RISK MANAGEMENT WITH DERIVATIVES

Introduction
In recent years, derivatives have become increasingly important in the world of
finance. A derivative (or derivative security) is a financial instrument whose value is
derived from the values of the other, more basic underlying variables such as foreign
exchange, treasury bills, bonds, shares, share indices, price of traded assets etc. A stock
option, for example, is a derivative whose value is dependent on the price of the stock.
The term derivative clubs the main instruments like Futures, Options, forwards rate
agreements (FRAs) and swaps.

The emergence of the market for derivative products can be traced back to the
willingness of risk-averse economic agents to guard themselves against uncertainties
arising out of fluctuations in asset prices. The financial marketed are marked by a very
high degree of volatility. Through the use of derivatives products, it is possible to
partially or fully transfer price risks by locking in asset prices. As instruments of risk
management, these generally don’t influence the fluctuation 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
investors.

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

FUTURES
A future contact is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. There are various types of futures like stock
Index Futures, Foreign currency, Interest rate futures.

Futures contracts need a futures exchange and cleaning house o function. So far,
India, we don’t have a futures exchange and clearing house for any financial future.
However, a beginning has been made by permitting futures trading in certain commodity
exchanges. However no beginning has made to setup separate futures exchanges for
capital market, money market and forex market.
National stock exchange (NSE) and Bombay stock Exchange (BSE) have set up
the necessary infrastructure for stock index futures.
A future contact on the stock market index gives its owner the right and
obligations to buy or sell the portfolio of stocks characterized by the index. Stock index
futures are cash settled, there is no delivery of underlying assets.
 On December 17, 2005, a chana contract for that month was trading at Rs.2083,
whereas the contract for March, 2006 was trading at Rs.1766. Actually, chana is shown
in the November-December and harvested in February-March. So, it is quite obvious that
during December supply will be less and that is the reason of high trading price for chana
December contract.
On the other hand, going by the speculation that there will be bumper crop for
Chana in February-March,2000, resulting in increase in the supply of Chana in the
market, the trading price is lower in comparison to December price.
Now, using cost of carry model, one can take position in the contracts and hope
to lock in some profit. In this case, March chana contract is running at a premium or in
other words, is overpriced because the fair value came out to be Rs.1550.
Hence, a producer, farmer, trader, could sell at this price level and make proit, if
price falls due to overproduction.
SEBI approved derivatives trading in June 2000. The first instruments to be
traded were index futures based on NSE’s Nifty and BSE’s Sensex. This was followed by
opinions trading on the two indices in june2005 and options in 30 individual securities in
Juy2005. Futures’ trading in individual stocks was permitted in Nov.2002. Less than a
month after the launch, NSE had achieved a record of sorts: the number of contracts
(11135 on Dec.14,2005), is the second highest in the world after Spain’s MEFF and
ahead of London International Financial Future Exchange (LIFFE).
17,000, September 26, 2007 The Sensex scaled yet another height during early
morning trade on September 26, 2007. Within minutes after trading began, the Sensex
crossed the 17,000-mark . Some profit taking towards the end, saw the index slip into red
to 16,887 - down 187 points from the day's high. The Sensex ended with a gain of 22
points at 16,921.
18,000, October 09, 2007 The BSE Sensex crossed the 18,000-mark on October
09, 2007. It took just 8 days to cross 18,000 points from the 17,000 mark. The index
zoomed to a new all-time intra-day high of 18,327. It finally gained 789 points to close at
an all-time high of 18,280. The market set several new records including the biggest
single day gain of 789 points at close, as well as the largest intra-day gains of 993 points
in absolute term backed by frenzied buying after the news of the UPA and Left meeting
on October 22 put an end to the worries of an impending election.
19,000, October 15, 2007 The Sensex crossed the 19,000-mark backed by revival
of funds-based buying in blue chip stocks in metal, capital goods and refinery sectors.
The index gained the last 1,000 points in just four trading days. The index touched a fresh
all-time intra-day high of 19,096, and finally ended with a smart gain of 640 points at
19,059.The Nifty gained 242 points to close at 5,670.
Margining system, this is similar to equity or commodity trading. The various
margins at the client level are initial, portfolio-based margining, calendar spread margins,
extreme loss margin etc., the computations are on real-time basis and mark to market
basis. The client margins have to be compulsory collected and penalty on members who
do not collect margins from their clients. The exchange shall also conduct regular
inspections to ensure margin collection from clients. The margins deposited on client
account shall not be utilized for fulfilling the dues which a clearing member may owe the
clearing corporation in respect of trades on the member’s own account. At the time of
opening/closing a position, the member should indicate whether it is a client or
proprietary position. Periodic risk evaluation report shall be generated to compare the
margins collected vis-à-vis the actual price changes. The position limits at clients and the
trading member level are prescribed to check market manipulation. The surveillance
systems/processes of the exchanges should be so designed to capture and monitor the
margins, positions limits (open interests), volatility and the price levels of the underlying.
The exchanges should study the practices at the global forex derivatives exchanges

Derivatives
Forwards Futures Options Complex Derivatives
• Interbank Commodity • Commodit • Swaps
foreign futures Options • Forward Rate
exchange • Financial • Financial Agreement
forwards futures Options (FRA)
• Specific . • Range forward
delivery • Exotic options
forward • Collars
contracts(non • Synthetic
transferable derivatives
/transferable • Credit derivatives

It simply shows that growth in derivatives trading is tremendous and Indian stock
market is ready for the next big lap.
In future, only 2 stock exchanges are expected to survive. The lead NSE has
gained over the BSE will only increase in the coming years. Already, NSE is perceived to
be more investor-friendly than BSE by most of the investors. The fact that NSE is a
preferred derivative destination-on Dec.6, while the NSE logged derivative trading of Rs.
956 crore, BSE did only Rs. 8 cr. Less than one percent of the former.- Is just another
reason why NSE can soon become the only exchange that matters in India
In the future, the trading volumes of a stock exchange in its cash and derivatives
market will increasingly feed off each other in a synergistic relationship
The NSE trading contacts are based on S&P CNX Nifty index. Nifty futures
contacts have a trading cycle of a maximum of three months, which are known as(i) the
near month(ii)the next month and(iii)the far month. A new contact is introduced on the
trading day following the expiry of the near month contract. Nifty contracts expire on the
last Thursday of expiry month. If the last Thursday is trading holiday, the contracts will
expire on the previous trading day.
In India, the NSE’s NIFTY and the and the BSE’s SENSEX are maturing both in
terms of volume and participation. Institutional investors both in Indian and abroad, as
money managers as well as small investors, use the NIFTY and SENSEX to gauge the
mood of Indian stock market. Both the indices are working proxies for the Indian stock
market.
The BSE SENSEX consists of 30 scripts. The contract multiplier is 50. If the
index point is 4000, then the value of the Sensex future contract will be Rs.2 lakh. The
profit and loss in SENSEX futures contacts depend upon the difference between the price
at which the position is opened and the price at which it is closed.
NIFTY index consists of the shares of 50 companies, each having market
capitalization of more than Rs.500 crore. NIFTY is a value weighted index. Each index
point has a value of Rs. 200 making the value of one contract more than Rs.2 lakh. If the
index is say, at 1100 points, than the value of one contract will be 1100 x 200 =
Rs2,20,000. For buying more than one contract, market lots in multiplier of 200 have to
be taken. Thus the calculations is very simple as any change in index points is multiplied
by 200 while marking to market and the profit/loss is worked out on a daily basis.

Top five stock Future(traded): NIFTY May,2007 NIFTY Apr.2007,Reliance

Apr.2007. SBIN Apr 2007,Centurytex Apr.2007. The total traded value for the month of
June2007 was Rs. 4,00,096 cr.
Month Total Traded Average Open
Value Daily Traded Interest
(Rs. Cr) Value(Rs.cr) (Rs. Cr)
Dec.2006 347747 17387 26282
Jan.2007 350817 17541 30708
Feb.2007 352653 18651 28895
Mar.2007 277378 13208 22333
Apr.2007 296629 14831 25609
May.2007 400096 19052 33168
(Source: www.nse-india.com)
Transaction in the derivative segments are through online trading based on an
order driven system. Members of exchanges are given separate membership for future
and options segments. Clearing is done by a clearing corporation.

Margin is collected to minimize the risk of default and to ensure the performance
of the truncations of index future. Margins are the payments for deposits taken by
exchanges/ clearing houses to minimize the risk of default by their counterparty. Clearing
houses in futures and options segments ensure the collections of margin in all transaction
on net basis. In case of any default, the trading for the members is stopped. The
settlement of transaction price is marked to the closing price of index futures contracts in
the settlement. On expiry of index futures contracts, open position is marked to final
settlement-price and profit/ loss are debited or credited in the bank a/c clearing members.
The settlement price is the closing value of the cash index.
OPTIONS
An option is contract between two parties in which one has the right, but not the
obligation to buy or sell some underlying asset. Options are differed delivery contracts
that give the right, but not the obligation, to buy or sell a specified commodity or security
stock index at a set price on or before a specified future date. The seller of the option has
no right, but has the obligation, to buy or sell any asset if the buyer exercises his right.
The buyer of the option pays a fee or premium to the seller for acquiring the right. Option
is of two types.
i. Call Option
ii. Put Option.
CALL OPTION
A call option is a contract that gives its owner the right, but does not impose an
obligation, to buy stock or nay financial asset at a specified price on or before a specified
date. For example if one buys a call option. Option on TISCO, one gets the right to
purchase 100 shares of TISCO common stock at the specified price any time between
today and a specified date. If the price of TISCO falls, the buyer of TISCO call option
need not exercise his call option he may instead buy the stock from the market at a
cheaper rate. The specified price is called the exercise price or strike price.
The thing that than be bought with the option is called the underlying asset. The
asset can be a commodity, financial instrument, the right to acquire a stock index, etc.,
the call option price is known as options premium. Options contracts are created when a
buyer or seller agree on a price. The buyer pays the premium to the seller. If the call
owner exercises the option, the seller must deliver the asset. If the call writer does not
own the asset, he is said to have written a ‘naked’ call. On the exercise of a naked call
option, the writer will have to buy the underlying asset from the market at the prevailing
spot price so that he can deliver the asset to the buyer. Call writer are required to deposit
a margin in the exchange. This margin acts as formal collateral to ensure that the option
writer can fulfill the terms of the contract. If the writer owns the underlying asset, the call
is known as a ‘covered’ call.
The call buyer’s price outlook is bullish. An investor would profit if the price
increases. For example if the investor owned a call to buy 100 shares of TISCO at a strike
price of Rs.340 per share and the price of TISCO subsequently rises to Rs.360 per share,
the option holder may take following stands till expiration.

• Do nothing
• Close out his position in the option market, one who owns an option can sell it at
the market price.
• Exercise the call on of before expiration depending on the type of the call, i.e.
European or American, if prices are favorable.
• If the price of the underlying asset is less than the strike price, then the call
expires worthless. For example the strike price of the stock is Rs.340 and on the
expiration day the stock price is Rs.330 then the call owner will not exercise the
call.
• If the price of the share exceeds the strike price, then the call owner would
exercise the call, since he has a right the obtain the share strike price if the spot
price is higher. In this situation, the call buyer gains in exercising his option and
the writer losses anything beyond the call premium that he collected.
• If the price of the asset and the strike price are the same, then the call owner need
not exercise the call.

PUT OPTION
A Put Option gives the holder the right but not the obligation to sell an
asset by a certain date for a certain price.
 The owner of an American put option has the right, but not the obligation,
e exercised only on the to sell stock, stock indices or other financial assets at the
specified executrices price on or before a specified expiration date. A European
put option can be exercised only on the expiration date. The seller of the put
options obliged to take delivery of the underlying asselieve that the price of the
underlying asset will fall and they will not be able to sell the asset at a higher
price. {Pet. When the put option is opened, the buyer pays a premium to the put
seller. If the price of the underlying assets rises above the strike price and stays
there, the seller of the put option will keep the premium as his profit. Put buyer
are bearish in nature as these investors believe that the price of the underlying
asset will fall and they will not be able to sell the asset at a higher price. Put
option sellers are bullish as these people believe that the price of the underlying
asset will rise.

OPTIONS TRADING
Exchange traded options started in India with the introduction of stock
Index Option contracts. The futures and options segments were introduced in
National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) in May
18th ,2007 with the introduction of index Futures trading in the SENSEX and
NIFTY. NSE introduced trading in NIFTY option in May 18th ,2007, while BSE
started trading in SENSEX option on May 18th ,2007. Options were also
introduced in selected individual stocks in July 2007.

Long Strangle on Nifty

Strike Option Price Buy/Sell
Price Type
4,220 Call 51.09 Buy
4,100 Put 25.85 Buy
Source:www.nse-india.com

The pay-off of a long strangle on the Nifty. The positions are opened when the
Nifty is trading at 4,210 as on May18, 2007. Both the call and the put option are
Out of Money.
A Gut is also created either by buying or selling a call and a put option.
While buying we create a Long Gut and by selling, a Short Gut. The important
thing to note here is that the Put Option has a higher strike prices than the Call
Option.
Long Gut on Nifty
Strike Option Price Buy/Sell
Price Type
4,100 Call 14.857 Buy
4,220 Put 72.2 Buy
Source: www.nse-india.com
 The pay-off of a Long Gut on the Nifty. The position is opened when the
Nifty is trading at 4,210 as on May 18,2007. Both the call and the put option are
in the money and the contract expiry is on May31, 2007.
These instruments will provide a variety of opportunities to both investors
and traders in post-badly scenario. The futures and options segments (F&Os) are
part of the existing stock exchange dealing in cash market shares. Only a member
of the exchange for the cash segment can be become a trading member on the
(F&O) segment.

The National Securities clearing corporation (NSCCL) is the clearing and

settlement agency for all deals executed on NSE’s (F&Os) segment. NSCCL acts
as a counter party to all deals on NSE’s F&O section and guarantee’s settlement.
Cleaning members are different from trading members for NSE’s F&O segments
are required to appoint a clearing member for clearing and settlement of their
deals before starting trading.

As far as BSE is concerned there is no separate clearing corporation in

BSE and, therefore, each trading member is responsible for his clearing and
settlement vis-à-vis the exchange. BSE has started limited trading memberships
aimed, exclusively at the derivatives segment of the exchange. Limited trading
members will be a trading obligation & liabilities of a trading member of the
derivatives segments for all purpose.

The hedgers take a position in futures or options or other contracts for the
purpose of reducing exposure to one or more types of risk. The further boost the
derivative market, the Govt. is considering the appointment of a committee to
examine if profits from derivative trading could be considered as emanating from
hedging transactions and not as speculative profits. The change will mean that
losses incurred or profits earned from trading in future will be allowed to be set
off require an amendment in the lines of business. This will require an amendment
in the Income Tax Act to remove the distinction in section 43(5) of the act which
at present treats hedge transactions and speculative transaction differently.

Top Five stock Options (traded): NIFTY Apr.2007. Total traded value for
the month of June.2007 was Rs.23,358 cr.
Month Total Traded Average Open
Value Daily Traded Interest
(Rs. Cr) Value(Rs.cr) (Rs. Cr)
Dec.2006 16408 820 3361
Jan.2007 19401 970 3815
Feb.2007 16785 883 3416
Mar.2007 12106 576 2800
Apr.2007 17050 853 3113
May,2007 23358 1112 4449
(Source: www.nse-india.com)
 Derivative instruments are highly geared and derivative markets move a
great speed. These can produce disastrous results, if used improperly. If Feb.1995,
the Bearing Bank of London collapsed as a result of losses from derivatives
trading. However, if used properly, they are the powerful tools for risk
management. India is one of the leaders in the production of various
commodities. It is also having a long history of derivative trading. The market has
made considerable progress in terms of technology, governance and the trading
activity. The most noticeable part is that this development has taken place on the
government has withdrawn the protection from many derivatives and allowed the
market to determine the price. Therefore, the price risk management should be
handled by the market forces and there should be no administered price
mechanism. Management of price risk will be very important one the free trade
policy is introduced.

REFERENCES
 Brinson, Gray P., Hood Randolf and Beebower, GilbertL.(1995),
Determinants of Portfolio Performance”, Financial analyst Journal,
1:133-137.
 Gupta, Amitabh (2002), Risk Management with commodities, Amol
Publications, New Delhi.
 Smith, Keith V. and Tito, Dennis A, “Trading strategies of
Derivatives”. Journal of Financial and Quantitative Analysis, 4:381-
390.
 Spaulding, David(1997), Measuring Investment Performance and
Risk management with stock prices, McGraw Hill Book Company,
New York.
 Warther, Vincent A. (1995), “Aggregate Mutual Funds Flows and
Security Returns.” Journal of Financial Economics, 39:209-235.
 Reilly, Frank K.(1982), “Investment”, Dryden Press: 643-648.

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