Derivatives

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BASICS OF DERIVATIVES

© Copyright 2002 India Infoline Ltd. All rights reserved. Regd. Off: 24, Nirlon Complex, Off W E Highway, Goregaon(E) Mumbai-400 063. Tel.: +(91 22) 685 0101/0505 Fax: 685 0585

BASICS OF DERIVATIVES

CONTENTS
FOREWORD ...................................................................................................................... 3 1.INTRODUCTION.......................................................................................................... 5 2. FUTURES .................................................................................................................... 11 3. OPTIONS..................................................................................................................... 26 4. TRADING STRATEGIES USING FUTURES AND OPTIONS ........................... 40 5. RISK MANAGEMENT IN DERIVATIVES............................................................ 50 6. SETTLEMENT OF DERIVATIVES ........................................................................ 52 7. REGULATORY AND TAXATION ASPECTS OF DERIVATIVES.................... 57 8. CASE STUDY- WHEN THINGS GO WRONG!..................................................... 58 ANNEXURE 1-GLOSSARY OF TERMS USED IN DERIVATIVES ...................... 63 ANNEXURE 2- GROWTH OF DERIVATIVES MARKET IN INDIA ................... 72 ANNEXURE 3- BLACK AND SCHOLES OPTION PRICING FORMULA .......... 74 ANNEXURE 4- L C GUPTA COMMITTEE REPORT............................................. 75

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BASICS OF DERIVATIVES

Foreword
New ideas and innovations have always been the hallmark of progress made by mankind. At every stage of development, there have been two core factors that drives man to ideas and innovation. These are increasing returns and reducing risk, in all facets of life.

The financial markets are no different. The endeavor has always been to maximize returns and minimize risk. A lot of innovation goes into developing financial products centered on these two factors. It has spawned a whole new area called financial engineering.

Derivatives are among the forefront of the innovations in the financial markets and aim to increase returns and reduce risk. They provide an outlet for investors to protect themselves from the vagaries of the financial markets. These instruments have been very popular with investors all over the world.

Indian financial markets have been on the ascension and catching up with global standards in financial markets. The advent of screen based trading, dematerialization, rolling settlement have put our markets on par with international markets.

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BASICS OF DERIVATIVES

As a logical step to the above progress, derivative trading was introduced in the country in June 2000. Starting with index futures, we have made rapid strides and have four types of derivative products- Index future, index option, stock future and stock options. Today, there are 30 stocks on which one can have futures and options, apart from the index futures and options.

This market presents a tremendous opportunity for individual investors .The markets have performed smoothly over the last two years and has stabilized. The time is ripe for investors to make full use of the advantage offered by this market.

We have tried to present in a lucid and simple manner, the derivatives market, so that the individual investor is educated and equipped to become a dominant player in the market.

Editorial Team July 11, 2002

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BASICS OF DERIVATIVES

1.Introduction

What are derivatives? A derivative is a financial instrument that derives its value from an underlying asset. This underlying asset can be stocks, bonds, currency, commodities, metals and even intangible, pseudo assets like stock indices.

Derivatives can be of different types like futures, options, swaps, caps, floor, collars etc. The most popular derivative instruments are futures and options.

There are newer derivatives that are becoming...
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