades at a higher premium. The call with
a strike of 1275 is out-of-the-money and trades at a low premium. The call with
a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely
event that the underlying will rise by more than 50 points on the expiration date.
Hence buying this call is basically like buying a lottery. There is a small probability
that it may be in-the-money by expiration, in which case the buyer will make
profits. In the more likely event of the call expiring out-of-the-money, the buyer
simply loses the small premium amount of Rs.27.50.
As a person who wants to speculate on the hunch that prices may rise, you can
also do so by selling or writing puts. As the writer of puts, you face a limited
upside and an unlimited downside. If prices do rise, the buyer of the put will let the
option expire and you will earn the premium. If however your hunch about an
upward movement proves to be wrong and prices actually fall, then your losses
directly increase with the falling price level. If for instance the price of the
underlying falls to 1230 and you've sold a put with an exercise of 1300, the buyer
of the put will exercise the option and you'll end up losing Rs.70. Taking into account
the premium earned by you when you sold the put, the net loss on the trade is
Rs.5.20.
Having decided to write a put, which one should you write? Given that there are a
number of one-month puts trading, each with a different strike price, the obvious
question is: which strike should you choose? This largely depends on how strongly
you feel about the likelihood of the upward movement in the prices of the
underlying. If you write an at-the-money put, the option premium earned by you
will be higher than if you write an out-of-the-money put. However the chances of
an at-the-money put being exercised on you are higher as well.

56

Table 3.1 One month calls and puts trading at different strikes
The spot price is 1250. There are five one-month calls and five one-month puts trading in the
market. The call with a strike of 1200 is deep in-the-money and hence trades at a higher premium.
The call with a strike of 1275 is out-of-the-money and trades at a low premium. The call with a strike of
1300 is deep-out-of-money. Its execution depends on the unlikely event that the price of underlying
will rise by more than 50 points on the expiration date. Hence buying this call is basically like buying a
lottery. There is a small probability that it may be in-the-money by expiration in which case the buyer
will profit. In the more likely event of the call expiring out-of-the-money, the buyer simply loses the
small premium amount of Rs. 27.50. Figure 3.10 shows the payoffs from buying calls at different
strikes. Similarly, the put with a strike of 1300 is deep in-the-money and trades at a higher premium
than the at-the-money put at a strike of 1250. The put with a strike of 1200 is deep out-of-the-money
and will only be exercised in the unlikely event that underlying falls by 50 points on the expiration date.
Figure 3.11 shows the payoffs from writing puts at different strikes.

1250

Strike price of
option
1200

1250
1250
1250
1250

1225
1250
1275
1300

Underlying

Call Premium(Rs.)
80.10
63.65
49.45
37.50
27.50

Put Premium(Rs.)
18.15
26.50
37.00
49.80
64.80

In the example in Figure 4.11, at a price level of 1250, one option is in-the-money
and one is out-of-the-money. As expected, the in-the-money option fetches the
highest premium of Rs.64.80 whereas the out-of-the-money option has the
lowest premium of Rs. 18.15.

Speculation: Bearish security, sell calls or buy puts

Do you sometimes think that the market is going to drop? That you could make a
profit by adopting a position on the market? Due to poor corporate results, or
the instability of the government, many people feel that the stocks prices would go
down. How does one implement a trading strategy to benefit from a downward
movement in the market? Today, using options, you have two choices:
1. Sell call options; or
2. Buy put options
We have already seen the payoff of a call option. The upside to the writer of the call
option is limited to the option premium he receives upright for writing the option. His
downside however is potentially unlimited. Suppose you have a hunch that the price
of a particular security is going to fall in a months time. Your hunch proves correct
and it does indeed fall, it is this downside that you cash in on. When the price
57

falls, the buyer of the call lets the call expire and you get to keep the premium.
However, if your hunch proves to be wrong and the market soars up instead, what
you lose is directly proportional to the rise in the price of the security.

Figure 3.10 Payoff for buyer of call options at various strikes

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

Figure 3.11 Payoff for writer of put options at various strikes

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

Having decided to write a call, which one should you write? Table 3.2 gives the
premiums for one month calls and puts with different strikes. Given that there are
58

a number of one-month calls trading, each with a different strike price, the obvious
question is: which strike should you choose? Let us take a look at call options with
different strike prices. Assume that the current stock price is 1250, risk-free rate is
12% per year and stock volatility is 30%. You could write the following options:
1. A one month call with a strike of 1200.
2. A one month call with a strike of 1225.
3. A one month call with a strike of 1250.
4. A one month call with a strike of 1275.
5. A one month call with a strike of 1300.
Which of this options you write largely depends on how strongly you feel about the
likelihood of the downward movement of prices and how much you are willing to
lose should this downward movement not come about. There are five one-month
calls and five one-month puts trading in the market. The call with a strike of 1200
is deep in-the-money and hence trades at a higher premium. The call with a strike
of 1275 is out-of-the-money and trades at a low premium. The call with a strike of
1300 is deep-out-of-money. Its execution depends on the unlikely event that the
stock will rise by more than 50 points on the expiration date. Hence writing this
call is a fairly safe bet. There is a small probability that it may be in-the-money by
expiration in which case the buyer exercises and the writer suffers losses to the
extent that the price is above 1300. In the more likely event of the call expiring outof-the-money, the writer earns the premium amount ofRs.27.50.
As a person who wants to speculate on the hunch that the market may fall, you can
also buy puts. As the buyer of puts you face an unlimited upside but a limited
downside. If the price does fall, you profit to the extent the price falls below the
strike of the put purchased by you. If however your hunch about a downward
movement in the market proves to be wrong and the price actually rises, all you
lose is the option premium. If for instance the security price rises to 1300 and
you've bought a put with an exercise of 1250, you simply let the put expire. If
however the price does fall to say 1225 on expiration date, you make a neat profit
of Rs.25.
Having decided to buy a put, which one should you buy? Given that there are a
number of one-month puts trading, each with a different strike price, the obvious
question is: which strike should you choose? This largely depends on how strongly
you feel about the likelihood of the downward movement in the market. If you buy
an at-the-money put, the option premium paid by you will by higher than if you
buy an out-of-the-money put. However the chances of an at-the-money put
expiring in-the-money are higher as well.

59

Table 3.2 One month calls and puts trading at different strikes
The spot price is 1250. There are five one-month calls and five one-month puts trading in the market.
The call with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a
strike of 1275 is out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-outof-money. Its execution depends on the unlikely event that the price will rise by more than 50 points on
the expiration date. Hence writing this call is a fairly safe bet. There is a small probability that it may be
in-the-money by expiration in which case the buyer exercises and the writer suffers losses to the extent
that the price is above 1300. In the more likely event of the call expiring out-of-the-money, the writer
earns the premium amount of Rs.27.50. Figure 3.12 shows the payoffs from writing calls at different
strikes. Similarly, the put with a strike of 1300 is deep in-the-money and trades at a higher premium than
the at-the-money put at a strike of 1250. The put with a strike of 1200 is deep out-of-the-money and will
only be exercised in the unlikely event that the price falls by 50 points on the expiration date. The choice
of which put to buy depends upon how much the speculator expects the market to fall. Figure 3.13 shows
the payoffs from buying puts at different strikes.

Price

Strike price of
option

Call
Premium(Rs.)

Put Premium(Rs.)

1250
1250
1250
1250
1250

1200
1225
1250
1275
1300

80.10
63.65
49.45
37.50
27.50

18.15
26.50
37.00
49.80
64.80

Figure 3.12 Payoff for seller of call option at various strikes

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

60

Figure 3.13 Payoff for buyer of put options at various strikes

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

Bull spreads - Buy a call and sell another

There are times when you think the market is going to rise over the next two
months, however in the event that the market does not rise, you would like to
limit your downside. One way you could do this is by entering into a spread. A
spread trading strategy involves taking a position in two or more options of the
same type, that is, two or more calls or two or more puts. A spread that is
designed to profit if the price goes up is called a bull spread.
How does one go about doing this? This is basically done utilizing two call
options having the same expiration date, but different exercise prices. The
buyer of a bull spread buys a call with an exercise price below the current index
level and sells a call option with an exercise price above the current index level.
The spread is a bull spread because the trader hopes to profit from a rise in
the index. The trade is a spread because it involves buying one option and
selling a related option. What is the advantage of entering into a bull spread?
Compared to buying the underlying asset itself, the bull spread with call options
limits the trader's risk, but the bull spread also limits the profit potential.

61

Figure 3.14 Payoff for a bull spread created using call options
The figure shows the profits/losses for a bull spread. As can be seen, the payoff obtained is the
sum of the payoffs of the two calls, one sold at Rs.40 and the other bought at Rs.80. The cost of
setting up the spread is Rs.40 which is the difference between the call premium paid and the call
premium received. The downside on the position is limited to this amount. As the index moves
above 3800, the position starts making profits (cutting losses) until the index reaches 4200.
Beyond 4200, the profits made on the long call position get offset by the losses made on the
short call position and hence the maximum profit on this spread is made if the index on the
expiration day closes at 4200. Hence the payoff on this spread lies between -40 to 360. Who
would buy this spread? Somebody who thinks the index is going to rise, but not above 4200.
Hence he does not want to buy a call at 3800 and pay a premium of 80 for an upside he believes
will not happen.

In short, it limits both the upside potential as well as the downside risk. The
cost of the bull spread is the cost of the option that is purchased, less the
cost of the option that is sold. Table 3.3 gives the profit/loss incurred on a
spread position as the index changes. Figure 3.14 shows the payoff from the
bull spread.
Broadly, we can have three types of bull spreads:
1.

Both calls initially out-of-the-money.

2.

One call initially in-the-money and one call initially out-of-the-money,

and

3.

Both calls initially in-the-money.

62

The decision about which of the three spreads to undertake depends upon how
much risk the investor is willing to take. The most aggressive bull spreads are
of type 1. They cost very little to set up, but have a very small probability of
giving a high payoff.
Table 3.3 Expiration day cash flows for a Bull spread using two-month calls
The table shows possible expiration day profit for a bull spread created by buying calls at a strike
of 3800 and selling calls at a strike of 4200. The cost of setting up the spread is the call premium
paid (Rs.80) minus the call premium received (Rs.40), which is Rs.40. This is the maximum loss
that the position will make. On the other hand, the maximum profit on the spread is limited to
Rs.360. Beyond an index level of 4200, any profits made on the long call position will be
cancelled by losses made on the short call position, effectively limiting the profit on the
combination.

Nifty
3700
3750
3800
3850
3900
3950
4000
4050
4100
4150
4200
4250
4300

Buy Jan 3800 Call

0
0
0
+50
+100
+150
+200
+250
+300
+350
+400
+450
+500

Sell Jan 4200 Call

0
0
0
0
0
0
0
0
0
0
0
-50
-100

Cash Flow Profit&Loss (Rs.)

0
-40
0
-40
0
-40
50
+10
100
+60
150
+110
200
+160
250
+210
300
+260
350
+310
400
+360
400
+360
400
+360

Bear spreads - sell a call and buy another

There are times when you think the market is going to fall over the next two
months. However in the event that the market does not fall, you would like to
limit your downside. One way you could do this is by entering into a spread. A
spread trading strategy involves taking a position in two or more options of the
same type, that is, two or more calls or two or more puts. A spread that is
designed to profit if the price goes down is called a bear spread.
How does one go about doing this? This is basically done utilizing two call
options having the same expiration date, but different exercise prices. How is a
bull spread different from a bear spread? In a bear spread, the strike price of
the option purchased is greater than the strike price of the option sold. The
buyer of a bear spread buys a call with an exercise price above the current
63

index level and sells a call option with an exercise price below the current
index level. The spread is a bear spread because the trader hopes to profit
from a fall in the index. The trade is a spread because it involves buying one
option and selling a related option. What is the advantage of entering into a
bear spread? Compared to buying the index itself, the bear spread with call
options limits the trader's risk, but it also limits the profit potential. In short,
it limits both the upside potential as well as the downside risk.
A bear spread created using calls involves initial cash inflow since the price of
the call sold is greater than the price of the call purchased. Table 3.4 gives the
profit/loss incurred on a spread position as the index changes. Figure 3.15
shows the payoff from the bear spread.
Broadly we can have three types of bear spreads:
1.

Both calls initially out-of-the-money.

2.

One call initially in-the-money and one call initially out-of-the-money, and

3.

Both calls initially in-the-money.

The decision about which of the three spreads to undertake depends upon how
much risk the investor is willing to take. The most aggressive bear spreads
are of type 1. They cost very little to set up, but have a very small probability
of giving a high payoff. As we move from type 1 to type 2 and from type 2 to
type 3, the spreads become more conservative and cost higher to set up.
Bear spreads can also be created by buying a put with a high strike price and
selling a put with a low strike price.

Figure 3.15 Payoff for a bear spread created using call options
The figure shows the profits/losses for a bear spread. As can be seen, the payoff obtained is the
sum of the payoffs of the two calls, one sold at Rs. 150 and the other bought at Rs.50. The
maximum gain from setting up the spread is Rs. 100 which is the difference between the call
premium received and the call premium paid. The upside on the position is limited to this amount.
As the index moves above 3800, the position starts making losses (cutting profits) until the spot
reaches 4200. Beyond 4200, the profits made on the long call position get offset by the losses
made on the short call position. The maximum loss on this spread is made if the index on the
expiration day closes at 2350. At this point the loss made on the two call position together is
Rs.400 i.e. (4200-3800). However the initial inflow on the spread being Rs.100, the net loss on the
spread turns out to be 300. The downside on this spread position is limited to this amount. Hence
the payoff on this spread lies between +100 to -300.

64

Table 3.4 Expiration day cash flows for a Bear spread using two-month calls
The table shows possible expiration day profit for a bear spread created by selling one market lot of calls at a
strike of 3800 and buying a market lot of calls at a strike of 4200. The maximum profit obtained from
setting up the spread is the difference between the premium received for the call sold (Rs. 150) and the
premium paid for the call bought (Rs.50) which is Rs. 100.
In this case the maximum loss obtained is limited to Rs.300. Beyond an index level of 4200, any profits
made on the long call position will be canceled by losses made on the short call position, effectively limiting the
profit on the combination.

Nifty

Buy Jan 4200 Call

3700

Sell Jan 3800

Call
0

3750
3800
3850
3900
3950
4000
4050
4100
4150
4200
4250
4300

0
0
0
0
0
0
0
0
0
0
+50
+100

0
0
-50
-100
-150
-200
-250
-300
-350
-400
-450
-500
65

Cash Flow
0

Profit&Loss
(Rs.)
+100

0
0
-50
-100
-150
-200
-250
-300
-350
-400
-400
-400

+100
+100
+50
0
-50
-100
-150
-200
-250
-300
-300
-300

THE GREEKS
Delta (

is the rate of change of option price with respect to the price of the
underlying asset. For example, the delta of a stock is 1. It is the slope of the
curve that relates the option price to the price of the underlying asset.
Suppose the
of a call option on a stock is 0.5. This means that when the
stock price changes by one, the option price changes by about 0.5, or 50% of
the change in the stock price. Figure 3.16 shows the delta of a stock option.
Figure 3.16

as slope

Expressed differently,

is the change in the call price per unit change in the

spot.
= C/S. In the Black-Scholes formula, = N(d1) for a call. The
of a call is always positive and the of a put is always negative.

Gamma ( )
is the rate of change of the option's Delta (

) with respect to the price of

the underlying asset. In other words, it is the second derivative of the option
price with respect to price of the underlying asset.

Theta (

of a portfolio of options, is the rate of change of the value of the portfolio

66

with respect to the passage of time with all else remaining the same.
also referred to as the time decay of the portfolio.

is

is the change in the

portfolio value when one day passes with all else remaining the same. We can
either measure
"per calendar day" or "per trading day". To obtain the
per calendar day, the formula for Theta must be divided by 365; to obtain
Theta per trading day, it must be divided by 250.

Vega
The vega of a portfolio of derivatives is the rate of change in the value of the
portfolio with respect to volatility of the underlying asset. If is high in
absolute terms, the portfolio's value is very sensitive to small changes in
volatility. If
is low in absolute terms, volatility changes have relatively little
impact on the value of the portfolio.

Rho(
The

)
of a portfolio of options is the rate of change of the value of the

portfolio with respect to the interest rate. It measures the sensitivity of the
value of a portfolio to interest rates.

67

CHAPTER 4
TRADING
In this chapter we shall take a brief look at the trading system for NSE's
futures and options market. However, the best way to get a feel of the trading
system is to actually watch the screen and observe trading.

FUTURES AND OPTIONS TRADING SYSTEM

The futures & options trading system of NSE, called NEAT-F&O trading
system, provides a fully automated screen-based trading for Index futures &
options and Stock futures & options on a nationwide basis as well as an
online monitoring and surveillance mechanism. It supports an order driven
market and provides complete transparency of trading operations. It is
similar to that of trading of equities in the cash market segment.
The software for the F&O market has been developed to facilitate efficient
and transparent trading in futures and options instruments. Keeping in view
the familiarity of trading members with the current capital market trading
system, modifications have been performed in the existing capital market
trading system so as to make it suitable for trading futures and options.

Entities in the trading system

There are four entities in the trading system. Trading members, clearing
members, professional clearing members and participants.
1)

Trading members: Trading members are members of NSE. They can

trade either on their own account or on behalf of their clients including
participants. The exchange assigns a trading member ID to each
trading member. Each trading member can have more than one user.
The number of users allowed for each trading member is notified by
the exchange from time to time. Each user of a trading member must
be registered with the exchange and is assigned an unique user ID.
The unique trading member ID functions as a reference for all
orders/trades of different users. This ID is common for all users of a
particular trading member. It is the responsibility of the trading member to
maintain adequate control over persons having access to the firms User IDs.
68

2)

Clearing members: Clearing members are members of NSCCL. They carry

out risk management activities and confirmation/inquiry of trades
through the trading system.

3)

Professional clearing members: A professional clearing members is a

clearing member who is not a trading member. Typically, banks and
custodians become professional clearing members and clear and settle for
their trading members.

4)

Participants: A participant is a client of trading members like financial

institutions. These clients may trade through multiple trading members
but settle through a single clearing member.

Figure 4.1 Market by price in NEAT F&O

Basis of trading
The NEAT F&O system supports an order driven market, wherein orders
match automatically. Order matching is essentially on the basis of security, its
69

price, time and quantity. All quantity fields are in units and price in rupees.
The exchange notifies the regular lot size and tick size for each of the
contracts traded on this segment from time to time. When any order enters
the trading system, it is an active order. It tries to find a match on the other
side of the book. If it finds a match, a trade is generated. If it does not find a
match, the order becomes passive and goes and sits in the respective
outstanding order book in the system.

Corporate hierarchy
In the F&O trading software, a trading member has the facility of defining a
hierarchy amongst users of the system. This hierarchy comprises corporate
manager, branch manager and dealer.
1)

Corporate manager: The term 'Corporate manager' is assigned to a

user placed at the highest level in a trading firm. Such a user can
perform all the functions such as order and trade related activities,
receiving reports for all branches of the trading member firm and also
all dealers of the firm. Additionally, a corporate manager can define
exposure limits for the branches of the firm. This facility is available
only to the corporate manager.

2)

Branch manager: The branch manager is a term assigned to a user

who is placed under the corporate manager. Such a user can perform
and view order and trade related activities for all dealers under that
branch.

3)

Dealer: Dealers are users at the lower most level of the hierarchy. A
Dealer can perform view order and trade related activities only for
oneself and does not have access to information on other dealers under
either the same branch or other branches.

Below given cases explain activities possible for specific user categories:
1)

Clearing member corporate manager: He can view outstanding

orders, previous trades and net position of his client trading members
by putting the TM ID (Trading member identification) and leaving the
Branch ID and Dealer ID blank.

2)

Clearing member and trading member corporate manager: He

can view:
(a)

Outstanding orders, previous trades and net position of his

client trading members by putting the TM ID and leaving the
Branch ID and the Dealer ID blank.

70

(b)

Outstanding orders, previous trades and net positions entered

for himself by entering his own TM ID, Branch ID and User ID.
This is his default screen.

(c)

Outstanding orders, previous trades and net position entered for

his branch by entering his TM ID and Branch ID fields.

(d)

Outstanding orders, previous trades, and net positions entered

for any of his users/dealers by entering his TM ID, Branch ID
and user ID fields.

3)

Clearing member and trading member dealer: He can only view

requests entered by him.

4)

Trading member corporate manager: He can view:

5)

6)

(a)

Outstanding requests and activity log for requests entered by

him by entering his own Branch and User IDs. This is his default
screen.

(b)

Outstanding requests entered by his dealers and/or branch

managers by either entering the Branch and/or User IDs or
leaving them blank.

Trading member branch manager: He can view:

(a)

Outstanding requests and activity log for requests entered by

him by entering his own Branch and User IDs. This is his default
screen.

(b)

Outstanding requests entered by his users either by filling the User ID

field with a specific user or leaving the User ID field blank.

Trading member dealer: He can only view requests entered by him.

Client Broker Relationship in Derivative Segment

A trading member must ensure compliance particularly with relation to the
following while dealing with clients:
1.

Filling of 'Know Your Client' form

2.

Execution of Client Broker agreement

3.

Bring risk factors to the knowledge of client by getting acknowledgement of

71

client on risk disclosure document

4.

Timely execution of orders as per the instruction of clients in respective client

codes.

5.

Collection of adequate margins from the client

6.

Maintaining separate client bank account for the segregation of client money.

7.

Timely issue of contract notes as per the prescribed format to the client

8.

Ensuring timely pay-in and pay-out of funds to and from the clients

9.

Resolving complaint of clients if any at the earliest.

10.

Avoiding receipt and payment of cash and deal only through account payee
cheques

11.

Sending the periodical statement of accounts to clients

12.

Not charging excess brokerage

13.

Maintaining unique client code as per the regulations.

Order types and conditions

The system allows the trading members to enter orders with various
conditions attached to them as per their requirements. These conditions are
broadly divided into the following categories:

Time conditions

Price conditions

Other conditions

Several combinations of the above are allowed thereby providing enormous

flexibility to the users. The order types and conditions are summarized below.

72

Figure 4.2 Security/contract/portfolio entry screen in NEAT F&O

Time conditions
-

Day order: A day order, as the name suggests is an order

which is valid for the day on which it is entered. If the order is
not executed during the day, the system cancels the order
automatically at the end of the day.

Immediate or Cancel (IOC): An IOC order allows the user to

buy or sell a contract as soon as the order is released into the
system, failing which the order is cancelled from the system.
Partial match is possible for the order, and the unmatched
portion of the order is cancelled immediately.

Price condition
-

Stop-loss: This facility allows the user to release an order into

the system, after the market price of the security reaches or
crosses a threshold price e.g. if for stop-loss buy order, the
trigger is 1027.00, the limit price is 1030.00 and the market
(last traded) price is 1023.00, then this order is released into
73

the system once the market price reaches or exceeds 1027.00.

This order is added to the regular lot book with time of
triggering as the time stamp, as a limit order of 1030.00. For
the stop-loss sell order, the trigger price has to be greater than
the limit price.

Other conditions
-

Market price: Market orders are orders for which no price is

specified at the time the order is entered (i.e. price is market
price). For such orders, the system determines the price.

Trigger price: Price at which an order gets triggered from the

stop-loss book.

Limit price: Price of the orders after triggering from stop-loss

book.

Pro: Pro means that the orders are entered on the trading
member's own account.

Cli: Cli means that the trading member enters the orders on
behalf of a client.

THE TRADER WORKSTATION

The market watch window
The following windows are displayed on the trader workstation screen:

Title bar
Ticker window of futures and options market
Ticker window of underlying(capital) market
Toolbar
Market watch window
Inquiry window
Snap quote
Order/trade window
System message window

As mentioned earlier, the best way to familiarize oneself with the screen and
its various segments is to actually spend some time studying a live screen. In
this section we shall restrict ourselves to understanding just two segments of
the workstation screen, the market watch window and the inquiry window.
74

The market watch window is the third window from the top of the screen
which is always visible to the user. The purpose of market watch is to allow
continuous monitoring of contracts or securities that are of specific interest to
the user. It displays trading information for contracts selected by the user. The
user also gets a broadcast of all the cash market securities on the screen. This
function also will be available if the user selects the relevant securities for
display on the market watch screen. Display of trading information related to
cash market securities will be on "Read only" format, i.e. the dealer can only
view the information on cash market but, cannot trade in them through the
system. This is the main window from the dealer's perspective.

Inquiry window
The inquiry window enables the user to view information such as Market by
Price (MBP), Previous Trades (PT), Outstanding Orders (OO), Activity log (AL),
Snap Quote (SQ), Order Status (OS), Market Movement (MM), Market Inquiry
(MI), Net Position, On line backup, Multiple index inquiry, Most active security
and so on. Relevant information for the selected contract/security can be
viewed. We shall look in detail at the Market by Price (MBP) and the Market
Inquiry (MI) screens.
1.

Market by price (MBP): The purpose of the MBP is to enable the user to
view passive orders in the market aggregated at each price and are displayed
in order of best prices. The window can be invoked by pressing the [F6] key.
If a particular contract or security is selected, the details of the selected
contract or security can be seen on this screen.

2.

Market inquiry (MI): The market inquiry screen can be invoked by using
the [F11] key. If a particular contract or security is selected, the details of
the selected contract or selected security defaults in the selection screen or
else the current position in the market watch defaults. The first line of the
screen gives the Instrument type, symbol, expiry, contract status, total
traded quantity, life time high and life time low. The second line displays the
closing price, open price, high price, low price, last traded price and
indicator for net change from closing price. The third line displays the last
traded quantity, last traded time and the last traded date. The fourth line
displays the closing open interest, the opening open interest, day high open
interest, day low open interest, current open interest, life time high open
interest, life time low open interest and net change from closing open
interest. The fifth line display very important information, namely the
carrying cost in percentage terms.

75

Placing orders on the trading system

For both the futures and the options market, while entering orders on the
trading system, members are required to identify orders as being proprietary
or client orders. Proprietary orders should be identified as 'Pro' and those of
clients should be identified as 'Cli'. Apart from this, in the case of 'Cli' trades,
the client account number should also be provided.
The futures market is a zero sum game i.e. the total number of long in any
contract always equals the total number of short in any contract. The total
number of outstanding contracts (long/short) at any point in time is called the
"Open interest". This Open interest figure is a good indicator of the liquidity in
every contract. Based on studies carried out in international exchanges, it is
found that open interest is maximum in near month expiry contracts.

Market spread/combination order entry

The NEAT F&O trading system also enables to enter spread/combination
trades. Figure 4.3 shows the spread/combination screen. This enables the
user to input two or three orders simultaneously into the market. These
orders will have the condition attached to it that unless and until the whole
batch of orders finds a countermatch, they shall not be traded. This facilitates
spread and combination trading strategies with minimum price risk.

Basket trading
In order to provide a facility for easy arbitrage between futures and cash
markets, NSE introduced basket-trading facility. Figure 4.4 shows the basket
trading screen. This enables the generation of portfolio offline order files in
the derivatives trading system and its execution in the cash segment. A
trading member can buy or sell a portfolio through a single order, once he
determines its size. The system automatically works out the quantity of each
security to be bought or sold in proportion to their weights in the portfolio.

76

Figure 4.3 Market spread/combination order entry

FUTURES AND OPTIONS MARKET INSTRUMENTS

The F&O segment of NSE provides trading facilities for the following derivative
instruments:
1.
2.
3.
4.

Index based futures

Index based options
Individual stock options
Individual stock futures

77

Figure 4.4 Portfolio office order entry for basket trades

Contract specifications for index futures

NSE trades Nifty, CNX IT, BANK Nifty, Nifty Midcap 50 and Mini Nifty 50 futures
contracts having one-month, two-month and three-month expiry cycles. All
contracts expire on the last Thursday of every month. Thus a January
expiration contract would expire on the last Thursday of January and a February
expiry contract would cease trading on the last Thursday of February. On the Friday
following the last Thursday, a new contract having a three-month expiry would be
introduced for trading. Thus, as shown in Figure 5.5 at any point in time, three
contracts would be available for trading with the first contract expiring on the
last Thursday of that month. Depending on the time period for which you want
to take an exposure in index futures contracts, you can place buy and sell orders
in the respective contracts. The Instrument type refers to "Futures contract on
index" and Contract symbol - NIFTY denotes a "Futures contract on Nifty index"
and the Expiry date represents the last date on which the contract will be available
for trading. Each futures contract has a separate limit order book. All passive
78

orders are stacked in the system in terms of price-time priority and trades take
place at the passive order price (similar to the existing capital market trading
system). The best buy order for a given futures contract will be the order to
buy the index at the highest index level whereas the best sell order will be the
order to sell the index at the lowest index level.
Example: If trading is for a minimum lot size of 100 units. If the index level
is around 2000, then the appropriate value of a single index futures contract
would be Rs.200,000. The minimum tick size for an index future contract is
0.05 units. Thus a single move in the index value would imply a resultant gain
or loss of Rs.5.00 (i.e. 0.05*100 units) on an open position of 100 units.
Table 4.1 gives the contract specifications for index futures trading on the
NSE.
Figure 4.5 Contract cycle
The figure shows the contract cycle for futures contracts on NSE's derivatives market. As can be seen, at
any given point of time, three contracts are available for trading - a near-month, a middle-month and
a far-month. As the January contract expires on the last Thursday of the month, a new three-month
contract starts trading from the following day, once more making available three index futures
contracts for trading.

Contract specification for index options

On NSE's index options market, there are one-month, two-month and threemonth expiry contracts with minimum nine different strikes available for
trading. Hence, if there are three serial month contracts available and the
scheme of strikes is 4-1-4, then there are minimum 3 x 9 x 2 (call and put
options) i.e. 54 options contracts available on an index. Option contracts are
specified
as
follows:
DATE-EXPIRYMONTH-YEAR-CALL/PUT-AMERICAN/
EUROPEAN-STRIKE. For example the European style call option contract on
79

the Nifty index with a strike price of 2040 expiring on the 30th June 2005 is
specified as '30 JUN 2005 2040 CE'.
Just as in the case of futures contracts, each option product (for instance, the
28 JUN 2005 2040 CE) has it's own order book and it's own prices. All index
options contracts are cash settled and expire on the last Thursday of the
month. The clearing corporation does the novation. The minimum tick for an
index options contract is 0.05 paise. Table 4.2 gives the contract
specifications for index options trading on the NSE.
Table 4.1 Contract specification: S&P CNX Nifty Futures
Underlying index
S&P CNX Nifty
Exchange of trading
National Stock Exchange of India Limited
Security descriptor
NFUTIDX NIFTY
Contract size
Permitted lot size shall be 50
(minimum value Rs.2 lakh)
Price steps
Re. 0.05
Price bands
Not applicable
Trading cycle
The futures contracts will have a maximum of
three month trading cycle - the near month
(one), the next month (two) and the far month
(three). New contract will be introduced on the
next trading day following the expiry of near
month contract.
Expiry day
The last Thursday of the expiry month or the
previous trading day if the last Thursday is a
trading holiday.
Settlement basis
Mark to market and final settlement will be
cash settled on T+1 basis.
Settlement price
Daily settlement price will be the closing price
of the futures contracts for the trading day and
the final settlement price shall be the closing
value of the underlying index on the last
trading day.
Table 4.2 Contract specification: S&P CNX Nifty Options
Underlying index
S&P CNX Nifty
Exchange of trading National Stock Exchange of India Limited
Security descriptor
NOPTIDX NIFTY
Contract size
Permitted lot size shall be 50
(minimum value Rs.2 lakh)
Price steps
Re. 0.05
Price bands
Not applicable

80

Trading cycle

Expiry day
Settlement basis
Style of option
Strike price interval
Daily settlement
priceFinal settlement
price

The options contracts will have a maximum of

three month trading cycle - the near month
(one), the next month (two) and the far month
(three). New contract will be introduced on the
next trading day following the expiry of near
month contract.
The last Thursday of the expiry month or the
previous trading day if the last Thursday is a
trading holiday.
Cash settlement on T+1 basis.
European.
Rs.10
Not applicable
Closing value of the index on the last trading
day.

Generation of strikes
The exchange has a policy for introducing strike prices and determining the
strike price intervals. Table 5.3 and Table 5.4 summarises the policy for
introducing strike prices and determining the strike price interval for stocks
and index.
Let us look at an example of how the various option strikes are generated by
the exchange.

Suppose the Nifty has closed at 2000 and options with strikes 2040,
2030, 2020, 2010, 2000, 1990, 1980, 1970, 1960 are already
available.

It is further assumed when the Nifty index level is upto 4000, the
exchange commits itself to an inter-strike distance of say 10 and the
scheme of strikes of 4-1-4.

If the Nifty closes at around 2020 to ensure strike scheme of 4-1-4, two
new further contracts would be required at 2050 and 2060.

Conversely, if Nifty closes at around 1980 to ensure strike scheme of 4-1-4,

two new further contracts would be required at 1940 and 1950.

81

Table 4.3 Generation of strikes for stock options

Price of underlying

Strike Price
interval

Less than or equal to Rs.50

> Rs.50 - Rs.250
> Rs.250 - Rs.500
> Rs.500 - Rs.1000
> Rs.1000 - Rs.2500
> Rs.2500

Scheme of strikes
to be introduced
(ITM-ATM-OTM)

2.5
5
10
20
20
50

5-1-5
5-1-5
5-1-5
5-1-5
10-1-10
10-1-10

Table 4.4 Generation of strikes for Index options

Index level

Upto 2000
From 2001 To 4000
From 4001 To 6000
>6000

Strike
interval

Scheme of strikes
to be introduced
(ITM-ATM-OTM)

50
100
100
100

4-1-4
6-1-6
6-1-6
7-1-7

Contract specifications for stock futures

Trading in stock futures commenced on the NSE from November 2001. These
contracts are cash settled on a T+1 basis. The expiration cycle for stock futures is
the same as for index futures, index options and stock options. A new contract is
introduced on the trading day following the expiry of the near month contract.
Table 4.5 gives the contract specifications for stock futures.
Table 4.5 Contract specification: Stock futures
Underlying
Individual securities
Exchange of trading
National Stock Exchange of India Limited
Security descriptor
N FUTSTK
Contract size
As specified by the exchange (minimum value of
Rs.2 lakh)
Price steps
Re. 0.05
Price bands
Not applicable

82

Trading cycle

Expiry day

Settlement basis
Settlement price

The futures contracts will have a maximum of

three month trading cycle - the near month
(one), the next month (two) and the far month
(three). New contract will be introduced on the
next trading day following the expiry of near
month contract.
The last Thursday of the expiry month or the
previous trading day if the last Thursday is a
trading holiday.
Mark to market and final settlement will be cash
settled on T+1 basis.
Daily settlement price will be the closing price of
the futures contracts for the trading day and the
the final settlement price shall be the closing
price of the underlying security on the last
trading day.

Contract specifications for stock options

Trading in stock options commenced on the NSE from July 2001. These contracts
are American style and are settled in cash. The expiration cycle for stock
options is the same as for index futures and index options. A new contract is
introduced on the trading day following the expiry of the near month contract. NSE
provides a minimum of seven strike prices for every option type (i.e. call and put)
during the trading month. There are at least three in-the-money contracts, three
out-of-the-money contracts and one at-the-money contract available for
trading. Table 4.6 gives the contract specifications for stock options.

83

Table 4.6 Contract specification: Stock options

Underlying
Individual securities available
for trading in cash market
Exchange of trading National Stock Exchange of India Limited
Security descriptor
N OPTSTK.
Style of option
American.
Strike price interval
As specified by the exchange
Contract size
As specified by the exchange (minimum value of
Rs.2 lakh)
Price steps
Re. 0.05
Price bands
Not applicable
Trading cycle
The options contracts will have a maximum of
three month trading cycle - the near month
(one), the next month (two) and the far month
(three). New contract will be introduced on the
next trading day following the expiry of near
month contract.
Expiry day

Settlement basis
Daily settlement
priceFinal settlement
price
Settlement day

The last Thursday of the expiry month or the

previous trading day if the last Thursday is a
trading holiday.
Daily settlement on T+1 basis and final option
exercise settlement on T+1 basis
Premium value (net)
Closing price of underlying on exercise day or
expiry day
Last trading day

New Products in the F&O Segment : The Year 2008 witnessed the launch
of new products in the F&O Segment of NSE. The Mini derivative (Futures and
Options) contracts on S&P CNX Nifty were introduced for trading on January
1, 2008. The mini contracts have smaller contract size than the normal Nifty
contract and extend greater affordability to individual investors and helps the
individual investor to hedge risks of a smaller portfolio. The Long Term
Options Contracts on S&P CNX Nifty were launched on March 3, 2008. The
long term options have a life cycle of maximum 5 years duration and offer
long term investors to take a view on prolonged price changes over a longer
duration, without needing to use a combination of shorter term option
contracts.

84

CRITERIA FOR STOCKS AND INDEX ELIGIBILITY FOR

TRADING
Eligibility criteria of stocks

The stock is chosen from amongst the top 500 stocks in terms of
average daily market capitalisation and average daily traded value in
the previous six months on a rolling basis.

The stock's median quarter-sigma order size over the last six months
should be not less than Rs. 5 lakhs. For this purpose, a stock's
quarter-sigma order size should mean the order size (in value terms)
required to cause a change in the stock price equal to one-quarter of a
standard deviation.

The market wide position limit in the stock should not be less than
Rs.100 crores. The market wide position limit (number of shares) is
valued taking the closing prices of stocks in the underlying cash
market on the date of expiry of contract in the month. The market
wide position limit of open position (in terms of the number of
underlying stock) on futures and option contracts on a particular
underlying stock shall be 20% of the number of shares held by nonpromoters in the relevant underlying security i.e. free-float holding.
For an existing F&O stock, the continued eligibility criteria is that market
wide position limit in the stock shall not be less than Rs. 60 crores and
stocks median quarter-sigma order size over the last six months shall be
not less than Rs. 2 lakh. If an existing security fails to meet the eligibility
criteria for three months consecutively, then no fresh month contract will
be issued on that security. However, the existing unexpired contracts can
be permitted to trade till expiry and new strikes can also be introduced in
the existing contract months.
Further, once the stock is excluded from the F&O list, it shall not be
considered for re-inclusion for a period of one year.

Futures & Options contracts may be introduced on (new) securities which

meet the above mentioned eligibility criteria, subject to approval by SEBI.

Eligibility criteria of indices

The exchange may consider introducing derivative contracts on an index if the
stocks contributing to 80% weightage of the index are individually eligible for
derivative trading. However, no single ineligible stocks in the index should
have a weightage of more than 5% in the index. The above criteria is applied
every month, if the index fails to meet the eligibility criteria for three months
consecutively, then no fresh month contract would be issued on that index,
85

However, the existing unexpired contacts will be permitted to trade till expiry
and new strikes can also be introduced in the existing contracts.

Eligibility criteria of stocks for derivatives trading

especially on account of corporate restructuring
The eligibility criteria for stocks for derivatives trading on account of corporate
restructuring is as under:
I.

II.

All the following conditions shall be met in the case of shares of a

company undergoing restructuring through any means for eligibility to
reintroduce derivative contracts on that company from the first day of
listing of the post restructured company/(s) (as the case may be)
stock (herein referred to as post restructured company) in the
underlying market,
a)
the Futures and options contracts on the stock of the original
(pre restructure) company were traded on any exchange prior
to its restructuring;
b)

the pre restructured company had a market capitalisation of at

least Rs.1000 crores prior to its restructuring;

c)

the post restructured company would be treated like a new

stock and if it is, in the opinion of the exchange, likely to be at
least one-third the size of the pre restructuring company in
terms of revenues, or assets, or (where appropriate) analyst
valuations; and

d)

in the opinion of the exchange, the scheme of restructuring

does not suggest that the post restructured company would
have any characteristic (for example extremely low free float)
that would render the company ineligible for derivatives
trading.

If the above conditions are satisfied, then the exchange takes the
following course of action in dealing with the existing derivative
contracts on the pre-restructured company and introduction of fresh
contracts on the post restructured company
a)

In the contract month in which the post restructured company

begins to trade, the Exchange introduce near month, middle
month and far month derivative contracts on the stock of the
restructured company.

b)

In subsequent contract months, the normal rules for entry and

exit of stocks in terms of eligibility requirements would apply. If
86

these tests are not met, the exchange shall not permit further
derivative contracts on this stock and future month series shall
not be introduced.

CHARGES
The maximum brokerage chargeable by a trading member in relation to
trades effected in the contracts admitted to dealing on the F&O segment of
NSE is fixed at 2.5% of the contract value in case of index futures and stock
futures. In case of index options and stock options it is 2.5% of notional value
of the contract [(Strike Price + Premium) * Quantity)], exclusive of statutory
levies. The transaction charges payable to the exchange by the trading
member for the trades executed by him on the F&O segment are fixed at the
rate of Rs. 2 per lakh of turnover (0.002%) subject to a minimum of Rs.
1,00,000 per year. However for the transactions in the options sub-segment
the transaction charges are levied on the premium value at the rate of 0.05%
(each side) instead of on the strike price as levied earlier. Further to this,
trading members have been advised to charge brokerage from their clients on
the Premium price(traded price) rather than Strike price. The trading members
contribute to Investor Protection Fund of F&O segment at the rate of Re. 1/per Rs. 100 crores of the traded value (each side).

87

CHAPTER 5
CLEARING AND SETTLEMENT
National Securities Clearing Corporation Limited (NSCCL) undertakes clearing and
settlement of all trades executed on the futures and options (F&O) segment of the
NSE. It also acts as legal counterparty to all trades on the F&O segment and
guarantees their financial settlement.

CLEARING ENTITIES
Clearing and settlement activities in the F&O segment are undertaken by NSCCL
with the help of the following entities:

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

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

88

Table 5.1 Proprietary position of trading member Madanbhai on Day 1

Trading member Madanbhai trades in the futures and options segment for himself and two of his clients.
The table shows his proprietary position. Note: A buy position '200@ 1000"means 200 units bought at
the rate of Rs. 1000.

Trading member Madanbhai

Buy
Sell
200@1000 400@1010

Proprietary position

Table 5.2 Client position of trading member Madanbhai on Day 1

Trading member Madanbhai trades in the futures and options segment for himself and two of his clients.
The table shows his client position.

Trading member
Madanbhai
Client
position

Buy Open

Sell Close

400@1109

200@1000

Client A
Client B

Sell Open

Buy Close

600@1100

200@1099

CLEARING MECHANISM
The clearing mechanism essentially involves working out open positions and
obligations
of
clearing
(self-clearing/trading-cum-clearing/professional
clearing) members. This position is considered for exposure and daily margin
purposes. The open positions of CMs are arrived at by aggregating the open
positions of all the TMs and all custodial participants clearing through him, in
contracts in which they have traded. A TM's open position is arrived at as the
summation of his proprietary open position and clients' open positions, in the
contracts in which he has traded. While entering orders on the trading
system, TMs are required to identify the orders, whether proprietary (if they
are their own trades) or client (if entered on behalf of clients) through 'Pro/
Cli' indicator provided in the order entry screen. Proprietary positions are
calculated on net basis (buy - sell) for each contract. Clients' positions are
89

arrived at by summing together net (buy - sell) positions of each individual

client. A TM's open position is the sum of proprietary open position, client
open long position and client open short position.
Consider the following example given from Table 5.1 to Table 5.4. The
proprietary open position on day 1 is simply = Buy - Sell = 200 - 400 = 200
short. The open position for client A = Buy (O) Sell (C) = 400 - 200 = 200
long, i.e. he has a long position of 200 units. The open position for Client B =
Sell (O) Buy (C) = 600 - 200 = 400 short, i.e. he has a short position of 400
units. Now the total open position of the trading member Madanbhai at end of
day 1 is 200(his proprietary open position on net basis) plus 600 (the Client open
positions on gross basis), i.e. 800.
The proprietary open position at end of day 1 is 200 short. The end of day open
position for proprietary trades undertaken on day 2 is 200 short. Hence the net
open proprietary position at the end of day 2 is 400 short. Similarly, Client A's open
position at the end of day 1 is 200 long. The end of day open position for trades
done by Client A on day 2 is 200 long. Hence the net open position for Client A at
the end of day 2 is 400 long. Client B's open position at the end of day 1 is 400
short. The end of day open position for trades done by Client B on day 2 is 200
short. Hence the net open position for Client B at the end of day 2 is 600 short.
The net open position for the trading member at the end of day 2 is sum of the
proprietary open position and client open positions. It works out to be 400 +
400 + 600, i.e. 1400.
The following table illustrates determination of open position of a CM, who clears
for two TMs having two clients.
Table 5.3 Proprietary position of trading member Madanbhai on Day 2
Assume that the position on Day 1 is carried forward to the next trading day and the following
trades are also executed.

Trading member Madanbhai

Buy
200@1000

Proprietary position

90

Sell
400@1010

Table 5.4 Client position of trading member Madanbhai on Day 2

Trading member Madanbhai trades in the futures and options segment for himself and two of his clients.
The table shows his client position on Day 2.

Trading member Madanbhai

Client position

Buy Open

Sell Close

Client A
Client B

400@1109

200@1000

Sell Open

Buy Close

600@1100 400@1099

SETTLEMENT MECHANISM
All futures and options contracts are cash settled, i.e. through exchange of
cash. The underlying for index futures/options of the Nifty index cannot be
delivered. These contracts, therefore, have to be settled in cash. Futures and
options on individual securities can be delivered as in the spot market. However,
it has been currently mandated that stock options and futures would also be
cash settled. The settlement amount for a CM is netted across all their
TMs/clients, with respect to their obligations on MTM, premium and exercise
settlement.

Table 5.5 Determination of open position of a clearing member

TMs clearing
through CM

Proprietary trades

Trades: Client 1

Buy

Sell

Net

Buy

Sell

ABC

4000

2000

2000

3000

1000 2000

PQR

2000

3000

(1000)

2000

Total

6000

5000

+2000

5000

Buy

Sell

Open position

Net

Long

Short

4000 2000

2000

6000

1000 1000

1000 2000

(1000) 1000

2000

2000 +3000

5000 4000

+2000

2000

-1000

Net

Trades: Client 2

-1000

91

7000

Settlement of futures contracts

Futures contracts have two types of settlements, the MTM settlement which
happens on a continuous basis at the end of each day, and the final settlement
which happens on the last trading day of the futures contract.
MTM settlement:
All futures contracts for each member are marked-to-market(MTM) to the daily
settlement price of the relevant futures contract at the end of each day. The
profits/losses are computed as the difference between:
1. The trade price and the day's settlement price for contracts executed during
the day but not squared up.
2. The previous day's settlement price and the current day's settlement
price for brought forward contracts.
3. The buy price and the sell price for contracts executed during the day and
squared up.
Table 5.6 explains the MTM calculation for a member. The settlement price for
the contract for today is assumed to be 105.
The CMs who have a loss are required to pay the mark-to-market (MTM) loss
amount in cash which is in turn passed on to the CMs who have made a MTM
profit. This is known as daily mark-to-market settlement. CMs are responsible
to collect and settle the daily MTM profits/losses incurred by the TMs and their
clients clearing and settling through them. Similarly, TMs are responsible to
collect/pay losses/profits from/to their clients by the next day. The pay-in and
pay-out of the mark-to-market settlement are effected on the day following
the trade day. In case a futures contract is not traded on a day, or not traded
during the last half hour, a 'theoretical settlement price' is computed as per the
following formula:

where:
F

Theoretical futures price

Value of the underlying index

Cost of financing (using continuously compounded interest rate) or

rate of interest (MIBOR)

Time till expiration

2.71828
92

After completion of daily settlement computation, all the open positions are
reset to the daily settlement price. Such positions become the open positions for
the next day.
Table 5.6 Computation of MTM at the end of the day
The table gives the MTM charged on various positions. The margin charged on the brought forward
contract is the difference between the previous day's settlement price of Rs.100 and today's settlement
price of Rs.105. Hence on account of the position brought forward, the MTM shows a profit of Rs.500. For
contracts executed during the day, the difference between the buy price and the sell price determines
the MTM. In this example, 200 units are bought @ Rs. 100 and 100 units sold @ Rs. 102 during the day.
Hence the MTM for the position closed during the day shows a profit of Rs.200. Finally, the open position
of contracts traded during the day, is margined at the day's settlement price and the profit of Rs.500
credited to the MTM account. So the MTM account shows a profit of Rs. 1200.

Trade details

Quantity
bought/sold

Settlement
price

MTM

Brought forward from

previous day

100@100

105

500

Traded during day

Bought
Sold

200@100
100@102

102

200

Open position

100@100

105

500

(not squared up)

Total

1200

Final settlement for futures

On the expiry day of the futures contracts, after the close of trading hours, NSCCL
marks all positions of a CM to the final settlement price and the resulting
profit/loss is settled in cash. Final settlement loss/profit amount is debited/
credited to the relevant CM's clearing bank account on the day following expiry
day of the contract.
Settlement prices for futures
Daily settlement price on a trading day is the closing price of the respective
futures contracts on such day. The closing price for a futures contract is currently
calculated as the last half an hour weighted average price of the contract in the
F&O Segment of NSE. Final settlement price is the closing price of the relevant
93

underlying index/security in the capital market segment of NSE, on the last

trading day of the contract. The closing price of the underlying Index/security is
currently its last half an hour weighted average value in the capital market
segment of NSE.

Settlement of options contracts

Options contracts have three types of settlements, daily premium settlement,
exercise settlement, interim exercise settlement in the case of option contracts
on securities and final settlement.
Daily premium settlement
Buyer of an option is obligated to pay the premium towards the options purchased
by him. Similarly, the seller of an option is entitled to receive the premium for the
option sold by him. The premium payable amount and the premium receivable
amount are netted to compute the net premium payable or receivable amount
for each client for each option contract.
Exercise settlement
Although most option buyers and sellers close out their options positions by
an offsetting closing transaction, an understanding of exercise can help an option
buyer determine whether exercise might be more advantageous than an offsetting
sale of the option. There is always a possibility of the option seller being assigned
an exercise. Once an exercise of an option has been assigned to an option seller,
the option seller is bound to fulfill his obligation (meaning, pay the cash
settlement amount in the case of a cash-settled option) even though he may not
yet have been notified of the assignment.
Interim exercise settlement
Interim exercise settlement takes place only for option contracts on securities. An
investor can exercise his in-the-money options at any time during trading
hours, through his trading member. Interim exercise settlement is effected for
such options at the close of the trading hours, on the day of exercise. Valid
exercised option contracts are assigned to short positions in the option contract
with the same series (i.e. having the same underlying, same expiry date and same
strike price), on a random basis, at the client level. The CM who has exercised the
option receives the exercise settlement value per unit of the option from the CM
who has been assigned the option contract.
Final exercise settlement
Final exercise settlement is effected for all open long in-the-money strike
price options existing at the close of trading hours, on the expiration day of
94

an option contract. All such long positions are exercised and automatically
assigned to short positions in option contracts with the same series, on a
random basis. The investor who has long in-the-money options on the expiry
date will receive the exercise settlement value per unit of the option from the
investor who has been assigned the option contract.
Exercise process
The period during which an option is exercisable depends on the style of the
option. On NSE, index options are European style, i.e. options are only
subject to automatic exercise on the expiration day, if they are in-the-money.
As compared to this, options on securities are American style. In such cases,
the exercise is automatic on the expiration day, and voluntary prior to the
expiration day of the option contract, provided they are in-the-money.
Automatic exercise means that all in-the-money options would be exercised
by NSCCL on the expiration day of the contract. The buyer of such options
need not give an exercise notice in such cases. Voluntary exercise means that
the buyer of an in-the-money option can direct his TM/CM to give exercise
instructions to NSCCL. In order to ensure that an option is exercised on a
particular day, the buyer must direct his TM to exercise before the cut-off time
for accepting exercise instructions for that day. Usually, the exercise orders
will be accepted by the system till the close of trading hours. Different TMs
may have different cut-off times for accepting exercise instructions from
customers, which may vary for different options. An option, which expires
unexercised becomes worthless. Some TMs may accept standing instructions
to exercise, or have procedures for the exercise of every option, which is inthe-money at expiration. Once an exercise instruction is given by a CM to
NSCCL, it cannot ordinarily be revoked. Exercise notices given by a buyer at
anytime on a day are processed by NSCCL after the close of trading hours on
that day. All exercise notices received by NSCCL from the NEAT F&O system
are processed to determine their validity. Some basic validation checks are
carried out to check the open buy position of the exercising client/TM and if
option contract is in-the-money. Once exercised contracts are found valid,
they are assigned.
Assignment process
The exercise notices are assigned in standardized market lots to short
positions in the option contract with the same series (i.e. same underlying,
expiry date and strike price) at the client level. Assignment to the short
positions is done on a random basis. NSCCL determines short positions, which
are eligible to be assigned and then allocates the exercised positions to any
one or more short positions. Assignments are made at the end of the trading
day on which exercise instruction is received by NSCCL and notified to the
members on the same day. It is possible that an option seller may not receive
notification from its TM that an exercise has been assigned to him until the
next day following the date of the assignment to the CM by NSCCL.
95

Exercise settlement computation

In case of index option contracts, all open long positions at in-the-money strike
prices are automatically exercised on the expiration day and assigned to short
positions in option contracts with the same series on a random basis. For options
on securities, where exercise settlement may be interim or final, interim exercise
for an open long in-the-money option position can be effected on any day till the
expiry of the contract. Final exercise is automatically effected by NSCCL for all
open long in-the-money positions in the expiring month option contract, on the
expiry day of the option contract. The exercise settlement price is the closing price
of the underlying (index or security) on the exercise day (for interim exercise) or
the expiry day of the relevant option contract (final exercise). The exercise
settlement value is the difference between the strike price and the final settlement
price of the relevant option contract. For call options, the exercise settlement
value receivable by a buyer is the difference between the final settlement price and
the strike price for each unit of the underlying conveyed by the option contract,
while for put options it is difference between the strike price and the final
settlement price for each unit of the underlying conveyed by the option contract.
Settlement of exercises of options on securities is currently by payment in cash
and not by delivery of securities. It takes place for in-the-money option
contracts.
The exercise settlement value for each unit of the exercised contract is
computed as follows:
Call options = Closing price of the security on the day of exercise Strike price
Put options = Strike price Closing price of the security on the day of exercise
For final exercise the closing price of the underlying security is taken on the
expiration day. The exercise settlement value is debited / credited to the relevant
CMs clearing bank account on T + 1 day (T = exercise date).
Special facility for settlement of institutional deals
NSCCL provides a special facility to Institutions/Foreign Institutional Investors
(FIIs)/Mutual Funds etc. to execute trades through any TM, which may be cleared
and settled by their own CM. Such entities are called custodial participants (CPs). To
avail of this facility, a CP is required to register with NSCCL through his CM. A
unique CP code is allotted to the CP by NSCCL. All trades executed by a CP
through any TM are required to have the CP code in the relevant field on the
trading system at the time of order entry. Such trades executed on behalf of a CP
are confirmed by their own CM (and not the CM of the TM through whom the order
is entered), within the time specified by NSE on the trade day though the on-line
confirmation facility. Till such time the trade is confirmed by CM of concerned CP,
the same is considered as a trade of the TM and the responsibility of settlement
96

of such trade vests with CM of the TM. Once confirmed by CM of concerned CP,
such CM is responsible for clearing and settlement of deals of such custodial clients.
FIIs have been permitted to trade in all the exchange traded derivative contracts
subject to compliance of the position limits prescribed for them and their subaccounts, and compliance with the prescribed procedure for settlement and
reporting. A FII/a sub-account of the FII, as the case may be, intending to
trade in the F&O segment of the exchange, is required to obtain a unique
Custodial Participant (CP) code allotted from the NSCCL. FII/sub-accounts of
FIIs which have been allotted a unique CP code by NSCCL are only permitted
to trade on the F&O segment. The FD/sub-account of FII ensures that all
orders placed by them on the Exchange carry the relevant CP code allotted by
NSCCL.

ADJUSTMENTS FOR CORPORATE ACTIONS

The basis for any adjustment for corporate actions is such that the value of
the position of the market participants, on the cum and ex-dates for the
corporate action, continues to remain the same as far as possible. This
facilitates in retaining the relative status of positions, namely in-the-money,
at-the-money and out-of-money. This also addresses issues related to exercise and
assignments.
Corporate actions can be broadly classified under stock benefits and cash
benefits. The various stock benefits declared by the issuer of capital are
bonus, rights, merger/de-merger, amalgamation, splits, consolidations, hiveoff, warrants and secured premium notes (SPNs) among others. The cash
benefit declared by the issuer of capital is cash dividend.
Any adjustment for corporate actions is carried out on the last day on which a
security is traded on a cum basis in the underlying equities market, after the
close of trading hours. Adjustments may entail modifications to positions and/or
contract specifications as listed below, such that the basic premise of adjustment
laid down above is satisfied:
1. Strike price
2. Position
3. Market lot/multiplier
The adjustments are carried out on any or all of the above, based on the nature of the
corporate action. The adjustments for corporate actions are carried out on all
open, exercised as well as assigned positions.

97

RISK MANAGEMENT
NSCCL has developed a comprehensive risk containment mechanism for the
F&O segment. The salient features of risk containment mechanism on the
F&O segment are:
1. The financial soundness of the members is the key to risk
management. Therefore, the requirements for membership in terms of
capital adequacy (net worth, security deposits) are quite stringent.
2. NSCCL charges an upfront initial margin for all the open positions of a CM.
It specifies the initial margin requirements for each futures/options contract
on a daily basis. It also follows value-at-risk (VaR) based margining
through SPAN. The CM in turn collects the initial margin from the TMs
and their respective clients.
3. The open positions of the members are marked to market based on
contract settlement price for each contract. The difference is settled in
cash on a T+1 basis.
4. NSCCL's on-line position monitoring system monitors a CM's open positions
on a real-time basis. Limits are set for each CM based on his capital
deposits. The on-line position monitoring system generates alerts whenever
a CM reaches a position limit set up by NSCCL. NSCCL monitors the CMs
for MTM value violation, while TMs are monitored for contract-wise
position limit violation.
5. CMs are provided a trading terminal for the purpose of monitoring the
open positions of all the TMs clearing and settling through him. A CM may
set exposure limits for a TM clearing and settling through him. NSCCL
assists the CM to monitor the intra-day exposure limits set up by a CM and
whenever a TM exceed the limits, it stops that particular TM from further
trading.
6. A member is alerted of his position to enable him to adjust his exposure or
bring in additional capital. Position violations result in withdrawal of trading
facility for all TMs of a CM in case of a violation by the CM.
7. A separate settlement guarantee fund for this segment has been created out
of the capital of members.
The most critical component of risk containment mechanism for F&O segment
is the margining system and on-line position monitoring. The actual position
monitoring and margining is carried out on-line through Parallel Risk
Management System (PRISM). PRISM uses SPAN(r) (Standard Portfolio
Analysis of Risk) system for the purpose of computation of on-line margins,
98

based on the parameters defined by SEBI.

NSCCL-SPAN
The objective of NSCCL-SPAN is to identify overall risk in a portfolio of all futures
and options contracts for each member. The system treats futures and options
contracts uniformly, while at the same time recognizing the unique exposures
associated with options portfolios, like extremely deep out-of-the-money short
positions and inter-month risk. Its over-riding objective is to determine the
largest loss that a portfolio might reasonably be expected to suffer from one
day to the next day based on 99% VaR methodology. SPAN considers uniqueness
of option portfolios. The following factors affect the value of an option:
1. Underlying market price
2. Strike price
3. Volatility (variability) of underlying instrument
4. Time to expiration
5. Interest rate
As these factors change, the value of options maintained within a portfolio also
changes. Thus, SPAN constructs scenarios of probable changes in underlying
prices and volatilities in order to identify the largest loss a portfolio might suffer
from one day to the next. It then sets the margin requirement to cover this
one-day loss. The complex calculations (e.g. the pricing of options) in SPAN are
executed by NSCCL. The results of these calculations are called risk arrays. Risk
arrays, and other necessary data inputs for margin calculation are provided to
members daily in a file called the SPAN risk parameter file. Members can apply
the data contained in the risk parameter files, to their specific portfolios of futures
and options contracts, to determine their SPAN margin requirements. Hence,
members need not execute complex option pricing calculations, which is
performed by NSCCL. SPAN has the ability to estimate risk for combined futures
and options portfolios, and also re-value the same under various scenarios of
changing market conditions.

Types of margins
The margining system for F&O segment is explained below:

Initial margin: Margin in the F&O segment is computed by NSCCL upto

client level for open positions of CMs/TMs. These are required to be
paid up-front on gross basis at individual client level for client positions
and on net basis for proprietary positions. NSCCL collects initial margin
99

for all the open positions of a CM based on the margins computed by

NSE-SPAN. A CM is required to ensure collection of adequate initial
margin from his TMs up-front. The TM is required to collect adequate
initial margins up-front from his clients.

Premium margin: In addition to initial margin, premium margin is

charged at client level. This margin is required to be paid by a buyer of
an option till the premium settlement is complete.

Assignment margin for options on securities: Assignment margin is

levied in addition to initial margin and premium margin. It is required
to be paid on assigned positions of CMs towards interim and final
exercise settlement obligations for option contracts on individual
securities, till such obligations are fulfilled. The margin is charged on
the net exercise settlement value payable by a CM towards interim and
final exercise settlement.

Client margins: NSCCL intimates all members of the margin liability of

each of their client. Additionally members are also required to report
details of margins collected from clients to NSCCL, which holds in trust
client margin monies to the extent reported by the member as having
been collected form their respective clients.

MARGINING SYSTEM
Derivatives enable traders to take on leveraged positions. This can be very
risky because a small movement in prices of underlying could result in either
big gains or big losses. Hence the margining system for derivatives becomes
an important aspect of market functioning and determines the integrity of this
market. In this chapter we look at some margining concepts and the
methodology used for computing margins.
NSCCL has developed a comprehensive risk containment mechanism for the
Futures & Options segment. The most critical component of a risk containment
mechanism is the online position monitoring and margining system. The
actual margining and position monitoring is done on-line, on an intra-day
basis using PRISM (Parallel Risk Management System) which is the real-time
position monitoring and risk management system. The risk of each trading and
clearing member is monitored on a real-time basis and alerts/disablement
messages are generated if the member crosses the set limits. NSCCL uses the
SPAN (Standard Portfolio Analysis of Risk) system, a portfolio based margining
system, for the purpose of calculating initial margins.

100

SPAN approach of computing initial margins

The objective of SPAN is to identify overall risk in a portfolio of futures and
options contracts for each member. The system treats futures and options
contracts uniformly, while at the same time recognizing the unique exposures
associated with options portfolios like extremely deep out-of-the-money short
positions, inter-month risk and inter-commodity risk.
Because SPAN is used to determine performance bond requirements (margin
requirements), its overriding objective is to determine the largest loss that a
portfolio might reasonably be expected to suffer from one day to the next
day.
In standard pricing models, three factors most directly affect the value of an
option at a given point in time:
1. Underlying market price
2. Volatility (variability) of underlying instrument
3. Time to expiration
As these factors change, so too will the value of futures and options
maintained within a portfolio. SPAN constructs sixteen scenarios of probable
changes in underlying prices and volatilities in order to identify the largest loss
a portfolio might suffer from one day to the next. It then sets the margin
requirement at a level sufficient to cover this one-day loss.
The computation of worst scenario loss has two components. The first is the
valuation of each contract under sixteen scenarios. The second is the
application of these scenario contract values to the actual positions in a
portfolio to compute the portfolio values and the worst scenario loss. The
scenario contract values are updated at least 5 times in the day, which may be
carried out by taking prices at the start of trading, at 11:00 a.m., at 12:30
p.m., at 2:00 p.m., and at the end of the trading session.

Mechanics of SPAN
The complex calculations (e.g. the pricing of options) in SPAN are executed by
NSCCL. The results of these calculations are called risk arrays. Risk arrays,
and other necessary data inputs for margin calculation are then provided to
members on a daily basis in a file called the SPAN Risk Parameter file. Members
can apply the data contained in the risk parameter files, to their specific
portfolios of futures and options contracts, to determine their SPAN margin
101

requirements. Hence members do not need to execute complex option pricing

calculations. SPAN has the ability to estimate risk for combined futures and
options portfolios, and re-value the same under various scenarios of changing
market conditions.
Risk arrays
The SPAN risk array represents how a specific derivative instrument (for
example, an option on NIFTY index at a specific strike price) will gain or lose
value, from the current point in time to a specific point in time in the near
future, for a specific set of market conditions which may occur over this time
duration.
The results of the calculation for each risk scenario i.e. the amount by which
the futures and options contracts will gain or lose value over the look-ahead
time under that risk scenario - is called the risk array value for that scenario.
The set of risk array values for each futures and options contract under the
full set of risk scenarios, constitutes the risk array for that contract.
In the risk array, losses are represented as positive values, and gains as
negative values. Risk array values are represented in Indian Rupees, the
currency in which the futures or options contract is denominated.
Risk scenarios
The specific set of market conditions evaluated by SPAN, are called the risk
scenarios, and these are denned in terms of:
1.

How much the price of the underlying instrument is expected to change

over one trading day, and

2.

How much the volatility of that underlying price is expected to change over
one trading day.

SPAN further uses a standardized definition of the risk scenarios, defined in

terms of:
1.

The underlying price scan range or probable price change over a one day
period, and

2.

The underlying price volatility scan range or probable volatility change of the
underlying over a one day period.

Table 5.7 gives the sixteen risk scenarios. +1 refers to increase in volatility
and -1 refers to decrease in volatility.
102

Table 5.7 Worst scenario loss

Risk scenario
Price move in Volatility move in Fraction of loss
number multiples of price
multiples of
considered (%)
scan range volatility range
1

+1

100

2
3
4
5
6
7
8
9
10
11
12
13
14
15
16

0
+1/3
+1/3
-1/3
-1/3
+2/3
+2/3
-2/3
-2/3
+1
+1
-1
-1
+2
-2

-1
+1
-1
+1
-1
+1
-1
+1
-1
+1
-1
+1
-1
0
0

100
100
100
100
100
100
100
100
100
100
100
100
100
35
35

Method of computation of volatility

The exponential moving average method is used to obtain the volatility
estimate every day. The estimate at the end of day t, t is estimated using the
previous day's volatility estimate t-1 (as at the end of day t-1), and the return
rt observed in the futures market on day t.

where

is a parameter which determines how rapidly volatility estimates

change. A value of 0.94 is used for

SPAN uses the risk arrays to scan probable underlying market price changes
and probable volatility changes for all contracts in a portfolio, in order to
determine value gains and losses at the portfolio level. This is the single most
important calculation executed by the system.
Scanning risk charge
As shown in the table giving the sixteen standard risk scenarios, SPAN starts
at the last underlying market settlement price and scans up and down three
even intervals of price changes (price scan range). At each price scan point,
103

the program also scans up and down a range of probable volatility from the
underlying market's current volatility (volatility scan range). SPAN calculates
the probable premium value at each price scan point for volatility up and
volatility down scenario. It then compares this probable premium value to the
theoretical premium value (based on last closing value of the underlying) to
determine profit or loss.
Deep-out-of-the-money short options positions pose a special risk identification
problem. As they move towards expiration, they may not be significantly
exposed to "normal" price moves in the underlying. However, unusually large
underlying price changes may cause these options to move into-the-money,
thus creating large losses to the holders of short option positions. In order to
account for this possibility, two of the standard risk scenarios in the risk array,
Number 15 and 16, reflect an "extreme" underlying price movement, currently
denned as double the maximum price scan range for a given underlying.
However, because price changes of these magnitudes are rare, the system
only covers 35% of the resulting losses.
After SPAN has scanned the 16 different scenarios of underlying market price
and volatility changes, it selects the largest loss from among these 16
observations. This "largest reasonable loss" is the scanning risk charge for the
portfolio.
Calendar spread margin
A calendar spread is a position in an underlying with one maturity which is
hedged by an offsetting position in the same underlying with a different
maturity: for example, a short position in a July futures contract on Reliance
and a long position in the August futures contract on Reliance is a calendar
spread. Calendar spreads attract lower margins because they are not exposed
to market risk of the underlying. If the underlying rises, the July contract would
make a profit while the August contract would make a loss.
As SPAN scans futures prices within a single underlying instrument, it assumes
that price moves correlate perfectly across contract months. Since price moves
across contract months do not generally exhibit perfect correlation, SPAN adds
an calendar spread charge (also called the inter-month spread charge) to the
scanning risk charge associated with each futures and options contract. To put
it in a different way, the calendar spread charge covers the calendar basis risk
that may exist for portfolios containing futures and options with different
expirations.
For each futures and options contract, SPAN identifies the delta associated each
futures and option position, for a contract month. It then forms spreads using
these deltas across contract months. For each spread formed, SPAN assesses
a specific charge per spread which constitutes the calendar spread charge.
The margin for calendar spread is calculated on the basis of delta of the
104

portfolio in each month. Thus a portfolio consisting of a near month option

with a delta of 100 and a far month option with a delta of 100 would bear a
spread charge equivalent to the calendar spread charge for a portfolio which is
long 100 near month futures contract and short 100 far month futures
contract. A calendar spread position on Exchange traded equity derivatives may
be granted calendar spread treatment till the expiry of the near month
contract.
Margin on calendar spreads is levied at 0.5% per month of spread on the far
month contract of the spread subject to a minimum margin of 1% and a
maximum margin of 3% on the far month contract of the spread.
Short option minimum margin
Short options positions in extremely deep-out-of-the-money strikes may
appear to have little or no risk across the entire scanning range. However, in
the event that underlying market conditions change sufficiently, these options
may move into-the-money, thereby generating large losses for the short
positions in these options. To cover the risks associated with deep-out-of-themoney short options positions, SPAN assesses a minimum margin for each
short option position in the portfolio called the short option minimum charge,
which is set by the NSCCL. The short option minimum charge serves as a
minimum charge towards margin requirements for each short position in an
option contract.
For example, suppose that the short option minimum charge is Rs.50 per short
position. A portfolio containing 20 short options will have a margin
requirement of at least Rs. 1,000, even if the scanning risk charge plus the
calendar spread charge on the position is only Rs. 500.
The short option minimum margin equal to 3% of the notional value of all
short index options is charged if sum of the worst scenario loss and the
calendar spread margin is lower than the short option minimum margin. For
stock options it is equal to 7.5% of the notional value based on the previous
days closing value of the underlying stock. Notional value of option positions is
calculated on the short option positions by applying the last closing price of
the relevant underlying.
Net option value
The net option value is calculated as the current market value of the option
times the number of option units (positive for long options and negative for
short options) in the portfolio.
Net option value is added to the liquid net worth of the clearing member.
This means that the current market value of short options are deducted
from the liquid net worth and the market value of long options are added
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thereto. Thus mark to market gains and losses on option positions get
adjusted against the available liquid net worth.
Net buy premium
To cover the one day risk on long option positions (for which premium shall
be payable on T+1 day), net buy premium to the extent of the net long
options position value is deducted from the Liquid Networth of the
member on a real time basis. This would be applicable only for trades
done on a given day. The net buy premium margin shall be released
towards the Liquid Networth of the member on T+1 day after the
completion of pay-in towards premium settlement.

Overall portfolio margin requirement

The total margin requirements for a member for a portfolio of futures and
options contract would be computed by SPAN as follows:
1.

Adds up the scanning risk charges and the calendar spread

charges.

2.

Compares this figure to the short option minimum charge and

selects the larger of the two. This is the SPAN risk requirement.

3.

Total SPAN margin requirement is equal to SPAN risk requirement

less the net option value, which is mark to market value of
difference in long option positions and short option positions.

4.

Initial margin requirement = Total SPAN margin requirement +

Net Buy Premium.

Forms of collaterals acceptable at NSCCL

Members and dealer authorized dealer have to fulfill certain requirements and
provide collateral deposits to become members of the F&O segment. All
collateral deposits are segregated into cash component and non-cash
component. Cash component means cash, bank guarantee, fixed deposit
receipts, T-bills and dated government securities. Non-cash component mean
all other forms of collateral deposits like deposit of approved demat securities.

Requirements to become F&O segment member

The eligibility criteria for membership on the F&O segment is as given in Table
5.1. Table 5.2 gives the requirements for professional clearing membership.
Anybody interested in taking membership of F&O segment is required to take
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membership of CM and F&O segment or CM, WDM and F&O segment. An

existing member of CM segment can also take membership of F&O segment. A
trading member can also be a clearing member by meeting additional
requirements. There can also be only clearing members.
Table 5.1 Eligibility criteria for membership on F&O segment
Particulars

CM and F&O segment

CM, WDM and F&O

segment

100

200

125

275

25

25

(all values in Rs. Lakh)

Net worth

Interest free security deposit

(IFSD) 2
Collateral security deposit
(CSD) 3
Annual subscription
1:

No additional networth is required for self clearing members. However, a networth of

Rs. 300 Lakh is required for TM-CM and PCM.

2 & 3: Additional Rs. 25 Lakh is required for clearing memberships (SCM, TM-CM). In
addition, the clearing member is required to bring in IFSD of Rs. 2 Lakh and CSD of
Rs. 8 Lakh per trading member he undertakes to clear and settle.
Table 5.2 Requirements for professional clearing membership
Particulars

F&O segment

CM & F&O segment

(all values in Rs. Lakh)

Eligibility

Networth

Trading members of
NSE/SEBI registered
custodians/recognized
banks

Trading members of NSE/SEBI

registered
custodians/recognized banks

300

300

Interest free security

deposit (IFSD)

25

34

Collateral security deposit

25

50

Annual subscription

NIL

2.5

Note: The PCM is required to bring in IFSD of Rs. 2 Lakh and CSD of Rs. 8 Lakh per trading
member whose trades he undertakes to clear and settle in the F&O segment.

Requirements to become authorized / approved user

Trading members and participants are entitled to appoint, with the approval of
the F&O segment of the exchange authorized persons and approved users to
operate the trading workstation(s). These authorized users can be individuals,
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registered partnership firms or corporate bodies.

Authorized persons cannot collect any commission or any amount directly
from the clients he introduces to the trading member who appointed him.
However he can receive a commission or any such amount from the trading
member who appointed him as provided under regulation.
Approved users on the F&O segment have to pass a certification program
which has been approved by SEBI. Each approved user is given a unique
identification number through which he will have access to the NEAT system.
The approved user can access the NEAT system through a password and can
change such password from time to time.

Position limits
Position limits have been specified by SEBI at trading member, client, market
and FII levels respectively.
Trading member position limits
Trading member position limits are specified as given below:
1. Trading member position limits in equity index option contracts: The
trading member position limits in equity index option contracts is higher
of Rs.500 crore or 15% of the total open interest in the market in
equity index option contracts. This limit is applicable on open positions
in all option contracts on a particular underlying index.
2. Trading member position limits in equity index futures contracts: The
trading member position limits in equity index futures contracts is higher
of Rs.500 crore or 15% of the total open interest in the market in
equity index futures contracts. This limit is applicable on open
positions in all futures contracts on a particular underlying index.
3. Trading member position limits for combined futures and options
position:

For stocks having applicable market-wise position limit(MWPL) of

Rs.500 crores or more, the combined futures and options
position limit is 20% of applicable MWPL or Rs.300 crores,
whichever is lower and within which stock futures position cannot
exceed 10% of applicable MWPL or Rs.150 crores, whichever is
lower.

For stocks having applicable market-wise position limit (MWPL)

less than Rs.500 crores, the combined futures and options
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position limit is 20% of applicable MWPL and futures position

cannot exceed 20% of applicable MWPL or Rs.50 crore which
ever is lower. The Clearing Corporation shall specify the trading
member-wise position limits on the last trading day month
which shall be reckoned for the purpose during the next month.
Client level position limits
The gross open position for each client, across all the derivative contracts on
an underlying, should not exceed 1% of the free float market capitalization (in
terms of number of shares) or 5% of the open interest in all derivative
contracts in the same underlying stock (in terms of number of shares)
whichever is higher.
Market wide position limits
The market wide limit of open position (in terms of the number of underlying
stock) on futures and option contracts on a particular underlying stock is 20%
of the number of shares held by non-promoters in the relevant underlying
security i.e. freefloat holding. This limit is applicable on all open positions in
all futures and option contracts on a particular underlying stock. The
enforcement of the market wide limits is done in the following manner:

At end of the day the exchange tests whether the market wide open
interest for any scrip exceeds 95% of the market wide position limit for
that scrip. In case it does so, the exchange takes note of open position
of all client/TMs as at end of that day for that scrip and from next day
onwards they can trade only to decrease their positions through
offsetting positions.

At the end of each day during which the ban on fresh positions is in force
for any scrip, the exchange tests whether any member or client has
increased his existing positions or has created a new position in that
scrip. If so, that client is subject to a penalty equal to a specified
percentage (or basis points) of the increase in the position (in terms of
notional value). The penalty is recovered before trading begins next day.
The exchange specifies the percentage or basis points, which is set high
enough to deter violations of the ban on increasing positions.

The normal trading in the scrip is resumed after the open outstanding
position comes down to 80% or below of the market wide position
limit. Further, the exchange also checks on a monthly basis, whether a
stock has remained subject to the ban on new position for a significant
part of the month consistently for three months. If so, then the
exchange phases out derivative contracts on that underlying.
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FII and subaccount position limits

FII and subaccount position limits are specified as given below:
1.

The FII position limit in all index options contracts on a particular

underlying index is Rs. 500 crore or 15% of the total open interest of
the market in index options, whichever is higher, per exchange. This
limit is applicable on open positions in all option contracts on a particular
underlying index.

2. FII position limit in all index futures contracts on a particular

underlying index is the same as mentioned above for FII position limits
in index option contracts. This limit is applicable on open positions in
all futures contracts on a particular underlying index.
In addition to the above, FIIs can take exposure in equity index derivatives
subject to the following limits:
1. Short positions in index derivatives (short futures, short calls and long
puts) not exceeding (in notional value) the FIIs holding of stocks.
2. Long positions in index derivatives (long futures, long calls and short
puts) not exceeding (in notional value) the FIIs holding of cash,
government securities, T-bills and similar instruments.
The FIIs should report to the clearing member (custodian) the extent of the
FIIs holding of stocks, cash, government securities, T-bills and similar
instruments before the end of the day. The clearing member (custodian) in
turn should report the same to the exchange. The exchange monitors the FII
position limits. The position limit for sub-account is same as that of client level
position limits.
Position limits for mutual funds
Mutual Funds are allowed to participate in the derivatives market at par with
Foreign Institutional Investors (FII). Accordingly, mutual funds shall be
treated at par with a registered FII in respect of position limits in index
futures, index options, stock options and stock futures contracts. Mutual funds
will be considered as trading members like registered FIIs and the schemes of
mutual funds will be treated as clients like sub-accounts of FIIs.
The position limits for Mutual Funds and its schemes shall be as under:
1.

Position limit for mutual funds in index options contracts:

a) The mutual fund position limit in all index options contracts on a
particular underlying index shall be Rs.500 crore or 15% of the total
open interest of the market in index options, whichever is higher, per
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stock exchange.
b) This limit would be applicable on open positions in all options
contracts on a particular underlying index.
2.

Position limit for mutual funds in index futures contracts:

a) The mutual fund position limit in all index futures contracts on a
particular underlying index shall be Rs.500 crore or 15% of the
total open interest of the market in index futures, whichever is
higher, per stock exchange.
b) This limit would be applicable on open positions in all futures
contracts on a particular underlying index.

3.

Additional position limit for hedging: In addition to the position limits

above, mutual funds may take exposure in equity index derivatives
subject to the following limits:
a) Short positions in index derivatives (short futures, short calls and
long puts) shall not exceed (in notional value) the mutual Funds
holding of stocks.
b) Long positions in index derivatives (long futures, long calls and
short puts) shall not exceed (in notional value) the mutual Funds
holding of cash, government securities, TBills and similar
instruments.

4.

Foreign Institutional Investors and Mutual Fund Position limits on

individual securities:
a) For stocks having applicable market-wide position limit (MWPL)
of Rs. 500 crores or more, the combined futures and options
position limit shall be 20% of applicable MWPL or Rs. 300
crores, whichever is lower and within which stock futures
position cannot exceed 10% of applicable MWPL or Rs. 150
crores, whichever is lower.
b) For stocks having applicable market-wide position limit (MWPL)
less than Rs. 500 crores, the combined futures and options
position limit shall be 20% of applicable MWPL and stock
futures position cannot exceed 20% of applicable MWPL or Rs.
50 crores, whichever is lower.

5.

Position limit for each scheme of a mutual fund: The position limits for
each scheme of mutual fund and disclosure requirements shall be
identical to that prescribed for a subaccount of a FII. Therefore, the
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schemewise position limit/disclosure requirements shall be as follows:

a) For stock option and stock futures contracts, the gross open
position across all derivative contracts on a particular underlying
stock of a scheme of a mutual fund shall not exceed the higher
of 1% of the free float market capitalisation (number of shares)
or 5% of open interest (number of contracts) in derivative
contracts on a particular underlying stock.
b) This position limits shall be applicable on the combined position
in all derivative contracts on an underlying stock at a stock
exchange.
c) For index based contracts, mutual funds shall disclose the total
open interest held by its scheme or all schemes put together in
a particular underlying index, if such open interest equals to or
exceeds 15% of the open interest of all derivative contracts on
that underlying index.

Reporting of client margin

Clearing Members (CMs) and Trading Members (TMs) are required to collect
upfront initial margins from all their Trading Members/ Constituents.
CMs are required to compulsorily report, on a daily basis, details in respect of
such margin amount due and collected, from the TMs/ Constituents clearing
and settling through them, with respect to the trades executed/ open
positions of the TMs/ Constituents, which the CMs have paid to NSCCL, for the
purpose of meeting margin requirements.
Similarly, TMs are required to report on a daily basis details in respect of such
margin amount due and collected from the constituents clearing and settling
through them, with respect to the trades executed/ open positions of the
constituents, which the trading members have paid to the CMs, and on which
the CMs have allowed initial margin limit to the TMs.

ADJUSTMENTS FOR CORPORATE ACTIONS

Adjustments for corporate actions for stock options would be as follows:

The basis for any adjustment for corporate action shall be such that the
value of the position of the market participants on cum and ex-date for
corporate action shall continue to remain the same as far as possible.
This will facilitate in retaining the relative status of positions namely inthe-money, at-the-money and out-of-money. This will also address
112

issues related to exercise and assignments.

Adjustment for corporate actions shall be carried out on the last day on
which a security is traded on a cum basis in the underlying cash
market.

Adjustments shall mean modifications to positions and/or contract

specifications namely strike price, position, market lot, multiplier. These
adjustments shall be carried out on all open, exercised as well as
assigned positions.

The corporate actions may be broadly classified under stock benefits and
cash benefits. The various stock benefits declared by the issuer of
capital are bonus, rights, merger/demerger, amalgamation, splits,
consolidations, hiveoff, warrants and secured premium notes and
dividends.

The methodology for adjustment of corporate actions such as bonus,

stock splits and consolidations is as follows:

Strike price: The new strike price shall be arrived at by dividing

the old strike price by the adjustment factor as under.

Market lot/multiplier: The new market lot/multiplier shall be

arrived at by multiplying the old market lot by the adjustment
factor as under.
Position: The new position shall be arrived at by multiplying the
old position by the adjustment factor, which will be computed
using the pre-specified methodology.

The adjustment factor for bonus, stock splits and consolidations is arrived at as
follows:

Bonus: Ratio - A:B; Adjustment factor: (A+B)/B

Stock splits and consolidations: Ratio - A:B ; Adjustment factor:

B/A

Right: Ratio - A:B

*
*
*
*

Premium: C
Face value: D
Existing strike price: X
New strike price: ((B * X) + A * (C + D))/(A+B)

Existing market lot / multiplier/ position: Y ; New issue size : Y *

(A+B)/B
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The above methodology may result in fractions due to the corporate

action e.g. a bonus ratio of 3:7. With a view to minimizing fraction
settlements, the following methodology is proposed to be adopted:
1. Compute value of the position before adjustment.
2. Compute value of the position taking into account the exact
adjustment factor.
3. Carry out rounding off for the Strike Price and Market Lot.
4. Compute value of the position based on the revised strike price and
market lot.
The difference between 1 and 4 above, if any, shall be decided in the
manner laid down by the group by adjusting strike price or market lot,
so that no forced closure of open position is mandated.

Dividends which are below 10% of the market value of the underlying
stock, would be deemed to be ordinary dividends and no adjustment in
the strike price would be made for ordinary dividends. For extra-ordinary
dividends, above 10% of the market value of the underlying stock, the
strike price would be adjusted.

The exchange will on a case to case basis carry out adjustments for other
corporate actions as decided by the group in conformity with the above
guidelines.

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CHAPTER 6
ACCOUNTING FOR DERIVATIVES
Accounting for futures
The Institute of Chartered Accountants of India (ICAI) has issued guidance
notes on accounting of index futures contracts from the view point of parties
who enter into such futures contracts as buyers or sellers. For other parties
involved in the trading process, like brokers, trading members, clearing
members and clearing corporations, a trade in equity index futures is similar
to a trade in, say shares, and does not pose any peculiar accounting
problems. Hence in this section we shall largely focus on the accounting
treatment of equity index futures in the books of the client. But before we do
so, a quick re-look at some of the terms used.
1. Clearing corporation/house: Clearing corporation/house means the
clearing corporation/house approved by SEBI for clearing and
settlement of trades on the derivatives exchange/segment. All the
clearing and settlement for trades that happen on the NSEs market is
done through NSCCL.
2. Clearing member: Clearing member means a member of the clearing
corporation and includes all categories of clearing members as may be
admitted as such by the clearing corporation to the derivatives
segment.
3. Client: A client means a person, on whose instructions and, on whose
account, the trading member enters into any contract for the purchase
or sale of any contract or does any act in relation thereto.
4. Contract month: Contract month means the month in which the
exchange/clearing corporation rules require a contract to be finally
settled.
5. Daily settlement price: Daily settlement price is the closing price of the
equity index futures contract for the day or such other price as may be
decided by the clearing house from time to time.
6. Derivative exchange/segment: Derivative exchange means an
exchange approved by SEBI as a derivative exchange. Derivative
segment means segment of an existing exchange approved by SEBI as
derivatives segment.
7. Final settlement price: The final settlement price is the closing price of
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the equity index futures contract on the last trading day of the contract
or such other price as may be specified by the clearing corporation, from
time to time.
8. Long position: Long position in an equity index futures contract means
outstanding purchase obligations in respect of the equity index futures
contract at any point of time.
9. Open position: Open position means the total number of equity index
futures contracts that have not yet been offset and closed by an
opposite position.
10. Settlement date: Settlement date means the date on which the
settlement of outstanding obligations in an equity index futures
contract are required to be settled as provided in the Bye-Laws of the
Derivatives exchange/segment.
11. Short position: Short position in an equity index futures contract means
outstanding sell obligations in respect of an equity index futures
contract at any point of time.
12. Trading member: Trading member means a Member of the Derivatives
exchange/segment and registered with SEBI.
Accounting at the inception of a contract
Every client is required to pay to the trading member/clearing member, the
initial margin determined by the clearing corporation as per the byelaws/regulations of the exchange for entering into equity index futures
contracts. Such initial margin paid/payable should be debited to Initial
margin - Equity index futures account. Additional margins, if any, should also
be accounted for in the same manner. It may be mentioned that at the time
when the contract is entered into for purchase/sale of equity index futures, no
entry is passed for recording the contract because no payment is made at
that time except for the initial margin. At the balance sheet date, the balance
in the Initial margin - Equity index futures account should be shown
separately under the head current assets. In those cases where any amount
has been paid in excess of the initial/additional margin, the excess should be
disclosed separately as a deposit under the head current assets. In cases
where instead of paying initial margin in cash, the client provides bank
guarantees or lodges securities with the member, a disclosure should be made
in the notes to the financial statements of the client.
Accounting at the time of daily settlement
This involves the accounting of payment/receipt of mark-to-market margin
money. Payments made or received on account of daily settlement by the
116

client would be credited/debited to the bank account and the corresponding

debit or credit for the same should be made to an account titled as Mark-tomarket margin - Equity index futures account.
Sometimes the client may deposit a lump sum amount with the
broker/trading member in respect of mark-to-market margin money instead
of receiving/paying mark-to-market margin money on daily basis. The amount
so paid is in the nature of a deposit and should be debited to an appropriate
account, say, Deposit for mark-to-market margin account. The amount of
mark-to-market margin received/paid from such account should be
credited/debited to Mark-to-market margin - Equity index futures account
with a corresponding debit/credit to Deposit for mark-to-market margin
account. At the year-end, any balance in the Deposit for mark-to-market
margin account should be shown as a deposit under the head current
assets.
Accounting for open positions
Position left open on the balance sheet date must be accounted for.
Debit/credit balance in the mark-to-market margin - Equity index futures
account, maintained on global basis, represents the net amount
paid/received on the basis of movement in the prices of index futures till the
balance sheet date. Keeping in view prudence as a consideration for
preparation of financial statements, provision for anticipated loss, which may
be equivalent to the net payment made to the broker (represented by the
debit balance in the mark-to-market margin - Equity index futures account)
should be created by debiting the profit and loss account. Net amount received
(represented by credit balance in the mark-to-market margin - Equity index
futures account) being anticipated profit should be ignored and no credit for
the same should be taken in the profit and loss account. The debit balance in
the said mark-to-market margin - Equity index futures account, i.e., net
payment made to the broker, may be shown under the head current assets,
loans and advances in the balance sheet and the provision created thereagainst should be shown as a deduction therefrom. On the other hand, the
credit balance in the said account, i.e., the net amount received from the
broker, should be shown as a current liability under the head current
liabilities and provisions in the balance sheet.
Accounting at the time of final settlement
This involves accounting at the time of final settlement or squaring-up of the
contract. At the expiry of a series of equity index futures, the profit/loss, on
final settlement of the contracts in the series, should be calculated as the
difference between final settlement price and contract prices of all the
contracts in the series. The profit/loss, so computed, should be recognized in
the profit and loss account by corresponding debit/credit to mark-to-market
margin - Equity index futures account. However, where a balance exists in
117

the provision account created for anticipated loss, any loss arising on such
settlement should be first charged to such provision account, to the extent of
the balance available in the provision account, and the balance of loss, if any,
should be charged to the profit and loss account. Same accounting treatment
should be made when a contract is squared-up by entering into a reverse
contract. It appears that, at present, it is not feasible to identify the equity
index futures contracts. Accordingly, if more than one contract in respect of the
series of equity index futures contracts to which the squared-up contract
pertains is outstanding at the time of the squaring of the contract, the
contract price of the contract so squared-up should be determined using FirstIn, First-Out (FIFO) method for calculating profit/loss on squaring-up.
On the settlement of an equity index futures contract, the initial margin paid in
respect of the contract is released which should be credited to Initial margin Equity index futures account, and a corresponding debit should be given to
the bank account or the deposit account (where the amount is not received).
Accounting in case of a default
When a client defaults in making payment in respect of a daily settlement, the
contract is closed out. The amount not paid by the Client is adjusted against
the initial margin. In the books of the Client, the amount so adjusted should
be debited to mark-to-market - Equity index futures account with a
corresponding credit to Initial margin - Equity index futures account. The
amount of initial margin on the contract, in excess of the amount adjusted
against the mark-to-market margin not paid, will be released. The accounting
treatment in this regard will be the same as explained above. In case, the
amount to be paid on daily settlement exceeds the initial margin the excess is
a liability and should be shown as such under the head current liabilities and
provisions, if it continues to exist on the balance sheet date. The amount of
profit or loss on the contract so closed out should be calculated and
recognized in the profit and loss account in the manner dealt with above.
Disclosure requirements
The amount of bank guarantee and book value as also the market value of
securities lodged should be disclosed in respect of contracts having open
positions at the year end, where initial margin money has been paid by way
of bank guarantee and/or lodging of securities.
Total number of contracts entered and gross number of units of equity index
futures traded (separately for buy/sell) should be disclosed in respect of each
series of equity index futures.
The number of equity index futures contracts having open position, number of
units of equity index futures pertaining to those contracts and the daily
settlement price as of the balance sheet date should be disclosed separately
for long and short positions, in respect of each series of equity index futures.
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Accounting for options

The Institute of Chartered Accountants of India issued guidance note on
accounting for index options and stock options from the view point of the
parties who enter into such contracts as buyers/holder or sellers/writers.
Following are the guidelines for accounting treatment in case of cash settled
index options and stock options:
Accounting at the inception of a contract
The seller/writer of the option is required to pay initial margin for entering
into the option contract. Such initial margin paid would be debited to Equity
Index Option Margin Account or to Equity Stock Option Margin Account, as the
case may be. In the balance sheet, such account should be shown separately
under the head Current Assets. The buyer/holder of the option is not
required to pay any margin. He is required to pay the premium. In his books,
such premium would be debited to Equity Index Option Premium Account or
Equity Stock Option Premium Account, as the case may be. In the books of
the seller/writer, such premium received should be credited to Equity Index
Option Premium Account or Equity Stock Option Premium Account as the case
may be.
Accounting at the time of payment/receipt of margin
Payments made or received by the seller/writer for the margin should be
credited/debited to the bank account and the corresponding debit/credit for
the same should also be made to Equity Index Option Margin Account or to
Equity Stock Option Margin Account, as the case may be. Sometimes, the
client deposit a lump sum amount with the trading/clearing member in respect
of the margin instead of paying/receiving margin on daily basis. In such case,
the amount of margin paid/received from/into such accounts should be
debited/credited to the Deposit for Margin Account. At the end of the year
the balance in this account would be shown as deposit under Current Assets.
Accounting for open positions as on balance sheet dates
The Equity Index Option Premium Account and the Equity Stock Option
Premium Account should be shown under the head Current Assets or
Current Liabilities, as the case may be.
In the books of the buyer/holder, a provision should be made for the amount
by which the premium paid for the option exceeds the premium prevailing on
the balance sheet date. The provision so created should be credited to
Provision for Loss on Equity Index Option Account to the Provision for Loss
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on Equity Stock Options Account, as the case may be. The provision made as
above should be shown as deduction from Equity Index Option Premium or
Equity Stock Option Premium which is shown under Current Assets.
In the books of the seller/writer, the provision should be made for the amount
by which premium prevailing on the balance sheet date exceeds the premium
received for that option. This provision should be credited to Provision for
Loss on Equity Index Option Account or to the Provision for Loss on Equity
Stock Option Account, as the case may be, with a corresponding debit to
profit and loss account. Equity Index Options Premium Account or Equity
Stock Options Premium Account and Provision for Loss on Equity Index
Options Account or Provision for Loss on Equity Stock Options Account
should be shown under Current Liabilities and Provisions.
In case of any opening balance in the Provision for Loss on Equity Stock
Options Account or the Provision for Loss on Equity Index Options Account, the
same should be adjusted against the provision required in the current year and
the profit and loss account be debited/credited with the balance provision
required to be made/excess provision written back.
Accounting at the time of final settlement
On exercise of the option, the buyer/holder will recognize premium as an
expense and debit the profit and loss account by crediting Equity Index
Option Premium Account or Equity Stock Option Premium Account. Apart
from the above, the buyer/holder will receive favorable difference, if any,
between the final settlement price as on the exercise/expiry date and the strike
price, which will be recognized as income. On exercise of the option, the
seller/writer will recognize premium as an income and credit the profit and loss
account by debiting Equity Index Option Premium Account or Equity Stock
Option Premium Account. Apart from the above, the seller/writer will pay the
adverse difference, if any, between the final settlement price as on the
exercise/expiry date and the strike price. Such payment will be recognized as
a loss.
As soon as an option gets exercised, margin paid towards such option would
be released by the exchange, which should be credited to Equity Index Option
Margin Account or to Equity Stock Option Margin Account, as the case may
be, and the bank account will be debited.
Accounting at the time of squaring off an option contract
The difference between the premium paid and received on the squared off
transactions should be transferred to the profit and loss account. Following are
the guidelines for accounting treatment in case of delivery settled index
options and stock options: The accounting entries at the time of inception,
payment/receipt of margin and open options at the balance sheet date will be
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the same as those in case of cash settled options. At the time of final
settlement, if an option expires un-exercised then the accounting entries will
be the same as those in case of cash settled options. If the option is exercised
then shares will be transferred in consideration for cash at the strike price. For
a call option the buyer/holder will receive equity shares for which the call
option was entered into. The buyer/holder should debit the relevant equity
shares account and credit cash/bank. For a put option, the buyer/holder will
deliver equity shares for which the put option was entered into. The
buyer/holder should credit the relevant equity shares account and debit
cash/bank. Similarly, for a call option the seller/writer will deliver equity
shares for which the call option was entered into. The seller/writer should
credit the relevant equity shares account and debit cash/bank. For a put
option the seller/writer will receive equity shares for which the put option was
entered into. The seller/writer should debit the relevant equity shares account
and credit cash/bank. In addition to this entry, the premium paid/received will
be transferred to the profit and loss account, the accounting entries for which
should be the same as those in case of cash settled options.

TAXATION OF DERIVATIVE TRANSACTION IN

SECURITIES
Taxation of Profit/Loss on derivative transaction in
securities
Prior to Financial Year 200506, transaction in derivatives were considered as
speculative transactions for the purpose of determination of tax liability under
the Income-tax Act. This is in view of section 43(5) of the Income-tax Act
which defined speculative transaction as a transaction in which a contract for
purchase or sale of any commodity, including stocks and shares, is
periodically or ultimately settled otherwise than by the actual delivery or
transfer of the commodity or scrips. However, such transactions entered into by
hedgers and stock exchange members in course of jobbing or arbitrage activity
were specifically excluded from the purview of definition of speculative
transaction.
In view of the above provisions, most of the transactions entered into in
derivatives by investors and speculators were considered as speculative
transactions. The tax provisions provided for differential treatment with
respect to set off and carry forward of loss on such transactions. Loss on
derivative transactions could be set off only against other speculative income
and the same could not be set off against any other income. This resulted in
payment of higher taxes by an assessee.
Finance Act, 2005 has amended section 43(5) so as to exclude transactions in
derivatives carried out in a recognized stock exchange for this purpose. This
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implies that income or loss on derivative transactions which are carried out in a
recognized stock exchange is not taxed as speculative income or loss. Thus,
loss on derivative transactions can be set off against any other income during
the year. In case the same cannot be set off, it can be carried forward to
subsequent assessment year and set off against any other income of the
subsequent year. Such losses can be carried forward for a period of 8
assessment years. It may also be noted that securities transaction tax paid on
such transactions is eligible as deduction under Income-tax Act, 1961.

Securities transaction tax on derivatives transactions

As per Chapter VII of the Finance (No. 2) Act, 2004, Securities Transaction
Tax (STT) is levied on all transactions of sale and/or purchase of equity shares
and units of equity oriented fund and sale of derivatives entered into in a
recognized stock exchange.
As per Finance Act 2008, the following STT rates are applicable w.e.f. 1st June,
2008 in relation to sale of a derivative, where the transaction of such sale in
entered into in a recognized stock exchange.
Sr. No.

Taxable securities transaction

Rate

Payable by

(a)

Sale of an option in securities

0.017%

Seller

(b)

Sale of an option in securities,

where option is exercised

0.125%

Purchaser

(c)

Sale of a futures in securities

0.017%

Seller

Consider an example. Mr. A. sells a futures contract of M/s. XYZ Ltd. (Lot
Size: 1000) expiring on 29-Sep-2005 for Rs. 300. The spot price of the share
is Rs. 290. The securities transaction tax thereon would be calculated as
follows:
1.

Total futures contract value = 1000 x 300 = Rs. 3,00,000

2.

Securities transaction tax payable thereon 0.017% = 3,00,000 x

0.017% = Rs. 51

Note: No tax on such a transaction is payable by the buyer of the futures

contract.

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