EQUITY DERIVATIVE MODULES Presented by S.Kannan MBA.

Derivative is a contract or a product whose value is derived from value of some other asset known as underlying. Derivatives are based on wide range of underlying assets. These include: Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead Energy resources such as Oil and Gas, Coal, Electricity Agri commodities such as wheat, Sugar, Coffee, Cotton, Pulses Financial assets such as Shares, Bonds and Foreign Exchange.

Forward: A forward contract is a private agreement between two parties giving the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time. Futures: A futures contract is similar to a forward, except that the deal is made through an organized and regulated exchange rather than being negotiated directly between two parties.

Swaps: A swap is an agreement made between two parties to exchange cash flows in the future according to a prearranged formula. Swaps are series of forward contracts. interest rates, currency exchange rates commodity prices

Index is a statistical indicator that measures changes in the economy in general or in particular areas. In case of financial markets, an index is a portfolio of securities that represent a particular market or a portion of a market

Market capitalization weighted index Free float market capitalization index Price weighted index Equal weighted index

Market capitalization weighted index:

A company mkt capitalization MCWI=

total mkt cap of all companies market capitalization = share price* total no of shares Example :nifty index Free float market capitalization index:
FFMCI: share price*(no of shares outstanding locked shares) locked shares means promoters holding, FII holdings, govt holdings Example : sensex index

Price weighted index total share price PWI = no of shares Example : Dow jones Equal weighted index EWI=100*1/N *(S1D2/S1D1+S2D2/S2D1+.) N- no of days S1- share price S2- another share price D1- day1 D2- day2

Tick size: It is minimum move allowed in the price quotations Ex: Tick size for Nifty futures is 5 paisa Contract Size: Futures contracts are traded in lots Ex: CNX Nifty, lot size is 50 Cost of carry: Cost of Carry is the relationship between futures prices and spot prices Open Interest: Open Interest and Volumes Traded An open interest is the total number of contracts outstanding Long position: Long position Outstanding/ unsettled buy position in a contract is called Long Position

Naked and calendar spread positions: same strike price or same script and different expiry contract example: buy june 5800 call and sell july 5800 call
Cash and Carry Model: Fair price of future = spot price * exp (days of expairy/365) * interest rate/100) Unsystematic Risk: unsystematic risk is the component of price risk that is unique to particular events of the company and/or industry. Systematic Risk: Number of contracts for perfect hedge = Vp*p/ Vi Vp Value of the portfolio p Beta of the portfolio Vi- contract size

Hedging : Long hedge: Long hedge is the transaction when we hedge our position in cash market by going long in futures market. Short hedge: Short Hedge is a transaction when the hedge is accomplished by going short in futures market Cross hedge: They may trade in futures in this asset to protect the value of their asset in cash market. Arbitrage: Cash and carry arbitrage: Cash and carry arbitrage refers to a long position in the cash or underlying market and a short position in futures market. Reverse cash and carry arbitrage: Reverse cash and carry arbitrage refers to long position in futures market and short position in the underlying or cash market. Inter-Exchange arbitrage: This arbitrage entails two positions on the same contract in two different markets/ exchanges.

Options may be categorized into two main types:Call Options: buyer a right to buy the underlying asset Put Option: buyer a right to sell the underlying asset Writer of an option: one who receives the option premium and American option: The owner of such option can exercise his right at any time on or before the expiry date European option: The owner of such option can exercise his right only on the expiry date Strike price : Strike price is the price per share for which the underlying security may be purchased or sold by the option holder

At the money : At the money option would lead to zero cash flow spot price = strike price Out of the money: Out of the money option is negative cash flow call option spot price < strike price put option spot price > strike price In the money: This option would give holder a positive cash flow call option spot price > strike price put option spot price < strike price Leverage: An option buyer pays a relatively small premium for market exposure in relation to the contract value

Option Greeks: Delta: Delta = Change in option premium/ Unit change in price of the underlying asset Gamma: Gamma = Change in an option delta/ Unit change in price of underlying asset Theta: Theta =Change in an option premium/ Change in time to expiry Vega: Vega = Change in an option premium/ Change in volatility Rho: Rho = Change in an option premium/ Change in risk-free interest rate

These are limited profit and limited loss positions. They are primarily categorized into three sections as Vertical Spreads Horizontal Spreads Diagonal Spreads Vertical Spreads: same expiry but different strike prices bull spread bear spread

Horizontal Spread: Horizontal spread involves same strike, but different expiry

Diagonal spread: different expiries as well as different strikes

Straddle: Two options of same strike prices and same maturity

Strangle:
Both option buy or sell and same or different strike price and same expiry

Covered Call: same stock option

Protective Put: same stock option

Collar:

same stock option

Butterfly Spread:

The Trading system of BSE is called Derivatives Trading & Settlement System (DTSS) and that of NSE is called NEAT-F&O trading system. Entities in the trading system: Trading Members Trading cum Clearing Members Professional Clearing Members and Participants Corporate Hierarchy: Corporate Manager Branch Manager and Dealer

Time conditions: Day order: A Day order is an order which is valid for a single day Immediate or cancel (IOC): An unmatched order will be immediately cancelled Price condition: Limit order: It is an order to buy or sell a contract at a specified price Market order: A market order is an order to buy or sell a contract at the bid or offer price currently available in the market Order Matching Rules: Matching is essentially on the basis of security, its price, time and quantity Price Band: For Index Futures: at 10% of the base price For Futures on Individual Securities: at 20% of the base price For Index and Stock Options: A contract specific price range based on its delta value is computed and updated on a daily basis.

Eligibility criteria of stocks: chosen from amongst the top 500 stock median quarter-sigma order size (MQSOS) over the last six months shall be not less than Rs.10 Lakhs The market wide position limit (MWPL) in the stock shall not be less than Rs.300 crores Exit criteria for stocks in equity derivatives: MQSOS last six months shall not be less than Rs. 5 Lakhs MWPL of the stock shall not be less than Rs. 200 crores monthly turnover last three months shall not be less than Rs. 100 crores Eligibility criteria of Indices: At least 80% weightage of constituent stocks of the index no single ineligible stock in the index shall have a weightage of more than 5% in the index Dividends: below 10% of the market value above 10% of the market value the Strike Price would be adjusted.

Clearing member: can do both clearing & trading Professional Clearing member: can only do clearing Self Clearing member: can clear own trades only

Custodian: A Custodian is an entity that helps register and safeguard the securities of its clients and also keeps track of corporate actions Maintaining a clients securities account rights accruing to the client in respect of securities Keeping the client informed of the actions taken or to be taken by the issue of securities criteria of trading members: minimum of Rs. 5 lakh as a deposit is required 25% of the base minimum capital is to be maintained in cash with the exchange 25% in the form of long term (3years or more) fixed deposit with the bank with which the stock exchange has given complete lien the remaining shall be in form of securities with 30% margin (the securities should be in the name of members) the base minimum capital is not less than 8% of the gross outstanding business in the Exchange.

Settlement Price for derivatives: T+2 settlement cycle is followed in the Indian equities market The settlement of derivative trades is on T + 0 or T + 1 working day basis The securities pay out time 10.30am to 1.30 pm
Product Futures Contracts on Index or Individual Security Futures Contracts on Index or Individual Security Options Contracts on Index and Individual Securities Settlement Daily Settlement Final Settlement Price Closing price of trading day last trading day of the futures contracts

Final Exercise Settlement

Closing price of such underlying security

Adjustment: Corporate Actions to be adjusted by Bonus Rights Merger / De-merger Amalgamation Splits Consolidations Hive-off Bonus - Ratio A:B Adjustment factor : (A+B)/B Stock Splits and Consolidations Ratio - A : B Adjustment factor : A/B Settlement of Custodial Participant (CP) Deals: Clearing corporation provides a facility to any trading member CP is required to register with clearing corporation All trades executed by such CP through any TM which allots them a unique CP code Initial margin: Initial margins can be paid by members in the form of Cash, Bank Guarantee, Fixed Deposit Receipts A Clearing Member collects initial margin from TM whereas TM collects from his clients

Premium Margin: Premium Margin is also charged at client level. This margin is required to be paid by a buyer of an option till the premium settlement is complete. Exposure Margins : Clearing members are subject to exposure margins in addition to initial margins. Risk Management: Clearing corporations on-line position monitoring system monitors a CMs open position on a real-time basis. It sets limit for each CM based on his effective deposits and simultaneously generates alert messages whenever a CM reaches 70 %, 80 %, 90 % and a disablement message at 100 % of the limit Trading member position limits: higher of Rs.500 crore or 15% of the total open interest in the market in equity index option contracts

Client level position limits: A cross 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 Market wide position limits: contracts on a particular underlying stock. OI > 95% of MWPL - Scrip banned in f/o OI <= 80% of MWPL Scrip ban lifted FII / MFs position limits: a. Short positions in index derivatives not exceeding (in notional value) the FIIs/MFs holding of stocks. b. Long positions in index derivatives not exceeding (in notional value) the FIIs/MFs holding of cash, government securities, Tbills and similar instruments.

Penalties: shortage of value more than Rs.5 lakhs

Instances of Disablement 1st instance 2nd to 5th instance of disablement 6th to 10th instance Penalty to be levied 0.07% per day 0.07% per day + Rs.5,000/- per instance from 2nd to 5th instance 0.07% per day + Rs.20,000/- ( for 2nd to 5th instance) + Rs.10000/- per instance from 6th to 10th instance 0.07% per day + Rs.70,000/- ( for 2nd to 10th instance) + Rs.10,000/- per instance from 11th instance onwards. Additionally, the member will be referred to the Disciplinary Action Committee for suitable action

11th instance onwards

At the end of each day during which the ban on fresh positions is in force for any security penalty 1% of the value minimum of Rs.5000 and maximum of Rs.100000

Securities Contracts (Regulation) Act, 1956:

Settled on the clearing house of the recognized stock exchange, in accordance with the rules and byelaws of such stock exchanges chairmanship of Dr. L.C.Gupta was set by SEBI to develop the appropriate regulatory framework for derivatives trading in India The derivatives exchange/segment should have a separate governing council and representation of trading/clearing members shall be limited to maximum of 40% of the total members of the governing council The Exchange should have a minimum of 50 members

Eligibility criteria for membership on F&O segment:

Particulars (all values in Rs. Lakhs) Networth CM and F&O segment 100 CM, WDM and F&O 200

Interest free security deposit (IFSD)

Collateral security deposit (CSD) Annual subscription

125

275

25

25

The minimum networth for clearing members of the derivatives clearing corporation/house shall be Rs.300 Lakhs

Liquid assets: The total liquid assets comprise of at least 50% of the cash component and the rest is non cash component. Cash Component: Cash Bank fixed deposits Bank Guarantees mutual fund and Gilt funds where applicable haircut is 10%. Government Securities and T-Bills Non Cash Component: Equity Shares Mutual fund units other than those listed under cash component decided by clearing corporation Calendar spreads on futures will attract lower margins (minimum 1% and maximum 3% - the margin itself being 0.5% per month of spread on the far month value)

When forward contract is for hedging: The premium or discount Exchange difference (difference between the value of settlement date/ reporting date and value at previous reporting date/ inception of the contract) is recognized in Profit & Loss statement of the year. Profit/ loss on cancellation/ renewal of forward contract are recognized in P&L of the year. Securities Transaction Tax (STT) Trading member has to pay securities transaction tax on the transaction executed on the exchange shall be as under: STT rates: 1. Sale of an futures/ option in securities 0.017 per cent 2. Sale of an option in securities, where option is exercised 0.125 per cent ( Paid by Purchaser)

Churning : Churning refers to when securities professionals making unnecessary and excessive trades in customer accounts for the sole purpose of generating commissions. Customer Due Diligence: Obtaining sufficient information in order to identify persons who beneficially ensure that the transactions being conducted are consistent with the registered intermediarys knowledge of the customer Investors Grievance Mechanism: These include the Investor Service Committees (ISC) consisting of Exchange officials SEBI also monitors exchange performance related to investor grievance redressal

Clients of special categories (CSC): Non resident clients. High networth clients. Trust, Charities, NGOs and organizations receiving donations. Companies having close family shareholdings or beneficial ownership. Politically exposed persons (PEP) of foreign origin. Companies offering foreign exchange offerings. Clients in high risk countries Non face to face clients. Arbitration: Arbitration is a quasi judicial process of settlement of disputes between Trading Members, Investors, Sub-brokers & Clearing Members and between Investors and Issuers SEBI Complaints Redress System (SCORES): [http://scores.gov.in] SEBI has launched a centralized web based complaints redress system

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