Investment planning

funding medium to long-term liabilities although in isolation they may not generate sufficient earnings to fund the liabilities. In times of falling interest rates, bond prices increase. Indexed fixed interest securities provide a hedge against long-term inflation. Factors Affecting Demand and Prices Risk premiums or discounts will depend on factors such as:  perceptions of future currency trends and rates;  expectation of future inflation trends and rates;  current economic and expected future economic conditions at a macro level; and  the current supply and future expected supply of domestic debt securities. Duration Treasury and State Government bonds are default-free, so the yield represented by the purchase price will be realised if held to maturity, apart from the erosion brought about by inflation. If the bonds are traded before maturity, risk arises from the fact that if interest rates have risen sharply, the bonds may be worth less than what was originally paid for them. In any event they may not reflect an adequate return on investment. Fund managers try to avoid this risk, in part, by matching maturity dates of bonds to expected liabilities, and holding the bonds to maturity. Active fixed interest managers use a concept called duration to assist in bond trading and bond portfolio management. Not only are bonds held to maturity less risky than shares; in active bond portfolio management there is a risk-management tool available to fund managers which has no analogy in other asset classes. This tool is duration. Duration is a technical quantity calculated by weighting and summing the time to each of a bond‘s discounted cash flows. Every bond has a value of duration which depends on its term to maturity and the coupon it promises. The duration of the bond (not to be confused with its maturity value) determines how much its price will change as yields change. The larger a bond‘s duration, the more its price is affected by a change in yield. Long-term bonds have larger values of duration than short-term bonds. This means that the proportional price rise of long-term bonds is greater than that of short- term bonds when yields fall. Why will the price of a bond rise when its yield falls? It is also true that bonds decrease in price with increasing yield. This is just a manifestation of the fact that the less you pay for a bond, the greater your return. Long- term bonds are ‗riskier‘ than short-term bonds in that their price is more sensitive to change in yield. However, if fund managers anticipate a fall in bond yields they can shift their holdings into long-term bonds, to achieve maximum benefit from the resultant rise in bond prices. Risk Management Instruments Risk management (derivative) instruments are recently introduced in the Indian market. For example, NSE offers Interest Rate Futures. In addition, banks also use 241

swap contracts to manage interest rate risk. 3. Money Market Cash is the least volatile asset class. It would be a mistake, however, to think that real returns on money market instruments are necessarily lower in any particular year than returns in other investment classes. In many years the real, after-tax rate of return on cash has been higher than in many of the other asset classes. Cash is a highly liquid, low risk asset. Treasury bills and commercial paper issued by corporations are some of the securities traded on the money market. General Characteristics of the Cash Class Fund managers like to park spare cash in very liquid securities in order to avail themselves of good opportunities as they arise in other asset classes, particularly the share market. Opportunities exist for returns well above market maturity yields quoted, by buying and selling at favourable rates before maturity. In times of high volatility in markets in general, or uncertainty for an individual fund manager, a large proportion of fund assets may be invested in cash ‗till the dust settles‘. Risk Management Instruments Ninety-day bank bill futures and put and call options on those futures are among the most actively traded of derivative securities on international markets. Investors can lock into future investment and borrowing rates using futures, or construct investment floor rates or borrowing caps using options on the futures. It would take some time for these instruments to be introduced in our market. 4 International Investment While the opportunity to invest globally might seem ‗only‘ to offer investment in the aforesaid asset classes all over again, it provides much more than that. International investment allows fund managers to take advantage of (for instance) interest rate movements in different countries. Mutual funds are allowed to invest in ADRs/GDRs issued by Indian Companies within overall limit of US$5 billion. With a sub-ceiling for individual mutual fund which should not exceed 10% of the net assets managed by them as on the date of the last audited balance sheet.  Mutual funds should invest only in rated securities with fully convertible currencies, short term and long term debt instruments with highest rating by accredited / registered credit rating agencies.  Mutual funds are also allowed to invest in government securities where the countries are AAA rated.  They may also invest in units/securities issued by overseas mutual funds / unit trusts which invest in the aforesaid securities. In some countries, in addition to the options listed above, fund managers are allowed to make investment in equities and to take positions in currencies while investing in overseas assets if they so choose. Overseas income and receipts can be hedged by 242

forward foreign exchange agreements (i.e. the investment and currency decisions can be separated). They can also hedge or trade in other derivative instruments. Implications of global investment include complex taxation and legislative considerations, putting this arena beyond the reach of most individual investors but within that of most managed funds. Portfolio Construction & Management We have seen the essential characteristics of various classes of assets in which a fund manager makes investment. The most important and difficult task of the mutual fund manager is how to allocate funds and manage the portfolio in a manner suitable to the investment objectives of the scheme and produce a comparatively better return than the market to the investors. Once the fund is collected, (may be once the scheme is launched) the process of investment management commences. Initially, the funds are parked in short term money market instruments and deposits with banks and financial institutions but suitable investment opportunities are scouted keeping in mind the investment objectives published in the offer document. This involves a) Portfolio Construction and b) Managing the portfolio. These are the two specialized areas where the skills of professional investment managers are utilized. The first and formidable task before the fund manager is to select securities that would suit the time horizon of the scheme. From a universe of securities, based on the investment objective, the manager has to identify the investment opportunities and construct the portfolio. SEBI has laid down the basic objectives of investment management. The regulations state that the moneys collected under any scheme of mutual fund shall be invested only in transferable securities in the money market or in the capital market or in privately placed debentures or securities or securitised debt. SEBI Regulations also lay down prudential investment norms (to ensure that the investment portfolios of the mutual funds are diversified to reduce the inherent risk associated with such investments) and list down the investment opportunities (from where the fund managers can choose the investments). From the following, you will get a general idea of opportunities available to and restrictions faced by the fund managers of mutual funds. Opportunities Available Mutual funds are allowed  to invest in overseas securities subject to a maximum limit of US$50 million.  to trade in derivative transactions for the purpose of hedging and portfolio balancing.  to underwrite after obtaining certification of registration from SEBI.  to participate in securities lending, subject to certain disclosures and reporting requirements. Restrictions on Investments  A mutual fund scheme shall not invest more than 15% of its NAV in the debt instruments investments debt instruments issued by a single issuer, which are rated not below investment grade by a credit rating agency authorized to carry out such activity under the Act. Such investment limit may be extended to 20% of the NAV of the scheme with the prior approval of the Board of Trustees and the Board of the asset management company. 243

 A mutual fund scheme shall not invest more than 10% of its NAV in un-rated debt instruments issued by a single issuer and the total investment in such instruments shall not exceed 25% of the NAV of the scheme. All such investments shall be made with the prior approval of the Board of Trustees and the Board of the asset management company.  No mutual fund under all its schemes should own more than ten per cent of any company‘s paid up capital carrying voting rights.  Such transfers are done at the prevailing market price for quoted instruments on spot basis.  The securities so transferred shall be in conformity with the investment objective of the scheme to which such transfer has been made.  A scheme may invest in another scheme under the same asset management company or any other mutual fund without charging any fees, provided that aggregate inter- scheme investment made by all schemes under the same management or in schemes under the management of any other asset management company shall not exceed 5% of the net asset value of the mutual fund.  Every mutual fund shall buy and sell securities on the basis of deliveries and shall in all cases of purchases, take delivery of relative securities and in all cases of sale, deliver the securities and shall in no case put itself in a position whereby it has to make short sale or carry forward transaction or engage in badla finance.  No mutual fund scheme shall make any investment in;  Any unlisted security of an associate or group company of the sponsor; or  Any security issued by way of private placement by an associate or group company of the sponsor; or  The listed securities of group companies of the sponsor which is in excess of 30% of the net assets of all the schemes of a mutual fund  No mutual fund scheme shall invest more than 10 per cent of its NAV in the equity shares or equity related instruments of any company. Provided that, the limit of 10 per cent shall not be applicable for investments in index fund or sector or industry specific scheme.  A mutual fund scheme shall not invest more than 5% of its NAV in the unlisted equity shares or equity related investments in case of open-ended scheme and 10% of its NAV in case of close-ended scheme.  No mutual fund is allowed to advance loans for any purpose. Given the regulatory limits and restrictions and the investment goals of the scheme, the fund manager allocates the assets and formulates the strategies for the management, whether continuous monitoring and rebalancing or periodic reviews and reshuffling. Both the initial asset allocation and the strategy of rebalancing have a significant impact on the risk-return profile of mutual fund schemes. The information on the fund allocation is available in the Fact books published by AMFI and are disclosed to the investors by mutual funds in the periodic reports sent to them. Financial planners shall compare the allocation pattern with the pattern indicated in the offer document over a period of time and advise clients on the risks that are likely to be associated with investment. This aspect assumes significance in the light of findings that the initial pattern is drastically changed at a later 244

stage for various reasons. With this information, the financial planners can also see how the fund managers make use of trading opportunities by shifting funds say from equities to debt instruments or among various industrial sectors etc. How the fund managers select a portfolio or allocate assets? In the professional investment set up, it is expected that the managers construct a diversified portfolio which is an efficient one. The quantitative tools available to the fund managers for optimal portfolio selection include Markowitz‘s model and Sharpe‘s model. (A more detailed discussion on these models is given in Topic1). Generally, the fund managers are said to be using Markowitz‘s model for asset allocation and Sharpe‘s model for the portfolio construction within the asset class). Another widely used method of stock selection is on the basis of fundamental analysis. All these tools require lot of data and involve rigorous research. Approaches to Portfolio Management The performance of the mutual funds depends on the investment approach adopted. There are two distinctive styles of investment management - passive and active. Passive Management: Under passive management, the fund manager‘s objective is to construct a portfolio that seeks to equal the return on a given market index. The fund manager simply invests allocates money among various indices according to the investment objectives of the fund. For example, assets of an equity fund may be invested in Sensex or Nifty stocks in the same proportion of market capitalization as that of the index components or as per the number of stocks in each industry category included in the index. Alternatively, if the index stocks are too many, he can purchase a statistical1y representative sample of stocks whose combined total return will closely approximate that of the index. The choice of this sample is important and can require some amount of research into the behaviour of index stocks. This approach does not require any bargain hunting and the expenses involved are low. This is more suitable for income oriented, close ended funds. Mutual fund schemes adopting this strategy are popularly known as Index Funds. There are some mutual funds in India that offer Index funds. Active Management: An active manager seeks to give a better performance than the return on the index based on constant reviews, frequent rebalancing / shuffling of the portfolios. Unlike under passive strategy, stock selection in this management style assumes an integral part of portfolio construction. Shares with different risk characteristics, changes in economy and business cycles etc., are scrutinized by these investment managers to construct portfolios, which are expected to beat the market. Whatever be the style of management, the financial planners and investors will have to judge the kind of investments the fund manager prefers, and try to see if the investor‘s objective coincides with the investment objective of the fund. Active Portfolio Management Active portfolio management refers to a portfolio management strategy where the investment manager makes specific investments with the goal of generating more returns and/ or creating less risk in comparison to a pre-stated benchmark index. In this case, the investment manager exploits market inefficiencies by purchasing securities that are undervalued or by short selling securities that are overvalued. 245

Either of these methods may be used alone or in combination. Passive Portfolio Management Passive portfolio management refers to a portfolio management strategy that seeks to replicate the risk and return characteristics of an index or market sector by matching its composition. In a passive portfolio management, the portfolio manager deals with a fixed portfolio designed to match the current market scenario. Active V/S Passive STYLES Active Fund Management  Aim for Out-performance  Higher costs  Stocks Selection and timing Passive Fund Management  Index linked returns  Lower costs  Replicates a chosen Index 4.1.2. Frequent Churning of Portfolio to Book Profits/Losses Churning is the practice of executing trades for an investment account by a salesman or broker in order to generate commission from the account. It is a breach of securities law in many jurisdictions, and it is generally actionable by the account holder for the return of the commissions paid, and any losses occasioned by the broker's choice of stocks. Courts generally look at the turnover of an investment account, or the number of times the investment capital has been re-invested during a year. For example, for an actively traded mutual fund, the entire assets of the fund will be involved in buying and selling transactions once every six to twenty-four months. In churning cases, the entire assets of the investor are often traded once a month, or even more frequently. As a commission is paid on each trade, commissions can substantially destroy the value of an investment account in a very short period of time. Critics of the practice of paying brokers commissions for managing investment accounts point to churning as one of the indicators that the brokerage system indirectly encourages such behavior by brokers to the detriment of investors. Accounts invested in securities with steady returns and little price fluctuation generate no commissions, and brokers are therefore not encouraged to invest their client's money in such investments. Frequent trading in fee-based accounts is not an example of churning, since no commissions are generated in those transactions. However, the practice of putting clients who trade 246

infrequently into a fee-based brokerage account is known as \"reverse churning\", since clients are charged fees in accounts with few if any transactions. Churning Activity Depends on a Number of Factors Such as: Objective: If one endeavours to focus on opportunities present across sectors and benefit from company specific opportunities, it may indulge in excessive churning. Growth and opportunities oriented approach may have higher portfolio churning than rest. On the other hand, value oriented approach would have lower portfolio churning. Philosophy: Some do not mind churning portfolio aggressively if there is an opportunity to generate superior returns. Market Conditions: It is observed that, usually under flat market conditions, portfolio turnover is lower. However, volatile markets throw up good buying and selling opportunities. Therefore, portfolio churning tends to be higher when markets are volatile. Macroeconomic Outlook: When the macroeconomic outlook is expected to turn negative from positive or vice-versa, one tends to restructure their portfolios thereby giving rise to overall churning activity. For example, in today's context as the new government is expected to give a big push to manufacturing and infrastructure; one may take fresh positions in stocks belonging to these sectors. At the same time, companies belonging to consumer non-durable segment are falling out of favour on valuation concerns. 4.1.3. Hunting for Gains from Investing in Temporarily Undervalued Sectors/Stocks A financial security or other type of investment that is selling for a price presumed to be below the investment's true intrinsic value. A undervalued stock can be evaluated by looking at the underlying company's financial statements and analyzing its fundamentals, such as cash flow, return on assets, profit retention and capital management, to determine said stock's intrinsic value. Buying stocks when they are undervalued is a key component of mogul Warren Buffett's value investing strategy. Value investing is not foolproof, however. There is no guarantee as to when or whether a stock that appears undervalued will appreciate. There is also no single correct way to determine a stock's intrinsic value - it is basically an educated guessing game. Ratios used for Finding Undervalued Sectors/ Stocks: P/E Ratio You've probably heard financial analysts comment that a stock is selling for some number \"times earnings,\" such as 30-times earnings or 12.5-times earnings. This means that P, the price the stock is currently trading at, is 30 times higher than E, the company's annual earnings per share, or EPS.. However, for now, all you need to know is that value investors like the P/E ratio to be as low as possible, preferably even in the single digits. The number that results from calculating P/E is called the earnings multiple. So a stock that sells for 50 (P) and generates 2 EPS (E) would have an earnings multiple of 50/2, or 25. A value investor would normally pass on this stock. 247

Earnings Yield Earnings yield is simply the inverse of the earnings multiple. So a stock with an earnings multiple of 5 has an earnings yield of 1/5, or 0.2, more commonly stated as 20%. Since value investors like stocks with a low earnings multiple and earnings yield is the inverse of that number, we want to see a high earnings yield. Ordinarily, a high earnings yield tells investors that the stock is able to generate a large amount of earnings relative to the share price. The key to buying an undervalued stock that is actually worth more than it is currently trading for is to thoroughly research the company and not just buy a stock because a few of its ratios looks good or because its price has recently dropped. It's not quite that simple to tell if a stock is a good buy. Applying your common sense and critical thinking skills to stock selection is essential. 4.1.4. Speculation, Hedging and Arbitrage Strategies Hedging In general, hedging using futures refers to a position being taken in the futures market, be it buy or sell, as a means of reducing the risk of price fluctuation in the physical or cash market. Futures can best be used as a short-term hedge against potential losses on a position in the underlying market. For example, a client with a large holding of shares in a particular company might sell a futures contract if he or she is expecting the share price fall but does not wish to sell the shares at this point in time for whatever reason. The short futures position would be fully covered by the shares (which may be accepted as collateral by the clearing house, and in that case the futures position would not be subject to margin calls). If the price of stock falls the futures sale position shall provide returns which shall offset the losses in the cash market. However, because futures gain or lose value symmetrically without limit, selling futures as a hedge against losses on an underlying position can also eliminate any profits on the underlying position in a rising market. In the above example, if the share price rises and the downside risk appears to have passed, the client would be best advised to close the futures position quickly by buying back the short sale position in the futures markets (and book only a small loss as the cost of the hedge). There are other hedging strategies involving share futures and Index futures. For example, after applying the technique of fundamental analysis in can be concluded that a particular share is intrinsically overvalued or undervalued. You also strongly feel that the profitability of the company. Has been overstated and the market price would soon witness a down correction. On the basis of this opinion if you advise your clients to take a short position on the scrip, the client will face the following risks.  Your understanding about company financials may go wrong and the market continues to be upbeat about the strengths.  There is a bullish trend in the market which makes the share to move up even though your understanding about the scrip has been right. 248

This short position on the stock can be hedged by buying futures of the stock in the derivative market. Arbitrage Arbitrage means locking in a profit by simultaneously entering in to transactions in two or more markets. If the Relationship between spot prices and futures prices in terms of basis or between prices of two future contracts in terms of spread changes, it gives rise to arbitrage opportunities. Difference in the equilebrium prices determined by demand in two different markets also gives opportunities to arbitrage. Futures price must be equal to spot price + cost of carrying the commodity to the futures delivery dates else arbitrage opportunity arises. Arbitrage creates market efficiencies in equity futures and hance prices are quoted at their fair value most of the times. Speculation, Hedging and Arbitrage Strategies - Options Contracts A. Hedging: Buy Puts to Hedge Current Portfolio To protect the value of your portfolio from falling below a particular level, buy the right number of put options with the right strike price. If you are only concerned about the value of a particular stock that you hold, buy put options on that stock. If you are concerned about the overall portfolio, buy put options on the index. When the stock/index price falls, your stock/portfolio will lose value and the put options bought by you will gain, effectively ensuring that the total value of your stock/portfolio plus put does not fall below a particular level. B. Speculation (By Calls or Sell Puts or Both, if Bullish) There are times when investors believe that security prices are going to rise. A trading strategy to benefit from an upward movement includes:  Buy Call Options  Sell Put Options  Both of the above Call Option: The loss to the buyer is limited to the option premium and profit however is potentially unlimited. Put Option: The profit to the seller is limited to the option premium and loss however is potentially unlimited. C. Speculation (Buy Puts or Sell Calls or Both, If Bearish) There are times when investors believe that security prices are going to fall. A trading strategy to benefit from a downward movement includes:  Buy Put Options 249

 Sell Call Options  Both of the above Put Option: The loss to the buyer is limited to the option premium and profit however is potentially unlimited. Call Option: The profit to the seller is limited to the option premium and loss however is potentially unlimited. Speculation, Hedging and Arbitrage Strategies - Futures Contract A. Hedging (Sell Futures to Hedge Current Portfolio) Futures can be used as a risk-management tool. If an investor who holds the shares of a company sees the value of his security falling, he can minimize his price risk using security futures. All he needs to do is enter into an offsetting stock futures position, in this case, take a short futures position. B. Speculation (Bullish Security, Buy Futures) If a Speculator has a view on the direction of the market and believes that a particular security is undervalued and expects its price to go up in the next two-three months. He can trade based on this belief? In the absence of a deferral product, he would have to buy the security and hold on to it. Today a speculator can take exactly the same position on the security by using futures contracts and that too with a small margin. C. Speculation: (Bearish Security, Sell Futures) Stock futures can be used by a speculator who believes that a particular security is overvalued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a deferral product, there wasn‘t much he could do to profit from his opinion. Today all he needs to do is sell stock futures. D. Cash & Carry Arbitrage (Overpriced Futures Buy Spot, Sell Futures) If you notice that futures on a security that you have been observing seem overpriced, how can you cash in on this opportunity to earn riskless profits? As an arbitrageur, you can make riskless profit by entering into the following set of transactions. On day one, borrow funds; buy the security on the cash/spot market. Simultaneously, sell the futures on the security. Take delivery of the security purchased and hold the security for a month. On the futures expiration date, the spot and the futures price converge. Now unwind the position. Sell the security. Return the borrowed funds. The result is a riskless profit. 250

E. Reverse Cash & Carry Arbitrage (Underpriced Futures Buy Futures, Sell Spot) If you notice that futures on a security you hold seem underpriced, how can you cash in on this opportunity to earn riskless profits? As an arbitrageur, you can make riskless profit by entering into the following set of transactions. On day one, sell the security in the cash/spot market. Make delivery of the security. Simultaneously, buy the futures on the security. On the futures expiration date, the spot and the futures price converge. Now unwind the position. Buy back the security. The result is a riskless profit. 4.1.5. Options and Futures Introduction In everyday conversation, you will no doubt hear the word ‗option‘: ‗I‘d like to keep my options open‘ or ‗If I give you ₹100, will you give me a week for the first option to buy a house?‘ Options on shares are no different. In return for an up-front premium, the owner of the option can decide whether or not to exercise it and buy the share in question. This is in contrast to a legally binding agreement to buy the same item at some time in the future. These two alternatives, whether the buyer is bound to buy the item or merely has the option to do so, are the foundation of all derivatives trading. Their value is ‗derived‘ from an underlying agreement to do something within a stipulated time. An option contract gives the owner a right, but not an obligation, to do something with the object of attention (e.g. the house or a stock certificate); while a futures or forwards contract stipulates a no-option, binding agreement. This distinction must be made clear to any client considering investing in derivative products. Many planners feel that they have little or no need to study derivatives, as they don‘t think that they are likely to use them for client portfolios. The common argument is that these things are only for the big end of town, such as investment banks and hedge funds. Many planners fail to realise that derivatives have many diverse uses. For example, the banks use derivatives to create fixed rate home loans, while exporters and importers fix their foreign exchange cover to protect themselves from adverse moves. In recent years the options market has allowed funds managers to provide capital guaranteed products. The earliest derivatives date back to the 16th century with the use of rice tickets in Japan. Today, their uses range from assisting in the pricing of consumer credit through to the funding of government debt and from portfolio protection through to assisting farmers to budget their income. One of the strongest objections to studying derivatives relates to a perception that the planner needs a degree in nuclear physics to be able to understand the subject. Admittedly, while some of the more convoluted products do use mathematics of a very high level, this topic is merely an introduction to the concepts. It is very important to understand what derivatives are in a general sense and how they may be used in products and strategies that you, as a planner, may implement for your 251

clients. This topic does not aim to position you to run a ‗book‘ on an underlying asset, just to increase your awareness of a very important group of techniques that will have an ever- increasing influence on the universe of investment products and vehicles. Derivative is a product whose value is derived from the value of an underlying asset, called bases. The underlying asset can be a commodity, index, share, foreign exchange bond interest or anything). The basic financial derivative products are options, forwards and futures. Option contracts may be traded on an exchange (and are then called exchange- traded options, ETOs), or they may be sold directly over the counter by the issuer (and are then called over-the-counter options, OTCs). Similarly, forwards contracts may be traded in an organised marketplace (and are then termed ‗futures‘), or may be traded directly party- to-party (in which case they are just called ‗forwards‘). An example of a ‗forward‘ is a ‗forward rate agreement‘ (FRA), wherein a borrower negotiates with a bank or investment bank for an interest rate on a notional capital amount that the borrower can lock into for a future loan for a specified period of time. The best known derivative marketplaces in India are the National Stock Exchange (NSE), and The Bombay Stock Exchange, (BSE). Though financial derivatives Started at BSE yet the focus of attention in the derivatives markets got completely shifted to NSE with no trades for derivatives executed on BSE. However, lately in 2012 derivatives trading at BSE has been reinitiated. While we examine how a financial planner can use derivatives, only registered representatives of these stock exchanges are legally entitled to trade on derivative products, and the exchange-traded derivatives are subject to stock exchange rules. As a financial planner, you cannot trade in that marketplace as a principal, and you should be doubly vigilant in any advice you give to clients in the high-risk territory of derivatives products. One of the reasons why derivatives are risky is that they are generally short-term investments, requiring a view of short-term trends in the market. Any number of factors, domestic or international, can affect investor sentiment in the short term and therefore, the prices in the futures markets. Shares in the long term out-perform every other asset class (as measured by a suitable cumulative index of each asset class). Long-term investors are therefore on the safer ground than that of the short-term investors. In the following discussion, we first examine options contracts (focusing on the exchange-traded options), proceed to forwards and futures contracts, and conclude with a discussion of warrants. Options Contracts Options are available for many products, but the most relevant for you, as a financial planner, are options on equities. Options on shares are available for purchase or sale through an organised exchange in many countries such as the New York Stock Exchange, Australian Stock Exchange, the Chicago Mercantile Exchange or the Singapore International Metals Exchange as also National Stock Exchange in India. There are also options on futures. Options have a finite life span which depends in part on the trading volume of the underlying share. In India, the time span of options is one to 3 months. In some developed countries, you may find options having longer life span of even 1 year or 2 years. For instance, in New York Stock Exchange, you will find an option called LEAPS. This is an acronym for Long Term Equity Anticipation Securities. These options have a maturity of upto three years. Most options can be traded at any time prior to their expiration. In 252

technical language, these exercise-at-any-time-until-expiration options are called American- style options, compared to European- style options which can only be exercised on their expiry date. The options traded on the exchanges in India are American-style options. The majority of options transactions today are in securities (i.e. financial options) rather than physical assets. In understanding the mechanics of pricing options on shares, the easiest route to take is to presume options can only be exercised on expiry and not before (i.e. we initially find a way to price European-style options, and only then move on to the more common American-style ones). Also, to keep the discussion as simple as possible, we will initially presume the underlying shares pay no dividends. Details of the previous day‘s trading in options are published in the leading financial dailies such as Economic Times, Financial Express Business Standard etc., Trading details are also available in the options prices section of the Internet site of the stock exchanges: http://www.nseindia.com. Option prices are also available from brokers. Call Options and Put Options The sellers are writers of options and offer a deal that may or may not be ‗taken up‘ by the buyer. It is always the buyer who has an option to exercise, not the seller. The writer is obliged to do what the buyer decides. Writers can offer a call option, meaning shares can be ‗called‘ away from the owners at an agreed price; or they can offer put options, meaning a buyer can insist that the writer buys shares at an agreed price. The buyer is known as the option taker (who ‗bids‘ for the option) and seller its known as option writer. If options bought on an exchange are exercised, the clearing house randomly decides whom amongst all the writers must deliver, that is, who must sell an agreed stock at the exercise price (for a call writer) or buy a specified stock at the exercise price (a put writer). Of these two types of option, calls are more popular, well known and perhaps easiest to understand. To facilitate your understanding of how to use options for a client‘s particular needs, we will focus on dealing in calls. The rights and obligations of option buyers and sellers are summarised in the table below. In case, option is in the money at the time of expiration for buyer, it is automatically exercised by stock exchange. Buyer Seller/writer CALL OPTION Right to buy Obligation to sell PUT OPTION Right to sell Obligation to buy The Role of Options Exchanges Options exchanges act as a conduit through which buyers and sellers meet, but they do more than that. The exchange ensures compliance of the terms and conditions of the options contract, and also standardises the expiry date and exercise prices. The clearing house also guarantees the performance of all options contracts. By intervening between buyers and sellers, a process legally known as novation, the exchange enables both parties to an option transaction to have faith in the promises made to deliver the underlying asset if required. Buyers and sellers need not concern themselves with the financial integrity of the other party to deliver the goods as promised. Only the clearing house needs to worry about this. 253

In developed countries, apart from Exchange Traded Options, investment banks issue Over-the-counter options (OTC). For a premium to be determined, such institutions will usually provide specified options on shares at a given exercise price up to and including a certain date. Features such as the underlying stock, term to expiry and exercise price can be set by the investor. The bank will then establish a price for the option. Modernisation of commercial and investment banking and globalisation of financial activities have led to the development of OTC derivative products in recent years. While both exchange traded as well as over the counter derivatives offer many advantages, the former have strict regulation compared to the latter. The OTC Derivatives Market Vs Exchange Traded Derivatives Market: OTC Market Exchange traded (ETC) Market Counter party risk is decentralized with Exchange acts as counter party for every individual institutions trade, thus counter party risk is centralized. Regulation is through national legal Operations are regulated by regulator (like system, and banking supervision and SEBI in India) the exchange‘s self regulatory market surveillance. organization. No formal centralized limits on Exchanges specify limits on positions and individual positions, leverage or leverage. margining. When asset prices that underlie derivative contracts change rapidly, the counter party exposures become huge and trigger rapid offloading of position. In view of the inherent risks associated with OTC derivatives, it is not permitted by regulators for trading in India. Options are usually inexpensive relative to the price of the underlying stock. It is not unusual for options to double or triple in value over some stage of their life. They thus offer opportunities for highly leveraged investments. The drawback is that they have a maturity of short span. Most common maturities are 30, 60 or 90 days. Usually the exercise prices are at intervals of ₹5, with some exercise prices below the current share price, and some above. This enables both buyers and sellers to approach a potential options investment systematically. Advantages of Option Trading: Clients considering trading in options can expand their investment horizon, allowing them to take advantage of some benefits not otherwise readily available to traditional investors. Following are the advantages of investing in options. 1 Income Generation Shareholders can earn income in addition to receiving dividends by writing call options against their shares. They receive the option price up front (this is explained further under ‗How options work‘ later in this topic). 254

2 Speculation Investors wishing to purchase shares, expecting the market to rise, can buy call options which enable them to buy the underlying share at a lower price than if they had delayed the purchase. Conversely, if they expect the market to fall, they can buy put options, which on exercise guarantee them a sale price above current market price. They can lock in profit by repurchasing shares at the lower market price. 3 Leverage Option prices have the capacity to change proportionally by much more than the underlying shares. This ‗leverage‘ (purchased at the price of short option life) provides the potential to make a higher return from a smaller initial outlay than investing directly in the underlying share. 4 Diversification Options allow investors to build a diversified portfolio for a lower outlay than purchasing shares directly. Alternatively, for the same outlay a much more diversified share portfolio can be achieved, lowering an investor‘s overall risk exposure by reducing the company- specific risk component. 5 Risk Management Put options allow investors holding shares to hedge against price fluctuations in the underlying shares. Purchase of a put option guaranteeing a certain sale price for a share has obvious analogies with insurance. 6 Time to Decide Buying options gives the holder time to decide what to do. The call option holder has until the expiry date to decide whether or not to exercise and buy the underlying shares or sell the option, while the taker of a put option has time to decide to sell (either the shares or the options). 7 Strategies By combining put and call options in special strategies, investors can tailor a range of potential payoff scenarios depending on their view of future share price movements. Some Definitions Buyer & Writer of an Option The Buyer of a call/put option contract is the one who by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. 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/holder exercises on him. Option Price / Premium 255

Option Price is the price which the option Buyer pays to the option Seller. Irrespective of a Call or a Put, the Buyer is the one who pays the Premium while the Seller is the one who receives the Premium. Strike Price Strike Price is the price specified in the options contract. Strike Price is also called the Exercise Price. As the Strike Price refers to the price at which a contract entered into, all profits or losses are calculated from this price. Expiration Date Expiration Date is specified in the options contract. It is also called Exercise Date or Strike Date or Maturity. American & European Options American Options are those option contracts that can be exercised at any time upto the expiration date. Usually option contracts on individual securities traded on the NSE are American. European Options are those option contracts that can be exercised only on the expiration date itself. Usually option contracts on the indices traded on the NSE are European. Currently all option contracts on indices as well as on individual securities are European. ITM, ATM & OTM ITM option contracts would generate positive cash flow if exercised immediately [Call: Spot Price > Strike Price]. ATM option contracts would generate zero cash flow if exercised immediately [Call: Spot Price = Strike Price]. OTM option contracts would generate negative cash flow if exercised immediately [Call: Spot Price < Strike Price]. Note: The amount of Option Premium increases as we move from OTM to ATM to ITM. Comparative Analysis Type Criteria Call Option Put Option M.P. = E.P. ATM Would generate zero cash flow for the M.P. = E.P. option holder, if exercised immediately M.P. < E.P. ITM Would generate positive cash flow for the M.P. > E.P. M.P. > E.P. OTM option holder, if exercised immediately M.P. < E.P. M.P. = Would generate negative cash flow for the (E.P. – option holder, if exercised immediately PREM) BREAKEVEN Price at which profit would be generated M.P. = on a net basis for the option holder, if exercised immediately (E.P. + PREM) 256

Intrinsic & Time Value of an Option: Option Premium = Intrinsic Value + Time Value. Intrinsic Value of an option contract measures how much the contract is ITM. It can either be +ve or zero but not –ve. Time Value of an option contract refers to the value for the time available for a contract until expiration. The longer the time to expiration, the greater is an option‘s Time Value. The maximum Time Value exists when the option is ATM. An option contract that is ATM or OTM has only Time Value. Index & Stock Options: Index Options have an index as the underlying. Stock Options have individual stocks as the underlying. Futures vs Options Options Same as futures. Futures Same as futures. Exchange traded, with novation Strike price is fixed, price moves. Price is always positive. Exchange defines the product Nonlinear payoff. Price is zero, strike price moves Only short at risk. Price is zero Linear payoff Both long and short at risk Index Options As well as offering the advantages of diversification, options on a basket of shares may be cheaper in terms of transaction and other costs than buying options on individual shares. Therefore, rather than investing in options on individual securities and basing strategies on single stock options, the investor may find it more useful to invest in a selection or group of shares as represented by a stock market index such as the Nifty index. Index options can be used to boost returns on a share portfolio or to hedge the value of a share portfolio against price fluctuations. Hedging a Portfolio Assume that you or your client own an equity portfolio. Due to impending war in Gulf region, you feel that the market will slide. You also know that your client does not have appetite for a big loss. One thing that you can do is to sell the portfolio and keep the money in fixed deposits till the time to invest in shares again. Another way to protect the value of portfolio from falling prices is to buy right number of put options on index, which will gain in the event of a fall. This strategy will be of immense use to high Networth individuals having well diversified portfolios. How do you do this? You are already aware of the concept of systematic risk, measured in terms of beta. You, as a financial planner, have to calculate the beta of the portfolio; it is just the weighted average of 257

individual stock betas. In general, beta of a well-diversified portfolio is close 1. Assuming that the beta of your client is 1, how many puts would you recommend him to buy to insure against a decline in the market? This calls for a decision on your part – choose the strike at which the put option will be bought. Assume that the spot Nifty is 1250 and you decide to buy puts with a strike price of 1125. This will protect the portfolio when index falls below 1125. As the portfolio beta is one, the number of puts to be bought is simply equal to the portfolio value divided by the spot index. Example: Portfolio value ₹1 lakh Spot index 1250 Market lot 200 Number of index puts to be bought to cover the portfolio is 1,00,000 / 1250 = 4 contracts. Contract Specifications: Index Options Underlying Index CNX Nifty Exchange of Trading Security Descriptor NSE Ltd. Contract Size Price Steps OPTIDX Price Bands 25 (minimum 2 Lacs) Trading Cycles ₹0.05 Expiry Day Settlement Basis A contract specific price range based on its delta value and is Style of Option computed and updated on a daily basis. Strike Price Interval Settlement Price 1, 2 & 3 Months. New contract is introduced on the day following the expiry of the near term contract. Also, long term options have 3 quarterly and 5 half yearly expiries. Last Thursday of the expiry month. Cash settled on a T+1 basis. European As specified by the Exchange. Daily Settlement on net Premium Value and Final Settlement on the basis of closing value of the index on the last trading session. CONTRACT SPECIFICATIONS: STOCK OPTIONS Underlying Index Individual Securities Exchange of Trading Security Descriptor NSE Ltd. Contract Size Price Steps OPTSTK Price Bands As specified by the Exchange (minimum 2 Lacs). Trading Cycles ₹0.05 A contract specific price range based on its delta value is computed and updated on a daily basis. 1, 2 & 3 Months. New contract is introduced on the day 258

Expiry Day following the expiry of the near term contract. Settlement Basis Style of Option Last Thursday of the expiry month. Strike Price Interval Settlement Price Daily Settlement as well as Final Settlement on a T+1 basis. Options Payoff European As specified by the Exchange. Daily Settlement on net Premium Value and Final Settlement on the basis of closing value of the underlying on exercise day or the last trading day. Pricing Options There are various models which help us get close to the true price of an option. Most popular among them are: 1. Binomial Model 259

2. Black & Scholes Model Factors Affecting Option Premium Six factors affect option prices as outlined. The first three are the more obvious factors, while the last three are truly critical for any investor hoping to make money out of options. The factor to examine closely is volatility. 1. The Share Price S The share price S is the current market price of the share underlying the option. In the case of a call option, the higher the share price, the higher the premium, assuming other things remaining equal. Exercise prices are set fixed so the share price will determine whether the call expires in-the-money and if so by how much. 2. The Exercise Price X The strike or exercise price is the other side of the tug-of-war with the share price in determining the intrinsic value of an option. The strike price is fixed at origination of the option contract. The lower the exercise price X, the more likely any call option will find itself in-the-money before termination date. So, for any given list of options, lower-priced options (options with lower strike price) will have larger premiums. 3. Time to Expiry t The time to expiry determines the time value component of an option‘s price. The longer the time left to expiry, the greater will be the time value. Options close to expiry have little or no time value. 4. The Risk-free Interest Rate r The risk-free rate determines the discount factor r used in determining a call option‘s price. In practice, the risk-free rate is the yield on T-notes, or the yield on suitably repackaged T-note products such as a cash management trust unit or a bank sweep account. 5. The Volatility of the Underlying Share The volatility of the return on the asset underlying the option will dramatically affect the price of the option. As a rule, if all other things remain equal, the higher the volatility of the asset return, the higher the premium. This happens because an option has a greater chance of being in-the-money if the share price movement is likely to be substantial than if it is likely to be miniscule. This is reflected in the time value of a call option (which is the gap between the share price and the exercise price). However, highly volatile stock must be given time to come into the money. 6. Other Factors ‗Other factors‘ refers to the many other influences not previously mentioned. Sometimes difficult to quantify, these factors should not be underestimated, because substantial profits may be made in acting on these imponderables. Since options 260

derive their value from underlying assets, anything that affects the value of the assets will affect the option price, and will do so by a leveraged amount. For example, in the case of an equity call option, if an investor observes that a more capable management team has taken over a company, then its earnings should increase, driving its share price upwards. Other things being equal, the value of the call option on these shares should also increase, since they will now be more in-the- money (or less out-of-the-money) than they had been previously. If this increase in the share value had not been anticipated by the market, an option taker could benefit significantly by taking a long position in calls on its shares. The Effect of Dividends on Call Option Values The payment of dividends does not make a great deal of difference to this general conclusion either. If the underlying stock pays a dividend, the value of the share drops by the amount of the dividend, after this has been paid. This reduces the share‘s future value and so squeezes the intrinsic value, but the time value remains intact. The net result is that even with the possibility of early exercise, and even for dividend-paying shares, most option holders will not elect to take advantage of early exercise unless other factors compel them to do so. Put-call Parity Theorem We can now use the general relationships considered above to look at a fixed relationship that exists between the premiums of European put and call options, called the Put-Call Parity Theorem. In order to develop this theorem, we first need to show that not only does S + P - C = B, but also that the net outcome from the portfolio investment of S + P - C is equal to the exercise price of the options, which we will call X. Suppose shares in the ABC company have a current market value of l00p and both the call and put options in the shares have an exercise price of l00p (so the options are ‗at the money‘) and have two years to maturity. Furthermore, suppose the annual risk-free rate of return is 6%. (We will see shortly why we need to know this.) We arrange our portfolio of investments in the following way: 1. Buy a share in ABC. 2. Buy a put option in ABC shares. 3. Sell a call option in ABC shares. Let us now look at what the outcome would be under the two alternative scenarios: ABC‘s share price goes up (Example 1) and ABC‘s share price goes down (Example 2). However, before doing so, remember that if, at expiry, the share price is below the exercise price, call options are worthless. Similarly, if at expiry, the share price is above the exercise price, put options are worthless. 261

Example-1 Scenario 1: In two year‘s time ABC‘s share price has risen to, say, ₹140. Value of the shares ₹: 140 Value of put option 0 Value of call option ₹: 40 Net value of the investment portfolio ₹: 100 *Notice that you will lose ₹40 on the call options that you sold because on expiry they will be worth exercising, so the investor who bought the call from you will want to buy from an ABC share which is now worth ₹140 for only ₹100 - the exercise price - thus you lose ₹40 on the option being exercised. We can see algebraically that the net outcome of your investment portfolio must always be equal to an amount X, which is equal to the exercise price of the option, whatever the price of the shares on expiry: Net value of portfolio = S + P - C, where: S = Value of share. P = Value of put option. C = Loss on call option sold = S - X) Again, remember that the value of the put option will be zero. (P = 0), as a rising share price makes them worthless. Therefore S + P -c = S + 0 - (S - X) and so, S + P - C = S + 0- S + X = + X Example-2 Scenario 2: In two years‘ time ABC‘s share price has fallen to, say, 35. Value of shares ₹35 Value of put option ₹65 Value of call option ₹0 Net value of the investment portfolio = ₹100 = Exercise price of the options. You have bought a put option which allows you to sell a share, which is now worth only ₹35 for, ₹100. Thus the value of the option is the resulting profit of ₹65 (₹100 - ₹35) We obtain exactly the same result from the second scenario, where the share price, on the expiry of the options, has fallen. Once gain, the predictability of this outcome can be seen algebraically: Net value of portfolio: S + P - C = S + ( X - S) - 0 = + X As the value of the portfolio at the expiry date, in all circumstances, will be equal to X - the exercise price of the options - then the present value of the portfolio‘s worth will be given by: 262

X (l+RF)- (or, more strictly, X.e-RF.T if we were to use continuous discounting). Notice that the risk- free interest rate is used for discounting because, as we know, the S + P - C portfolio has an outcome equivalent to a risk-free bond investment: S+P-C=B The present value of the portfolio in our example, given RF is 6%, is: ₹100 ( 1 + 0.06 )-2 = ₹89. As a result, we are now able to take this general relationship: S + P - C = X (l + RF) - rearrange it: S - X (1 + RF) - T = C - P and insert the known current data: S =₹ 100 To give: ₹100 - ₹ 89 = C - P = ₹11 X (1 + RF)- = ₹89 That is to say, the value of the put is equal to the value of the call, plus the present value of the exercise price, less the current share price. Options Greeks A. Delta (Δ) It is also called the Hedge Ratio. Delta (Δ) is defined as the change in the price of the option premium corresponding to a change in the price of the underlying asset. It ranges between - 1 & +1. ∆ = 0.5 means option price changes by 50% or 0.50 if stock price changes by 1. Delta (Δ) of a Call is always positive. Delta (Δ) of a Put is always negative. The value of Delta (Δ) decreases when the futures price moves from in-the-money to at-the-money to out-of-the- money & vice-versa. B. Gamma (Γ) Gamma (Γ) measures the change in the value of Delta (Δ) corresponding to a change in the underlying asset. C. Theta (θ) Theta (θ) is the measure of the change in the option premium corresponding to one day change in its time to expiration. It is also called time decay. D. Vega (ν) Vega (ν) is the change in the option premium corresponding to a 1% change in volatility of the underlying asset. If Vega (ν) is high, the option premium is very sensitive to small changes in volatility and vice-versa. 263

E. Rho (ρ) Rho (ρ) measures the sensitivity of the option premium with respect to interest rate. Put Call Ratio Signals Rally or Reaction An Investor buys call options if he expects the markets or the stocks to go up: Correspondingly, he buys put option when the market is expected to go down. If there are more puts than call options it should indicate a bearish outlook, while a preponderance of call options would indicate a more optimistic outlook. It NIFTY futures (Index) are trading at a discount - this Backwardation reflects the makets expectations of a further fall in Price. (Bearish Indications). If NIFTY PUTS in general are more expensive than calls at similar distance from the money - It shows bearish sentiment. If NIFTY Put Cal Ratio is Fairly High It suggests markets are oversold. there is a statistically significant (Negative) correlation between the PCR and NIFTY & put movements. But its not very strong relationship. However, the high PCR does suggest that up moves are marginally move likely in the next week than sharp down moves. An Investor buys call options if he expects the markets or the stocks to go up: Correspondingly, he buys put option when the market is expected to go down. If these are more puts than call options it should indicate a bearish outlook, while a preponderance of call options would indicate a more optimistic outlook. Option Trading Strategies Option Spreads  Spreads involve combining options on the same underlying and of same type (call/ put) but with different strikes and maturities.  These are limited profit and limited loss positions.  They are primarily categorized into three sections as:  Vertical Spreads  Horizontal Spreads  Diagonal Spreads 264

Vertical Spreads  Vertical spreads are created by using options having same expiry but different strike prices. Further, these can be created either using calls as combination or puts as combination. These can be further classified as: Bullish Vertical Spread  Using Calls  Using Puts  Bearish Vertical Spread  Using Calls  Using Puts Vertical Bull Call Spread  Strategy: Buy a Call with a lower Strike Price + Sell a Call with a higher Strike Price.  When to Use: When investor is moderately bullish.  Initial Payoff: Difference between the Premium (-ve).  Maximum Profit: Maximum Profit is limited. Maximum Profit is generated when underlying is at the higher Strike Price or above.  Maximum Loss: Maximum Loss is limited to the difference of the Premiums. Maximum Loss is generated when the underlying is at the lower Strike Price or below. VERTICAL BULL PUT SPREADS  Strategy: Buy a Put with a lower Strike Price + Sell a Put with a higher Strike Price. 265

 When to Use: When investor is moderately bullish.  Initial Payoff: Difference between the Premium (-ve).  Maximum Profit: Maximum Profit is limited. Maximum Profit is generated when underlying is at the higher Strike Price or above.  Maximum Loss: Maximum Loss is limited to the difference of the Premiums. Maximum Loss is generated when the underlying is at the lower Strike Price or below. Vertical Bear Call Spreads  Strategy: Buy a Call with a higher Strike Price + Sell a Call with a lower Strike Price.  When to Use: When investor is moderately bearish.  Initial Payoff: Difference between the Premium (+ve).  Maximum Profit: Maximum Profit is limited to the difference of the Premiums. Maximum Profit is generated when underlying is at the lower Strike Price or below.  Maximum Loss: Maximum Loss is limited. Maximum Loss is generated when the underlying is at the higher Strike Price or above. 266

Vertical Bear Put Spreads  Strategy: Buy a Put with a higher Strike Price + Sell a Put with a lower Strike Price.  When to Use: When investor is moderately bearish.  Initial Payoff: Difference between the Premium (+ve).  Maximum Profit: Maximum Profit is limited to the difference of the Premiums. Maximum Profit is generated when underlying is at the lower Strike Price or below.  Maximum Loss: Maximum Loss is limited. Maximum Loss is generated when the underlying is at the higher Strike Price or above. Vertical Bear Put Spreads 267

Horizontal Spreads  Also called Time Spread or Calendar Spread.  Meaning: It is a combination of two similar types of options (either call or put) having:  Same underlying  Same strike price  Different expiration date  This strategy in undertaken if a trader believes that difference between the time values of these two options would shrink or widen.  This is essentially a play on premium difference between two options prices squeezing or widening. Diagonal Spreads  Diagonal spread involves combination of options having:  Same underlying  Different strike price  Different expiration date  These are much more complicated in nature and in execution.  These strategies are more suitable for the OTC market than for the exchange traded markets. Straddles  A Long Straddle position is created by buying a call and a put option of same strike and same expiry.  A Short Straddle is created by shorting a call and a put option of same strike and same expiry  Expected Outcome:  A Long Straddle is undertaken when trader‘s view on price of the underlying is uncertain but he thinks that in whatever direction the market moves, it would move significantly in that direction.  A Short Long Straddle is undertaken when trader‘s view is that the price of underlying would not move much or remain stable. 268

Long Straddles Short Straddles Strangles  A Long Strangle position is created by buying a call and a put option of different strike and same expiry.  A Short Straddle is created by shorting a call and a put option of different strike and same expiry  Expected Outcome:  A Long Straddle is undertaken when trader‘s view on price of the underlying is uncertain but he thinks that in whatever direction the market moves, it would move significantly in that direction.  A Short Long Straddle is undertaken when trader‘s view is that the price of underlying would not move much or remain stable. 269

Long Strangles Short Strangles Covered Call  This strategy is used to generate extra income from existing holdings in the cash market.  If an investor has bought shares and intends to hold them for some time, then he would like to earn some income on that asset, without selling it, by selling call options thereby reducing his cost of acquisition. 270

Covered Call Protective Put  Any investor, long in the cash market, always runs the risk of a fall in prices and thereby reduction of portfolio value and MTM losses.  A mutual fund manager, who is anticipating a fall, can either sell his entire portfolio or short futures to hedge his portfolio.  In both cases, one can buy put options which will be useful to negate the MTM losses in the cash market portfolio. Protective Put Collar A collar strategy is an extension of covered call strategy.   In case of covered call, the downside risk remains for falling prices.  To put a floor to this downside, we long a put option, which essentially negates the downside of the short underlying. 271

Collar Butterfly Spread Meaning:  It is a combination of a bull spread and a bear spread using either calls or puts  It involves positions in options at three different strike prices Types:  Long butterfly spreads  Short butterfly spreads Long Butterfly Spreads Meaning:  It is created by four (4) similar types of options having same expiration dates  It is a combination of two (2) short identical options (either call or put at the same strike price), one (1) long option with an immediate lower strike price and one (1) long option having a higher strike price Implementation  It is used when the market is expected to be trading in a narrow price range Expected Outcome:  The maximum profit will occur when the underlying futures price of the commodity trades close to the middle strike price at expiration  The maximum loss is equal to the premium paid 272

Long Butterfly Spreads Short Butterfly Spreads Meaning:  It is created by four (4) similar types of options having same expiration dates  It is a combination of two (2) long identical options (either call or put at the same strike price), one (1) short option with an immediate lower strike price and one (1) short option having a higher strike price Implementation  It is used when the market is expected to be trading in a narrow price range Expected Outcome:  The maximum profit for a short butterfly is the premium received and occurs when the underlying futures prices of the commodity trades outside the extreme strike prices at expiration  The maximum loss occurs when the underlying futures price of the commodity reaches the middle strike price at expiration. Futures Introduction to Futures: Unlike Forward Contracts, Futures Contracts are standardised and exchange traded. The standardised items in a futures contract are:  Quantity of the underlying.  Quality of the underlying.  The date and month of delivery. 273

 The units of price quotation and minimum price change.  Location of settlement. Forward vs Futures Contracts: Futures Market Forward Market Trade on an organized exchange OTC in nature Standardized contract terms Customised contract terms More liquid Less liquid Requires margin payments No margin payment Follows daily settlement Settlement happens at end of period Terminologies Spot Price: Spot price is the price at which an asset trades in the Spot Market. Futures Price: Future Price is the price that is agreed upon at the time of the contract for the delivery of an asset at a specific future date. In real terms, Futures Price is the price at which the futures contract trades in the Futures Market. Contract (Trading) Cycle: Contract Cycle refers to the period over which a contract trades. The Futures Contract on the NSE has 1, 2 and 3 month‘s expiry cycles. Futures Contracts expire on the last Thursday of the month. Thus the near month Futures Contract expire on Thursday and on Friday a new contract having a 3 month expiry is introduced. Expiry Date: Expiry Date is the date on which the final settlement of the contract takes place. It is the last day on which the Futures Contract will be traded, at the end of which the contract will cease to exist. The Expiry Date is specified in the Futures Contact. Contract Size: Contract Size is also known as Lot Size. It refers to the amount of asset that has to be delivered under each Futures Contract. Basis: Basis can be defined as [Spot price - Futures price]. In a normal market, Basis is negative. The Basis will be different for each delivery month for each contract. As the date of expiration comes near, the basis reduces and there is a convergence of the futures price towards the spot price. On the date of expiration, the basis is zero. 274

Cost of Carry: Cost of Carry establishes the relationship between Futures Prices and Spot Prices. It is measured as: [Storage cost + Interest for financing the asset – Income earned on the asset]. Initial Margin: Initial Margin is the amount that must be deposited in the Margin Account at the time of entering into a Futures Contract. Mark-to-Market: At the end of each day, the Margin Account is adjusted to reflect the investor‘s gain or loss. Gain or loss depends upon the price at which one enters into a Futures Contract and Futures closing price for the day. From the following day, gain or loss is calculated based on last day closing prices and the following day closing prices. In other words Mart-to-Market means marking the trade to each day closing price. Maintenance Margin: Maintenance Margin is somewhat lower than the Initial Margin. If the balance in the Margin Account falls below the Maintenance Margin, the investor receives a Margin Call. The investor thereafter is expected to top up the Margin Account to the Initial Margin level before the next day trading commences. This is done to ensure that the balance in the Margin Account never becomes negative. Trading: Underlying Vs Futures Trading Underlying Trading Futures  One opens a Security Trading a/c with a  One opens a Futures Trading broker. a/c with a broker.  One opens a Demat a/c with a depository.  One is required to pay only the margin money upfront  One is required to pay full amount of money and not the full amount. upfront to buy shares. One does not get ownership  One becomes the shareholder or part  in the company nor does one ownership in the company and is eligible to get associated privileges receive all associated rights and privileges like available to a shareholder dividends etc.  One may also sell shares, provided he holds it or borrows it. Pricing Stock & Index Futures Difference Between Commodity & Equity Futures  There are no costs of storage involved in holding equity.  Equity comes with a dividend stream, which is a negative cost if you are long the stock and positive costs if you are short the stock. Therefore, Cost of carry = Financing cost – Dividends A. Futures are priced on the basis of the Cost-of-Carry logic. F = S*ert r = Cost of Financing (Continuously Compounded) t = Time till expiration in Years e = 2.7182 B. Futures pricing given expected dividend yield. F = S*e(r-q)t 275

r = Cost of Financing (Continuously Compounded) q = Expected dividend yield t = Time till expiration in Years e = 2.7182 C. Futures pricing given expected dividend amount. F = S*ert - D*ert’ r = Cost of Financing (Continuously Compounded) D = Dividend amount t = Time till expiration in Years t‘ = Time till expiration in years from the date of dividend payment. e = 2.7182 Futures Payoffs The Benefits of Futures Relative to investments in the underlying cash market, the main benefit of futures market is leverage. For example, share futures provide much the same exposure as shares (except futures holders do not receive dividends) for a much smaller initial outlay (called the initial deposit), which is typically around 3–7 per cent of the underlying value. In other words, rather than buying 1000 shares in a company at ₹15 each or spend ₹15 000 in total, an investor can buy a futures contract of 1000 shares in the same company and pay an initial deposit of, say, only 5to i.e. ₹750. Relative to exchange-traded options (ETOs) and warrants, futures provide more efficient leverage because buyers of futures do not pay a premium (which includes a payment for time value). For related reasons, futures can also offer a more efficient means of hedging an underlying investment than ETOs because the price performance of a future is much more directly related to price movements in the underlying investment. It‘s primarily because of the leverage benefits that Indian derivative market have major volumes of trades in stock futures (Readings 3.4). Though the markets have realized 276

belatedly the benefits of Index trading culminating into larger volumes in Index futures rather than stock futures. The benefits gained from futures depend on the specifications of the particular futures contract and the investor‘s position in the underlying market. However, generally speaking, benefits might include:  leveraging exposure to price movements (speculation); and playing bullish or bearish.  short-term hedging for a share, bond portfolio or currency or commodity exposure;  establishing a price in advance of buying or selling in the underlying market;  creating tactical exposure to additional shares outside a core portfolio;  implementing spreads between market sectors and particular companies;  implementing spreads between different points on the interest rate yield curve; Risks Associated with Futures Futures markets are a highly leveraged form of investment, where price movements can be rapid and extensive. This makes futures a particularly attractive investment medium for the individual with small capital to risk and the temperament to trade. Margin deposits to trade futures which generally haver around 5% to 10% are not much as compared to the full value of the underlying contract, which means that it is possible to make substantial profits on smaller investment value. By the same token, it is also possible to sustain substantial losses. Futures trades therefore are highly rewarding as well as highly risky. For more than a century, futures markets have attracted individuals who have been willing to risk their capital with the aim of profiting by correctly judging short, medium or long-term trends in prices. But consistently profiting from the futures markets is certainly not easy. In fact it is often quoted that around 80 per cent of inexperienced traders lose money in futures markets. This statistic in itself is most valuable. It suggests that in order to be successful, the trader not only has to have a well planned strategy and an enormous amount of self- discipline. Commodity Futures Futures of commodities may be of some interest to financial planners, to the extent that they enhance and reflect price discovery in the commodity markets that some listed companies are involved in—which in turn impacts on the share prices of those companies. However, futures over financial products such as shares, share price indices, bonds and currencies are more likely to be of interest to your clients. Commodity futures are generally the province of buyers, sellers and the end users of the products (e.g. Turmeric and wheat). These are primarily meant for hedgers and arbitragers. However, an understanding of commodity futures shall be of great usage to the financial analysts too because of the strong linkage between commodity markets and overall economic performance. Commodity Markets Commodity markets are markets where raw or primary products are exchanged. It is similar to an equity market, but instead of buying or selling shares one buys or sells 277

commodities. Historically, dating from ancient Sumerian use of sheep or goats, or other peoples using pigs, rare seashells, or other items as commodity money, people have sought ways to standardize and trade contracts in the delivery of such items, to render trade itself more smooth and predictable. Commodity money and commodity markets in a crude early form are believed to have originated in Sumer where small baked clay tokens in the shape of sheep or goats were used in trade. Sealed in clay vessels with a certain number of such tokens, with that number written on the outside, they represented a promise to deliver that number. This made them a form of commodity money - more than an ―I.O.U.‖ but less than a guarantee by a nation- state or bank. However, they were also known to contain promises of time and date of delivery- this made them like a modern futures contract. Regardless of the details, it was only possible to verify the number of tokens inside by shaking the vessel or by breaking it, at which point the number or terms written on the outside became subject to doubt. Eventually the tokens disappeared, but the contracts remained on flat tablets. This represented the first system of commodity accounting. History of Futures Trading Globally Futures trading in commodities is said to have originated in Japan in the 17th century for silk and rice.6 The Dojima Rice Exchange in Osaka, Japan, is said to be the world‘s first organised futures exchange, where trading started in 1710. Strategically located at the base of the Great Lakes, close to the farmlands and well connected by railroad and telegraph lines, Chicago became a commercial hub in the 1840s. Inadequate storage facilities led to surplus or shortages in the markets, which in turn led to huge fluctuations in the commodity prices. In order to hedge themselves from the risk of declining prices, grain merchants, farmers and processors began entering ‗forward contracts‘, wherein they agreed to exchange a certain quantity of a specified commodity for an agreed sum on a certain date in the future. This was beneficial for both parties involved: the seller knew how much he would receive for his produce and the buyer knew his costs in advance. However, not all such contracts were honoured. For instance, if the price agreed upon in the forward contract was far lower than the prevailing market price, the seller would back out. On April 3 1848, the Chicago Board of Trade (CBOT) was established by 83 merchants to facilitate trade in spot produce and forward contracts. It was only in 1865 that standardised futures contracts were introduced. The Chicago Produce Exchange was established in 1874 and the Chicago Butter and Egg Board in 1898. In 1919, it was reorganised to enable future trading and was renamed Chicago Mercantile Exchange. History of future trading in Agri-commodities in India There are strong grounds to believe that Commodity futures could have existed in India for thousands of years. References to the existence of market operations similar to the modern day Futures market are found in Kautilya‘s ‗Arthasastra‖. Other factors which support such a belief is the existence of words like ―teji‘, ‗mandi‘. ‗gali‘, ‗phatak‘ etc., for centuries. Be that as it may, the Futures markets in its organized form appeared only in the late 19th Century, with the advent of the British. The subject of futures trading was placed in the Union list, and Forward Contracts (Regulation) Act, 1952 was enacted. Futures trading in commodities, particularly, cotton, oilseeds and bullion was at its peak during this period. However, 278

following the scarcity in various commodities, futures trading in most commodities were again prohibited in mid-sixties. There was a time when trading was permitted only two minor commodities, viz., pepper and turmeric. By 1996 there was almost a complete ban on Futures Trading. Steps Taken Towards Revival of Futures Trading by Government of India The Government of India during the period 1950 to 1993 constituted many Expert Committees to study the various aspects of Futures Trading. These were (1) The Shroff Committee; (2) Dantwalla Committee; (3) Khusro Committee and (4) Kabra Committee. The reports of these Committees helped to lay down the framework for the revival of Futures Trading in Commodities in India. In the early 1990s the Forex Crisis and liberalization of the economy lead to policy changes in India. These led to the re-introduction of futures trading in commodities. With a view to protect Farmers, Traders & Exporters from Price fluctuations of Commodities and to serve as an efficient ‗Price Discovery‘ mechanism, Government of India took the landmark decision in April 1999 to remove all the commodities from the restrictive list for Futures Trading. Government also allowed setting up of new, modern, demutualised, Nation-wide multi- commodity Exchanges with investment support from public and private institutions. National Multi Commodity Exchange of India Limited (NMCE), was the first such exchanges to be granted permanent recognition by the Government. NMCE commenced futures trading in 24 commodities on 26th November 2002 on a national scale. Currently (August 2007) 62 commodities are being traded in NMCE. Multi Commodity Exchange of India (MCX) was established in November 2003 and is a leading Exchange for Bullion & Energy sectors. National Commodity & Derivatives Exchange Limited (NCDEX) commenced operations in December 2003 and currently facilitates trading in 57 commodities. The establishment of Exchange accredited Warehouses, which issue Warehouse Receipts, which can be traded, added impetus to the growth of Futures Trading. Introduction of ‗scrip‘ less Trading (in Dematerialised or DMAT form) in Capital Markets paved the way for introduction of Demat-holdings of Commodities. Commodity futures can be looked upon as an option for those who want to diversify their portfolios beyond equities, interest bearing securities or investments and real estate. For Traders & Exporters, it is an efficient mechanism to protect themselves against price fluctuations. Last but definitely not the least, for the farmers, Commodity Futures is a very efficient Price discovery as well as Price recovery mechanism. Today, futures trading is permissible in 95 commodities in India. There are 25 recognised futures exchanges with more than 3000 registered members. Trading platforms can be accessed through 20,000 terminals spread over 800 towns/cities. The volume of trade in the exchanges in 2006 07 was ₹36.77 lakh crore, 97.2 per cent of which is accounted for by the four national exchanges, viz. National Commodity and Derivatives Exchange Ltd. (NCDEX), Bombay; Multi Commodity Exchange (MCX), Bombay; National Multi Commodity Exchange (NMCE), Ahmedabad; and National Board of Trade (NBOT), Indore. The commodity exchanges are regulated by the Forward Markets Commission (FMC), which was established in 1952. In terms of value of trade, agricultural commodities 279

constituted the largest commodity group in the futures market till 2005 06 (55.32 per cent). Since 2006 07, bullion and metals has taken this place. Between April 2007 and January 2008, agriculture futures amounted to ₹7.34 lakh crore, 23.22 per cent of all commodity futures. Commodities Vs Stock Markets…… Particular Stock markets Commodity markets Quality One unit of a security does not differ from Each commodity/product have Price another of the same type several grades or varieties and each Discovery in terms of its face value lot in a grade may vary from other and characteristics. lots in the same grade Factors Contract Most investors in Quality also deteriorates due to Specifications securities do not need any improper storage and transport facility for hedging. They conditions. Commodity deliveries invest in securities either therefore have far greater implications to earn regular income for buyers and sellers than mere from dividend or interest, payment or receipt of contractual or to profit from the price, as in the case of buying or subsequent price rise. selling of securities Security futures prices have no such equivalent A commodity futures market is role. primarily a hedging market, and not a market for delivery. Deliveries need Not many (its supply is to be issued and received only in a almost fixed, with residual sense to maintain a parallel demand varying as per or near-parallel relationship between the financial performance the physical and futures market prices of the company, or the to facilitate efficient hedging authority, and general market expectations), Price discovery by a futures market also has a much more basic role to For an individual security play in a commodity market than in futures, or even for an the securities market. index futures of several Factors affecting commodity prices 280 are far too many and complex Supply side: depends on conditions such as area or production capacity, weather, infrastructure supplies and inputs like water, power, seeds, yields or processing/ manufacturing out- turns, imports and exports. Demand is determined by the population growth and shifts in demographic characteristics, changes in incomes and exports, besides the diverse elasticities of incomes and prices. More complex and involves specification of quality,

securities put together, is delivery, duration etc. a relatively simple exercise How Commodity Market works? There are two kinds of trades in commodities. The first is the spot trade, in which The second is futures trade. one pays cash and carries away the goods. The underpinning for futures is the warehouse. A person deposits certain amount of say, good X in a ware house and gets a warehouse receipt. Which allows him to ask for physical delivery of the good from the warehouse. But someone trading in commodity futures need not necessarily posses such a receipt to strike a deal. A person can buy or sale a commodity future on an exchange based on his expectation of where the price will go. Futures have something called an expiry date, by when the buyer or seller either closes (square off) his account or give/take delivery of the commodity. The broker maintains an account of all dealing parties in which the daily profit or loss due to changes in the futures price is recorded. Squiring off is done by taking an opposite contract so that the net outstanding is nil. For commodity futures to work, the seller should be able to deposit the commodity at warehouse nearest to him and collect the warehouse receipt. The buyer should be able to take physical delivery at a location of his choice on presenting the warehouse receipt. But at present in India very few warehouses provide delivery for specific commodities. Who Regulates the Commodity Market? Forward Markets Commission (FMC) headquartered at Mumbai, is a regulatory authority which is overseen by the Ministry of Consumer Affairs, Food and Public Distribution, Govt. of India. It is a statutory body set up in 1953 under the Forward Contracts (Regulation) Act, 1952. 281

―The Act provides that the Commission shall consist of not less than two but not exceeding four members appointed by the Central Government out of them being nominated by the Central Government to be the Chairman thereof. Currently Commission comprises three members among whom Shri B.C. Khatua, IAS, is the Chairman, Shri Rajeev Kumar Agarwal, IRS and Shri D.S. Kolamkar, IES are the Members of the Commission.‖ The functions of the Forward Markets Commission are as follows: (a) To advise the Central Government in respect of the recognition or the withdrawal of recognition from any association or in respect of any other matter arising out of the administration of the Forward Contracts (Regulation) Act 1952. (b) To keep forward markets under observation and to take such action in relation to them, as it may consider necessary, in exercise of the powers assigned to it by or under the Act. (c) To collect and whenever the Commission thinks it necessary, to publish information regarding the trading conditions in respect of goods to which any of the provisions of the act is made applicable, including information regarding supply, demand and prices, and to submit to the Central Government, periodical reports on the working of forward markets relating to such goods; (d) To make recommendations generally with a view to improving the organization and working of forward markets; (e) To undertake the inspection of the accounts and other documents of any recognized association or registered association or any member of such association whenever it considerers it necessary. Futures are financial instruments based on a physical underlying (commodity, equities etc.). A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Therefore (delete), the futures price of wheat is the price of a financial instrument called wheat futures at say, ₹10/kg at a future date. Market participants are able to buy and sell a certain commodity at a pre-determined price at a later date as specified by the Exchange. For example, if a person wants to buy 10 gms of gold after three months when the price today is say, ₹6000 per 10 gms (spot prices) and ₹6050 after three months (futures prices). He enters into a contract through a member of NCDEX to buy gold. On the due date if the price in the spot market is say, ₹6100, then he still has to pay only ₹6050, and has hence hedged himself against the price risk. Price forecasting of commodity involves analyzing commodity under using two methodologies i.e. Fundamental and Technical. Fundamental analysis of any commodity involves knowing facts such as production and consumption, import and export, distance between consuming center to producing center, cost of transportation, means of transportation, usual trade practice, cultivation period, impact of weather and technology on crop cultivation, scope and potential of production and consumption for particular commodity and its rivalry with other similar kind of commodity that may in turn may be near substitute for it. The relationship between cash price and futures price can be explained in terms of cost of carry. Cost of storage, cost of insurance and cost of financing constitute cost of carry. Cost of carry is an important element in determining pricing relationship between 282

spot and futures prices as well as between prices of futures contracts of different expiry months. When there is expected shortage of physical commodity in the future then additional cost of holding the commodity is added to the spot price besides cost of carry, which is termed as Convenience Yield. Open Position Calculation As index futures and index options contract are cash settled, obligation calculation in the futures and options market would involve the determination of open position in contracts in the following manner:  Proprietary position – net basis  Client position – gross basis In case of proprietary trades, open position in a given contract is arrived at by reducing the sell quantity from the total of buy quantity i.e. Buy-Sell quantity. If the result is positive then it is considered as a long position and if the result is negative then it is a short position. As client trades are subject to gross margining, ―Long Open‖ position for entire client pool is computed as: Buy (Open) – Sell (Close) quantity whereas the ―Short Open‖ position is computed as: Sell (Open) – Buy (Close) quantity. The trading member‘s open position is the sum of proprietary open position, client open long position and client short position. This position will be considered for exposure and daily margin purposes. Following is an example given by the NSE on the calculation of open position: The open position for proprietary = Buy – Sell = 200-400 = 200 short. The open position for client trades = Buy (O) – Sell(C) = 400 – 200 = 200 long. Sell (O) – Buy(C) = 600 – 200 = 400 short. Proprietary position of member on day 2: Assume that the position on Day 1 is carried forward to the next trading day and the following trades are also executed: Buy Sell Proprietary position 200 at ₹1000 400 at 1010 Client position of member on day 2: Trading member trades in the futures and options segment for himself and two of his clients. His client position on day 2 is Buy Open Sell Close Sell Open Buy Close Client A 400 at 1109 200 at 1000 Client B 600 at 1100 400 at 1099 The open position for proprietary is 200 – 600 = 400 short. The open position for client trades is Long brought forward + Buy – Sell = 600 – 200 Long; and Short bought forward + Sell - Buy = 1000 – 400 = 600 short. 283

Regulatory Framework The trading of derivatives is governed by the provisions contained in Securities Contract Regulations Act, the SEBI Act, the rules and regulations framed there under and the rules and bye-laws of stock exchanges. Few years ago, trading in derivatives was not possible in view of the prohibition in the SC (R) Act. Section 20 of the Act explicitly prohibited all options in securities. Section 16 of the Act empowered Central Government to prohibit by notification any type of transaction in any security. In exercise of this power, Government by its notification in 1969 prohibited all forward trading in securities. Introduction of trading in derivatives therefore required withdrawal of these prohibitions. The Securities Laws (Amendment) Ordinance, 1995, withdrew the prohibitions by repealing section 20 of the SC (R) Act. The Securities Contract Regulation (Amendment) Act expanded the definition of ‗securities‘ (section 2(h) of SC(R) Act) to include derivatives within its ambit so that trading in derivatives could be introduced and regulated under the SC(R) Act. The term ‗derivative‘ includes:  A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.  A contract which derives its value from prices or index of prices of underlying securities. Section 18A provides that notwithstanding anything contained in any other law for the time being in force, contracts in derivatives shall be legal and valid if such contracts are:  Traded on a recognized stock exchange  Settled on the clearing house of the recognized stock exchange, in accordance with the rules and bye-laws of such stock exchanges. The intermediaries such as brokers and sub-brokers are regulated as per the provisions of SEBI (Brokers and Sub-Brokers) Regulations, 1992. These regulations specify, interalia, the qualifications required for becoming a member of the exchange and the code of conduct for the brokers. Taxation issues The Income Tax Act does not have any specific provision regarding taxability from derivatives. Hence we restrict ourselves to a discussion on the topic of taxability of derivatives. The financial planner may keep track of the developments in this regard as and when they occur. The provisions which have an indirect bearing on derivative transactions are sections 73(1) and 43(5) of The Income Tax Act.  Section 73(1) provides that any loss, computed in respect of a speculative business carried on by the assessee, shall not be set off except against profits and gains, if any, of speculative business.  Section 43(5) of the Act defines a speculative transaction as a transaction in which a contract for purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by actual delivery or transfer of the commodity or scrips. 284

The latter section excludes the following types of transactions from the ambit of speculative transactions: 1. A contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holding of stocks and shares through price fluctuations; 2. A contract entered into by a member of a forward market or a stock exchange in the course of any transaction in the nature of jobbing or arbitrage to guard against loss which may arise in ordinary course of business to such member. From the above, it appears that a transaction is speculative, if it is settled otherwise than by actual delivery. The hedging and arbitrage transactions, even though not settled by actual delivery are considered non-speculative. A transaction to be speculative therefore requires that:  The transaction is in commodities, shares, stock or scrips  The transaction is settled otherwise than by actual delivery  The participant has no underlying position  The transaction is not for jobbing/arbitrage In the absence of a specific provision, it is apprehended that the derivative contracts, particularly the index futures which are essentially cash-settled, may be construed as speculative transactions, and therefore the losses, if any, will not be eligible for set off against other income of the assessee and will be carried forward and set off against speculative income only up to maximum of eight years. The fact, however, is that derivative contracts are not for purchase/sale of any commodity, stock, share or scrip. Derivatives are a special class of securities under the SC(R)A, 1956 and do not any way resemble any other type of securities like share, stocks or scrips. Derivative contracts, particularly index futures are cash-settled, as these cannot be settled otherwise. As explained earlier, derivative contracts are entered into by hedgers, speculators and arbitrageurs. A derivative contract has any of these two parties and hence some of the derivative contracts, not all, have an element of speculation. At least one of the parties to a derivative contract is a hedger or an arbitrageur. It would, therefore, be unfair to treat derivative transactions as speculative. Section 43 is relevant in case of contracts where actual delivery is possible, but these are settled otherwise than by actual delivery. This provision cannot be applied to derivatives, particularly index futures, which can be settled only by cash. There cannot be actual delivery. Hence the actual delivery for a contract to be non-speculative cannot be applied to derivatives contracts. As regards taxability, the questions remain: whether law should treat income of the hedgers, speculators and arbitrageurs differently? Or should the income of all the participants from derivatives be treated uniformly? Can income of all traders involved in derivatives trading be treated as normal or ordinary income? Hope that a clear cut picture emerges on this issue soon. Case Study You are approached by a prospective investor Mrs. Aparna Sen, who is an entrepreneur dealing with steel products. She is 45 and owns a house and a farm land in Kolkata. Her 285

husband is a doctor having a well established hospital in the metro. Their only son, Ashish, had completed B.Tech. from IIT and completed higher studies in the USA. He is now employed with an MNC, drawing a compensation of around US$1,00,000 plus perquisites per annum. Mrs. Sen concluded an export contract which fetched handsome gains. She would require the funds after 2-3 months for the expansion of her production unit. She wanted to park this money for short term, preferably in a modest return investment vehicle. She is willing to take some amount of risk, but prefers to have a risk free investment as far as possible . When she discussed this with her friends, who are regular investors in the stock market, they suggested her to lend money in the stock market. As she has not heard anything about lending in the market, she approaches you for the details. You, as a financial planner, explain Mrs. Sen on the concepts of Futures contracts and basics of Futures trading. You explain to her that money she wants to invest for a short term can be lent in the stock market with the least risk by using futures contract. What she actually has to do is to buy stocks of an index (say, 50 shares of Nifty or 30 shares of Sensex) on the spot market and simultaneously sell them on the futures market at a future date. This strategy has the least risk because the price risk is completely hedged and there is no credit risk involved as the exchange acts as a counter party for the transactions in spot as well as futures market. For the clear understanding of this strategy, you are making following chart. What are the steps involved in this futures strategy? The financial planner takes the following example to explain this. On 1 August, Nifty is at 1200. A futures contract is trading with 27 August expiration for 1230. Mrs. Sen wants to earn this return (30/1200 for 27 days). 1. Buying of ₹30 lakhs worth of Nifty stocks on the spot market. In doing this, the investor has to place 50 market orders and ends up paying slightly more transaction costs. (he has bought Nifty spot for 1204) 2. Selling ₹30 lakhs of the futures at 1230. The futures market is extremely liquid so impact cost on the order is negligible. 3. Taking delivery of the shares by payment of cash. 4. During the holding period, if few companies pay dividend, the investor would receive those dividends. Let us assume that the dividends work out to ₹7000. 5. On expiry date, selling off share portfolio (representing Nifty stocks), by placing 50 market orders. If Nifty happens to close at 1210 and his sell orders (which suffer impact cost) goes through at 1207. 6. The futures position expires on 27 August at 1210 (the value of the futures on the last day is always equal to the Nifty spot). What is the gain or loss on this transaction? The transaction gained ₹3 (0.25%) on the spot Nifty and ₹20 (1.63%) on the futures for a return of near 1.88%. In addition, she has gained ₹ 7000 or 0.23% owning to the dividends for a total return of 2.11% for 27 days, risk free. 286

It is easier to make a rough calculation of the return. To do this, we ignore the gain from dividends and we assume that transactions costs account for 0.4%. In the above case, the return is roughly 1230/1200 or 2.5% for 27 days, and we subtract 0.4% for transactions costs giving 2.1% for 27 days, which is very close the actual number. It is also possible to lend securities to the market and simultaneously buy futures to create a risk free strategy which would earn a reasonably good return in the short run. Another client, Mr. Dasgupta, on learning the modus operandi of this strategy, wants to actually lend his shares in the market. Suppose he has a portfolio (resembling Nifty stocks) worth ₹50lakhs and wants you to guide him in devising the strategy of lending to market. Show how he can implement this strategy. Also show the returns and risk associated with this strategy. Spot Nifty Index 1100 2 month Nifty Index Futures 1110 Risk free rate of interest 1% per month Answer: Sell all 50 shares of the NSE-50 portfolio (in their correct proportion, with each 1. share being present in the portfolio with a weight that is proportional to its market capitalization) on the cash market, when the Nifty is at 1010 2. 3. Buy index futures of an equal value at a future date, say at 1110. 4. A few days later, Mr. Dasgupta will receive money and have to make delivery 5. of the ₹ 50 lakh shares. 6. Invest this money at the riskless interest rate, at the rate of 1% per month. On the date that the futures expire, buy the entire NSE-50 portfolio. A few days later, you will need to pay in the money and get back your shares. It is easy to approximate the return obtained in stocklending. To do this, we assume that 287

transactions costs account for 0.4%. Suppose the spot-futures basis is x% and suppose the rate at which funds can be invested is y%. Then the total return is y-x-0.4%, over the time that the position is held. This can also be interpreted as mechanism to obtain a cash loan using your portfolio of Nifty shares as collateral. In this case, it may be worth doing even if the spot-futures basis is somewhat wider. What is the return? Nifty spot is 1100 and the two-month futures are at 1110. Hence the spot future basis (1110/1100) is 0.9%. Cash was invested at a risk free rate of 1% per month. Over two months, funds invested at 1% per month yield 2.01%. Hence the total return that can be obtained in stock lending is 2.01-0.9- 0.4 or 0.71% over the two month period. What is the risk involved? When the spot-futures basis (the difference between spot Nifty and the futures Nifty) is smaller than the riskless interest rate that you can find in the economy. If the spot-futures basis is 2.5% per month and you are loaning out the money at 1.5% per month, it is not profitable. Conversely, if the spot-futures basis is 1% per month and you are loaning out money at 1.25% per month, this stock lending could be profitable. 288

SUMMARY A derivative is a tradable instrument whose value is ‗derived‘ from some underlying instruments. The underlying instrument might be real goods (such as commodities), or they might be securities (equities or debentures etc.,). With regard to financial derivatives, the main types are options, futures, forwards and hybrids thereof. An option contract gives the buyer the right, but not an obligation, to call the security away from the seller of the option, or to put the security to the seller for a predetermined price. A forwards contract is a binding agreement to perform an agreed activity at some time in the future. If options and forwards are traded on an exchange, the option contracts are called exchange-traded options, while the forwards contracts become standardised futures contracts. Derivatives can be used to hedge portfolios of the underlying asset, or to speculate on price movements. Hedging involves combining the right number of derivatives contracts with the underlying asset. Profit-taking opportunities can be exploited if the potential investor can value derivatives correctly and anticipate short-term market movements correctly. Most options are traded (bought and sold) rather than exercised because sale of an option provides the seller with time value as well as intrinsic value. Intrinsic value is the profit (ignoring transaction costs) available from exercising in-the-money options. In futures markets, profitable opportunities arise if the normal relationship between spot and forwards prices is replaced by backwardation (where the futures price is less than the spot price). By use of appropriate option strategies (appropriate derivative and underlying share combinations), it is usually possible to create a synthetic instrument with a payoff function which rewards the correct prediction of virtually any share or market outcome, no matter how specific. 4.1.6. Market Timing The performance of the portfolio of a fund, to a large extent, depends on the market timing abilities of the fund manager. How correctly and quickly he makes decisions to buy / sell securities anticipating the market movements? How he switches the investment between sectors and asset classes? Academic research on this subject based on data from Indian mutual funds generally indicates that the fund managers do not exhibit any superior market timing abilities. It should be noted here that the regulator mandates the disclosure of the investment objectives and the broad investment pattern. However, funds are not required to disclose the investment strategy that they intend to follow. Financial planners may be required to do some homework to explain these aspects to their clients. As the name suggests, this strategy takes into account the short term expectations or forecasts of general market movements. Specialists may employ macro-economic analysis and advanced statistical tools to forecast the market movements and investors may just go by the market sense. If as an investor, you feel that the prices of stocks in the equity market have bottomed out and the index has declined substantially, you may feel that it is the right time to invest in stock market. If the short-term outlook for the economy is good, you may decide to divert more funds to equities than what is normally invested in stocks. For instance, you, a risk averse investor who normally allocates only 25% of investible funds for share purchases, may decide to increase the holdings in equities to 40%, as a result of the analysis that you have made. If your analysis had been proven right, the returns on the portfolio would be higher than what would have been earned on the asset mix usually 289

employed. Like any active strategy, this also involves transaction costs. In addition, cost of errors – the cost of your forecast about market movements going wrong. 4.1.7. Securities Selection This strategy basically involves identification of ‗mispriced‘ securities. There are numerous mathematical / statistical models that are widely used by investors for the identification of ‗mispriced‘ securities. In case of equity segment, two popular stock selection approaches are 1) Fundamental Analysis and b) Technical Analysis. The former approach considers macro- economic indicators and industry as well as company specific factors in the calculation of intrinsic value of a share, the latter approach studies the patterns and trends of share prices. Underpriced securities are included in the portfolio whereas overpriced shares are excluded from selection process. Bonds having high yield to maturity is preferred to low YTM bonds in the bond portfolio construction. Securities Selection Methodology Portfolio management requires detailed research of securities traded in the market. While the objective of research is to establish a view on future prices, it usually takes any of three alternate forms.  Fundamental analysis involves research into the operations and finances of a company with the objective of estimating its future earnings. The researcher considers many factors such as the company‘s position relative to other industry players, impact of the regulatory environment and quality of management.  Technical analysis involves the study of historical data on the company‘s share-price movements and trading volume. Therefore, factors such as market sentiment and trends in supply/demand are of particular relevance in this form of research. The objective is to recognize patterns in the market price behaviour and use that knowledge to try to predict the future course of the market price of a share, or even an industry. It is generally accepted that Fundamental Analysis forms the basis of a fund manager’s decision on whether to buy a given share, while Technical Analysis would guide the decision on the right timing to make the investment.  Quantitative analysis uses mathematical models for equity valuation and may also use fundamental and technical information in tandem. In today‘s environment, computer- based models form the basis for such analysis. This analysis is more likely to be done to evaluate the market as a whole or particular sectors/ industries. As portfolio management requires specialist knowledge and skills, mutual funds generally following organizational setup: 1. Fund Managers, each assigned to a specific scheme or set of schemes 2. Security Analysts and Researchers and 3. Security Dealers Fund Managers are strategists who take overall decisions on asset allocation or industry exposures, and ensure that the investments remain in line with the scheme‘s objectives. Security analysts support the fund‖ managers with continuous tracking of the fund‘s target sectors, companies and the overall markets. Both fundamental and technical analyses are 290