CHAPTER – 1

INTRODUCTION

1
1.1 INTRODUCTION

A derivative is a financial instrument, which derives its value from some other financial
price. This "other financial price" is called the underlying. For example, in the case of Nifty
futures, Nifty index is the underlying. Futures are standardized contracts between two
parties to buy or sell an asset (underlying) at a certain time in the future for ascertain price.
Futures trading provide transparency, liquidity, anonymity of trades, and also eliminate the
counter party risks due to the guarantee provided by National Securities Clearing
Corporation Limited. An option is a contract that gives the buyer the right, to buy or sell
the underlying at a stated date and at a specific price. A call option gives the right to buy
and a put option gives the right to sell. This paper aims to measure investors’ perception
towards risk, participation and derivative products in derivatives with reference to option
and future. A derivative security is a security whose value depends on the value of together
more basic underlying variable. These are also known as contingent claims. Derivatives
securities have been very successful in innovation in capital markets. 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, financial
markets are markets by a very high degree of volatility. Through the use of derivative
products, it is possible to transfer price risks partially or fully by locking – in asset prices.
As instruments of risk management these generally don’t influence the fluctuations in the
underlying asset prices. However, by locking-in asset prices, derivative products minimize
the impact of fluctuations in asset prices on the profitability and cash-flow situation of risk-
averse investor. Derivatives are risk management instruments which derives their value
from an underlying asset. Underlying asset can be Bullion, Index, Share, Currency, Bonds,
Interest, etc. The term Derivative has been defined in Securities Contracts (Regulation) Act
1956, as: 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. A
contract, which derives its value from the prices, or index of prices, of underlying
securities. The derivative of a function of a single variable at a chosen input value, when it
exists, is the slope of the tangent line to the graph of the function at that point. The tangent
line is the best linear approximation of the function near that input

2
value. For this reason, the derivative is often described as the "instantaneous rate of
change", the ratio of the instantaneous change in the dependent variable to that of the
independent variable. Derivatives may be generalized to functions of several real variables.
In this generalization, the derivative is reinterpreted as a linear transformation whose graph
is (after an appropriate translation) the best linear approximation to the graph of the original
function. The Jacobian matrix is the matrix that represents this linear transformation with
respect to the basis given by the choice of independent and dependent variables. It can be
calculated in terms of the partial derivatives with respect to the independent variables. For
a real-valued function of several variables, the Jacobian matrix reduces to the gradient
vector.

The process of finding a derivative is called differentiation. The reverse process is

called anti differentiation. The fundamental theorem of calculus relates anti differentiation
with integration. Differentiation and integration constitute the two fundamental operations
in single-variable calculus. In finance, a derivative is a contract that derives its value from
the performance of an underlying entity. This underlying entity can be an asset, index,
or interest rate, and is often simply called the "underlying". Derivatives can be used for
several purposes, including insuring against price movements (hedging), increasing
exposure to price movements for speculation or getting access to otherwise hard-to-trade
assets or markets. Some of the more common derivatives
include forwards, futures, options, swaps, and variations of these such as
synthetic collateralized debt obligations and credit default swaps. Most derivatives are
traded over-the-counter (off-exchange) or on an exchange such as the New York Stock
Exchange, while most insurance contracts have developed into a separate industry. In
the United States, after the financial crisis of 2007–2009, there has been increased pressure
to move derivatives to trade on exchanges. Derivatives are one of the three main categories
of financial instruments, the other two being stocks i.e., equities or
shares)and debt i.e., bonds and mortgages. From the economic point of view, financial
derivatives are cash flows that are conditioned stochastically and discounted to present
value. The market risk inherent in the underlying asset is attached to the financial derivative
through contractual agreements and hence can be traded separately. The underlying asset
does not have to be acquired. Derivatives therefore allow the breakup of

3
ownership and participation in the market value of an asset. This also provides a
considerable amount of freedom regarding the contract design. That contractual freedom
allows derivative designers to modify the participation in the performance of the
underlying asset almost arbitrarily. Thus, the participation in the market value of the
underlying can be effectively weaker, stronger (leverage effect), or implemented as
inverse. Hence, specifically the market price risk of the underlying asset can be controlled
in almost every situation. There are two groups of derivative contracts: the privately
traded over-the-counter (OTC) derivatives such as swaps that do not go through an
exchange or other intermediary, and exchange-traded derivatives (ETD) that are traded
through specialized derivatives exchanges or other exchanges.

Derivatives are more common in the modern era, but their origins trace back several
centuries. One of the oldest derivatives is rice futures, which have been traded on
the Dojima Rice Exchange since the eighteenth century. Derivatives are broadly
categorized by the relationship between the underlying asset and the derivative (such
as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign
exchange derivatives, interest rate derivatives, commodity derivatives, or credit
derivatives); the market in which they trade (such as exchange-traded or over-the-counter);
and their pay-off profile.

Derivatives may broadly be categorized as "lock" or "option" products. Lock products

(such as swaps, futures, or forwards) obligate the contractual parties to the terms over the
life of the contract. Option products (such as interest rate swaps) provide the buyer the
right, but not the obligation to enter the contract under the terms specified. Derivatives can
be used either for risk management (i.e., to "hedge" by providing offsetting compensation
in case of an undesired event, a kind of "insurance") or for speculation i.e., making a
financial "bet". This distinction is important because the former is a prudent aspect of
operations and financial management for many firms across many industries; the latter
offers managers and investors a risky opportunity to increase profit, which may not be
properly disclosed to stakeholders.

4
1.2 SIGNIFICANCE

Society benefits because the prices of the underlying goods more accurately reflect
the goods true economic value. Therefore, the derivative markets provide a means of
managing risk, discovering prices, reducing costs, improving liquidity, selling short and
making the market more efficient. This study will act as a reference point to other
researchers in the same field. The study will also add to the existing body of knowledge
and stimulate further research on different aspects.

1.3 STATEMENT OF THE PROBLEM

Investors are not as much of knowledge about the derivative market. Investor
always marksperson investment in expectation of return. On the hand, return is always
associated with the risk. Investors do need a “hedging mechanism” to offset the risk of
investing in shares and debentures. There has been a quest for finding out the suitable
hedging mechanism. Some of these are forward contracts, future, and options. These are
collectively known a “Derivatives”, because these contracts derive value from some
underlying assets such as interest rates, Stock, currency, commodity etc. Many investors
are not aware of hedging the risk and also cannot diversified the risk in various investment
option. From the economic point of view, financial derivatives are cash flows that are
conditioned stochastically and discounted to present value. Because investment promotes
production, production creates employment, employment creates income, income creates
savings and finally savings becomes investment, and the cycle continues. While investing
a lot of questions may come front of an investor, like what are the investment avenues?
Where to invest? What I am to consider? And so on. Hence the prime most importance is
financial literacy. Therefore, it would be interesting to see an investor from all these
dimensions. Hence the present project is undertaken keeping in mind all this paramount
issues. This study throws light on the effect of derivative investors. This in turn will
enhance the development of economy.

5
1.4 SCOPE OF THE STUDY

The scope of the study is vast and wide. The study is relevant from both academic
as well as the professional perspectives. In the present study the researcher has only
selected the investors, a unique group of individuals who are investing in derivatives in the
society. This study will act as a reference point to other researchers in the same field. The
study will also add to the existing body of knowledge and stimulate further research on
different aspects.

1.5 OBJECTIVES OF THE STUDY

 To know the investors perception towards derivatives.

 To know the investment pattern towards derivatives special references to
future, option.
 To know whether there is a relationship between age and investment pattern
towards derivatives.
 To study the investor’s level of awareness about future and options in
Derivatives market.
 To study the existing literature related to the study area.
 To present the origin and growth of Equity Derivative Market in Mumbai.
 To offer suitable suggestions based on the findings of the study area.

1.6 HYPOTHESIS

There is no significant relationship between age and investment pattern towards

derivatives.

1.7 RESEARCH METHODOLOGY

RESEARCH DESIGN

Research design of the study is descriptive in nature

6
SAMPLING

1. SAMPLING SIZE

Sampling size of 50 respondents is taken for this study in Mumbai dist.

2. TYPES OF SAMPLING

Purposive sampling method has been followed for collecting response from
respondents

SOURCES OF DATA COLLECTION

• PRIMARY DATA
The primary data were collected directly from the traders who are trading equity derivatives
in the National Stock Exchange and Bombay Stock Exchange in Indian stock market
through a well devised interview schedule. For data collection, the researcher has
interviewed the respondents at different places including their workplace. A pretest was
conducted among thirty traders in the NSE and BSE in Indian stock market. Observations
are made on the individual differences in the various components of trading. The interview
schedule was prepared for the respondents have been pre-tested by the researcher in person.
Comments on the question were noted and after careful analysis necessary modification
have been made in the interview schedule. In the course of the time, the researcher had
experienced some difficulties in getting answers to some of the questions raised and
suitable changes have been incorporated before finalizing the well-structured interview
schedule.

• SECONDARY DATA
The secondary data for the study were collected from books, journals, research articles,
magazines, reports, newspapers, and websites that too mainly the official sites that are
National Stock Exchange and Bombay Stock Exchange in India and annual reports of
SEBI. The researcher also visited various university libraries in India.

7
DATA COLLECTION TOOL
The investigator has prepared a well-structured questionnaire for both understanding
investment pattern and age of investors in Palakkad district. The dimensions used for
questionnaire are the perception on risk, objective of investment, perception on investment
avenues and factors considered while selecting the avenue.

DATA ANALYSIS TOOL

On the basis of data collected from respondents, are to be analysed through Percentage
analysis, correlation analysis. The analysis and interpretation of data is done with the help
of tables and diagrams like bar diagrams and pie diagrams. The tools were administered
among investors who are investing in derivatives of Mumbai district, Mumbai and the
statistical techniques used were Percentage analysis, Correlation analysis.

1.8 PERIOD OF STUDY

The researcher has undertaken to study the relationship age and investment behaviour for
six weeks

1.9 LIMITATIONS OF THE STUDY

1. There may be a limitation in the generalization to the population.

2. The size of the sample is small, say 50, while considering the scope of the
topic.

3. There is a chance of non- response or reluctance on the part of respondents.

1.10 STATEMENT OF THE PROBLEM

In India, Traders want maximum gain with minimum risk, so is the case with derivatives.
Derivatives are among the forefront of the innovations in the financial markets and aim to
increase returns and reduce risk. A derivative is a financial product which has been derived
from another financial product or commodity. The derivatives do not have independent
existence without underlying product and market. Derivatives are contracts which are

8
written between two parties for easily marketable assets. It is derived by the means of a
mutual agreement; the types of derivative products are limited only by imagination and so
there is no definitive list of derivative products. Forward market, future market, option and
swaps are the basic types of derivatives. A forward contract is an agreement to buy or sell
an asset on a specified date for a specified price. The forward contracts are normally traded
outside the exchanges and is present in India from long time back, but future option have
emerged in few years in financial market and has brought improvement from the forward
market as they are traded on exchange, therefore there is more transparency and less risk.
A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a
certain underlying instrument at a certain date in the future, at a pre-set price. And a futures
contract gives the holder the right and the obligation to buy or sell, which differs from an
options contract.

The trading of derivative securities commenced in India after much debate over the
introduction of derivatives to hedge the risks posed by the securities and a long waiting
period. The National Stock Exchange (NSE) sought permission from the Securities and
Exchange Board of India (SEBI) to trade stock index futures in December 1995, but it was
only after five years that the first derivative security, i.e., stock index futures, was traded
on the exchange. Stock index futures were introduced in June 2000, and thereafter, stock
index options in June 2001. The options and futures on individual shares were introduced
in July 2001 and November 2001, respectively. Later, more indices and shares were added
in this segment. (Table I exhibits chronology of events relating to the development of
derivative market in India.) As on December 31, 2009, there were 179 individual shares
for which futures and options were traded. They are traded on the Bombay Stock Exchange
(BSE) and the National Stock Exchange (NSE) wherein the latter contributes to more than
95 per cent of the total turnover in the derivative market in India (Srivastava et al., 2008).
Derivatives are gaining importance due to increased volatility in capital and foreign
currency markets. RBI finds ways for healthy development of market and takes steps to
popularise the use of derivative instruments, but still awareness about the derivative
instruments and its uses are quite low. Hence, it is necessary to find out the level of
awareness among investing public and if found low, how to create adequate awareness to
encourage the use of derivative products as hedge tools. Financial derivatives were

9
introduced as a risk management tool; but now they have become the riskiest instruments
in the markets as the experience in US markets in recent years would corroborate. Though
it is widely known that derivatives can be used for hedge, extent of effectiveness has not
been systematically and scientifically proved. Moreover, individual Traders are
extensively using derivatives for speculation ignoring its use as a hedge tool. Hence, it is
necessary to assess how far financial derivatives are effective for hedge from Trader’s point
of view (Soma Nathan, 2003). Derivative market has shown a great potential in the last
few years, but the real issues are yet not been resolved. Instruments traded under derivative
market and its volume of trade is also increasing day by day, but the main objective. Setting
up of different exchanges yet not achieved. On the other hand, future prospects of
derivative markets are not sound because of the unresolved issues, and they are framed as
big challenges in the way. The percentage of physical settlement under commodity
derivatives is very less because of the Forward Contract Act, 1952. In this Act, cash
settlement of outstanding contracts at maturity is disallowed. In other words, all
outstanding contracts at maturity should be settled in physical delivery. To overcome this
huddle participants, settle their positions before maturity. This Act needs to be adjusted
which is a big challenge in front of derivative market. Regulators and Supervisory bodies
are having an eye on the counter derivative market due to its rapid growth. Some OTC
(Over the Counter) derivatives are taken as stress relievers in the tough time of global crisis.
But the big challenge is to overcome the assumption of the critics that this market is less
transparent, weaker capital requirement and systematic risk. Derivative market requires a
setting up of a regulatory system like security market which is regulated by Security
Exchange Board of India which is an independent body. On other side derivative is
controlled by FMC (Forward Market Commission) which depends upon the funds of
Department of Consumer Affairs for the development of this market a sole powered body
is required. Both the regulatory authorities‟ i.e., SEBI and FMC are also required to work
closely for better results Competition of OTC derivatives with the Exchange traded
derivatives. Advisors are having the view that this will increase the transparency, liquidity
and on the other side clearing and settlement procedure is better. All the above advice are
based on the assumption that the existing method of trading in OTC products is all based
on telephone trading and there is no clearing system in place. Despite the developments

10
happening in the capital market in India and even after a decade of existence of a vibrant
capital market, the equity instruments are not considered as an attractive household
investment. The recent economic recession had a great impact on stock market. The
developing countries also taste the economic downtrend. The Indian economy is also not
left out. Before the recession, Indian economy was moving at a faster rate because of the
growth in information technology and other sectors. But after the recession the economic
level comes down and there will be some velocity in the Indian stock market conditions.
As the regulatory system is so strong in India, the stock market can withstand many odds.
Since the stock market is all the time unpredictable and unstable, the Traders are all the
time at very high risk. They must consider many factors like Economic environment,
Political stability, Industrial growth etc., before they invest. Though there are many studies
on the stock market related areas, the information provided to the Trader and industry is
not sufficient. As a result, the Trader and the stock market players will be searching for
required information. There are some research gaps in the existing literature relating to the
stock market. Hence, the present study is aimed to study the traders‟ awareness and
perception towards equity derivative markets in MUMBAI District.

Chapterisation

The project is presented in Five Chapters.

Chapter 1: Introduction

Chapter 2: Review of literature

Chapter 3: Investment in Derivatives (Option& Future) A Theoretical framework

Chapter 4: Investors Attitude towards derivatives - an analysis

Chapter 5: Findings, Suggestions and Conclusion

Appendix

Bibliography

11
 CHAPTER – 2

REVIEW OF LITREATURE

12
INTRODUCTION

This chapter deals with a comprehensive review of literature on financial derivatives. The
literature review is one of the vital prerequisites of a proper structured research work. A
detail review of the prior research in the related areas assists in the formulation of research
hypotheses and identification of variables related to the hypotheses. The financial
derivatives have a short history of three to four decades, notwithstanding they have been
extensively subjected to the rigors of research. In India, it has barely been over a decade
since trading in financial derivatives, index as well as stock options & futures, and was
introduced. As a result, research on this topic is comparatively lesser. The purpose of this
chapter is to review the studies dealing with the impact of derivatives on financial markets
of Mumbai district and within it, with a view to crystallizing the focus, scope and
methodology to be adopted for the present research and to identify gaps which the present
study proposes to fill.

According to Greenspan (1997) “By far the most significant event in finance during the
past decades has been the extraordinary development and expansion of financial
derivatives…”

Avadhani (2000) stated that a derivative, an innovative financial instrument, emerged to

protect against the risks generated in the past, as the history of financial markets is repleted
with crises. Events like the collapse of the fixed exchange rate system in 1971, the Black
Monday of October 1987, the steep fall in the Nikkei in 1989, the US bond debacle of
1994, occurred because of very high degree of volatility of financial markets and their
unpredictability. Such disasters have become more frequent with increased global
integration of markets.

Marlowe (2000) argues that the emergence of the derivative market 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

13
asset prices. It is generally stated that regulation has an important and critical role to ensure
the efficient and smooth functioning of the markets.

Kumar R. & Chandra A. (2000) critically examined arbitrage opportunities in derivative

market. They concluded that individuals often invest in securities based on approximate
rule of thumb, not strictly in tune with market conditions. Their emotions drive their
trading behaviour, which in turn drives asset (stock) prices. Investors fall prey to their own
mistakes and sometimes other’s mistakes, referred to as herd behaviour. Markets are
efficient, increasingly proving a theoretical concept as in practice they hardly move
efficiently. The purely rational approach is being subsumed by a broader approach based
upon the trading sentiments of investors.

Bose Suchismita (2006), in their study “The Indian Derivatives Market Revisited”
examined derivative as a risk management tool. It was found that Derivatives products
provide certain important economic benefits such as risk management or redistribution of
risk away from risk-averse investors towards those more willing and able to bear risk.
Derivatives also help price discovery, i.e., the process of determining the price level for
any asset based on supply and demand. These functions of derivatives help in efficient
capital allocation in the economy; at the same time their misuse also poses a threat to the
stability of the financial sector and the overall economy.

Ravichandran, (2008) studied investors preferences towards various investment avenues

in Capital Market with special reference to Derivatives. The study shows that in the current
scenario, investing in stock markets is a major challenge even for professionals.
Derivatives act as a major tool for reducing the risk involved in investing in the stock
markets for getting the best results out of it. The study also focuses that investors should
be aware of the various hedging and speculation strategies, which can be used for reducing
their risk. Awareness regarding various uses of derivatives can help investors to reduce
risk and increase profits.

Lovric M. et al., (2008), presented a description model of individual investor behaviour in

which investment decisions are seen as an iterative process of interactions between the
investor and the investment environment. The investment process was influenced by a
number of interdependent variables. They suggested that this conceptual model can be

14
used to build stylized representations of individual investors and further studied using the
paradigm of agent-based artificial financial markets.

Hvidkjaer S (2008) analysed the relationship between retail investor trading behaviour
and the cross section of future stock returns. The result suggests that stocks favoured by
retail investors subsequently experience prolonged underperformance relative to stock out
of favour with them. These results link the systematic component of retail investor
behaviour to future returns, i.e., informed investors might begin selling stocks that they
believe to be overvalued. The overvaluation that these investors perceived could be driven
by changes in firms fundamental.

Devi. S and Renuga Bharathi, N (2008) found that the following factors namely
advertisement, risk factor, investor grievances, investment pattern, change in lifestyle,
stockbroker service, investment knowledge, investment information, personal savings,
size of investment, economic condition and decreasing level of Sensex influences the
perception of investors on investment.

Talati and Sanghvi (2010) made an attempt to identify the awareness and perception of
the investors towards hedge funds as an investment avenue with special reference to
Gujarat state. It was found that the awareness level regarding hedge funds was very less
in the area covered for study. The investors were not aware of the advantage that they
could get by investing in hedge funds nor were they aware of the basic functioning of
hedge funds. Investors in Gujarat preferred to invest in government securities and fixed
deposits of nationalize banks where they had a complete safety of their funds, though they
got less returns.

Mark fenton, Emma Soane, Nigel Nicolson and Paul Williame(2011) document a
quantitative investigation to find difference between high and low performing traders and
studied the role of intuition in the decision making process. The emotional regulation
strategies adopted by experts reveals that high performing traders are qualitatively
different from low performing traders as former are inclined to cope up with negative
feelings and formulate effective strategies to regulate their emotions.

15
Varadharajan.P and Vikkraman.P (2011) in their study has stated that an investor
decides on an investment after getting opinion from family, friends and colleagues,
Broker’s recommendation, and other professional advice. The investor also takes into
consideration the market situations like financial results of the companies, bonus issue,
price earnings ratio and the reputation of the company.

Shanmnga Sundaram V (2011) examined the impact of behavioural dimensions of

investors in Capital market and found that investor decisions are influenced by
psychological factors as well as behavioural dimensions and this psychological effect is
created by the fear of losing money, sudden decline in stock indices, greed, and lack of
confidence about their decision-making capability.

Sahoo (2012) opines “Derivatives products initially emerged, as hedging devices against
fluctuation in commodity prices and the commodity-linked derivatives remained the sole
form of such products for many years”. According to him the legal framework for
derivatives trading is a critical part of overall regulatory framework of derivative markets.
The purpose of regulation is to encourage the efficiency and competition rather than
impeding it.

Kousalya P R and Gurusamy P (2012) in their research has concluded that investors
make self- decision regarding their investment. Investments are made for a period of less
than three years and there is a significant relationship between age and awareness.

Manasa Vipparthi and Ashwin Margam (2012) revealed that the investors’ perception
is dependent on the demographic profile and assesses that the investors age, marital status
and occupation has direct impact on the investor’s choice of investment. The study further
revealed that female segment are not fully tapped and even there is low target on higher
income people. It reveals that Liquidity, Flexibility, Tax savings, Service Quality and
Transparency are the factors which have a higher impact on perception of investors.

Arvid O.I. Hoffmann, Thomas Post and Joost M.E. Penning’s (2012) in their research
found out that investor perception during 2008-09 financial crisis fluctuate significantly
with risk tolerance and risk perceptions being less volatile than return expectations. During
the worst months of the crisis investors’ return expectations and risk tolerance decrease

16
while risk perception increase. Towards the end of the crisis, investor perceptions recover.
They also documented substantial swings in trading and risk-taking behaviour that are
driven by changes in investors’ perceptions. Overall individual investors continued to
trade actively and did not de-risk their investment portfolios during the crisis.

Gagan Kukreja(2012) has found in his research that age, educational qualification, tax
advantages, liquidity and investment attributes are mediating factor for investors’
perception. Investment influences and investment benefits are having high relevance.

Pasha (2013) studied retail investors’ perception on financial derivatives in India. It is

found that 55 percent of the small investors (respondents) are of the opinion that
derivatives are new, complex, and high-tech products. 38 percent of the respondents, who
are familiar with derivatives, said derivatives are not new, complex, and high – tech
products. And the remaining 7 percent of the investors could not answer the question. This
shows that many investors are not familiar with derivatives. The study also found that 62
percent of the small investors are of the opinion that derivatives are purely speculative and
highly leveraged instruments.

Narang Sunita (2013) has discussed the implications of financial derivatives on the
Indian capital market and conducted a survey among members and sub members of NSE
and BSE to understand their perception towards derivative trading. She found that lack of
awareness, high transaction costs, malpractices adopted by illegal financial advisors and
shorter trade timings are few impediments to derivative trading in India.

Neel Kamal Purohit (2013) in his research has found out that income has significant impact
on frequency of trading in stock market, selection of mode of trading and selection of
market segments. Age and income have significant impact on taking exposure.

Tripathi (2014) studied investor’s perception towards derivative trading. The

study shows Indian investors mainly invest their money in real estates and insurance as
they are the options offering great returns with minimum risk associated with it. It is found
that morethan 75 percent of investors are aware about derivatives, out of which 74 percent
have invested in derivatives. Most of the users often invest 10 percent – 20 percent of

17
their total investment in derivatives followed by users who invest 20 percent – 35 percent
of their total investment in derivatives.

Supriya (2014) reviewed derivative as a tool for managing risk which comes out of
uncertainty and makes it difficult for businesses to estimate their future production cost
and revenues. The NSE figures reveal that in equity derivative almost 90% of activity is
due to stock futures and index futures, whereas trading in options is still limited to few
stocks, partly because they are settled in cash and not the underlying stock. Further she
found NSE has programmes to inform and educate brokers, dealers, traders and market
personnel.

Dr. Y. Nagaraju (2014) studied investors' perception towards derivative instruments and
markets. The study shows that even though most people look at derivatives with fear, they
should understand the fact that derivatives help in shifting the risk to the other party. There
are many myths that surround derivative market. All these can be done away with proper
system in place. Derivative instruments and derivative markets are not so popular among
individual investors. Only educated investors with the help of friends and brokers are
investing in this market. The reasons for not investing in this market are lack of knowledge
and very complex nature of instruments. Some people have a wrong perception about
derivatives. The study suggests that measures should be taken to make sure that the
investors get a right picture of the instruments and their risk factors.

Bhatt Babaraju K and Chauhan Apurva A (2014) studied investor’s perception

towards derivatives as an investment avenue and found that most of the investors invest in
derivative market on the basis of their own awareness, guidance from financial advisor
and broker. They found that there is a significant positive correlation between age of the
respondents and their decision to invest in derivatives and a negative correlation between
annual income of the respondents with their decision to invest in derivatives. Hedging
fund, risk control, knowledge regarding financial product and high volatility in the stock
market were some of the important factors influencing the investor’s decision.

18
 CHAPTER – 3

THEORATICAL FIRMWARE

19
INTRODUCTION

Financial derivatives like stock futures, stock options, swaps etc. have been developed to
mitigate the risk level of derivative traders. Increased financial risks have threatened the
very existence of business firms. Financial derivatives came up as a mode of reducing these
risks. Transactions in derivatives market are used to offset the risk of price changes in the
underlying assets. Every business firm is at high risk due to the uncertainty in price
fluctuations. Derivatives provide them a valuable set of tools to manage this risk. New
products and different combinations of existing products are widely used to cope with the
changing environment.

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 underlying prices. However, by locking –in asset prices, derivative products
minimize the impact of fluctuations in asset prices on the profitability and cash flow
situation of risk–averse investors.

DEFINITION: -
Understanding the word itself, Derivatives is a key to mastery of the topic. The word
originates in mathematics and refers to a variable, which has been derived from another
variable. For example, a measure of weight in pound could be derived from a measure of
weight in kilograms by multiplying by two. In financial sense, these are contracts that
derive their value from some underlying asset. Without the underlying product and market
it would have no independent existence. Underlying asset can be a Stock, Bond, Currency,

20
Index, or a Commodity. Someone may take an interest in the derivative products without
having an interest in the underlying product market, but the two are always related and may
therefore interact with each other.

IMPORTANCE OF DERIVATIVES:

Derivatives are becoming increasingly important in world markets as a tool for risk
management. Derivatives instruments can be used to minimize risk. Derivatives are used
to separate risks and transfer them to parties willing to bear these risks. The kind of hedging
that can be obtained by using derivatives is cheaper and more convenient than what could
be obtained by using cash instruments. It is so because, when we use derivatives for
hedging, actual delivery of the underlying asset is not at all essential for settlement
purposes. Moreover, derivatives would not create any risk. They simply manipulate the
risks and transfer to those who are willing to bear these risks. For example, Mr. A owns a
bike If he does not take insurance, he runs a big risk. Suppose he buys insurance [a
derivative instrument on the bike] he reduces his risk. Thus, having an insurance policy
reduces the risk of owing a bike. Similarly, hedging through derivatives reduces the risk of
owing a specified asset, which may be a share and currency etc.

RATIONALE BEHIND THE DEVELOPMENT OF DERIVATIVE MARKET: -

Holding portfolio of securities is associated with the risk of the possibility that the investor
may realize his returns, which would be much lesser than what he expected to get. There
are various influences, which affect the returns. 1. Price or dividend (interest). 2. Sum are
internal to the firm like: Industry policy Management capabilities Consumer’s preference
Labour strike, etc. These forces are to a large extent controllable and are termed as “Non-
systematic Risks”. An investor can easily manage such non- systematic risks by having a

21
well- diversified portfolio spread across the companies, industries, and groups so that a loss
in one may easily be compensated with a gain in other.
There are other types of influences, which are external to the firm, cannot be controlled,
and they are termed as “systematic risks”.
Those are
• Economic
• Political
• Sociological changes are sources of Systematic Risk
Their effect is to cause the prices of nearly all individual stocks to move together in the
same manner. We therefore quite often find stock prices falling from time to time despite
company’s earnings rising and vice –versa. Rational behind the development of derivatives
market is to manage this systematic risk, liquidity. Liquidity means, being able to buy &
sell relatively large amounts quickly. In debt market, a much larger portion of the total risk
of securities is systematic. Debt instruments are also finite life securities with limited
marketability due to their small size relative to many common stocks. These factors favour
for the purpose of both portfolio hedging and speculation. India has vibrant securities
market with strong retail participation that has evolved over the years. It was until recently
a cash market with facility to carry forward positions in actively traded “A” group scripts
from one settlement to another by paying the required margins and borrowing money and
securities in a separate carry forward session held for this purpose. However, a need was
felt to introduce financial products like other financial markets in the world.

CHARACTERISTICS OF DERIVATIVES: -

1. Their value is derived from an underlying instrument such as stock index, currency, etc.
2. They are vehicles for transferring risk.
3. They are leveraged instruments.

22
MAJOR PLAYERS IN DERIVATIVE MARKET: -

There are three major players in the derivatives trading.

1. Hedgers
2. Speculators
3. Arbitrageurs

 Hedgers: The party, which manages the risk, is known as “Hedger”. Hedgers seek to
protect themselves against price changes in a commodity in which they have an interest.
Speculators: They are traders with a view and objective of making profits. They are
willing to take risks and they bet upon whether the markets would go up or come down.
Arbitrageurs: Risk less profit making is the prime goal of arbitrageurs. They could be
making money even without putting their own money in, and such opportunities often
come up in the market but last for very short time frames. They are specialized in
making purchases and sales in different markets at the same time and profits by the
difference in prices between the two centres.

TYPES OF DERIVATIVES: -

Most used derivative contracts are: -

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

settlement takes place on a specific date in the futures at today’s pre-agreed price. Forward
contracts offer tremendous flexibility to the parties to design the contract in terms of the
price, quantity, quality, delivery, time and place. Liquidity and default risk are very high.

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.

23
Options: Options are 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: Longer – dated
options are called warrants and are generally traded over the counter. Options generally
have life up to one year, the majority of options traded on options exchanges having a
maximum maturity of nine months.

LEAPS: The acronym LEAPS means Long Term Equity Anticipation Securities. These
are options having a maturity of up to 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 pre-arranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are: - Interest rate swaps: This entail
swapping only the interest related cash flows between the parties in the same currency.
Currency swaps: These entail swapping both the principal and interest between the parties,
with the cash flows in one direction being in a different currency than those in opposite
direction.

RISKS INVOLVED IN DERIVATIVES: -

Derivatives are used to separate risks from traditional instruments and transfer these risks
to parties willing to bear these risks. The fundamental risks involved in derivative business
include

A. Credit Risk: This is the risk of failure of a counterpart to perform its obligation as per
the contract. Also known as default or counterparty risk, it differs with different
instruments.

24
 B. Market Risk: Market risk is a risk of financial loss because of adverse movements of
prices of the underlying asset/instrument.

C. Liquidity Risk: The inability of a firm to arrange a transaction at prevailing market

prices is termed as liquidity risk. A firm faces two types of liquidity risks:
D. Legal Risk: Derivatives cut across judicial boundaries, therefore the legal Aspects
associated with the deal should be investigated carefully.

DERIVATIVES IN INDIA: -
Indian capital markets hope derivatives will boost the nation’s economic prospects. Fifty
years ago, around the time India became independent men in Mumbai gambled on the price
of cotton in New York. They bet on the last one or two digits of the closing price on the
New York cotton exchange. If they guessed the last number, they got Rs.7/- for every Rupee
layout. If they matched the last two digits, they got Rs.72/- Gamblers preferred using the
New York cotton price because the cotton market at home was less liquid and could easily
be manipulated. Now, India is about to acquire own market for risk. The country, emerging
from a long history of stock market and foreign exchange controls, is one of the vast major
economies in Asia, to refashion its capital market to attract western investment. A hybrid
over the counter, derivatives market is expected to develop alongside. Over the last couple
of years, the National Stock Exchange has pushed derivatives trading, by using fully
automated screen-based exchange, which was established by India's leading institutional
investors in 1994 in the wake of numerous financial & stock market scandals.
1. Contract Periods: - At any point of time there will always be available nearly 3months
contract periods in Indian Markets. These were
1) Near Month
2) Next Month
3) Far Month
For example, in the month of September 2007 one can enter into September futures contract
or October futures contract or November futures contract. The last Thursday of the month
specified in the contract shall be the final settlement date for the contract at both NSE as
well as BSE; it is also known as Expiry Date.

25
 Settlement: -
The settlement of all derivative contracts is in cash mode. There is daily as well as final
settlement. Outstanding positions of a contract can remain open till the last Thursday of
that month. As long as the position is open, the same will be marked to market at the daily
settlement price, the difference will be credited or debited accordingly, and the position
shall be brought forward to the next day at the daily settlement price. Any position which
remains open at the end of the final settlement day (i.e., last Thursday) shall be closed out
by the exchange at the final settlement price which will be the closing spot value of the
underlying asset.
2. Margin: - There are two types of margins collected on the open position, viz., initial
margin which is collected upfront which is named as “SPAN MARGIN” and mark to
market margin, which is to be paid on next day. As per SEBI guidelines it is mandatory
for clients to give margins, failing in which the outstanding positions are required to be
closed out.
3. Forwards: - Forwards are the simplest and basic form of derivative contracts. These are
instruments are basically used by traders/investors in order to hedge their future risks. It is
an agreement to buy/sell an asset at certain in future for a certain price. They are private
agreements mainly between the financial institutions or between the financial institutions
and corporate clients. One of the parties in a forward contract assumes a long position i.e.,
agrees to buy the underlying asset on a specified future date at a specified future price.
The other party assumes short position i.e., agrees to sell the asset on the same date at the
same price. This specified price referred to as the delivery price. This delivery price is
chosen so that the value of the forward contract is equal to zero for both the parties. In
other words, it costs nothing to the party to hold the long/short position. A forward contract
is settled at maturity. The holder of the short position delivers the asset to the holder of the
long position in return for cash at the agreed upon rate. Therefore, a key determinate of
the value of the contract is the market price of the underlying asset. A forward contract
can, therefore, assume a positive/negative value depending on the movements of the price
of the asset. For example, if the price of the asset rises sharply after the two parties entered
the contract, the party holding the long position stands to benefit, that is the value of the
contract is positive for him. Conversely the value of the contract becomes negative for the

26
 party holding the short position. The concept of forward price is also important. The
forward price for a certain contract.

MEANIG OF FORWARDS

It is defined as that delivery price which would make the value of the contract zero. To
explain further, the forward price and the delivery price are equal on the day that the
contract is entered into. Over the duration of the contract, the forward price is liable to
change while the delivery price remains the same. Essential features of
Forward Contracts: -A forward contract is a Bi-party contract, to be performed in the
future, with the terms decided today. Forward contracts offer tremendous flexibility to the
parties to design the contract in terms of the price, quantity, quality, delivery time and
place, Forward contracts suffer from poor liquidity and default risk. Contract price is
generally not available in public domain. On the expiration date the contract will settle by
delivery of the asset. If the party wishes to reverse the contract, it is compulsorily to go to
the same counter party, which often results high prices.

 Forward Trading in Securities: The Securities Contract (amendment) Act of 1999 has
allowed the trading in derivative products in India. As a further step to widen and deepen
the securities market the government has notified that with effect from March 1st, 2000,
the ban on forward trading in shares and securities is lifted to facilitate trading in forwards
and futures. It may be recalled that the ban on forward trading in securities was imposed
in 1986 to curb certain unhealthy trade practices and trends in the securities market. During
the past few years, thanks to the economic and financial reforms, there have been many
healthy developments in the securities markets. The lifting of ban on forward deals in
securities will help to develop index futures and other types of derivatives and futures on
stocks. This is a step in the right direction to promote the sophisticated market segments
as in the western countries.

27
MEANING OF FUTURES: -

FUTURES: The future contract is an agreement between two parties to buy or sell an asset
at a certain specified time in future for certain specified price. In this, it is similar to a
forward contract. A futures contract is a more organized form of a forward contract; these
are traded on organized exchanges. However, there are a number of differences between
forwards and futures. These relate to the contractual futures, the way the markets are
organized, profiles of gains and losses, kind of participants in the markets and the ways
they use the two instruments. Futures contracts in physical commodities such as wheat,
cotton, gold, silver, cattle, etc. have existed for a long time. Futures in financial assets,
currencies, and interest-bearing instruments like treasury bills and bonds and other
innovations like futures contracts in stock indexes are relatively new developments. The
futures market described as continuous auction markets and exchanges providing the latest
information about supply and demand with respect to individual commodities, financial
instruments, and currencies, etc. Futures exchanges are where buyers and sellers of an
expanding list of commodities; financial instruments and currencies come together to trade.
Trading has also been initiated in options on futures contracts. Thus, option buyers
participate in futures markets with different risk. The option buyer knows the exact risk,
which is unknown to the futures trader.

FEATURES OF FUTURES CONTRACTS:

The principal features of the contract are as follows. Organized Exchanges: Unlike forward
contracts which are traded in an over- the- counter market, futures are traded on organized
exchanges with a designated physical location where trading takes place. This provides a
ready, liquid market which futures can be bought and sold at any time like in a stock
market. The factor analysis each variable is expressed as a linear combination of underlying
factors. The amount of variance a variable share with all other variables included in the
analysis is referred to communality

28
 Standardization: In the case of forward contracts the number of commodities to be
delivered and the maturity date are negotiated between the buyer and seller and can be
Tailor made to buyer’s requirement. In a futures contract both these are standardized by
the exchange on which the contract is traded. Clearing House: The exchange acts a clearing
house to all contracts struck on the trading floor. For instance, a contract is struck between
capital A and B. Upon entering into the records of the exchange, this is immediately
replaced by two contracts, one between A and the clearing house and another between B
and the clearing house. In other words, the exchange interposes itself in every contract and
deal, where it is a buyer to seller, and seller to buyer. The advantage of this is that A and B
do not have to undertake any exercise to investigate each other’s credit worthiness. It also
guarantees financial integrity of the market. This enforces the delivery for the delivery of
contracts held for until maturity and protects itself from default risk by imposing margin
requirements on traders and enforcing this through a system called marking – to – market.
Actual delivery is rare: In most of the forward contracts, the commodity is delivered by the
seller and is accepted by the buyer. Forward contracts are entered into for acquiring or
disposing of a commodity in the future for a gain at a price known today. In contrast to
this, in most futures markets, actual delivery takes place in less than one percent of the
contracts traded. Futures are used as a device to hedge against price risk and as a way of
betting against price movements rather than a means of physical acquisition of the
underlying asset. To achieve this most of the contracts entered are nullified by the matching
contract in the opposite direction before maturity of the first.

 Margins: To avoid unhealthy competition among clearing members in reducing margins

to attract customers, mandatory minimum margins are obtained by the members from the
customers. Such a stop insures the market against serious liquidity crisis arising out of
possible defaults by the clearing members. The members Collect margins from their clients
as may be stipulated by the stock exchanges from time to time and pass the margins to the
clearing house on the net basis i.e., at a stipulated percentage of the net purchase and sale
position. The stock exchange imposes margins as follows:  Initial margins on both the
buyer as well as the seller. The accounts of buyer and seller are marked to the market daily.

29
 The concept of margin here is same as that of any other trade, i.e., to introduce a financial
stake of the client, to ensure performance of the contract and to cover day to day adverse
fluctuations in the prices of the securities.
The margin for future contracts has two components: 

 Initial margin
Marking to market Initial margin: In futures contract both the buyer and seller are
required to perform the contract. Accordingly, both the buyers and the sellers are required
to put in the initial margins. The initial margin is also known as the “performance margin”
and usually 5% to 15% of the purchase price of the contract. The margin is set by the stock
exchange keeping in view the volume of business and size of transactions as well as
Operative risks of the market in general. The concept being used by NSE to compute initial
margin on the futures transactions is called “value- at –Risk” (VAR) whereas the options
market had SPAN based margin system”. Marking-to-Market: Marking to market means,
debiting, or crediting the client’s equity accounts with the losses/profits of the day, based
on which margins are sought. It is important to note that through marking to market
process, the clearinghouse substitutes each existing futures contract with a new contract
that has the settlement price or the base price. Base price shall be the previous day’s closing
Nifty value. Settlement price is the purchase price in the new contract for the next trading
day.

FUTURES TERMINOLOGY:

 Spot price: The price at which an asset is traded in spot market.

 Futures price: The price at which the futures contract is traded in the futures
market.
 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. For
instance, contract size on NSE futures market is 100 Nifties.

30
  Basis/Spread: 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 formal 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. Multiplier: It is a pre-determined value, used to arrive at the contract
size. It is the price per index point.
 Tick Size: It is the minimum price difference between two quotes of similar nature.
Open Interest: Total outstanding long/short positions in the market in any specific
point of time. As total long positions for market would be equal to total short
positions for calculation of open Interest, only one side of the contract is counted.
 Long position: Outstanding/Unsettled purchase position at any point of time.
 Short position: Outstanding/unsettled sale position at any time point of time. Index
Futures: Stock Index futures are most popular financial futures, which have been
used to hedge or manage systematic risk by the investors of the stock market. They
are called hedgers, who own portfolio of securities and are exposed to systematic
risk. Stock index is the apt hedging asset since, the rise or fall due to systematic risk
is accurately shown in the stock index.
Stock index futures contract is an agreement to buy or sell a specified amount of an
underlying stock traded on a regulated futures exchange for a specified price at a specified
time in future. Stock index futures will require lower capital adequacy and margin
requirement as compared to margins on carry forward of individual scrips. The brokerage
cost on index futures will be much lower. Savings in cost is possible through reduced bid-
ask spreads where stocks are traded in packaged forms. The impact cost will be much lower
in case of stock index futures as opposed to dealing in individual scraps. The market is
conditioned to think in terms of the index and therefore, would refer trade in stock index
futures. Further, the chances of manipulation are much lesser. The stock index futures are
expected to be extremely liquid, given the speculative nature of our markets and
overwhelming retail participation expected to be fairly high. In the near future stock index

31
futures will definitely see incredible volumes in India. It will be a blockbuster product and
is pitched to become the most liquid contract in the world in terms of contracts traded. The
advantage to the equity or cash market is in the fact that they would become less volatile
as most of the speculative activity would shift to stock index futures. The stock index
futures market should ideally have more depth, volumes, and act as a stabilizing factor for
the cash market. However, it is too early to base any conclusions on the volume or to form
any firm trend. The difference between stock index futures and most other financial futures
contracts is that settlement is made at the value of the index at maturity of the contract
Stock Futures With the purchase of futures on a security, the holder essentially makes a
legally binding promise or obligation to buy the underlying security at same 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 same 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 owing them simply obligates the trader to sell a certain amount of the underlying
security at same point in the future. It can be done just as easily as buying futures, which
obligates the trader to buy a certain amount of the underlying security at some point in
future.

OPTIONS
An option is a derivative instrument since its value is derived from the underlying asset. It
is essentially a right, but not an obligation to buy or sell an asset. Options can be a call
option (right to buy) or a put option (right to sell). An option is valuable if and only if the
prices are varying. An option by definition has a fixed period of life, usually three to six
months. An option is a wasting asset in the sense that the value of an option diminishes as
the date of maturity approaches and on the date of maturity it is equal to zero. An investor
in options has four choices before him. Firstly, he can buy a call option meaning a right to
There are two main stages in factor analysis. As the first stage in the factor analysis,
principal component analysis was used for the initial extraction of the factors. Pac is a
technique for forming a set of new variables that are linear combinations of the original set
of variables. The new variables are called principal components of factors.

32
 buy an asset after a certain period of time. Secondly, he can buy a put option meaning a
right to sell an asset after a certain period of time. Thirdly, he can write a call option
meaning he can sell the right to buy an asset to another investor. Lastly, he can write a put
option meaning he can sell a right to sell to another investor. Out of the above four cases
in the first two cases the investor has to pay an option premium while in the last two cases
the investors receive an option premium.

 DEFINITION: -
An option is a derivative i.e. its value is derived from something else. In the case of the
stock option its value is based on the underlying stock (equity). In the case of the index
option, its value is based on the underlying index.
Options clearing corporation The Options Clearing Corporation (OCC)
It is guarantor of all exchange-traded options once an option transaction has been
completed. Once a seller has written an option and a buyer has purchased that option, the
OCC takes over it. It is the responsibility of the OCC who over sees the obligations to fulfil
the exercises. If I want to exercise an ACC November 100-call option, I notify my broker.
My broker notifies the OCC, the OCC then randomly selects a brokerage firm, which is
short of One ACC stock. That brokerage firm then notifies one of its customers who have
written one ACC November 100 call option and exercises it. The brokerage firm customer
can be chosen in two ways. He can be chosen at random or FIFO basis. Because, OCC has
a certain risk that the seller of the option can’t fulfil the contract, strict margin requirement
is imposed on sellers. This margin requirements acts as a performance Bond. It assures that
OCC will get its money. European options: European options are the options that can be
exercised only on the expiration date itself. European options are easier to analyse than the
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 option (ITM) is an option that would lead to a
positive cash flow to the holder if it were exercised immediately. A call option in the index
is said to be in the money when the current index stands at higher level that the strike price
(i.e., spot price > strike price). If the index is much higher than the strike price

33
 the call is said to be deep in the money. In the case of a put option, the put is in the money
if the index is below the strike price.

 At-the-money option: An At-the-money option (ATM) is an option that would lead to

zero cash flow if it 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 cash flow if it were exercised immediately. A call option on the index
is out of the money when the current index stands at a level, which is less than the strike
price (i.e., spot price < strike price). If the index is much lower than the 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: It is one of the components of option premium.
The intrinsic value of a call is the amount the option is in the money if it is in the money.
If the call is out of the money, its intrinsic value is Zero. For example, X, take that ABC
November-call option. If ABC is trading at 102 and the call option is priced at 2, the
intrinsic value is 2. If ABC November-100 put is trading at 97 the intrinsic value of the
put option is 3. If ABC stock was trading at 99 an ABC November call would have no
intrinsic value and conversely if ABC stock was trading at 101 an ABC November-100
put option would have no intrinsic value. An option must be in the money to have intrinsic
value.
 Time value of an option: The 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 options time value. At expiration an
option should have no time value.

CHARACTERISTICS OF OPTIONS:

The following are the main characteristics of options:

34
 1. Options holders do not receive any dividend or interest.
2. Options holders receive only capital gains.
3. Options holder can enjoy a tax advantage.
4. Options are traded at O.T.C and in all recognized stock exchanges.
5. Options holders can control their rights on the underlying asset.
6. Options create the possibility of gaining a windfall profit.
7. Options holders can enjoy a much wider risk-return combinations.
8. Options can reduce the total portfolio transaction costs.
9. Options enable the investors to gain a better return with a limited amount of investment.

 Call Option: An option that grants the buyer the right to purchase a desired instrument is
called a call option. A call option is contract that gives its owner the right but not the
obligation, to buy a specified asset at specified prices on or before a specified date. An
American call option can be exercised on or before the specified date. But a European
option can be exercised on the specified date only. The writer of the call option may not
own the shares for which the call is written. If he owns the shares, it is a ‘Covered Call’
and if he does not own the shares it is a ‘Naked call’. Strategies: The following are the
strategies adopted by the parties of a call option. Assuming that brokerage, commission,
margins, premium, transaction costs and taxes are ignored.
A call option buyer’s profit/loss can be defined as follows:
• At all points where spot price < exercise price, there will be a loss.
• At all points where spot prices > exercise price, there will be a profit.
• Call Option buyer’s losses are limited, and profits are unlimited. Conversely, the call
option writer’s profits/loss will be as follows: • At all points where spot prices < exercise
price, there will be a profit
• At all points where spot prices > exercise price, there will be a loss
• Call Option writer’s profits are limited, and losses are unlimited.

Following is the table, which explains in the-money, Out-of-the-money and At-the- money
position for a Call option. Exercise call option Spot price>Exercise price In-The-Money

35
Do not exercise Spot price<Exercise price Out of the-Money Exercise/Do not exercise
Spot price=Exercise price

At-The-Money Payoff for buyer of call option: long call The profit/loss that the buyer
makes on the option depends on the spot price of the underlying asset. 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 asset is less than the strike price, he lets
his option un-exercise. His loss in Payoff for writer of put option: Short put the figure
below shows the profit/losses for the seller/writer of a three-month 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 4850, the buyer would exercise his option on
writer who would suffer losses to the extent of the difference between the strike price and
Nifty-close.
Meaning of swap: -
SWAPS Financial swaps are a funding technique, which permit a borrower to access one
market and then exchange the liability for another type of liability. Global financial markets
present borrowers and investors with a variety of financing and investment vehicles in
terms of currency and type of coupon – fixed or floating. It must be noted that the swaps
by themselves are not a funding instrument: They are devices to obtain the desired form of
financing indirectly. The borrower might otherwise as find this too expensive or even
inaccessible. A common explanation for the popularity of swaps concerns the concept of
comparative advantage. The basic principle is that some companies have a comparative
advantage when borrowing in fixed markets while other companies have a comparative
advantage in floating markets. Swaps are used to transform the fixed rate loan into a
floating rate loan.

Types of swaps: -

All Swaps involves exchange of a series of payments between two parties. A swap
transaction usually involves an intermediary who is a large international financial
Institution. The two payment streams estimated to have identical present values at the

36
outset when discounted at the respective cost of funds in the relevant markets. The most
widely prevalent swaps are

1. Interest rate swaps.

2. Currency swaps.

Interest rate swaps, as a name suggest involves an exchange of different payment streams,
which are fixed and floating in nature. Such an exchange is referred to as an exchange of
borrowings. For example, ‘B’ to pay the other party ‘A’ cash flows equal to interest at a
pre- determined fixed rate on a notional principal for a number of years. At the same time,
party ‘A’ agrees to pay ‘B’ cash flows equal to interest at a floating rate on the same
notional principal for the same period of time. The currencies of the two sets of interest
cash flows are the same. The life of the swap can range from two years to fifty years.
Usually, two non-financial companies do not get in touch with each other to directly
arrange a swap. They each deal with a financial intermediary such as a bank. At any given
point of time, the swaps spreads are determined by supply and demand. If no participants
in the swaps market want to receive fixed rather than floating, Swap spreads tend to fall.
If the reverse is true, the swaps spread tend to rise.

37
 CHAPTER – 4
FRAMEWORK OF ANALYSIS

38
4.1 FACTOR OF ANAYLSIS

The factor analysis is a technique for data reduction and that tries to explain observed
relationships among multiple outcome measures as a function of some underlying
variables, or factors. The factor analysis differs from other statistical analysis; it focuses
on multiple dependent variables and tries to uncover patterns of relationships. In this part,
the researcher has an attempt to analyse the opinion of the respondents in the study area
regarding the Factors influencing the Opinion about awareness and perception towards
equity derivatives by using the Factor analysis. The factor analysis each variable is
expressed as a linear combination of underlying factors. The amount of variance a variable
share with all other variables included in the analysis is referred to communality. The
covariation among the variables is described in terms of a small number of common factors
plus a unique factor for each variable. These factors are not over observed. If the variables
are standardized, the factor model may be represented as: Xi = Ai1 F1 + Ai2 F2 + Ai3 F3
+ …… + Aim FM + ViUi Where, Xi = i th standardized variable, Aij = Standardized
multiple regression coefficient of variable i on common factor j F = Common factor, Vi =
Standardized regression coefficient of variable i on unique factor i Ui = The unique factor
for variable i m = Number of common factors The unique factors are uncorrelated with
each other and with the common factors. The common factors themselves can be expressed
as linear combinations of the observed variables. Fi = Wi1 Xi + Wi2 X2 + Wi3 X3 + ….
+ Wik + Xk Where, Fi = Estimate of ithfactor Wi = Weight or factor score coefficient K =
Number of variables. It is possible to select weights or factor score coefficients so that the
first factor explains the largest portion of the total variance. Then a second set of weight
can be selected, so that is the second factor accounts for most of the residual variance,
subject to being uncorrelated with the first factor. This same principle could be applied to
selecting additional weights for the additional factors. Thus, the factors can be estimated
so that their factors scores, unlike the value of the original variables, are not correlated.
Furthermore, the first factor accounts for the highest variance in the data, the second factor
the second highest, and so on.

39
4.2 TESTING THE SAMPLING ADEQUANCY

For testing the sampling adequacy, before extracting the factors to test the appropriateness
of the factor model, Barlett‟s test of sphericity was used. The test statistic for sphericity is
based on a chi-square transformation of the determinant of the correlation matrix. Another
useful statistic is Kaiser-Meyer-Olkin (KMO) test of Measuring the Sampling Adequacy.
The sample values of the KMO statistic indicate that the correlation between pair of
variables cannot be explained by other variables, and that factor analysis may not be
appropriate. Generally, a value which is greater than .0.5 is acceptable. The correlation
matrix was examined carefully and the two tests, viz., Bartlett’s test of sphericity and
Kaiser-Meyer-Olkin test were undertaken to test if it was judicious to proceed with factor
analysis in the present study. The following hypothesis tested is tested by factor analysis.
Ho: The factor analysis is not valid H1: The factor analysis is valid

4.3. FACTORS INFLUENCING THE OPINION ABOUT AWARENESS AND

PREPARATION TOWARDS EQUITY DERIVATIVE

Table -2. Reliability Statistics

Cronbach's Alpha N of Items

.756 20

Table -1 shows that an examination had been made from the reliability of the data to check
whether random error causing inconsistency and it turn lower reliability is at a manageable
level or not, by running reliability test. From Table 1, it is clear that the values of coefficient
Alpha (Cronbach's Alpha) have been obtained, the minimum value of coefficient Alpha
obtained was .756. This shows data has satisfactory internal consistency reliability.

Table-2. KMO and Bartlett's Test

Kaiser-Meyer-Olkin Measure of Sampling Adequacy. .704

Approx. Chi-Square 1261.494
Bartlett's Test of Sphericity Df 190
Sig. .000

40
Table -2 shows the significance (0.000) is less than the assumed value (0.05), so reject the
null hypothesis, and conclude that the factor analysis is valid. Next, one may look at the
kmo coefficient to cross check bartlett’s test. It can be seen 0.703 is more than 0.5, so one
agrees with bartletts test that the factor analysis valid.

4.4 EXTRACRTION OF FACTOR PRINCIPAL COMPONENT ANALYSIS

There are two main stages in factor analysis. As the first stage in the factor analysis,
principal component analysis was used for the initial extraction of the factors. Pca is a
technique for forming a set of new variables that are linear combinations of the original set
of variables. The new variables are called principal components of factors. By retaining
only, the variables with eigen values greater than one, one can infer that 11.212 per cent of
variance is explained by factor 1, 11.162 per cent of variance is explained by factor 2, 8.836
per cent of variance is explained by factor 3, 8.798 per cent of variance is explained by
factor 4 , 7.848 per cent of variance is explained by factor 5, 6.558 per cent of variance is
explained by factor 6 and 6.386 per cent of variance is explained by factor 7, these details
total variance are explained in table 3.

Table-3. Total Variance Explained

41
4.5 SCREEN PLOT

The researcher can also use the screen plot. In this study, the screen starts with the 7th
factor: so, it’s assumed the seven factors (selected using eigen values over one) have
influencing awareness and perception towards equity derivatives.

FIGURE – 1 SCREEN PLOT

Table-4. Component Transformation Matrix

42
 Figure-2. Component Plot Rotated Space

4.6. Rotated Factor Matrix for Factors Influencing the Opinion about Awareness and
Perception towards Equity Derivatives (Factor Analysis)

The Rotated Factor Matrix for the variables relating to traders in Madurai District regarding
the factors influencing Awareness and Perception towards Equity Derivatives of the overall
sample respondents are as follows. Table 5 exhibits the rotated factor loadings for the 20
statements (variables) indicating the Factors influencing the Opinion about awareness and
perception towards equity derivatives

43
Table-5. Rotated Factor Matrix for opinion about awareness and perception
towards equity derivatives

Table-6. Rotated Factor Matrix for opinion about awareness and perception
towards equity derivatives – cont.…

44
Extraction Method: Principal Component Analysis. Rotation Method: Varimax with Kaiser
Normalization. a. Rotation converged in 9 iterations.
Table -6 shows exhibits the rotated factor loadings for the 20 statements (factors) are the
factors influencing the Opinion about awareness and perception towards equity derivatives.
It is clear from Table 6 that all the 20 statements have been extracted into eight factors
namely F1, F2, F3, F4, F5, F6, and F7. The factors with identified new names which
influence the consumer opinion about awareness and perception towards equity derivatives
are discussed in the following.
FACTOR I
Among the traders opinion about awareness and perception towards equity derivatives,
Only large company shares should be allowed in derivatives trading, Derivatives are highly
preferred over equity shares, Derivatives enable the shifting of risk from those unwilling
to bear risk to those willing to bear risk, Investing in Option contracts are less risky
compared to Futures and Investing in derivatives is much better in terms of returns than
depositing money in banks are the factors with higher positive loadings on Factor I. The
above said five factors with high loadings on Factor I is characterized as “Better earning
and Risk”. Hence, F1 is termed as Better earning and Risk. The eigen value for the above
Factor I is 2.242and the percentage variance is 11.212. It is to be concluded that the traders‟
opinion regarding the derivatives market is getting better earning and also risk along with
them. It comes as the first important factor.
FACTOR II
The second factor consists of trader opinion regarding the awareness and perception
towards equity derivatives such as, “Derivatives contracts are settled in cash which
removes problems of bad delivery and counterparty risk, Derivative trading brings more
information to the market and allows for quicker disseminations of information and Traders
are generally unaware of various strategies that can be adopted in derivatives trading are
the factors with higher positive loadings on Factor II. Therefore, all the three factors with
high loadings on Factor II are characterized as “Proper settlement and getting more
information”. Hence, F2 is termed as Proper settlement and getting more information. The
eigen value for the above Factor II is 2.232and the percentage variance is 11.162. It is to
be concluded that the derivatives contract are cash on proper settlement and derivative
trading brings more information and security for the traders. It is the second important
factor.
FACTOR III
The significant loading statements under third factor (F3) are „Futures and options help to
hedge/transfer risk efficiently, Derivatives enhance liquidity in market and Futures and
options helps in discovery of prices in more better way are the important factors with higher
positive loadings on Factor III. Therefore, all the three variables with high loadings on
Factor III are characterized as “Transfer of Risk and enhance liquidity”. Hence, F3 is

45
termed as Transfer of Risk and enhance liquidity. The eigen value for the above Factor III
is 1.767 and the percentage variance is 8.836. It is to be concluded from the above analysis,
that Futures and options help to transfer risk efficiently and enhance liquidity in market.
FACTOR IV
The statements made regarding „Derivatives like Futures and Options are effective risk
management tools; Derivative market is properly regulated, and Derivatives are for risk
takers and not for conservative traders are the factors with higher positive loadings on
Factor IV. Therefore, all the three variables with high loadings on Factor IV are
characterized as “Good risk management tool”. Hence, F4 is termed as good risk
management tool. The eigen value for the above Factor IV is 1.760 and the percentage
variance is 8.798. It is to be concluded that the Derivatives are effective risk management
tools. It comes under fourth important factor.
FACTOR V
It is understood that the statements made regarding „Brokers are well educated about
Futures and Derivatives are not suitable to small traders are the factors with higher positive
loadings on Factor V. Therefore, the above two variables with high loadings on Factor V
are characterized as “Brokers well educated and Derivatives not suitable for small traders”.
Hence, F5 is termed as Brokers well educated and Derivatives not suitable for small traders.
The eigen value for the above Factor IV is 1.570 and the percentage variance is 7.848. It is
to be concluded that in derivatives market, the brokers are well educated and also this
market not suitable for small traders and it comes under fifth dominant factor.
FACTOR VI
The statement made regarding, „Lot size of derivative contracts should be reduced to
increase participation in the market‟ is the factor with another higher positive loadings on
Factor V. Therefore, the above variable with high loading on Factor VI is characterized as
“Lot size should be reduced”. Hence, F6 is termed as Lot size should be reduced. The eigen
value for the above Factor IV is 1.312 and the percentage variance is 6.558. It is to be
concluded that the Lot size of derivative market contracts should be reduced. Therefore, it
will lead to increase a greater number of members participation in the market. It comes
under fifth dominant factor.
FACTOR VII
It is exhibits from the above statements, „Volatility has increased in equity market after the
introduction of Futures and Options and Derivatives have the ability to weather the market
fluctuations are the factors with higher positive loadings on Factor VII. Therefore, the
above two variables with high loadings on Factor VI are characterized as “More Volatility
and Fluctuation”. Hence, F7 is termed as More Volatility and Fluctuation The eigen value
for the above Factor VII is 1.277 and the percentage variance is 6.386. It comes under fifth
dominant factor.

46
Table-7. Variables with the Highest Factor Loadings for Opinion About Awareness
and Perception towards Equity Derivatives

It is clear from Table 7 that „Only large company shares should be allowed in derivatives
trading 0.672, „Derivatives contracts are settled in cash which removes problems of bad
delivery and counterparty risk 0.735, „Futures and options help to hedge/transfer risk
efficiently 0.850, „Derivatives like Futures and Options are effective risk management
tools 0.817, „Brokers are well educated about Futures 0.691, Lot size of derivative
contracts should be reduced to increase participation in the market 0.832 and Volatility has
increased in equity market after the introduction of Futures and Options0.821 are the
variables with the highest factor loadings under factors F1, F2, F3, F4, F5,F6 and F7.
Therefore, these are the identified seven variables which influence the traders regarding
awareness and perception towards equity derivatives.

47