Part 1:- Stock Market Basics

1.1 What are corporations?

Companies are started by individuals or maybe a small circle of people. They pool their money or obtain loans, raising funds to launch the business. A choice is made to organize the business as a sole proprietorship where one person or a married couple owns everything, or as a partnership with others who may wish to invest money. Later they may choose to "incorporate". As a corporation, the owners are not personally responsible or liable for any debts of the company if the company doesn't succeed. Corporations issue official-looking sheets of paper that represent ownership of the company. These are called stock certificates, and each certificate represents a set number of shares. The total number of shares will vary from one company to another, as each makes its own choice about how many pieces of ownership to divide the corporation into. One corporation may have only 2,500 shares, while another, such as IBM or the Ford Motor Company, may issue over a billion shares. Companies sell stock (pieces of ownership) to raise money and provide funding for the expansion and growth of the business. The business founders give up part of their ownership in exchange for this needed cash. The expectation is that even though the owners have surrendered a portion of the company to the public, their remaining share of stock will become increasingly valuable as the business grows. Corporations are not allowed to sell shares of stock on the open stock market without the approval of the Securities and Exchange Commission (SEC). This transition from a privately held corporation to a publicly traded one is called going public, and this first sale of stock to the public is called an initial public offering, or IPO.

1.2 Why do people invest in the stock market?

When you buy stock in a corporation, you own part of that company. This gives you a vote at annual shareholder meetings, and a right to a share of future profits. When a company pays out profits to the shareholder, the money received is called a "dividend". The corporation's board of directors chooses when to declare a dividend and how much to pay. Most older and larger companies pay a regular dividend, most newer and smaller companies do not. The average investor buys stock hoping that the stock's price will rise, so the shares can be sold at a profit. This will happen if more investors want to buy stock in a company than wish to sell. The potential of a small dividend check is of little concern. What is usually responsible for increased interest in a company's stock is the prospect of the company's sales and profits going up. A company who is a leader in a hot industry will usually see its share price rise dramatically. Investors take the risk of the price falling because they hope to make more money in the market than they can with safe investments such as bank CD's or government bonds.

1.3 What is a stock market index?

In the stock market world, you need a way to compare the movement of the market, up and down, from day to day, and from year to year. An index is just a benchmark or yardstick expressed as a number that makes it possible to do this comparison. For e.g. S&P CNX Nifty is the index of NSE and SENSEX is the index of BSE.

Securities Market

Primary Market

Secondary Market

The Securities Market consists of two segments, viz. Primary market and Secondary market. Primary market is the place where issuers create and issue equity, debt or hybrid instruments for subscription by the public, the Secondary market enables the holders of securities to trade them. Secondary market essentially comprises of stock exchanges which provide platform for purchase and sale of securities by investors. In India, apart from the Regional Stock Exchanges established in different centers, there are exchange like the National Stock Exchange (NSE) and the Over the Counter Exchange of India (OTCEI), who provide nation wide trading facilities with terminals all over the country. The trading platform of stock exchanges are accessible only through brokers and trading of securities is confined only to stock exchanges. Thus, the securities market has two independent, inseparable segment, the new issues (primary) market and the stock (secondary) market. The primary market provides channel for sale of new securities while the secondary market deals in securities previously issued. The issuer of securities sells the securities to the primary market to raise funds for investment and/or to discharge some obligations. The secondary market enables them who hold securities to adjust their holdings in response to change in their assessment of risk and return. They also sell securities for cash to meet their liquidity needs. The corporate securities market dates back to the 18TH century when the securities of the East India Company were traded in Mumbai and Kolkata. The brokers used to gather under a banyan tree in Mumbai and under a neem tree in Kolkata for the purpose. However, the real beginning came in the 1850s with the introduction of the joint stock companies with limited liability. The 1860s witnessed beverish dealings in securities and securities speculation. This brought brokers to Bombay together in July 1875 to boom the first organized stock exchange in
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the country, viz. The Stock Exchange, Mumbai, Ahemadabad Stock Exchange in1894 and 22 others followed with 20TH century. The Stock Exchanges are the exclusive centers for trading in equities and the trading platform of an exchange is accessible only to brokers. The regulatory framework heavily favours the recognized stock exchanges by almost banning trading activity outside the stock exchanges. The securities are divided into two parts viz. Corporate securities and Government Securities Corporate Securities: The no of stock exchanges increased from 11 in1990 to 23 now. All the exchanges are fully computerized and offer 100% on-line trading. 9644 companies were available for trading on stock exchanges at the end of March 2002. The trading platform of the stock exchanges was accessible to 9687 members from over 400 cities on the same date. The sectoral distribution of turnover has undergone significant change over last few years. The share of manufacturing companies in turnover of top 50 companies, which was nearly 80% in 1995-96, declined sharply to about 6% in 201-02. During the same period the share of IT companies in turnover increased sharply from nil in 1995-96 to 67% in 2001-02. Government Securities: The aggregate turnover in central and state government dated securities, including treasury bills, through SGL transactions increased 31 times between 199495 and 2001-02. During 2001-02 it reached a level of Rs. 1,573,893 crore, higher than combined trading volumes in equity segments of all the exchanges in the country, reflecting deepening of the market. The share of outright transactions in government securities increased from 23.2% in 1995-96 to 77% in 2001-02. The share of repo transactions declined correspondingly from 76.8% in 1995-96 to 23% in 2001-02. The Share of dated securities in turnover of government securities increased from 69% in 1996-97 to 94% in 2001-02. The Tbills accounted for remaining SGL turnover. Derivatives Market: Derivatives trading commenced in India in June 200. The total exchange traded derivatives witnessed a volume of Rs. 442,343 crore during 2002-03 as against Rs. 4018 crore during the preceding year. While NSE accounted for about 99.5% of total turnover, BSE accounted for about 0.5% in 2002-03. The market witnessed higher volumes from June 2001 with introduction of index options, and still higher volumes with introduction of stock options in July 2001. There was a spurt in volumes in November 2001 when stock futures were introduced. It is believed that India is the largest market in the world for stock futures. The stock market or secondary market ensures free marketability, negotiability and price discharge. For these reasons the stock market is referred to as the nerve center of the capital
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market, reflecting the economic trend as well as the hopes, aspirations and apprehensions of the investors. Stock Market is also called the barometer of the economy. The broad structure of the secondary market is presented below:

Stock Exchanges Exchanges with Screen Based Trading system Exchanges having Trade/Settlement Guarantee Fund Exchanges with Internet Trading Registered Members (brokers) Registered Foreign Brokers Registered Corporate Members Registered Sub-Brokers Registered FIIS Listed Companies Market Capitalisation

24 24 16 1 9192 38 3136 5675 506 9871 Rs. 1192630 crore

1.4 Secondary Market Intermediaries

Stock brokers, sub-brokers, portfolio managers, custodians, share transfer agents constitute the important intermediaries in the Secondary Market. A Stock broker plays a very important role in the secondary market helping both the seller and the buyer of the securities to enter into a transaction. The buyer and seller may be either a broker or a client. The transaction entered cannot be annulled except in the case of fraud, willful misrepresentation or upon prima-facie evidence of a material mistake in the transaction,
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in the judgment of the existing authorities. If a member of the stock exchange (broker) has orders to buy and to sell the same kind of securities, he may complete the transaction between his clients concerned. When executing an order the stock may on behalf of his client buy or sell securities from his own account i.e. as principal or act as an agent. For each transaction he has to issue necessary contract note indicating whether the transaction has been entered into by him as principal or as an agent for another. While buying pr selling securities as a principal, the stock broker has to obtain the consent of his client and the prices charged should be fair and justified by the conditions of the market. A sub-broker is one who works along with the main broker and is not directly refistred with the stock exchange as a member. He acts on behalf of the stock broker as an agent or otherwise for assisting the investors in buying, selling or dealing in securities through such stock brokers. No stock brokers or sub-brokers shall buy, sell or deal in securities unless he holds a certificate of registration granted by SEBI under the Regulations made by SEBI ion relation to them. The Central Government has notified SEBI (Stock Brokers & Sub-Brokers) Rules, 1992 in exercise of the powers conferred by section 29 of SEBI Act, 1992. These rules came into effect on 20th August, 1992.

1.5 Ten Golden rules for Investing

Warren Buffet has suggested ten golden rules for investing which proves to be immense use to the investors who want a better investment in stock markets. The rules are as described below: Never invest in a business you can not understand. 1. Risk can be reduced by concentrating on a few holdings. 2. Stop trying to predict the direction of the stock market, the economy, interest rates, or elections. 3. Buy companies with strong histories of profitability and with a dominant business franchisee. 4. Be fearful when others are greedy and greedy when others are fearful.
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5. Unless you can watch your stock holding decline by 50% without becoming panicstricken, you should not be in the stock market. 6. Do not take yearly results too seriously. Instead, focus on four or five year averages. 7. Focus on return on equity, not earnings per share (EPS). 8. Calculate owner earnings to get a true reflection of value. Look for companies with high profit margins. 9. Always invest for the long term. Does the business have favourable long term prospects?

Part 2 :- Companys profile

About Sharekhan :

Sharekhan is Indias leading national network of stock-broking outlets. It is a part of SSKI (S.S. Kantilal Ishwarlal Securities Ltd.), an organization which over five decades of stock market experience. Sharekhan is not only a share-broking firm, but it avails of various services and other financial products to its clients. The services provided by Sharekhan includes the following services: 1. Online BSE and NSE executions (through BOLT, i.e. BSE Online Trading and NEAT, i.e. National Exchange Automated Trading ) 2. Free access to investment advice from Sharekhans Research team. 3. Depository services: Demat and Remat transactions (Sharekhan is registered with NSDL, i.e. National Securities Depository Ltd., as a Depository Participant) 4. Derivatives trading, i.e. Futures and Options ( through NEAT F&O) 5. Internet based online trading. 6. Other investment products: Mutual Funds, RBI Bonds, Insurance, etc.

2.1 Online BSE and NSE Trading

Sharekhan is a registered Stock Broker with the Bombay Stock Exchange and National Stock Exchange to trade on behalf of clients. The screen-based trading is done on BOLT- BSE Online Trading and NEAT- National Exchange Automated Trading, terminals. There are two types of transactions executed on these terminals viz. intra-day and delivery based transactions. Intraday transactions are those, in which the squaring up of deal is done on the same day, while in delivery based transaction the squaring up is not done on the same day, but the stock is to be traded on the basis of rolling settlement i.e. T+2. The Brokerage of Intraday transaction is 0.10% single side, while brokerage on delivery based transactions is 0.50% on both side, i.e. while purchasing as well as selling.

2.2 Free Access to Investment Advice through R&D Dept.

The Research and Development of Sharekhan is done at its Head office Mumbai. From there it forward the relevant data and tips on particular shares and scrips at the relevant time. The R&D department Head Mr. Hemang Jani forwards all the details regarding all stocks and scrips to all the branches through internet. At the end of each trading day there is a Teleconference, through which the R&D department Head MR. Hemang Jani talks with each Branch heads and discusses about each days closing position and shows their predictions about next days opening position. The quarries regarding stock positions and other relevant matter of the branch heads of each branch is being solved through teleconference. The various publications of Sharekhan viz. Derivatives Digest, Sharekhan Valueline, Eagle eye, High Noon, Investors Eye, Commodities Buzz, Commodities Beat, Commodity Traders corner, Sharekhan xclusive, etc. are being prepared by the research team of Sharekhan madeup of highly experienced people from diverse field.

2.3 Depository Participant

DEPOSITORY

ISSUER/R&T AGENT

CLEARING CORPORATION

CLEARING MEMBER

DEPOSITORY PARTICIPANT

STOCK EXCHANGE

TRADING MEMBER

INVESTOR

Sharekhan is a registered Depository Participant with National Securities Depository Ltd. (NSDL). The Particpants are required to enter into an agreement with beneficial owners. It is required that separate accounts shall be opened by every participant in the name of each of the beneficial owner and the securities of each beneficial owner shall be segregated and shall not be mixed up with the securities of other beneficial owners or with the participants own securities. The participants are obliged to reconcile the records with every depository on a daily basis. Participants are required to maintain the following records for a period of five years Records of all the transactions entered into with a depository and with a beneficial owner; Details of security dematerialized, rematerialized on behalf of beneficial owners with whom it has entered into an agreement; Records of instructions received from beneficial owners and statements of account provided to beneficial owners; and Record of approval, notice, entry and cancellation of pledge or hypothecation as the case may be.

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2.4 Derivatives Trading

Sharekhan is a Trading Member registered with the Stock Exchange, according to the norms and Guidelines given by the SEBI. The NEAT F&O trading system is accessed by two types of users. The Trading Membrs and the Clearing Members. The Trading Members(TM) has access to functions such as, order matching, order and trade managemant. The Clearing Member(CM) 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 to position, which a trading member can take. Sharekhan provides the service of derivatives trading on NEAT F&O to its clients.

2.5 Internet Based Online Trading

The Online trading facilities provided by Sharekhan is basically divided into two types of accounts, viz. Classic Account and Speedtrade and speedtradplus
1.

Classic Account: This account allows the client to trade through the website and is suitable for the retail investor. The online trading through Sharekhan website also comes with DialnTrade service that enables you to buy and sell shares by calling our dedicated toll-free number.

2.

Speedtrade and Speedtrade Plus: SPEEDTRADE is a next-generation online trading product that brings the power of the brokers terminal to the clients PC. Through SPEEDTRADE PLUS the client is also allowed to trade on Derivatives.

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The various benefits the clients gets from the online trading are:

Freedom from Paperwork: Integrated trading, bank and demat account (auto Instant Credit And Transfer: Instant transfer of funds from bank accounts of

payin and payout of securities) with digital contracts removes all paperwork.

clients choice to his/her Sharekhan trading account.

Trade Anywhere: Enjoy the ease of trading from any part of the world in a completelyt secure environment. Dial n Trade: Call Sharekhan on a toll free number to place orders through sharekhans telebrokers.

Timely Advice: Make informed decisions with expert advice, investment calls Real-Time Portfolio Tracking: Benefit from real-time information of your After-Hour Orders: The Client can place orders after the market hours, which

and live market commentary.

investment and current portfolio value.

get executed as soon as markets open.

2.6 Other Financial Products

Sharekhan is also providing the services to its clients who wants to deal in other financial products like Mutual Funds, Insurance, RBI Bonds, etc. The clients who wants to avail this service have to contact to their nearest branch of Sharekhan or can register their request on the website of the Sharekhan.

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Part 3: - Objective

The objective of my summer training was to give me an exposure to corporate environment and also give an opportunity to the students to get some practical knowledge in the field in which their interest lies. My summer training helped me a lot. My subject was derivatives, and as I was totally new to the stock market, I selected to take introduction to derivatives as my project. In todays era, trading in stocks is a risky venture and Derivatives are used to reduce this risk. Derivatives help minimising the risk and also give reasonable returns.

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Part 4: - Methodology

After signing my confirmation letter of summer training, I was enthusiastically waiting for 1st of June to arrive, the day on which my summer training started.

I meet Mr. Narendra Tanna(Branch Manager)Sharekhan on the first day suggested me some books to read in the initial days to get clear with the idea of derivatives, definitions, terminologies etc. He also suggested me to get enrolled with NCFM Derivatives core module. Thereafter I used to sit in the dealing room and have a look trading taking place on the stock market. This helped me to get acquainted with the practical aspects of day trading.

After getting acquainted with Stock market and Derivatives, I studied the Futures and Options Strategies, which were used to deal with risk and earn returns. I started gathering every day trades from NSE of Stock and Derivatives and read newspapers, which helped me analyse the trades. I separated the top 10 trades Calls, Puts and Futures, which gave me the view of the market. I used to prepare the Journal Voucher and the Trial Balance of all the clients having debit or credit balances in their account. The Journal Voucher Requests which is to be prepared is to be sent to the Head Office, Mumbai showing the net debit balance of the clients. The dealing is done on BSE, NSE or Derivatives. So the net debit balance of the client is to be forwarded to the Head Office and from there the notice is to be served to the clients.

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Part 5 :- Introduction to Derivatives

5.1 Introduction to derivatives

The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by lockingin asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of riskaverse investors.

5.2 Derivatives Defined

Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the underlying. Example :A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk, which in turn depends upon the demand, and supply of milk. See it this way. The price of Reliance Triple Option Convertible Debentures (Reliance TOCD) used to vary with the price of Reliance shares. And the price of Telco warrants depends upon the price of Telco shares. Do American depository receipts/ global depository receipts of ICICI, Satyam and Infosys traded on stock exchanges in the USA and England have their own values? No. They draw their price from the underlying shares traded in India. Consider how the value of mutual fund units changes on a day-to-day basis.
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Dont mutual fund units draw

their value from the value of the portfolio of securities under the schemes? Arent these examples of derivatives? Yes, these are. And you know what, these examples prove that derivatives are not so new to us. Nifty options and futures, Reliance futures and options, Satyam futures and options etc are all examples of derivatives. Futures and options are the most common and popular form of derivatives. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines derivative to include 1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.

5.3 History of Derivatives

The derivatives markets has existed for centuries as a result of the need for both users and producers of natural resources to hedge against price fluctuations in the underlying commodities. Although trading in agricultural and other commodities has been the driving force behind the development of derivatives exchanges, the demand for products based on financial instruments - such as bond, currencies, stocks and stock indiceshave now far outstripped that for the commodities contracts. India has been trading derivatives contracts in silver, gold, spices, coffee, cotton and oil etc for decades in the gray market. Trading derivatives contracts in organized market was legal before Morarji Desais government banned forward contracts. Derivatives on stocks were traded in the form of Teji and Mandi in unorganized markets. Recently futures contract in various commodities was allowed to trade on exchanges.

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In June 2000, National Stock Exchange and Bombay Stock Exchange started trading in futures on Sensex and Nifty. Options trading on Sensex and Nifty commenced in June 2001. Very soon thereafter trading began on options and futures in 31 prominent stocks in the month of July and November respectively. The market lots keeps on changing from time to time. The minimum quantity you can trade in is one market lot. The market lot list up to 27/05.2004 for different stocks/index is as follows: Instrument Name 1. Nifty future and option 2. Sensex future 3. Sensex options 4. ACC 5. Andhra Bank 6. Arvind Mill 7. Bajaj Auto 8. Bank of India 9. Bank of Baroda 10. BEL 11. Bharat Heavy Electricals 12. Bharat Petroleum Corporation 13. BSES 14. Canara Bank 15. Cipla 16. Dr Reddys Laboratories 17. Grasim Industries 18. GAIL 19. Gujarat Ambuja Cement 20. HCL Tech 21. HDFC 22. HDFC Bank 23. Hero Honda 24. Hindalco Industries 25. Hindustan Lever 27. ICICI Ban No. of Shares in One lot (200) (50) (100) (1500) (4600) (4300) (400) (3800) (1400) (550) (600) (550) (550) (1600) (1000) (400) (350) (1500) (1100) (1300) (600) (800) (400) (300) (2000) (1400)
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26. Hindustan Petroleum Corporation(650)

28. I-Flex 29. Infosys Technologies 30. IPCL 31. Indian Oil Corporation 32. ITC 33. Mahindra & Mahindra 34. Mruti Udyog Ltd. 35. Mastek 36. Mahanagar Telephone Nigam 37. National Aluminium 38. NIIT 39. ONGC 40. OBC 41. Punjab National Bank 42. Polaris Lab 43. Ranbaxy Laboratories 44. Reliance Industries 45. Satyam Computers 46. State Bank of India 47. Syndicate Bank 48. Shipping Corporation of India 49. Tata Power 50. Tata Tea 51. Tata Motors 52. Tisco 53. Union Bank 54. Wipro 55. CNX IT

(300) (50) (1100) (600) (300) (625) (400) (1600) (1600) (1150) (1500) (300) (1200) (1200) (1400) (400) (600) (1200) (500) (7600) (1600) (800) (550) (825) (900) (4200) (200) (100)

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5.4 Types of Derivatives

Derivatives

Options

Futures

Swaps

Forward

Put

Call Commodity

Security Interest Rate

Currency

1.

Forward: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price.

2.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

3.

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

4.

Commodities: Commodities includes various eatables on which the future contracts are possible. In India the screen based trading on various commodities is being started on Multi Commodity Exchange(MCX) and National Commodities and Derivatives Exchange(NCDEX). The contracts on commodities are ranging from 1 month to 3 months.

5.

Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.

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6.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years.

7.

Baskets Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.

8.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: 1.Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. 2.Currency swaps: These entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction.

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

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Part 6: - Forwards, Futures, Option and their Terminologies

6.1 Forward Contracts

CALANDER SPREAD

Strategy view:- Volatile - market will rise in short-term, but then it will fall sharply. Strategy Implementation:- Current months put option is sold and buy next months put option with the same strike price.

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BUY STRADDLE

Strategy view:- Volatile - market will be volatile in the short-term. Strategy Implementation:- A call option and a put option are bought at the same strike price a

BUY STRANGLE

Strategy view:- Volatile - market will be very volatile in the short-term and premium paid here is less. Strategy Implementation:- A put option is bought at a and a call option is bought at a higher strike price b

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other
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contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. Positive Aspects of Forward Contracts: 1. A business organization or institution can use the forward market to hedge or lock in the price of purchase or sale of a commodity or financial asset on a future commitment date. 2. Margins are not generally paid on forward contracts; there is also no up front premium so these contracts do not require an initial cost. 3. As forward contracts are tailor made, the risk of price can be hedged up to 100 per cent. This facility may not be possible in futures or options. Negative Aspects of Forward Contracts: 1. As there is no performance guarantee in a forward contract, there is always counter-party risk. In addition, the possibility that the counter-party could fail to perform his obligation on the due date creates additional risk. 2. Forward contracts do not allow investors to derive gain from a favorable price movement or to unwind a transaction once the contract is made. At the most, the can be cancelled on terms agreed upon by the counter-party. 3. It is difficult to get counter-party on ones own terms. In addition, as a forward contract is not traded on an exchange, it offers no ready liquidity. 4. In most cases, one counter-party of a forward contract is a bank or a trader who will square up his position by entering into reverse contract. These transactions do not take place simultaneously, so the bank of trader will normally keep large bid-ask to avoid any loss due to price fluctuations. This procedure increases the cost of hedging. However, forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward.
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If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator. In most markets, middlemen are required to bring buyers and sellers of forward contracts together. These middlemen charge a fee, for their services.

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6.2 Futures Contracts

Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: Quantity of the Underlying. Quality of the Underlying. The date and month of delivery. The units of price quotation and minimum price change. Location of settlement.

Distinction between futures and forwards contracts: Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counter-party risk and offer more liquidity.

Futures Trade on an organized exchange Standardized contract terms hence more liquid Requires margin payments Follows daily settlement

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

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Futures terminology: Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market. Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and three-months expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Contract size: The amount of asset that has to be delivered under one contract. For instance, the contract size on NSEs futures market is 200 Nifties. Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called markingtomarket. Maintenance margin: This is somewhat lower than the initial margin. This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

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6.3 Options
Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an upfront payment.

Option terminology
Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled. Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. Buyer of an option: The buyer of an option is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.

There are two basic types of options, call options and put options.

Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option price: Option price is the price, which the option buyer pays to the option seller. It is also referred to as the option premium.
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Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised at any time upto the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options, and properties of an American option are frequently deduced from those of its European counterpart. In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cashflow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price (i.e. spot price = strike price). Out-of-the-money option: An out-of-the-money (OTM) option is an option that would

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lead to a negative cashflow it were exercised immediately. A call option on the index is out-ofthe-money when the current index stands at a level, which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. Intrinsic value of an option: The option premium can be broken down into two components intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0,(St K)] which means the intrinsic value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is Max [0,(K St)], i.e. the greater of 0 or (K St). K is the strike price and is the spot price.
__

Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an options time value, all else equal. At expiration, an option should have no time value.

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

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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.

Features and Difference in Options and Futures: Futures Exchange traded, Exchange defines the product Price is zero, strike price moves Price is zero Linear payoff Both long and short are at risk Options Same as futures. Same as futures. Strike price is fixed, price moves. Price is always positive. Nonlinear payoff. Only short option is at risk.

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6.4 Index Derivatives

Index derivatives are derivative contracts which derive their value from an underlying index. The two most popular index derivatives are index futures and index options.

Types of Index Derivatives

1. Index Futures 2. Index Options

Requirements for an index derivatives market are:

1. Index: The choice of an index is an important factor in determining the extent to which the index derivative can be used for hedging, speculation and arbitrage. A well diversified, liquid index ensures that hedgers and speculators will not be vulnerable to individual or industry risk. 2. Clearing corporation settlement guarantee: 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 insulates a participant from credit risk of another. 3. Strong surveillance mechanism: Derivatives trading brings a whole class of leveraged positions in the economy. Hence the need to have strong surveillance on the market both at the exchange level as well as at the regulator level. 4. Education and certification: The need for education and certification in the derivatives market can never be overemphasized. A critical element of financial sector reforms is the development of a pool of human resources with strong skills and expertise to provide quality intermediation to market participants.

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Part 7: - Payoffs for Derivatives Contracts

7.1 Payoff for Futures
Long Position: The figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 1250. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses. Nifty 1,000 1,100 1,200 1,300 1,400
P off of Futures B er ay uy
200 Payoff 100 0 -100 -200 -300 N In ex ifty d 1,000 1,100
` 1,200

Payoff -250 -150 -50 50 150

1,300

1,400

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Short Position: The figure shows the profits/losses for a long futures position. The investor Sold futures when the index was at 1250. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses.

Nifty 1,000 1,100 1,200 1,300 1,400

Payoff 250 150 50 -50 -150

Payoff for Futures Seller

300 200

Payoff

100 0 -100 -200 Nifty Index 1,000 1,100 1,200 1,300 1,400

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7.2 Payoff for Call Option

Long Position
Buy a one-month call of nifty at strike price of 1250 with a premium of Rs. 100 Payoff table
Nifty Spot Value of 1250 Call Premium Paid Net Profit / (Loss) 1000 0 -100 -100 1050 0 -100 -100 1100 0 -100 -100 1150 0 -100 -100 1200 0 -100 -100 1250 0 -100 -100 1300 50 -100 -50 1350 100 -100 0 1400 150 -100 50 1450 200 -100 100 1500 250 -100 150

Pay Call Buy off er

200 150 100 50 0 -50 -100 -150

Payoff

1000

1050

1100

1150

1200

1250

1300

1350

1450

N Index ifty

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1500

1400

Short Position
Nifty Spot Value of 1250 Call Premium received Net Profit / (Loss) 1000 0 100 100 1050 0 100 100 1100 0 100 100 1150 0 100 100 1200 0 100 100 1250 0 100 100 1300 -50 100 50 1350 -100 100 0 1400 -150 100 -50 1450 -200 100 -100 1500 -250 100 -150

Payoff Call Seller

150 100

Profit/ Loss

50 0 1050 1150 1450 -50 -100 -150 -200 1500 1000 1100 1400 1300 1200 1250 1350

Nifty Index

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7.3 Payoff for Put Option

Long Position
Buy a one-month Put of nifty at strike price of 1250 with a premium of Rs. 100 Payoff table
Nifty Spot Value of 1250 Call Premium Paid Net Profit / (Loss) 1000 250 -100 150 1050 200 -100 100 1100 150 -100 50 1150 100 -100 0 1200 50 -100 -50 1250 0 -100 -100 1300 0 -100 -100 1350 0 -100 -100 1400 0 -100 -100 1450 0 -100 -100 1500 0 -100 -100

Payoff Buy Put

200

Profit/Loss

150 100 50 0 -50 -100 -150 1000 1050 1100 1150 1200 1250 1300 1350 1400 1450 1500

Nifty Index

Short Position
Nifty Spot Value of 1250 Call Premium received Net Profit / (Loss) 1000 -250 100 -150 1050 -200 100 -100 1100 -150 100 -50 1150 -100 100 0 1200 -50 100 50 1250 0 100 100 1300 0 100 100 1350 0 100 100 1400 0 100 100 1450 0 100 100 1500 0 100 100

Payoff Sell Put

Profit/ Loss
150 100 50 1000 1050 1200 1350 1450 -50 -100 -150 -200 1500 1100 1150 1250 1300 1400 0

Nifty Index

Part 8: - Option Strategies

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By using this kind of payoffs the traders form different strategies in the market to earn profits or restricts their losses. There are n numbers of strategies available in the market but some of them are basic strategies, which can help us learn about the trading in the Derivatives market. Different strategies can be implemented in Different kind of situtation such as Long Position or Short Position on a stock, call or put, Bullish view or Bearish view on a script/Underlying or the whole market. The Strategies can be divided on the view when they are implemented for Viz :- Bullish, Bearish, Neutral, Volatility.

8.1. Bullish View: -

COVERED CALL

Strategy view:- Bullish - Moderately bullish. Strategy Implementation:- Buy stock, Sell call at strike price a.

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COVERED PUT

Strategy view:- Bullish - Certain that the market will not rise Strategy Implementation:- Sell stock, Buy call at strike price a.

VERTICAL CALL OPTION BULLISH SPREAD

Strategy view:- Bullish - market is more likely to rise Strategy Implementation:- Buy call at a and Sell call at price at higher strike price b.

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VERTICAL PUT OPTION BULLISH SPREAD

Strategy view:- Bullish - market is more likely to rise Strategy Implementation:- Sell put at a and Buy put at price at higher strike price b.

DIAGONAL SPREAD - USING CALL

Strategy view:- Bullish - market will be weak in short term but will rally later. Strategy Implementation:- Sell put at a and Buy put at price at higher strike price b.

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8.2. Bearish View: -

SYNTHETIC CALL

Strategy view:- Bearish - worried about a market fall. Strategy Implementation:- Buy stock, Buy call at strike price a.

SYNTHETIC PUT

Strategy view:- Bearish - market will fall significantly in the short-term. Strategy Implementation:- Sell stock, Buy call at strike price a.

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VERTICAL CALL OPTION BEARISH SPREAD

Strategy view:- Bearish - market is more likely to fall. Strategy Implementation:- Buy call at price b and sell call at lower strike price a.

VERTICAL PUT OPTION BEARISH SPREAD

Strategy view:- Bearish - market is more likely to fall. Strategy Implementation:- Buy put at price b and sell put at lower strike price a.

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DIAGONAL SPREAD - USING PUT

Strategy view:- Bearish - market rise only in short term, but will then fall later. Strategy Implementation:- Sell put at a and Buy put at price at higher strike price b.

8.3 Neutral View: -

BUYING A BUTTERFLY USING CALL OPTION

Strategy view:- Neutral - market will not be volatile. Strategy Implementation:- Buy two call option one at
higher strike price c and one at relatively lower strike price b, and sell two call options at Mid-strike price a.

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BUYING A BUTTERFLY USING PUT OPTION

Strategy view:- Neutral - market will not be volatile. Strategy Implementation:- Buy two put option one at
higher strike price c and one at relatively lower strike price b, and sell two put options at Mid-strike price a.

CALANDER SPREAD

Strategy view:- Neutral - market will be weak in the short term, but will rally in the long -term. Strategy Implementation: Current months call option is sold and buy next months call option with the same strike price.

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SELL STRADDLE

Strategy view:- Neutral - Certain that the market will not be very volatile. Strategy Implementation:- A call option and a put option are sell at the same strike price a

SELL STRANGLE

Strategy view:- Neutral - market will not be volatile in broadish band. Strategy Implementation:- A call option is sold at b and a put option is sold at a lower strike price a

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8.4 Volatile View: -

SELLING A BUTTERFLY USING CALL OPTION

Strategy view:- Volatile - market will be mildly volatile. Strategy Implementation:- Sell two call option one at higher
strike price c and one at relatively lower strike price b, and Buy two call options at Mid-strike price a.

SELLING A BUTTERFLY USING PUT OPTION

Strategy view:- Volatile - market will be mildly volatile. Strategy Implementation:- Sell two put option one at higher
strike price c and one at relatively lower strike price b, a Buy two put options at Mid -strike price a. nd

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8.5 Using Derivatives: Investors can use basic options and Futures Strategy to achieve the following objectives: -

Protect your portfolio against a decline in the market. Improvement in your portfolio performance. To plan for acquisition or disposition of securities. To benefit from market fluctuation. To take advantage of leverage.

8.6 The truth is: Stock options, when used correctly and prudently, provide the investor with very powerful tools to: PREVENT catastrophic losses, such as Enron, without losing the upside potential. PROFIT more in short term up moves than by owning the stock alone, with NO additional risk. CONTROL your total exposure in a worst-case scenario. CONTROL exactly how much money you want to have at risk. LOCK in profits, but still make money as your stock appreciates. PROFIT from movement in the stock, regardless of direction.

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Part 9 Recommendations
Derivatives can be a very effective tool to take advantage of a rising, falling and range bound underlying. The following points may be kept in mind while trading in derivative products: Choose a month that allows enough time for the anticipated move in the underlying. In-the-money calls are initially more responsive to underlying price changes than out-of-the-money calls. Choose a strike price level that offers a good risk/reward ratio given the expected price movement. Watch for Bid/Ask price offered for Spot, Future, & Options simultaneously Liquidity of products involved Transaction Costs

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Part 10: - Other Experiences

Corporate Environment: I had a great time at Sharekhan, Rajkot Branch. I experienced the corporate environment with fun and dedication to work. I learnt the importance of time and work in todays world. The main things I gained from Mr. Narendre Tanna(Branch Manager) were the punctuality, dedication, knowledge and interest about all the subjects related to his work profile, and above all he loves his job. I will try to be like him as he has influenced me a lot. I will try and acquire as much knowledge as I can from my MBA course and in future will love my job. I never felt like working under a hierarchical environment, it was just like a flat organization where everybody was friendly.

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Part 11: - Bibliography

Books:
Hull, John Options, Futures and Other Derivatives, Third Edition, PHI Sharekhan Derivatives Digest Sharekhan Sharekhan Valueline ICSI Securities Laws and Regulation of Financial Markets ICSI Chartered Secretary

Websites :
www.sharekhan.com www.indiainfoline.com www.nseindia.com

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