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An
option is a contract, which gives the buyer (holder) the right, but not the
obligation,to buy or sell specified quantity of the underlying assets, at a
specific (strike) price on or before a specified time (expiration date),in
consideration of a sum called the option premium. To put it in more simple
terms,an option gives the holder an insurance against the risk of loss but a
promise of unlimited profits if his judgment (of the future direction of the
market or a particular stock) proves to be right. |
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2.What
are the important terms used in options trading?
·
Underlying : The specific
security / asset on which an options contract is based.
·
Option Premium - Premium is
the price paid by the buyer (of the the option) to the seller to
acquire the right to buy or sell.
·
Strike Price or Exercise Price - The strike
or exercise price of an option is the
specified/ pre-determined price of the underlying asset at which the same can be bought or sold if the option buyer exercises his right to buy/ sell on or before the expiration day.
·
Expiration date - The date on
which the option expires is known as Expiration Date. On Expiration date,
either the option is exercised or it expires worthless.
·
Exercise Date - The date on
which the option is actually exercised.
·
Open Interest - The total
number of options contracts outstanding in the market at any given point of
time.
·
Option Holder is the one
who buys an option, which can be a call, or a put option. He enjoys the right
to buy or sell the underlying asset at a specified price on or before
specified time. His upside potential (the ability to reap profits) is
unlimited while losses are limited to the premium paid by him to the option
writer.
·
Option Seller/ Writer is the one
who is obligated to buy (in case of Put option) or to sell (in case of call
option), the underlying asset in case the buyer of the option decides to
exercise his option. His profits are limited to the premium received from the
buyer while his downside is unlimited.
·
Option Class - All listed
options of a particular type (i.e., call or put) on a particular underlying
instrument, e.g., all Nifty Call Options (or) all Nifty Put Options.
·
Option Series - An option
series consists of all the options of a given class with the same expiration
date and strike price. e.g., Nifty-1100-February-Call is an options series
which includes all Nifty Call options that are traded with strike price of
1100 and expiry in February.
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3. What are Call Options?
A
call option gives the holder (buyer/ one who is long call), the right to buy
a specified quantity of the underlying asset at the strike price on or before
the expiration date. Note: The
seller (one who is short call) however, has the obligation to sell the
underlying asset if the buyer of the call option decides to exercise his
option to buy.An Illustration: An investor buys a call option on Infosys at the strike price of Rs. 3500 at a premium of Rs. 100. If the market price of Infosys rises above Rs. 3500, the option can be exercised. However, the investor will earn profits once the share price crosses Rs. 3600 (Strike Price + Premium i.e. 3500+100). Suppose the stock price is Rs. 3800, the option is exercised and the investor buys 1 share of Infosys from the seller of the option at Rs 3500 and sells it in the market at Rs 3800 making a profit of Rs. 200 The profit from a long call is equivalent to {(Spot price - Strike price) - Premium}. In another scenario, if at the time of expiry stock price falls below Rs. 3500 e.g. if it touches Rs. 3000, the buyer of the call option will choose not to exercise his option. In this case the buyer loses the premium (Rs. 100) paid which should be the profit earned by the seller/writer of the call option. |
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4. What are Put Options?
A
Put option gives the holder (buyer/ one who is long Put), the right to sell
specified quantity of the underlying asset at the strike price on or before
the expiry date. Note: The seller of the put option (one who is short Put)
however, has the obligation to buy the underlying asset at the strike price
if the buyer decides to exercise his option to sell.An Illustration: An investor buys one Put option on Reliance at the strike price of Rs. 300, at a premium of Rs. 25. If the market price of Reliance, on the day of expiry is less than Rs. 300, the option can be exercised as it is 'in the money'. The investor's break-even point is Rs. 275 (strike price - premium paid) i.e., investor will earn profits if the market falls below 275. Suppose stock price is Rs. 260, the buyer of the Put option can immediately buy a Reliance share in the market @ Rs. 260/- & exercises his option selling the Reliance share at Rs 300 to the option writer thus making a net profit of Rs. 15 The profit from a long put is equivalent to {(Strike price - Spot Price) - Premium paid}. In another scenario, if at the time of expiry, market price of Reliance is Rs. 320, the buyer of the Put option will choose not to exercise his option to sell as he can sell in the market at a higher rate. In this case the investor loses the premium paid (i.e. Rs. 25), which shall be the profit earned by the seller of the Put option.
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An
American style option is the one which can be exercised by the buyer on or
before the expiration date, i.e. anytime between the day of purchase of the
option and the day of its expiry. The European kind of option is the one
which can be exercised by the buyer on the expiration day only and not
anytime before that. In India,
Index Options are European style of options whereas Individual Stock Options
are American style of Options. |
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6. How are options different from futures?
The significant differences in Futures and Options are as under:
·
Futures are contracts to buy or sell specified quantity of
the underlying assets at a price agreed upon by the buyer & seller, on or
before a specified time. Both the buyer and seller are obligated to buy/sell
the underlying asset. This contract cannot be reversed at the option of any
of the parties. In case of Options, the holder (buyer) of the option holds
the right to exercise the option (although he is under no obligation to do so).
·
Futures Contracts have symmetric risk profile for both the
buyer as well as the seller, whereas options have asymmetric risk profile.
This, in simple terms, means that the risk of a buyer of a futures contract
is similar to that of one holding a stock in the spot market. However, in
case of options, the option holder's risk is limited to the premium paid by
him. The Option Writer/Sellers's risk is unlimited.
·
In case of Futures, the profit profile is linear… the
profit (or loss) increases or decreases in a straight line. In case of
Options, for a buyer the profits may be unlimited. For a seller or writer of
an option, profits are limited to the premium he has received from the buyer.
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7. What are, 'At the Money', 'In the Money'
& 'Out of the money' Options?
An
option is said to be 'at-the-money', when the option's strike price is equal
to the underlying asset price. This is true for both puts and calls.In case of call options: A call option is said to be in-the-money when the strike/exercise price of the option is less than the underlying asset price. For example, an Infosys call option with strike of 3500 is 'in-the-money', when the spot Infosys is at 3800. The exercise of this option leads to a positive money flow to the holder of the option. On the other hand, a call option is out-of-the-money when the strike price is greater than the underlying asset price. Using the earlier example of Infosys call option, if the Infosys falls to 3300, the call option no longer has positive exercise value. Naturally, the call holder will not exercise the option to buy Infosys at 3500 when the current price is at 3300. The option, in this case, expires worthless.
In case of Put Options:
A put option is in-the-money when the strike price of the option is greater than the spot price of the underlying asset. For example, an Infosys put at strike of 4000 is in-the-money when spot Infosys is at 3800. When this is the case, the put option has value because the put holder can sell Infosys at 4400, an amount greater than the current market price of Infosys of 3800. Likewise, a put option is out-of-the-money when the strike price is less than the spot price of underlying asset. In the above example, the buyer of Infosys put option won't exercise the option when the spot Infosys is at 4500. The put no longer has positive exercise value. Options are said to be deep in-the-money (or deep out-of-the-money) if the exercise price is at significant variance with the underlying asset price.
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8. What are Covered & Naked Calls?
A
call option position that is covered by an opposite position in the
underlying instrument (individual stocks or a basket of index stocks) is
called a covered call. Writing covered calls involves writing call options
when the shares that might have to be delivered (if option holder exercises
his right to buy), are already owned. E.g. A writer writes a call on Reliance
and at the same time holds shares of Reliance so that if the call is
exercised by the buyer, he can deliver the stock. Covered calls are far less risky than naked calls (where there is no opposite position in the underlying), since the worst that can happen is that the investor is required to sell shares already owned at below their market value. When a physical delivery uncovered/ naked call is assigned an exercise, the writer will have to purchase the underlying asset to meet his call obligation and his loss will be the excess of the purchase price over the exercise price of the call. The premium received on the writing, of course, to some extent mitigates this loss. |
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9. What is Intrinsic Value of an option?
The
intrinsic value of an option is defined as the amount by which an option is
in-the-money.For a call option: Intrinsic Value = Spot Price - Strike Price For a put option: Intrinsic Value = Strike Price - Spot Price As is evident, only an option that has an intrinsic value is exercised. The intrinsic value of an option must be a positive number or 0. It can't be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value. |
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10. What is Time Value with reference to
Options?
Time
value is the amount option buyers are willing to pay for the possibility that
the option may become profitable prior to expiration due to favorable change
in the price of the underlying. The time value also reflects the interest
cost of an option position. An option loses its time value as its expiration
date nears. At expiration an option is worth only its intrinsic value. Time
value too, cannot be negative. |
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11.
What are Stock Index Options?
The
Stock Index Options are options where the underlying asset is a Stock Index. top |
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12.
What are the uses of Index Options?
Index
options enable investors to gain exposure to a broad market (i.e. the entire
market), with one trading decision and frequently with one transaction. To
obtain the same level of diversification using individual stocks or
individual equity options, numerous decisions and trades would be necessary.
Since, broad exposure can be gained with one trade transaction cost is also
reduced by using Index Options. As a percentage of the underlying value,
premiums of index options are usually lower than those of equity options as equity
options are more volatile than the Index. top |
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13.
Who would use Index Options?
Index
Options are effective enough to appeal to a broad spectrum of users, from
conservative investors to more aggressive stock market traders. Individual
investors might wish to capitalize on market opinions (bullish, bearish or
neutral) by acting on their views of the broad market or one of its many
sectors. The more sophisticated market professionals might find the variety
of index option contracts excellent tools for enhancing market timing
decisions and adjusting asset mixes for asset allocation. top |
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14. What are Options on individual stocks?
Options
contracts where the underlying asset is an equity stock, are termed as
Options on stocks. They are American style options cash settled or settled by
physical delivery. Prices are normally quoted in terms of the premium per
share, although each contract is invariably for a larger number of shares. |
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15. Which stocks are eligible for options
trading and what is their contract size?
As on today, the following 31 stocks are eligible for
options trading:
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16. How does one price an option?
The
theoretical option pricing models are used by option traders for calculating
the fair value of an option on the basis of quantifiable and non-quantifiable
factors:There are two types of factors that affect the value of the option premium: Quantifiable Factors:
·
Underlying stock price,
·
The strike price of the option,
·
The volatility of the underlying stock,
·
The time to expiration and,
·
The risk free interest rate.
Non- Quantifiable Factors:
·
Individuals' varying estimates of future performance of
the underlying asset, based on fundamental or technical analysis,
·
Market participants' varying estimates of the underlying
asset's future volatility,
·
The effect of supply & demand; both in the options
marketplace and in the market for the underlying asset.
The two most popular option pricing models are: 1) Black & Scholes Model and 2) Binomial Model. These two models integrate the quantifiable factors for arriving at a fair price for the option. |
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17. Who decides on the premium paid on
options and how is it calculated?
The
Exchange does not fix Option Premium. The fair value/ theoretical price of an
option can be known with the help of pricing models and then depending on
market conditions the price is determined by competitive bids and offers in
the trading environment. An option's premium / price is the sum of its intrinsic value & time value. If the price of the underlying stock is held constant, the intrinsic value portion of an option premium will remain constant as well. Therefore, any change in the price of the option will be entirely due to a change in the option's time value. The time value component of the option premium can change in response to a change in the volatility of the underlying, the time to expiry, interest rate fluctuations, dividend payments and the effect of supply & demand for the option. Without going into the intricacies, suffice it to say that the fair value of an option can be determined by using online option calculators that make use of either of the two option pricing models. |
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18. Should I invest using Options?
Options
provide a highly efficient tool to invest. Besides options can be structured
based on your risk/return profile. Numerous strategies can be designed to
suit your specific investment outlook and risk bearing capabilities. Besides
offering flexibility to the buyer in form of right to buy or sell, the major
advantage of options is their versatility. They can be as conservative or as
speculative as his investment strategy dictates. |
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19.
But can't I achieve my investment objectives using traditional investment
channels?
Yes,
you can! But the advantages of options far outweigh traditional investment
making it highly attractive for most of us.Some of the benefits of Options are as under:
·
High leverage as by investing a small amount of capital
(in the form of premium), one can take exposure in the underlying asset of
much greater value. The only upfront amount to be paid is the option premium.
·
Clear understanding and calculation of risk for an option
buyer. (in the case of option writer, the exchange has put a strict margining
and risk management system in place that ensures that the risk of default is
almost negligible, if not nil)
·
Large profit potential for option buyer for a relatively
small investment.
·
Protection against decline in value by way of buying a
protective put wherein one buys a put against an existing stock position.
This option position can supply the insurance needed to overcome the
uncertainty of the marketplace. Hence, by paying a relatively small premium
(compared to the market value of the stock), an investor knows that no matter
how far the stock drops, it can be sold at the strike price of the Put
anytime until the Put expires. This gives the investor the flexibility to
lock in the sale of his stocks at a certain price without unduly worrying
about the downward movement in the price of those stocks.
An Illustration:Say, an investor holding 1 share of Infosys at a market price of Rs 3800/- thinks that the stock is over-valued and therefore decides to buy a Put option at a strike price of Rs. 3800/- by paying a premium of Rs 200/- If the market price of Infosys comes down to Rs 3000/-, he can still sell it at Rs 3800/- by exercising his put option. Thus by paying a premium of Rs. 200, he has insured his position in the underlying stock. In case the market price goes up, the option expires worthless, but that is the cost he has to pay for immense peace of mind! top |
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20.
How can I use options?
If
you anticipate a stock to move in a certain direction, at least acquire the
right to buy/sell the stock at a predetermined price, for a specific duration
of time. There can't be a more attractive investment opportunity. The
decision as to what type of option to buy is dependent on whether your
outlook for the respective security is positive (bullish) or negative
(bearish). If your outlook is positive, buying a call option creates the
opportunity to share in the upside potential of a stock without having to
risk more than a fraction of its market value (premium paid). Conversely, if
you anticipate downward movement, buying a put option will enable you to
protect against downside risk without limiting profit potential (talk of
short selling on the sly!). Purchasing options offer you the ability to
position yourself with your market expectations in a manner such that you can
both profit and protect. top |
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21.
But who will sell me an option for a song?
As
in any market, a trade takes place when people with diametrically opposite
view-points meet. Option writing can be profitable to a person who loves to
collect small premiums for what he believes is a fundamentally flawed outlook
about the future (yours', and not his!). Again, option writing also provides
incentives to people who prefer to earn some money out of an otherwise dead
investment in stocks. Suppose Mr. XYZ has a portfolio of 1000 shares of HLL.
Writing a covered call on HLL enables him to earn some premium at no cost.
(Of course, the game could turn messy if he finds HLL falling by the day, but
how many of us do sit on our shares whilst they fall). In case HLL continues
to rise (or even does not change), Mr. XYZ has made cool money (which can be
quite substantial on a yearly basis) on what was after all a non-interest
bearing security (the dividends declared during the period also accrue to
him!) top |
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22.
Once I have bought an option and paid the premium for it, how does it get
settled?
An
Option is a contract, which has a market value like any other tradable
commodity. Once an option is bought there are following alternatives that you
(as an option holder) have:
·
You can sell an option of the same series as the one you
had bought & close out /square off your position in that option at any
time on or before the expiration.
·
You can exercise the option on the expiration day in case
of an Index Option; on or before the expiration day in case of an Individual
stock option. In case the option is 'Out of the Money' at the time of expiry,
it will expire worthless.
top |
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23.
Who can write options in Indian Derivatives market?
In
the Indian Derivatives market, SEBI has not created any particular category
of options writers. Any market participant can write options. However, the
margin requirements (upfront amount/collateral deposited with your broker)
are stringent for options writers. top |
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24.
Should I write options?
The
writing of options, though lucrative in the long run, is a risky proposition
(and this risk can be unlimited). Moreover, the margin requirements are
pretty stringent and any failure to meet the margin calls can be disastrous. The risk of an Option Writer is unlimited whereas his gains are limited to the premiums earned. When a physical delivery of an uncovered call is exercised upon, the writer will have to purchase the underlying asset and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call. The writer of a put option bears a risk of loss if the value of the underlying asset declines below the exercise price. The risk of a decline in the price of the underlying asset can be potentially up to zero. top |
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25.
How can an option writer take care of his risk?
Option
writing is a specialized job, which is suitable only for the knowledgeable
investor who understands the risks, has the financial capacity and has
sufficient liquid assets to meet applicable margin requirements. The risk of
being an option writer may be reduced by the purchase of other options on the
same underlying asset and thereby assuming a spread position. top |
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26.
How will introduction of options in specific stocks benefit an investor?
Options
can offer an investor the flexibility one needs for countless investment
situations. An investor can create a simple investment position or an
entirely speculative one, through various strategies that reflect his
tolerance for risk. Investors of equity stock options will enjoy more leverage than their counterparts who invest in the underlying stock market itself in form of greater exposure by paying a small amount as premium. Investors can also use options in specific stocks to hedge (ability to protect ones position from a decline) their holding positions in the underlying (i.e. long in the stock itself), by buying a Protective Put. Thus they will insure their portfolio of equity stocks from the risk by paying a nominal sum called a premium. top |
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27.
Does the holder of an equity options contracts have all the rights that an
owner of equity shares have?
A
Holder of a call option contract does not have any of the rights that an
owner of equity shares has - such as voting rights and the right to receive
bonus, dividend etc. To obtain these rights a Call option holder must
exercise his contract and take delivery of the underlying equity shares. The
rights vests with the owner of the shares and not necessarily with the option
holder. top |
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28.
Where can I trade in Options and Futures contracts?
Like
stocks, options and futures contracts are also traded on NSE and BSE. On NSE
stocks are traded on their online trading system (NEAT) and options and
futures are traded on NEAT F&O System (NEAT F&O). Similarly on the
Bombay Stock Exchange, stocks are traded on BSE On Line Trading system (BOLT)
and options and futures are traded on Derivatives Trading and Settlement
System (DTSS). top |
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29.
What does an investor have to do if he wants to trade in options?
An
investor has to register himself with a broker who is a member of the BSE/NSE
Derivatives Segment. If he wants to buy an option, he can place the order for buying a Call or Put option with the broker. The Premium has to be paid up-front in cash. He can either hold on to the contract till its expiry or square up his position by entering into a reverse trade. If he closes out his position, he will receive Premium in cash, the next day. If the investor holds the position till expiry day and decides to exercise the contract, he will receive the difference between Option Settlement price & the Strike price in cash. If he is not able to exercise his option, it will expire worthless. If an investor wants to write/ sell an option, he will place an order for selling Call/ Put option. Initial margin based on his position will have to be paid up-front (adjusted from the collateral deposited with his broker) and he will receive the premium in cash, the next day. Everyday his position will be marked to market & variance margin will have to be paid. At the same time, he can close out his position by buying the option by paying requisite premium. The initial margin that he had paid on the first position will be refunded. If he waits till expiry, and the option is exercised, he will have to pay the difference in the Strike price & the options settlement price, in cash. If the option is not exercised, the investor will not have to pay anything.
The NEAT F&O system supports an order driven market,
wherein orders match automatically.
Order matching is essentially on the basis of security, its price, time and quantity. All quantity fields are in units and price in rupees. The lot size on the futures market is for 200 Nifties. The exchange notifies the regular lot size and tick size for each of the contracts traded on this segment from time to time. When any order enters the trading system, it is an active order. It tries to find a match on the other side of the book. If it finds a match, a trade is generated. If it does not find a match, the order becomes passive and goes and sits in the respective outstanding order book in the system. In the F&O trading software, a trading member has the facility of defining a hierarchy amongst users of the system. This hierarchy comprises corporate manager, branch manager and dealer. 1. Corporate manager: The term ‘Corporate manager’ is assigned to a user placed at the highest level in a trading fi rm. Such a user can perform all the functions such as order and trade h related activities, receiving reports for all branches of the trading member fi rm and also all dealers of the fi rm. Additionally, a corporate manager can defi ne exposure limits for the branches of the fi rm. This facility is available only to the corporate manager. 2. Branch manager: The branch manager is a term assigned to a user who is placed under the corporate manager. Such a user can perform and view order and trade related activities for all dealers under that branch. 3. Dealer: Dealers are users at the lower most level of the hierarchy. A Dealer can perform view order and trade related activities only for oneself and does not have access to information on other dealers under either the same branch or other branches. Below given cases explain activities possible for specific user categories: 1. Clearing member corporate manager: He can view outstanding orders, previous trades and net position of his client trading members by putting the TM ID (Trading member identifi cation) and leaving the Branch ID and and Dealer ID blank. 2. Clearing member and trading member corporate manager: He can view (a) Outstanding orders, previous trades and net position of his client trading members by putting the TM ID and leaving the Branch ID and the Dealer ID blank. (b) Outstanding orders, previous trades and net positions entered for himself by entering his own TM ID, Branch ID and User ID. This is his default screen. (c) Outstanding orders, previous trades and net position entered for his branch by entering his TM ID and Branch ID fi elds (d) Outstanding orders,previous trades, and net positions entered for any of his users/dealers by entering his TM ID, Branch ID and user ID fi elds. 3. Clearing member and trading member dealer: He can only view requests entered by him. 4. Trading member corporate manager: He can view (a) Outstanding requests and activity log for requests entered by him by entering his own Branch and User IDs. This is his default screen. (b) Outstanding requests entered by his dealers and/or branch managers by either entering the Branch and/or User IDs or leaving them blank. 5. Trading member branch manager: He can view (a) Outstanding requests and activity log for requests entered by him by entering his own Branch and User IDs. This is his default screen. (b) Outstanding requests entered by his users either by fi lling the User ID fi eld with a specifi c user or leaving the User ID fi eld blank. 6. Trading member dealer: He can only view requests entered by him.
Trading Mechanism The derivatives trading system at NSE, called NEAT-F&O trading system, provides a fully automated screen-based trading for derivatives on a nationwide basis. It supports an anonymous order driven market, which operates on a strict price/time priority. It provides tremendous flexibility to users in terms of kinds of orders that can be placed on the system. Various time and price related conditions like Good-till-Cancelled, Good-till-Date/Day, Immediate or Cancel, Limit/ Market Price, Stop Loss, etc. can be built into an order. The NEAT-F&O trading system distinctly identifies two groups of users. The trading user more popularly known as trading member has access to functions such as, order entry, order matching, order and trade management. The clearing user (clearing member) uses the trader workstation for the purpose of monitoring the trading member(s) for whom he clears the trades. Additionally, he can enter and set limits on positions, which a trading member can take. The trading terminals of F&O segment are available in 291 cities at the end of March, 2003. Besides the trading terminals can also be accessed through the Internet by the investors from anywhere. Contract Specification The contract specification for derivatives traded on NSE are summarised in Table below. The index futures and index options contracts traded on NSE are based on S&P CNX Nifty Index, while stock futures and options are based on individual securities. Presently stock futures and options are available on 41 securities. While the index options are European style, stock options are American style. There are a minimum of 5 strike prices, two 'in-the-money', one 'at-the-money' and two 'out-of-the-money' for every call and put option. The strike price is the price at which the buyer has a right to purchase or sell the underlying. At any point of time there are only three contracts available for trading, with 1 month, 2 months and 3 months to expiry. These contracts expire on last Thursday of the expiry month and have a maximum of 3-month expiration cycle. A new contract is introduced on the next trading day following the expiry of the near month contract. All the derivatives contracts are presently cash settled. Trading Volume (Notional) The F&O segment reported a total trading volume (notional) of Rs. 439,864 crore during 2002-03 as against Rs. 101,926 crore during the preceding year. The trading volume witnessed a sharp rise with the introduction of stock futures in November 2001.. The trading volumes in the F&O segment indicate that near month contracts are more popular than far month contracts; futures are more popular than options; contracts on securities are more popular than those on indexes; and call options are more popular than put options. The F&O segment provides a nationwide market. Mumbai accounts for 41.2% of total turnover. The share of Mumbai in total turnover has been declining over years reinforcing nationwide presence of NSE. Transaction Charges The maximum brokerage chargeable by a trading member in relation to trades effected in the contracts admitted to dealing on the F&O segment of NSE is fixed at 2.5% of the contract value in case of index futures and stock futures. In case of index options and stock options it is 2.5% of notional value of the contract [(Strike Price + Premium) × Quantity)], exclusive of statutory levies. The transaction charges payable to the exchange by the trading member for the trades executed by him on the F&O segment are fixed at the rate of Rs. 2 per lakh of turnover (0.002%) subject to a minimum of Rs. 1,00,000 per year. The trading members contribute to Investor Protection Fund of F&O segment at the rate of Rs. 10 per crore of turnover (0.0001%). Clearing and Settlement NSCCL undertakes clearing and settlement of all trades executed on the F&O segment of the Exchange. It also acts as legal counterparty to all trades on this segment and guarantees their financial settlement. The Clearing and Settlement process comprises of three main activities, viz., Clearing, Settlement and Risk Management. Clearing Mechanism The first step in clearing process is working out open positions and obligations of clearing (selfclearing/trading-cum-clearing/professional clearing) members (CMs). The open positions of a CM is arrived at by aggregating the open positions of all the trading members (TMs) and all custodial participants (CPs) clearing though him, in the contracts which they have traded. The open position of a TM is arrived at by summing up his proprietary open position and clients' open positions, in the contracts which they have traded. While entering orders on the trading system, TMs identify orders as either proprietary or client. Proprietary positions are calculated on net basis for each contract and that of clients are arrived at by summing together net positions of each individual client. A TM's open position is the sum of proprietary open position, client open long position and client open short position. Settlement Mechanism All futures and options contracts are cash settled at present. The settlement amount for a CM is netted across all their TMs/clients, across various settlements. For the purpose of settlement, all CMs are required to open a separate bank account with NSCCL designated clearing banks for F & O segment. Settlement of Futures Contracts Futures contracts have two types of settlements, the MTM settlement which happens on a continuous basis at the end of each day, and the final settlement which happens on the last trading day of the futures contract. MTM Settlement for Futures All futures contracts for each member are marked-tomarket to the daily settlement price of the relevant futures contract at the end of each day. The profits/ losses are computed as the difference between
i.
the trade price and the day's settlement price in respect of
contracts executed during the day but not squared-up,
ii.
the previous day's settlement price and the current day's
settlement price in respect of brought forward contracts,
iii.
the buy price and the sell price in respect of contracts executed
during the day and squared-up.
The
CMs who have suffered a loss are required to pay the mark-to-market (MTM) loss
amount in cash which is in turn passed on to the CMs who have made a MTM
profit. This is known as daily mark-to-market settlement. CMs are responsible
to collect and settle the daily MTM profits/losses incurred by the TMs and
their clients clearing and settling through them. Similarly, TMs are
responsible to collect/pay losses/ profits from/to their clients by the next
day. The pay-in and pay-out of the mark-to-market settlement are effected on
the day following the trade day.After completion of daily settlement computation, all the open positions are reset to the daily settlement price. Such positions become the open positions for the next day. Final Settlement for Futures On the expiry day of the futures contracts, after the close of trading hours, NSCCL marks all positions of a CM to the final settlement price and the resulting profit/loss is settled in cash. Final settlement loss/profit amount is debited/ credited to the relevant CM's clearing bank account on the day following expiry day of the contract. Settlement Prices for Futures Daily settlement price on a trading day is the closing price of the respective futures contracts on such day. The closing price for a futures contract is currently calculated as the last half an hour weighted average price of the contract in the F&O Segment of NSE. Final settlement price is the closing price of the relevant underlying index/security in the Capital Market segment of NSE, on the last trading day of the Contract. The closing price of the underlying Index/security is currently its last half an hour weighted average value in the Capital Market Segment of NSE. Settlement of Options Contracts Options contracts have three types of settlements, daily premium settlement, exercise settlement, interim exercise settlement in the case of option contracts on securities and final settlement. Daily Premium Settlement for Options Buyer of an option is obligated to pay the premium towards the options purchased by him. Similarly, the seller of an option is entitled to receive the premium for the option sold by him. The premium payable amount and the premium receivable amount are netted to compute the net premium payable or receivable amount for each client for each option contract. Exercise Settlement for Options Although most option buyers and sellers close out their options positions by an offsetting closing transaction, an understanding of exercise can help an option buyer determine whether exercise might be more advantageous than an offsetting sale of the option. There is always a possibility of the option seller being assigned an exercise. Once an exercise of an option has been assigned to an option seller, the option seller is bound to fulfill his obligation. Interim Exercise Settlement Interim exercise settlement takes place only for option contracts on securities. An investor can exercise his in-the-money options at any time during trading hours, through his trading member. Interim exercise settlement is effected for such options at the close of the trading hours, on the day of exercise. Valid exercised option contracts are assigned to short positions in the option contract with the same series (i.e. having the same underlying, same expiry date and same strike price), on a random basis, at the client level. The CM who has exercised the option receives the exercise settlement value per unit of the option from the CM who has been assigned the option contract. Final Exercise Settlement Final Exercise settlement is effected for all open long inthe- money strike price options existing at the close of trading hours, on the expiration day of an option contract. All such long positions are exercised and automatically assigned to short positions in option contracts with the same series, on a random basis. The investor who has long in-the-money options on the expiry date will receive the exercise settlement value per unit of the option from the investor who has been assigned the option contract. Settlement Statistics All derivative contracts are currently cash settled. The participants discharge their obligations through payment/receipt of cash. During the year, 2002-03, such cash settlement amounted to Rs. 2,311 crore. The settlement of futures andof options involved Rs. 1,783.6 crore and Rs. 527.1 crore respectively. The concept of Basis The difference between spot price and Futures price is known as basis. Although the spot price and Futures prices generally move in line with each other, the basis is not constant. Generally basis will decrease with time. And on expiry, the basis is zero and Futures price equals spot price. What is Contango? Under normal market conditions, Futures contracts are priced above the spot price. This is known as the Contango Market. What is Backwardation? It is possible for the Futures price to prevail below the spot price. Such a situation is known as backwardation. This may happen when the cost of carry is negative, or when the underlying asset is in short supply in the cash market but there is an expectation of increased supply in future - example agricultural products. What is convergence? This refers to the tendency of difference between spot and futures contract to decline continuously, so as to become zero on the date on maturity. What is cash settlement? It is a process for performing a options/futures contract by payment of money difference rather than by physical delivery What is Volatility? t is a measurement of the variability rate (but not the direction) of the change in price over a given time period. It is often expressed as a percentage and computed as the annualized standard deviation of percentage change in daily price. What is novation? It is the arrangement by which the Clearing Houses interpose between buyers and sellers as a legal counter party, i.e., the clearing house becomes buyer/or guarantor to every seller and vice versa. This obviates the need for ascertaining credit-worthiness of each counter party and the only credit risk that the participants face is the risk of clearing house committing a default. Clearing House puts in place a sound risk-management system to be able to discharge its role as a counter party to all participants. What is offset? It refers to the liquidation of a options/futures contract by entering into opposite (purchase or sale, as the case may be) of an identical contract. Market Maker A dealer is said to make a market when he quotes both bid and offer prices at which he stands ready to buy and sell the security. Thus, he is a person that brings buyers and sellers together. He lends liquidity in the system by making trading feasible. They are specialist-dealers in particular instruments. In the case of single-stock futures, a market maker, for instance, may deal with only Satyam and Infosys futures. A market maker is similar to a jobber in the open-outcry system BSE had earlier. The market maker is obligated to give a buy-sell quote at all times during the trading session. The two-way quotes provide liquidity in the instrument concerned. Marked-to-Market This is an arrangement whereby the profits or losses on the position are settled each day. This enables the exchange to keep appropriate margin so that it is not so low that it increases chances of defaults to an unacceptable level (by collecting MTM losses) and is not so high that it increases the cost of transactions to an unreasonable level (by giving MTM profits). The concept was earlier referred while dealing about margin requirements What is Gearing? Gearing (or leveraging) measures the value of your position as a ratio of the value of the risk capital actually invested. In case of index futures, if the margin requirement is 5%, the gearing possible is 20 times as on a given fund availability, an investor can take a position 20 times in size. "Exchange Delivery Settlement Price" or EDSP In respect of settlement systems for physical delivery in case it is impossible, or impractical, to effect physical delivery, open positions (open long positions always being equal to open short positions) are closed out on the last day of trading at a price determined by the spot "cash" market price of the underlying asset. This price is called "Exchange Delivery Settlement Price" or EDSP. In case of physical settlement short side delivers to the specified location while long side takes delivery from the specified location of the specified quantity / quality of underlying asset. The long side pays the EDSP to clearing house/ corporation which is received by the short side. The Role of the Clearing House/ Corporation The Clearing House / Corporation matches the transactions, reconciles sales & purchases and does daily settlements. It is also responsible for risk management of its members and does inspection and surveillance, besides collection of margins, capital etc. It also monitors the net-worth requirements of the members. The other role of the Clearing House / Corporation is to ensure performance of every contract. This can be done in two ways. One way is that Clearing house / Corporation imposes itself between the two counterparties thereby replacing the original contract (say between A & B) by two new contracts (between A and Clearing House /Corporation and between B and Clearing House / Corporation) thereby itself becoming counterparty to every trade. This is called full Novation. The other way is to guarantees performance of all the contracts done on the exchange. What is Price Risk? Price Risk is defined as the standard deviation of returns generated by any asset. This indicates how much individual outcomes deviate from the mean. For example, an asset with possible returns of 5%, 10% and 15% is less risky than one with possible returns of -10%, 1% and 25%. The Different Types of Price Risk Diversifiable risk (also known as non market risk or unsystematic risk) of a security arises from the security specific factors like strike in factory, legal claims, non availability of raw material, etc. This component of risk can be reduced by diversification. Non-diversifiable risk (also known as systematic risk or market risk) is an outcome of economy related events like diesel price hike, budget announcements, etc that affect all the companies. As the name suggests, this risk cannot be diversified away using diversification or adding stocks in portfolio. Can Price Risk be controlled? Price Risk can be controlled to an extent. The different types of price risk impacting any stock or company can be classified into two categories:
1.
Company specific; and
2.
Economy or market related.
As
discussed earlier, the Company specific risks (also known as diversifiable risk
or non market risk or unsystematic risk) can be reduced by proper
diversification. Market risks to a certain extent can be minimised through
hedging.Strategies of Hedging Hedging is a mechanism to reduce price risk inherent in open positions. Its purpose is to reduce the volatility of a portfolio, by reducing the risk. hedging does not mean maximization of return. It only means reduction in variation of return. It is quite possible that the return is higher in the absence of the hedge, but so also is the possibility of a much lower return. The basic logic is "If long in cash underlying - Short Future and If short in cash underlying - Long Future". Let us understand this by a simple example. If you have bought 100 shares of Company A and want to Hedge against market movements, you should short an appropriate amount of Index Futures. This will reduce your overall exposure to events affecting the whole market (systematic risk). In case a war breaks out, the entire market will fall (most likely including Company A). So your loss in Company A would be offset by the gains in your short position in Index Futures. Some examples of where hedging strategies are useful include:
·
Reducing the equity exposure of a Mutual Fund by selling Index
Futures;
·
Investing funds raised by new schemes in Index Futures so that
market exposure is immediately taken; and
·
Partial liquidation of portfolio by selling the index future
instead of the actual shares where the cost of transaction is higher.
What are the General Strategies for Speculating?
·
In general, the speculator takes a view on the market and plays
accordingly. If one is bullish on the market, one can buy Futures, and vice
versa for a bearish outlook.
·
There is another strategy of playing the spreads, in which case
the speculator trades the "basis". When a basis risk is taken, the
speculator primarily bets on either the cost of carry (interest rate in case of
index futures) going up (in which case he would pay the basis) or going down
(receive the basis).
·
Pay the basis implies going short on a future with near month
maturity while at the same time going long on a future with longer term
maturity.
·
Receiving the basis implies going long on a future with near month
maturity while at the same time going short on a future with longer term
maturity.
Circuit Breakers or Circuit FiltersCircuit Breaker means trading is halted for a specified period in stocks or / and stock index futures, if the market price moves out of a pre-specified band. Circuit filters do not result in trading halt but no order is permitted if it falls out of the specified price range. Advantages
1.
Allows participants to gather new information and to assess the
situation - controls panic.
2.
Brokerages firms can check on customer funding and compliance.
3.
Exchanges/ Clearing houses can monitor their members.
Disadvantages
1.
Only postpones the inevitable.
2.
Limits the flow of market information - no one knows the real
value of a stock.
3.
They precipitate the matter during volatile moves as participants
rush to execute their orders before anticipated trading halt.
Index FuturesIndex Futures are Future contracts where the underlying asset is the Index. This is of great help when one wants to take a position on market movements. Suppose you feel that the markets are bullish and the Sensex would cross 5,000 points. Instead of buying shares that constitute the Index you can buy the market by taking a position on the Index Future. Index futures can be used for hedging, speculating, arbitrage, cash flow management and asset allocation. Both the Bombay Stock exchange (BSE) and the National Stock Exchange (NSE) have launched index futures in June 2000. These are the most popular products traded in the derivatives market. In fact major share oif trading in the market comprises of transactions in Sensex and Nifty futures What is a Demutualised Exchange? In the demutualised Exchange, unlike the Mutual form of Exchange, the owners do not automatically get the trading right by virtue ot their ownership. Though demutualisation per se does not bar an owner (equity holder) from acquiring trading rights, he has to comply with the admission criteria laid down by the Exchange. Also, it is a good corporate governance practice to have, in the organization of the equity holder, a Chinese wall between the trading division and the division dealing with the ownership of the Exchange, to avoid conflict of interest. Compulsory Trading Through Stock Exchanges Derivatives in particular options and futures are to be traded compulsorily through a stock exchange approved by SEBI. The stock exchange through its regulated clearing system insulates the element of risk and provides safe trading environment to the buyers. Unlike spot trading, options and futures carry inherently several types of risks. Risk covering methods implemented the Stock exchanges are discussed in details separately in subsequent pages dealing with "options" and "futures" respec What is a "spot transaction"? In a spot market, transactions are settled “on the spot”. Once a trade is agreed upon, the settlement – i.e. the actual exchange of money for goods – takes place with the minimum possible delay. When a person selects a shirt in a shop and agrees on a price, the settlement (exchange of funds for goods) takes place immediately. That is a spot market That’s okay for shirts - but does it ever happen in finance? There are two real–world implementations of a spot market: rolling settlemen and real-time gross settlement (RTGS). With rolling settlement, trades are netted through one day, and settled x working days later; this is called T + x rolling settlement. For example, with T+5 rolling settlement, trades are netted through Monday, and the net open position as of Monday evening is settled on the coming Monday. Similarly, trades are netted through Tuesday, and settled on the coming Tuesday. With RTGS, all trades settle in a few seconds with no netting. Rolling settlement is a close approximation, and RTGS is a true spot market. The equity market in India today, for the major part, is not a spot market. For example, the bulk of trading on NSE takes place with netting from Wednesday to Tuesday, and then settlement takes place five days later. This is not a spot market. The “international standard” in equity markets is T+3 rolling settlement. Why is hedging using derivatives termed “risk transfer”? One key motivation for derivatives is to enable the transfer of risk between individuals and firms in the economy. This can be viewed as being like insurance, with the difference that anyone in the economy (and not just insurance companies) would be able to sell insurance. A risk averse person buys insurance; a risk–seeking person sells insurance. On an options market, an investor who tries to protect himself against a drop in then index buys put options on the index, and a risk-taker sells him these options. One special motivation which drives some (but not all) trades is mutual insurance between two persons, both exposed to the same risk, in an opposite way. In the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk. This is a situation where both parties in the transaction seek to avoid risk. In these ways, derivatives supply a method for people to do hedging and reduce their risks. As compared with an economy lacking these facilities, this is a considerable gain. The largest derivatives markets in the world are on government bonds (to help control interest rate risk), the market index (to help control risk that is associated with fluctuations in the stock market) and on exchange rates (to cope with currency risk). What happens to market quality and price formation on the cash market once derivatives trading commences? The empirical evidence broadly suggests that market efficiency and liquidity on the spot market improve once derivatives trading comes about. Speculators generally prefer implementing their positions using derivatives rather than using a sequence of trades on the underlying spot market. Hence, access to derivatives increases the rate of return on information gathering, research and forecasting activities, and thus serves to spur investments into information gathering and forecasting. This helps improve market efficiency. From a market microstructure perspective, derivatives markets may reduce the extent to which informed speculators are found on the spot market, thus reducing the adverse selection on the spot market. Derivatives also help reduce the risks faced by liquidity providers on the spot market, by giving them avenues for hedging. These effects help improve liquidity on the spot market. A liquid derivatives market tends to become the focus of speculation and price discovery. When news breaks, the derivative market reacts first. The information propagates down to the cash market a short while later, through the activities of arbitrageurs. Why is forward contracting useful? Forward contracting is valuable in hedging and speculation. The classic hedging application is that of a wheat farmer forward-selling his harvest at the time of sowing, in order to eliminate price risk. Conversely, a bread factory could buy wheat forward in order to assist production planning without the risk of price fluctuations. If a speculator has information or analysis which forecasts an upturn in a price, then she can adopt a buy position (go long) on the forward market instead of the cash market. The speculator would wait for the price to rise, and then close out the position on the forward market (by selling off the forward contracts). This is a good alternative to speculation using the spot market, which involves buying wheat, storing it for a while, and then selling it off. A speculator prefers transactions involving a forward market because (a) the costs of taking or making delivery of wheat is avoided, and (b) funds are not blocked for the purpose of speculation. What is “leverage”? Suppose a user of a forward market adopts a position worth Rs.100. As mentioned above, no money changes hands at the time the deal is signed. In practice, a good–faith deposit would be needed. Suppose the user puts up Rs.5 of collateral. Using Rs.5 of capital, a position of Rs.100 is taken. In this case, we say there is “leverage of 20 times”. This example involves a forward market. More generally, all derivatives involve leverage. Leverage makes derivatives useful; leverage is also the source of a host of disasters, payments crises, and systemic risk on financial markets. Understanding and controlling leverage is equivalent to understanding and controlling derivatives. Why are forward markets afflicted by counterparty risk? A forward contract is a bilateral relationship between two people. Each requires good behaviour on the part of the other for the contract to perform as promised. Suppose L agrees to buy gold from S at a future date T at a (forward) price of Rs.5,000/tola. If, on date T, the gold spot price is at Rs.4,000/tola, then L loses Rs.1,000/tola and S gains Rs.1,000/tola by living up to the terms of the contract. When L buys at Rs.5,000/tola by the terms of the contract, he is paying Rs.1,000 more than what could be obtained on the spot market at the same time. Hence, L is tempted to declare bankruptcy and avoid performing as per the contract. Conversely, if on date T the gold spot price is at Rs.6,000/tola, then L gains and S loses by living up to the terms of the contract. S stands to sell gold at Rs.5,000/tola by the terms of the contract, which is Rs.1,000/tola worse than what could be obtained by selling into the spot market at date T. In this case, S is tempted to declare bankruptcy and avoid performing as per the contract. In either case, this leads to counterparty risk. When one of the two sides of the transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic property: the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counterparty risk What is “price–time priority”? A market has price–time priority if it gives a guarantee that every order will be matched against the best available price in the country, and that if two orders are equal in price, the one which came first will be matched first. Forward markets, which involve dealers talking to each other on phone, do not have price–time priority. Floor–based trading with open–outcry does not have price–time priority. Electronic exchanges with order matching, or markets with a monopoly market maker, have price–time priority. On markets without price–time priority, users suffer greater search costs, and there is a greater risk of fraud. How does the futures market solve the problems of forward markets? Futures markets feature a series of innovations in how trading is organised: _ Futures contracts trade at an exchange with price–time priority. All buyers and sellers come to one exchange. This reduces search costs and improves liquidity. This harnesses the gains that are commonly obtained in going from a non–transparent club market (based on telephones) to an anonymous, electronic exchange which is open to participation. The anonymity of the exchange environment largely eliminates cartel formation. _ Futures contracts are standardised – all buyers or sellers are constrained to only choose from a small list of tradeable contracts defined by the exchange. This avoids the illiquidity that goes along with the unlimited customisation of forward contracts. A new credit enhancement institution, the clearing corporation, eliminates counterparty risk on futures markets. The clearing corporation interposes itself into every transaction, buying from the seller and selling to the buyer. This is called novation. This insulates each from the credit risk of the other. In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counterparty risk. Novation at the clearing corporation makes it possible to have safe trading between strangers. This is what enables large–scale participation into the futures market – in contrast with small clubs which trade by telephone – and makes futures markets liquid. What is cash settlement? The forward or futures contracts discussed so far involved physical settlement. On 31 Dec 2001, the seller was supposed to come up with 100 tolas of gold and the buyer was supposed to pay for it. In practice, settlement involves high transactions costs. This is particularly the case for products such as the equity index, or an inter–bank deposit, where effecting settlement is extremely difficult or impossible. In these cases, futures markets use “cash settlement”. Here, the terminal value of the product is deemed to be equal to the price seen on the spot market. This is used to determine cash transfers from the counterparties of the futures contract. The cash transfer is treated as settlement. Example. Suppose L has purchased 30 units of Nifty from S at a price of 1500 on 31 Dec 2000. Suppose we come to the expiration date, i.e. 31 Dec 2000, and the Nifty spot is actually at 1600. In this case, L has made a profit of Rs.100 per Nifty and S has made a loss of Rs.100 per Nifty. A profit/loss of Rs.100 per nifty applied to a transaction of 30 nifties translates into a profit/loss of Rs.3,000. Hence, the clearing corporation organises a payment of Rs.3,000 from S and a payment of Rs.3,000 to L. This is called cash settlement. into many products where physical settlement was unviable Why is the equity cash market in India said to have “futures-style settlement”? India’s “cash market” for equity is ostensibly a cash market, but it functions like a futures markets in every respect. NSE’s “ EQ” market is a weekly futures market with tuesday expiration. The trading modalities on NSE from wednesday to tuesday, in trading ITC, are exactly those that would be seen if a futures market was running on ITC with tuesday expiration. On NSE, when a person buys on thursday, he is not obligated to do delivery and payment right away, and this buy position can be reversed on friday thus leaving no net obligations. Equity trading on NSE involves leverage of seven times. Like all futures markets, trading at the NSE is centralised and there is no counterparty risk owing to novation at the clearing corporation ( NSCC). The only difference between ITC trading on NSE, and ITC trading on a true futures market, is that futures contracts with several different expiration dates would all trade at the same time on a true futures market; this is absent on India’s “cash market”. When would one use options instead of futures? Options are different from futures in several interesting senses. At a practical level, the option buyer faces an interesting situation. He pays for the option in full at the time it is purchased. After this, he only has an upside. There is no possibility of the options position generating any further losses to him (other than the funds already paid for the option). This is different from a futures: which is free to enter into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions. Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating “guaranteed return products”. The Nifty index fund industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which gives the investor protection against extreme drops in Nifty. Selling put options is selling insurance, so anyone who feels like earning revenues by selling insurance can set himself up to do so on the index options market. More generally, options offer “nonlinear payoffs” whereas futures only have “linear payoffs”. By combining futures and options, a wide variety of innovative and useful payoff structures can be created. Why have index derivatives proved to be more important than individual stock derivatives? Security options are of limited interest because the pool of people who would be interested (say) in options on ACC is limited. In contrast, every single person with any involvement in the equity market is affected by index fluctuations. Hence risk- management using index derivatives is of far more importance than risk management using individual security options. This goes back to a basic principle of financial economics. Portfolio risk is dominated by the market index, regardless of the composition of the portfolio. All portfolios of around ten stocks or more have a pattern of risk where 70% or more of their risk is index related. Hence investors are more interested in using index–based derivative products. Index derivatives also present fewer regulatory headaches when compared to leveraged trading on individual stocks. Internationally, this has led to regulatory encouragement for index futures and discouragement against futures on individual stocks. How would a seller “deliver” a market index? On futures markets, open positions as of the expiration date are normally supposed to turn into delivery by the seller and payment by the buyer. It is not feasible to deliver the market index. Hence open positions are squared off in cash on the expiration date, with respect to the spot Nifty. Specifically, on the expiration date, the last mark to market margin is calculated with respect to the spot Nifty instead of the futures price. What makes a good stock market index for use in an index futures and index options market? Several issues play a role in terms of the choice of index. Diversification: A stock market index should be well–diversified, thus ensuring that hedgers or speculators are not vulnerable to individual company– or industry–risk. This diversification is reflected in the Sharpe’s Ratio of the index Liquidity of the index: The index should be easy to trade on the cash market. This is partly related to the choice of stocks in the index. High liquidity of index components implies that the information in the index is less noisy. Liquidity of the market: Index traders have a strong incentive to trade on the market which supplies the prices used in index calculations. This market should feature high liquidity and be well designed in the sense of supplying operational conveniences suited to the needs of index traders. Operational issues: The index should be regularly maintained, with a steady evolution of securities in the index to keep pace with changes in the economy. The calculations involved in the index should be accurate and reliable. When a stock trades at multiple venues, index computation should be done using prices from the most liquid market. How do we compare Nifty and the BSE Sensex from this perspective? Nifty has a higher Sharpe’s ratio. Nifty is a more liquid index. Nifty is calculated using prices from the most liquid market (NSE). NSE has designed features of the trading system to suit the needs of index traders. Nifty is better maintained. Nifty is used by three index funds while the BSE Sensex is used by one. Who needs hedging using index futures? The general principle is: you need hedging using index futures when your exposure to movements of Nifty is not what you would like it to be. If your index exposure is lower than what you like, you should buy index futures. If your index exposure is higher than what you like, you should sell index futures When might I find that my index exposure is not what it should be? A few situations are:
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You are a speculator about an individual stock or an industry.
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You have an equity portfolio and become uncomfortable about equity
market risk for the near future.
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You expect to obtain funds at a known future date, but you would
like to lock in on equity investments right now at present prices.
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You have underwritten an IPO and are vulnerable to losses if the
market crashes and the IPO devolves on you.
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You are uncomfortable with the vulnerabilities of your business,
where cashflows swing dramatically with movements of Nifty.
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