CHAPTER 1 INTRODUCTION

Investing involves risk. If investors didn't know that before, they know it now. The performance of the stock market recently has severely damaged the financial position of many people, and has caused many to seek the advice of a Financial Advisor for the first time. For anyone who is uncertain about how the stock market will act in the near term and that describes just about every stockholder Options present tremendous opportunities. They allow investors to leverage their investment capital, giving greater flexibility when making investment decisions, and let them tailor risk to fit their comfort level. They can be used to speculate for profit, earn income to enhance investment returns, protect against a temporary decline in the value of a stock, and hedge a portfolio against market risk... Two types of risks are associated with options the price movement of the underlying and the changes in volatility. Factors contributing to these risks are many and varied. Some of the prominent factors are the state of economy, supply and demand factors in the options market and in other related markets. The factors affecting the values of the various underlying assets and those affecting the volatility, liquidity and efficiency of the markets or other markets also contributes to the risk. Other factors that may affect the pricing of particular options, the quality or operations of the various options markets at any particular time and the procedures of the various options markets etc also affects the risk associated with options. Risks are generally of same type to all underlying assets.

NEED FOR THE STUDY

The emergence of derivatives market in the late 20th century is the most notable development in the realm of financial markets. The derivative products serve as instruments of risk management for risk-averse investors by locking-in the asset prices to hedge against uncertainty. This study on financial derivatives is an attempt to bring out the pricing principles and practices followed in the derivatives market of India which introduced derivatives barely 7 years ago. The study majorly focuses on the option contracts which are most commonly used risk management instruments. The study is focused mainly on the various factors influencing the options premium and also to study the practical implication of Black-Scholes model of options pricing. It is also an attempt to know the investors perception towards derivatives markets. The study is also to focus on how the traders insure themselves using the derivatives. At the same time, to how in reality an investor uses it as a tool for speculation.

OBJECTIVES OF THE STUDY

To practically study the factors influencing the option premiums To study the practical application of Black-Scholes equation for pricing of options

To know the investors perception towards derivatives.

RESEARCH METHODOLOGY

Research Type This research is an exploratory type, where most of the analysis is done on the basis of the secondary data.

Data collection Two types of data are used in this research namely secondary and the primary data. The secondary data includes historical data of stock prices and the option prices for a period of 3 months was collected from the site of National Stock Exchange of India (www.nseindia.com). A survey which involves the perception of investors towards derivatives serves as the source of primary data which is collected through a structured questionnaire. The questionnaire includes a total of 17 questions, with 5 options per question. It also includes dichotomous and open ended questions.

Sample size The sample size used for the research is 50 and the investors are clients of Emkay Shares and Stock Brokers Ltd.

Data analysis methods As most of the research is an exploratory type, the data is analysed and interpreted by using simple line charts which gives a relation between two components. The primary data is represented by pie diagrams. One of the important objectives of testing the Black Scholes equation includes the calculation of standard deviation which is a measure of volatility of a stock. The following steps were followed to calculate the volatility. Step 1: In the first step Price Relative for each day using a fraction of years historical 90 days data is calculated. The price relative for a day is the ratio of days closing price to the closing price of the previous day. Step 2: The second step involves finding out the natural logarithms of the price relatives which gives the continuously compounded rate of return per day. Step 3: This step involves the calculation of standard deviation of the values obtained in the second step mentioned above and is calculated as follows: a) Calculating the mean rate of return,

= b)

X n

Finding out the total of squared deviations of rates of return from the mean

rate of return, (X ) 2 c) The following rule is used to calculate the standard deviation

= (X ) 2

n Step 4: is the continuously compounded daily standard deviation. It is converted into yearly standard deviation by multiplying it by square root of 252, for the number of trading days in a year. Annualized volatility = x 252

This annualized value is calculated and substituted in Black Scholes equation to find out the price of an option

LIMITATIONS OF THE STUDY The study is limited only to the Indian derivatives market segment in NIFTY The legalities in the entire process are difficult to analyze because of the time of work.

CHAPTER 2

LITERATURE REVIEW

Risk is a characteristic feature of all commodities and capital markets. Prices of all commodities be they agricultural like wheat, cotton, rice, coffee or tea, or non agricultural like silver, gold etc. are subject to fluctuations over time in keeping with prevailing demand and supply conditions. Producers or processors of these commodities obviously cannot be sure of the prices that their products or possession may fetch when they have to sell them, in the same way as the buyers or the possessors are not sure of what would have to pay for their buy. Similarly, prices of shares and debentures or bonds are also subject to continuous change. Those who are charged with the responsibility of managing money, their own or of others are constantly exposed to the threat of risk. In the same way, the foreign exchange rates are also subject to continuous change. Thus, an importer of a certain piece of machinery is not sure of the amount he would have to pay in rupee terms when the payment becomes due. While examples where risk is seen to exist, can be easily multiplied, it may be observed that parties involved in all such cases may see the benefits of, and are likely to desire, having some contractual form whereby forward prices may be fixed and the price risk facing them is eliminated. Derivatives came into being primarily for the reason of the need to eliminate price risk. Derivatives are important risk management tools used to necessitate its users to understand the intended function and the safety precautions before being put to use for the benefit of the society at large . In the coming sections we will discuss about what actually derivatives are and how these instrument are effectively used as the risk management tool.

INTRODUCTION TO DERIVATIVES

"We view them as time bombs both for the parties that deal in them and the economic system. In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." -------- Warren Buffett, the Chairman of Berkshire Hathaway and his critique of the derivatives market. (March 2003) You may have heard the word in your high school mathematics class, someone may have suggested you use derivatives as part of your investment strategy, or you may already work with derivatives already. But what many do not consider, is what derivatives really are on a fundamental level. You can come up with a hundreds of formulae for derivatives, use them within numerous applications, but in its pure form, derivatives are merely pieces of paper... Or in more modern day view, electronic contracts which give you a right or an obligation, or a combination of the two to receive or give something in the future. This can be a stock of a company, a foreign currency, wheat, oil, or to take it to its extreme, an agreement with your neighbour for 2 bags of sugar next week. A derivative is an instrument whose payoffs depend on a more primitive or fundamental good. It is a contractual relationship between parties where payoffs are derived from some agreed upon benchmark. These do not have independent existence without underlying product or commodity. Even, derivatives do not have their own value and rather they derive their value from some underlying product or commodity. A financial derivative is a financial instrument, whose payoffs depend on another financial instrument or we can say a financial derivative is a financial instrument, whose value is linked in some way to the value of another instrument, underlying the transaction. For example an option on a share of stock depends on the value of the underlying share.

Market deregulation, growth in global trade, and continuing technological developments have revolutionized the financial marketplace during the past two decades. A by-product of this revolution is increased market volatility, which has led 8

to a corresponding increase in demand for risk management products. This demand is reflected in the growth of financial derivatives from the standardized futures and options products of the 1970s to the wide spectrum of over-the-counter (OTC) products offered and sold in the 1990s. Many products and instruments are often described as derivatives by the financial press and market participants. In this guidance, financial derivatives are broadly defined as instruments that primarily derive their value from the performance of underlying interest or foreign exchange rates, equity, or commodity prices. Financial derivatives come in many shapes and forms, including futures, forwards, swaps, options, structured debt obligations and deposits, and various combinations thereof. Some are traded on organized exchanges, whereas others are privately negotiated transactions. Derivatives have become an integral part of the financial markets because they can serve several economic functions. Derivatives can be used to reduce business risks, expand product offerings to customers, trade for profit, manage capital and funding costs, and alter the risk-reward profile of a particular item or an entire balance sheet. Although derivatives are legitimate and valuable tools for banks, like all financial instruments they contain risks that must be managed. Managing these risks should not be considered unique or singular. Rather, doing so should be integrated into the bank's overall risk management structure. Risks associated with derivatives are not new or exotic. They are basically the same as those faced in traditional activities (e.g., price, interest rate, liquidity, credit risk). Fundamentally, the risk of derivatives (as of all financial instruments) is a function of the timing and variability of cash flows.

There have been several widely publicized reports on large derivative losses experienced by banks and corporations. Contributing to these losses were inadequate board and senior management oversight, excessive risk-taking, insufficient

understanding of the products, and poor internal controls. These events serve as a reminder of the importance of understanding the various risk factors associated with business activities and establishing appropriate risk management systems to identify, measure, monitor, and control exposure. EMERGENCE OF DERIVATIVE PRODUCTS The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives.

OPTIONS

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Option means several things to different people. It may refer to choice or alternative or privilege or opportunity or preference or right. To have options in normally regarded goods. Options are valuable since they provide protection against unwanted, uncertain happenings. Options can be exercised on the happening of certain event. Options may be explicit or implicit. When you buy insurance on you house, it is explicit option that will protect you in the event there is a fire or a theft in your house. If you own shares of a company, your liability is limited. Limited liability is an implicit option to default on the payment of debt. Options have assumed considerable significance in finance. They can be written on any asset, including shares, bonds, portfolios, stock indices, currencies, etc. they are quite useful in risk management. How are options defined in finance? What gives value to options? How are they valued? In a broad sense, an option is a claim without any liability. It is a claim contingent upon the occurrence of certain conditions. Thus an option is a contingent claim. More specifically, an option is a contract that gives the holder a right, without any obligation, to buy or sell an asset at an agreed price on or before a specified period of time. The option to buy an asset is called as a call option, and the option to sell an asset is called as put option. The price at which the option can be exercised is called an exercise price or a strike price. The asset on which the put or call is created is referred to as the underlying asset. Depending on the when an option can be exercised, it is classified in one of the following two categories: European option: when an option is allowed to be exercised only on the maturity date, it is called as a European option American option: when the option can be exercised any time before its maturity, it is called an American option

When will an option holder exercise his right? He will exercise his option when doing so provides him a benefit over buying or selling the secondary asset from the market at the prevailing prices. There are 3 possibilities

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In the money: A put or call option is said to in-the-money when it is advantageous for the investors to exercise it. In the case of in-the-money call options, the exercise price is less than the current value of the underlying asset, while in the case of the inthe-money put options, the exercise price is higher than the current value of the underlying asset. Out of the money : A put or call option is out-of-the-money if it is not advantageous for the investor to exercise it. In the case of out-of-the-money call options, the exercise price is higher than the current value of the underlying asset, while in the case of the out-of-the-money put options, the exercise price is lower than the current value of the underlying asset. At the money : When the holder of a put or a call option doesnt lose or gain whether or not he exercise his option, the option is said to be at-the-money. In the case of the at-the-money options the exercise price is equal to the current value of the underlying asset. If we consider S the spot price and E as the exercise price we get the following concept Condition S>E -money S<E S=E Out-of-the-money At-the-money In-the-money At-the-money Call option In the money Put option Out-ofthe

TYPES OF OPTIONS Call Option

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A call option is a financial contract between two parties, the buyer and the seller of this type of option. Often it is simply labeled a "call". The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right. The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for the premium (paid immediately) and retaining the opportunity to make a gain up to the strike price.

The above figure is a graphical interpretation of the payoffs and profits generated by a call option from the buyers perspective. The higher the stock price the higher the profit. Eventually, the price of the underlying security would become high enough to fully compensate for the price of the option.

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This is a graphical interpretation of the payoffs and profits generated by a call option from the writers perspective of the option. Profit is maximized when the strike price exceeds the price of the underlying security, because the option expires worthless and the writer keeps the premium.

Put Option A put option (sometimes simply called a "put") is a financial contract between two parties, the seller and the writer (buyer) of the option. The put allows the seller the right but not the obligation to sell a commodity or financial instrument (the underlying instrument) to the writer (buyer) of the option at a certain time for a certain price (the strike price). The writer (buyer) has the obligation to purchase the underlying asset at that strike price, if the seller exercises the option. The buyer of a put option wants the price of the underlying instrument to fall in the future; the seller either expects that it will not, or is willing to give up some of

14

the upside (profit) from a price fall in return for the premium (paid immediately) and retaining the opportunity to make a gain up to the strike price.

The above figure is a graphical interpretation of the payoffs and profits generated by a put option as seen by the buyer of the option. A lower stock price means a higher profit. Eventually, the price of the underlying security will be low enough to fully compensate for the price of the option.

15

This is a graphical interpretation of the payoffs and profits generated by a put option as seen by the writer of the option. Profit is maximized when the price of the underlying security exceeds the strike price, because the option expires worthless and the writer keeps the premium.

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OPTIONS PRICING Options do not come for free. They involve cost. The option premium is the price that the holder of an option has to pay for obtaining call or put option. The price will have to be paid, generally in advance, whether or not the holder exercises this option. The major goals here introduce investors to the factors that affect any listed equity option's price in the marketplace. While the effect of a change in any one of these factors may be examined in isolation, the sum effect of them all is a dynamic one. Most of these factors can and often do change during an option's lifetime, with some fluctuating in value on a continuing basis during any trading day. Certain of these factors can be quantified Underlying stock price Strike price Volatility Time to expiration Dividends Interest rates Understanding the effect that a change in any particular factor can have on the premium, or price, of a call or put can reduce surprises about the price behavior of an option position in a dynamic marketplace. And with the use of an option pricing model, specific values for each of these six factors may be used to predict an option contracts theoretical value at a given point in the future. The accuracy of any theoretical value generated with a pricing model has its limitations. The principal one being how option prices are actually determined in the open marketplace. Just as with any competitive securities market they reflect the current consensus of bids and offers from all investors, professional and individual alike.

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Theoretical option pricing, along with its quantifiable factors, can explain much of the observable behavior of option prices in the marketplace, but not everything. The forces of supply and demand play their part as well, and commonly override the predictive option values generated by pricing models. As option prices are set by competing bids and offers in the marketplace, a sustained imbalance of one over the other can result in market prices that diverge from theoretically expected values. Unexpected news about an stock, or underlying changing sentiment in the broad market due to either market fundamentals or a sudden political or military event, can frequently drive market prices one way or another significantly and abruptly. These influences that cannot be quantified or forecast can have a major impact on option prices. Here we focus on the quantifiable factors that can influence an options market price, and these factors are common among most option pricing models. The theoretical prices derived from these models can provide a reasonable degree of predictability and logic to real-life market price relationships, and may also raise useful questions about apparent price anomalies. Many professional traders and active options investors employ theoretical option pricing models as an essential trading guide. They may find subtle variations among specific models highly relevant, but for most individual investors the major factors, and the effects of their changing values, matter more than the details of the formulas themselves. Most pricing models tend to generate very similar results. Theoretical values have limits to their accuracy. Their main limitation lies in the fact that option premiums are ultimately set in the marketplace by a consensus of competitive bids and offers, not by a particular formula. However, an understanding of the key components of theoretical option pricing is still an excellent tool for investors to anticipate price movements of their call and put positions. In addition to generating theoretical values, option pricing models can be used to derive various sensitivities of an option contract's market price to changes in some of the quantifiable factors. The values of these sensitivities are labeled with letters of the Greek alphabet, such as delta, gamma, and theta. These are commonly referred to a Greeks.

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Black Scholes Options Pricing Model There are many option pricing models of equity options. One of the models which are used widely throught the world is Black Scholes model. In 1973 two professors, Fischer Black and Myron Scholes, published a pioneering mathematical model for pricing equity option contracts. The formulation of this model facilitated the introduction of listed option contracts and the simultaneous creation of listed option exchanges. The Black-Scholes option pricing model was immediately embraced as a standard for evaluating risk as it pertains to option pricing, and in 1997 earned two of its creators the Nobel Prize for Economics. Though many other pricing models are in use today, almost all of them build on the concepts of the original Black-Scholes model, which when devised focused on the pricing of European-style option contracts. The formula below represents the mathematics behind Black-Scholes. C = SN (d1) E e r t N (d2) P = E e r t N (d2) SN (d1)

d1 =

ln (S/E) + (r + 0.5 2) T T

d2 = d1 T C = current value of the call option P = current value of the put option r = continuously compounded risk free rate of interest S = current price of the stock E = exercise price of the option t = time remaining before the expiration date = volatility of the relative price change of the underlying stock price N (dx) = the value of the cumulative normal distribution network

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In order to understand the model itself, we divide it into two parts. The first part, SN(d1), derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the change in the call premium with respect to a change in the underlying stock price [N(d1)]. The second part of the model, Eert

N(d2), gives the present value of paying the exercise price on the expiration day. The

fair market value of the call option is then calculated by taking the difference between these two parts.

Assumptions of the Black and Scholes Model:

1) The stock pays no dividends during the option's life Most companies pay dividends to their share holders, so this might seem a serious limitation to the model considering the observation that higher dividend yields elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend from the stock price. 2) European exercise terms are used European exercise terms dictate that the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the option, making American options more valuable due to their greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same. 3) Markets are efficient This assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous It process. To understand what a continuous It process is, we must first know that a Markov process is "one where the observation in time period t depends only on the preceding observation." An It process is simply a

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Markov process in continuous time. If you were to draw a continuous process you would do so without picking the pen up from the piece of paper. 4) No commissions are charged Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that Individual investor's pay is more substantial and can often distort the output of the model. 5) Interest rates remain constant and known The Black and Scholes model uses the risk-free rate to represent this constant and known rate. 6) Returns are log normally distributed This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable for most assets that offer options. In practice, most professional traders and investors with large option positions rely on frequent theoretical value updates as a way to monitor the changing risk and value of their overall option positions, to adjust price interrelationships, and to facilitate quick trading decisions. In contrast, most individual investors find that understanding the ultimate risk and reward of their positions tends to be more useful than constant updates of input values and any specific differences between the outputs of various pricing formulas. Almost all of the elements that go into option pricing models are in flux during the lifetime of an option contract that is before it expires. It follows that an option positions theoretical value is also subject to perpetual changes based on new input values. While the mathematical formulas of theoretical option pricing models can be complex, the underlying concepts are not. The most important factors influencing an option's price are:

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Taken together, the combined effects of these six factors are a dynamic situation. During an options lifetime the values of these factors will change. The following pages describe the impact of each factor as isolated from the others. And a small attempt is made to study the above mentioned implications of the Black Scholes model of options pricing for equities. The factors are explained by taking live examples of equity option contracts of a 3 month contract listed on National Stock Exchange Of India, NIFTY.

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CHAPTER: 3 INDUSTRY AND COMPANY PROFILE

INDUSTRY PROFILE India Financial Market promotes the savings of the economy, providing an effective channel for transmitting the financial policies. It is a welldeveloped, competitive, efficient and integrated financial sector. There are large numbers of buyers and sellers of the financial product, the prices are fixed by the market forces of demand and supply within the Indian Financial Market. The other markets of the economy assist the functioning of the financial market in India. The Financial Market in India focuses on these features:

Real-time India Financial Indices BSE 30 Index, Sector Indexes, Stock Quotes, Sensex Charts, Bond prices, Foreign Exchange, Rupee Dollar Chart Indian Financial Market news Stock News Bombay Stock Exchange, BSE Sensex 30 closing index, S&P CNX-Nifty NSE, stock quotes, company information, issues on market capitalization, corporate earning statements, Indian Business Directory Fixed Income Corporate Bond Prices, Corporate Debt details, Debt trading activities, Interest Rates, Money Market, Government Securities, Public Sector Debt, External Debt Service Foreign Investment Foreign Debt Database composed by BIS, IMF, OECD,& World Bank, Investments in India & Abroad Global Equity Indexes Dow Jones Global indexes, Morgan Stanley Equity Indexes Currency Indexes FX & Gold Chart Plotter, J. P. Morgan Currency Indexes National and Global Market Relations Mutual Funds Insurance Loans Forex and Bullion The financial markets, including derivative markets, in India have been

through a reform process over the last decade and a half, witnessed in its growth in terms of size, product profile, nature of participants and the development of market infrastructure across all segments - equity markets, debt markets and forex markets

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Growth of derivatives markets Derivative markets worldwide have witnessed explosive growth in recent past. According to the BIS Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity as of April 2007 was released recently and the OTC derivatives segment, the average daily turnover of interest rate and non-traditional foreign exchange contracts increased by 71 % to $2.1 trillion in April 2007 over April 2004, maintaining an annual compound growth of 20 per cent witnessed since 1995. Turnover of foreign exchange options and cross-currency swaps more than doubled to $0.3 trillion per day, thus outpacing the growth in 'traditional' instruments such as spot trades, forwards or plain foreign exchange swaps. The traditional instruments also show an unprecedented rise in activity in traditional foreign exchange markets compared to 2004. Average daily turnover rose to $3.2 trillion in April 2007, an increase of 71% at current exchange rates and 65% at constant exchange rates. Relatively moderate growth was recorded in the much larger interest rate segment, where average daily turnover increased by 64 per cent to $1.7 trillion. While the dollar and euro clearly dominate activity in OTC interest rate derivatives, their combined share has fallen by nearly 10 percentage points since the 2004 survey, to 70 per cent in April 2007, as turnover growth in several non-core markets outstripped that in the two leading currencies. Indian forex and derivative markets have also developed significantly over the years. As per the BIS global survey the percentage share of the rupee in total turnover covering all currencies increased from 0.3 percent in 2004 to 0.7 percent in 2007. As per geographical distribution of foreign exchange market turnover, the share of India at $34 billion per day increased from 0.4 in 2004 to 0.9 percent in 2007. The activity in the forex derivative markets can also be assessed from the positions outstanding in the books of the banking system. As of August end, 2007, total forex contracts outstanding in the banks' balance sheet amounted to USD 1100 billion (Rs. 44 lakh crore), of which almost 84% were forwards and rest options. As regards interest rate derivatives, the inter-bank Rupee swap market turnover, as reported on the CCIL platform, has averaged around USD 4 billion (Rs. 16,000 crore) per day in notional terms. The outstanding Rupee swap contracts in banks balance sheet, as on August 31, 2007, amounted to nearly USD 1600 billion 24

(Rs. 64,00,000 crore) in notional terms. Outstanding notional amounts in respect of cross currency interest rate swaps in the banks books as on August 31, 2007, amounted to USD 57 billion (Rs. 2,24,000 crore). Buoyant conditions in the underlying markets boosted growth in derivatives in 2007.Notably, the index futures market appeared to reach critical mass, as activity surged alongside the cash market. Average daily volume jumped to 12,733 contracts from 6,618 a day in 2006 on greater foreign participation. Crude palm oil futures also drew strong foreign interest. The market tracked the worldwide boom in commodities and rediscovered its momentum following a lull at the beginning of the year. Trading activity for structured warrants soared in December 2006 and stayed high throughout 2007, providing a significant boost to the market in tradable structured products. Average daily volume increased from around 23 million contracts to nearly 144 million contracts in 12 months, reflecting strong retail demand. The Securities Commission said strong appetite for international markets led to a tripling in volume in October after warrants on foreign stocks, mainly blue-chip Chinese listings as well as a number of US technology favorites, were introduced to the market. Business growth in Derivatives at NIFTY
Index Futures Stock Futures Index Options Notional Turnover (Rs. cr.) 1362111 791906 338469 121943 52816 9246 3765 Stock Options Notional Turnover (Rs. cr.) 359136.6 193795 180253 168836 217207 100131 25163 -

Year 2007-08 2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

No. of contracts 1.57E+08 81487424 58537886 21635449 17191668 2126763 1025588 90580

Turnover (Rs. cr.) 3820667 2539574 1513755 772147 554446 43952 21483 2365

No. of contracts 203587952 104955401 80905493 47043066 32368842 10676843 1957856 -

Turnover (Rs. cr.) 7548563 3830967 2791697 1484056 1305939 286533 51515 -

No. of contracts 55366038 25157438 12935116 3293558 1732414 442241 175900 -

No. of contracts 9460631 5283310 5240776 5045112 5583071 3523062 1037529

Interest Rate Futures

Total Average Daily Turnover (Rs. cr.) 52153.3 29543 19220 10107 8388 1752 410 11

No. of contracts

Turnover (Rs. cr.) 0 0 0 0 0 0 0 0 202 -

No. of contracts 4.25E+08 2.17E+08 1.58E+08 77017185 56886776 16768909 4196873 90580

Turnover (Rs. cr.) 13090478 7356242 4824174 2546982 2130610 439862 101926 2365

COMPANY PROFILE

10781 -

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Emkay Share and Stock Brokers Limited was founded on 24th January 1995 as Emkay Share and Stock Brokers Private Limited, by two dynamic and young Chartered Accountants, Shri Krishna Kumar Karwa and Shri Prakash Kacholia. It was converted into a Public Limited Company in 20th October 2005 and the name was changed to Emkay Share and Stock Brokers Limited. The Company acquired the membership of: Bombay Stock Exchange 1996 National Stock Exchange 1999 Derivatives Segment BSE, Trading & Clearing Member 2000 Depository Participant CDSL 2000 Debt Market BSE 2001 Derivatives Segment NSE, Trading & Clearing Member 2001. Emkay is a full service brokerage house providing comprehensive advisory services to its clients under one umbrella, which would enable managing complete financial planning needs. It has expertise in advisory services in both cash and derivatives sides of the capital markets and are also distributors of savings / investment instruments like Mutual Fund Schemes, Saving Bonds, IPO etc. Emkay also provides commodity trading through its group subsidiaries, and is a member of the MCX and NCDEX. The services are offered under total confidentiality and integrity with the sole purpose of maximizing returns to our clients. The customer base is a mix of institutional, high net worth, and retail investors. These diversified base of customers together with its wide gamut of services, provides us with the necessary stability and strength to weather the volatility much better then that of the competitors and also maintain high standards of customer service levels through out. Emkay meets the support needs of this investor base through execution skills driven by an experienced sales team and research backed advice generated by a team of experienced analysts.

Emkay`s advisory services range from investing, trading, research, financial planning and portfolio management, which are offered, to a large number of high net 26

worth individuals and corporate. Most of these services are tailor-made to meet the needs of HNIs and Corporate in line with their investment objective. Subsidiaries Emkay Fincap Limited (EFL): is a subsidiary of our Company with 85% shares held by our Company. EFL was formed as a Private Limited Company on 16th May, 2005 for carrying on Share Financing activities and has been converted to Public Limited Company on February 14, 2006. Emkay Commotrade Limited is a subsidiary of our Company and our Company holds 100% shares held of ECL. The Company was formed on 5th January 2006 and proposes to carry on commodity broking business. It proposes to invest in the membership of two commodity exchanges namely

MCX Commodity Exchange NCDX Commodity Exchange

Companys Mission To provide research driven, unbiased investment advise with the objective of achieving sustainable superior investment returns for our clients. To provide flawless execution support to meet diverse client needs on a platform of professionalism and integrity. Companys Values To be fair, empathetic and responsive in serving our customers. To respect and reinforce our fellow employees and the power of teamwork To strive relentlessly to improve what we do and how we do it. To always earn and be worthy of our customer's trust.

Major Events

27

Executed first trade in Sensex futures market on BSE 2000 Executed first Sensex options trade 2000 Top 10 Domestic Brokerage houses rated by Asia Money Poll 2004 of fund Managers 2005

Board of Directors Mr. G.P. Gupta, Chairman, has 35 years experience in development Banking. He was formerly the Chairman and Managing Director of Industrial Development Bank of India and Chairman of Unit Trust of India. Besides, being a past Director of Bharat Heavy Electrical Limited, National Aluminium Co. Limited, Hindustan Aeronautics Ltd. Mr. Krishna Kumar Karwa, Managing Director, is a Chartered Accountant and has 17 years experience in the stock market across research, dealing and execution with special focus on the cash segment of the capital markets. He also directs the wealth management services business, which is aimed at providing portfolio advisory and risk management. Mr. Prakash Kacholia, Managing Director is a Chartered Accountant and has 15 years experience in Share Broking Activities. He leads our Companys derivatives business, generating trading strategies and identifying market opportunities. He has served the BSE in the capacity of a governing board member and on the derivatives committee of SEBI at the time of the launch of derivatives in the Indian market. He is currently on the Board of Bank Of India Share Holdings Ltd. Mr. S.K. Saboo, Director, has over 40 years of experience in the Management field. He is the Group Executive President and Business Head of Aditya Birla Group, the premier business group in India and responsible for independently managing the units. Mr. R.K. Krishnamurthi Director is a Solicitor and Senior Partner with Mulla & Mulla Craigie Blunt & Caroe, a reputed firm of Advocates, Solicitors and Notaries. He is a solicitor in the Mumbai High Court and Supreme Court of England. Mr. G.C. Vasudeo, Director, is a member of Institute of Chartered Accountant, Institute of Company Secretaries, Institute of Cost and Works Accountant and Law 28

Graduate. He has wide industrial experience of 25 years. He is presently DirectorFinance of Schenectady Herdilla Limited in charge of Corporate Finance, Accounts, Material Sourcing and Information Technology. He has been instrumental in the restructuring of the Herdilla Group and also in Mergers and Acquisition within the Group.

29

CHAPTER: 4 DATA ANALYSIS AND INTERPRETATION

To fulfill the major objective of various factors influencing the options premium, data was collected for the three most active stocks at NIFTY (in F&O segment). Options contracts ending on 27th march 2008 were observed and the option premiums were recorded. The data was collected from the day of December 27 th 2007, which includes the days high, low, close, last traded prices and the volume traded. Here we are going to analyse on the basis of the closing price of a particular day. Here we chose to analyse 3 companies namely Reliance Natural Resources Limited (RNRL) which is the most actively trades stock in both derivative and cash segment, the next company includes ICICI bank, which is also one of the actively traded stock derivatives segment and IFCI which is also traded actively on the derivative segment. The four quantifiable factors used for this study are:Price of the underlying stock Strike price Time remaining for expiration Volatility

FACTOR 1: PRICE OF THE UNDERLYING STOCK Arguably the single most important influence on the price of an equity option is the current market price of the underlying shares. Though the degree of this impact 30

varies, anything that affects the underlying stock price usually translates into a change in an options premium. Let us analyse how this affects. Here we are assuming all other pricing factors as constant. Table 4 .1: Type: Call
Date 28-Feb-08 29-Feb-08 3-Mar-08 4-Mar-08 5-Mar-08 7-Mar-08 10-Mar-08 11-Mar-08 12-Mar-08 13-Mar-08 14-Mar-08 17-Mar-08 18-Mar-08 19-Mar-08 24-Mar-08 25-Mar-08 26-Mar-08 27-Mar-08

Stock: RNRL

Strike: Rs 120
Spot (Rs) 133.95 132.9 124.75 119.85 120.25 106.65 107.8 116.1 117.15 103.75 108.3 101 101.25 99.9 95.9 102.25 99.8 100.15

Call premium (Rs) 36 36 14.5 11.85 12 6.05 6.45 8.2 7.65 3.75 4.4 1.9 1.85 0.6 0.2 0.3 0.05 0.05

Source: www.nseindia.com Figure 4.1: Chart showing relationship between the option premium and stock price

Interpretation The chart 4.1 shows the relationship between the spot price in a bearish market and the movement of the call option premium. We can observe that on February 28 31

and 29, the spot price (Rs 133.9 and 132.9) didnt show much difference and hence there is no effect on the call premium which remained at Rs 36. On March 3 rd, the spot price of the underlying stock (RNRL) has gone down to Rs 124.75 resulting in a change of nearly Rs 8 to the previous closing considerably affecting the call premium to fall to Rs 14.5, a change of Rs 21.5. Similarly on the next trading day, March 4th the spot price decreased by nearly Rs 5, decreasing the call price by approximately Rs 2.5. Further on March 7th the spot price came down to Rs 106.65, considerably decreasing the call price to Rs. 6.05, a change of nearly Rs 6. We can observe from the table 4.1 that as the spot price of the underlying stock decreases, there is a corresponding decrease in the call price of the stock, the same is reflected in the chart. This clearly shows a direct relationship between the spot price and the call premium, i.e, as the spot price of the underlying stock decreases the call premium also decreases. Hence it can be interpreted that, all other pricing factors remaining constant in a bearish market. As the price of the underlying stock decreases, call premium values decreases Table 4.2: Type: Put
Date 27-Feb-08 28-Feb-08 29-Feb-08 3-Mar-08 4-Mar-08 5-Mar-08 7-Mar-08 10-Mar-08 11-Mar-08 12-Mar-08 13-Mar-08 14-Mar-08 17-Mar-08 18-Mar-08 19-Mar-08 24-Mar-08 25-Mar-08 26-Mar-08 27-Mar-08

Stock: RNRL
Put Premium(Rs) 41.1 41.1 10 11.05 12.75 11.65 20.85 17.6 12.35 10.95 21.2 15.4 21.5 18 20.9 24.25 20 19.05 20

Strike: Rs 120
Spot (Rs) 134.75 133.95 132.9 124.75 119.85 120.25 106.65 107.8 116.1 117.15 103.75 108.3 101 101.25 99.9 95.9 102.25 99.8 100.15

Source: www.nseindia.com Figure 4.2: Chart showing the relationship between put premium and spot price

32

Interpretation The chart 4.2 shows the relationship between the spot price in a bearish market and the movement of the put option premium. As we can see that the market till February 29th, 2008 the underlying stock (Rs 132.9) was stable and the put premium was Rs 10. The next trading day of March 3 rd the stock price closed at Rs 124.75, a decrease of nearly Rs 8 than the previous closing. Correspondingly we can observe that there is an increase in the put premium of the option, which increased by Rs 1. On March 4th the stock price further decreased by nearly Rs 5, increasing the put price by Rs 1.7 to Rs 12.75. The stock price further decreased to Rs 106.65 on March 7th correspondingly increasing the put price by Rs 9.20, closing at Rs20.85. We can observe from the table 4.2 that as the spot price of the underlying stock decreases, there is a corresponding increase in the put price of the stock, the same is reflected in the chart We can observe that on 24th March, as the stock price was at the lowest and the put premium was Rs 24.25 showing an increase of Rs 10.45 from that of Feb 29th. This clearly shows a direct relationship between the spot price and the put premium, i.e. as the spot price of the underlying stock decreases the put premium increases. Hence it can be interpreted that, all

33

other pricing factors remaining constant in a bearish market. As the price of the underlying stock decreases, put prices increases

Table: 4.3
Date 10-Oct-07 11-Oct-07 12-Oct-07 15-Oct-07 16-Oct-07 17-Oct-07 18-Oct-07 19-Oct-07 22-Oct-07 23-Oct-07 24-Oct-07 25-Oct-07 26-Oct-07 29-Oct-07 30-Oct-07 31-Oct-07 1-Nov-07 2-Nov-07 5-Nov-07 6-Nov-07 7-Nov-07 8-Nov-07 9-Nov-07 12-Nov-07 13-Nov-07 14-Nov-07 15-Nov-07 16-Nov-07 19-Nov-07 20-Nov-07 21-Nov-07 22-Nov-07 23-Nov-07

Type: Call
Call Premium 22.35 22.35 7 7 6.5 5.9 7.85 6.05 4.55 5.9 6.65 5.7 7.15 12.45 14.8 16.8 23.3 36.65 71.95 52.9 44.25 48.5 48.5 43 59.35 58.55 63.85 59 59 57.5 39.85 38.6 49.5

Stock: RNRL

Strike: 110
Spot price 92.2 93.4 92.35 96.1 95.9 97.4 94 87.95 86.8 94.3 96.45 94.25 99.35 110.1 115.55 119.95 129.9 141.9 179.3 161.9 151.25 152.9 152.25 147.8 164.55 169.05 166.1 167.4 169.4 165.95 149.6 148 158.2

Source: www.nseindia.com

34

Figure 4.3: Chart showing the relationship between call premium and spot price in a bullish market

Interpretation The chart 4.3 shows the relationship between the spot price in a bullish market and the movement of the call option premium. We can observe that up to 18th October 2007, the underlying stock (Rs 94) was performing consistently and the call premium was Rs 7.85. We can observe that the stock price from 23rd October showed a bullish trend i.e. the stock price increased proportionately. We can see that on October 25th stock price was Rs 94.25 and the call premium was Rs 5.7, on the next trading day the stock price rose to Rs 99.35 an increase of Rs.5.10, resulting an increase in the call premium to Rs 7.15 a change of Rs 2.05, and on 29th October when the stock price raised to Rs 110.5 the call premium also raised to Rs 12.45, an of Rs 5.35 and on 5th November the stock price raised to Rs 179.3 the call premium increased by almost Rs 35 to Rs 71.95.The similar relationship we can observe in the remaining stock prices also. Hence it can be interpreted that, all other pricing factors remaining constant in a bullish market. As the price of the underlying stock increases, call prices increase Table 4.5: Type: Put Stock: RNRL Strike price: Rs 110

35

Date 16-Oct-07 17-Oct-07 18-Oct-07 19-Oct-07 22-Oct-07 23-Oct-07 24-Oct-07 25-Oct-07 26-Oct-07 29-Oct-07 30-Oct-07 31-Oct-07 1-Nov-07 2-Nov-07 5-Nov-07 6-Nov-07 7-Nov-07 8-Nov-07 9-Nov-07 12-Nov-07 13-Nov-07 14-Nov-07 15-Nov-07 16-Nov-07 19-Nov-07 20-Nov-07 21-Nov-07 22-Nov-07 23-Nov-07 26-Nov-07 27-Nov-07 28-Nov-07 29-Nov-07

Put premium(Rs) 30.3 30.3 11 11 11 11 11 13.6 10.2 6.7 4.5 3.2 2.2 1.6 0.85 2.05 2.4 2.15 2.65 1.95 1.25 0.95 0.9 0.7 0.55 0.5 0.5 0.4 0.2 0.15 0.1 0.05 0.05

Spot price (Rs) 95.9 97.4 94 87.95 86.8 94.3 96.45 94.25 99.35 110.1 115.55 119.95 129.9 141.9 179.3 161.9 151.25 152.9 152.25 147.8 164.55 169.05 166.1 167.4 169.4 165.95 149.6 148 158.2 157.55 153.55 156.45 152.75

Source: www.nseindia.com

Figure 4.4: Chart showing the relationship between put premium and spot price in bullish market 36

Interpretation The graph 4.4 shows the relationship between the spot price in a bullish market and the movement of the put option premium. We can observe that up to 18th October 2007, the underlying stock was performing consistently and the call premium was Rs 7. We can observe that the stock price from 23 rd October showed a bullish trend i.e. the stock price increased proportionately. We can see that on October 23rd the stock price was Rs. 94.25 and the corresponding put price was Rs 11. On 29th October when the stock price raised to Rs 110.5 an increase of Rs 1.75, the put premium has gone down to Rs 6.75, as decrease of Rs 4.5 from the previous closing. On 5th November the stock price raised to Rs 179.3 an increase of Rs 37.4 from the previous closing price, we can observe that put premium has gone down to Rs 0.85, decreasing almost 0.85 from the previous closing. The similar relationship we can observe in the remaining stock prices also. Whenever there is an increase in the stock price, there is a decrease in the put premium values and the same is reflected in the chart. Hence it can be interpreted that, all other pricing factors remaining constant in a bullish market. As the price of the underlying stock increases, put prices increase FACTOR 2: STRIKE PRICE

37

Unlike other pricing factors, an options strike price cannot change during its lifetime. It is one of the standardized terms of any equity option contract. However, it can effect on an options price because it determines at any specific time whether the contract is in-, at- or out-of-the-money compared to underlying stock price, and therefore the options possible intrinsic value. Let us analyse how this affects. Here we are assuming all other pricing factors as constant. Here in this case we have randomly chose a date and noted down the prices of options of different strike prices of ICICI Bank. Table 4.5 Stock: ICICIBANK Date: 20 Feb 2008

Strike price(Rs) 1080 1110 1140 1170 1200 1230 1260 1290 1320 1350 1380

Call Premium(Rs) 192..35 175..95 185..3 185.4 169.15 153.95 139..85 126..75 114..65 103..5 103..8

Source: www.nseindia.com Figure 4.5: Chart showing relationship between strike prices and call premium value

Interpretation

38

In the table 4.5 we can observe that on 20th February 2008, different strike prices of ICICIBANK have different call premium values. Furthermore we can observe that lower strike prices have higher call premium values (E=Rs 1080, C=Rs 192.35) and the higher strike price have lower call premium values (E=Rs1380, C=Rs103.8). As the strike price of the underlying was increasing the call premiums were showing inverse relation to these strike prices. Hence it can be interpreted that as the strike price of the underlying increases the corresponding call premium values decreases. Table 4.6 Stock: ICICIBANK Date: 20 Feb. 2008

Strike price(Rs) 1080 1110 1140 1170 1200 1230 1260 1290 1320 1350 1380

Put Premium(Rs) 83.1 96.25 74.55 83.2 96.25 110.45 125.65 141.95 159.2 177.4 221.1

Source: www.nseindia.com Figure 4.6: chart showing relationship between strike prices and put premium value

Interpretation

39

In the table 4.6 we can observe that on 20th February 2008, different strike prices of ICICIBANK have different put premium values. Furthermore we can observe that lower strike prices have lower put premium values (E=Rs 1080, P=Rs 83.1) and the higher strike price have higher call premium values (E=Rs1380, C=Rs 221.1). As the strike price of the underlying was increasing the put premiums were showing direct proportionality to these strike prices. Hence it can be interpreted that as the strike price of the underlying stock increases the corresponding put premium values also increases. From the above observations it can be inferred under the condition that all other pricing factors remaining constant, in general: With each incrementally higher strike price for a specific class of options, call prices decrease and put prices increase.

With each incrementally lower strike price for a specific class of options, call prices increase and put prices decrease.

FACTOR 3: TIME REMAINING TO EXPIRATION

40

Exchange-listed equity call and put options are eroding assets. If they are not either sold or exercised before they expire they become worthless. Their owners will no longer have a right to buy or sell underlying shares, and option writers no longer have an obligation to sell or buy shares.

Table 4.9

Type: Call

Stock: ICICIBANK
Days remaining for expiration 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0

Strike: Rs 1020
Call Premiums(Rs) 193.65 193.65 193.65 94.95 94.95 65.25 40.95 29.7 12.7 8.5 8.05 8.3 4.75 3.65 1.3 2 0.6 0.9 0.5 0.5 0.5

Date 26-Feb-08 27-Feb-08 28-Feb-08 29-Feb-08 29-Feb-08 3-Mar-08 4-Mar-08 5-Mar-08 7-Mar-08 10-Mar-08 11-Mar-08 12-Mar-08 13-Mar-08 14-Mar-08 17-Mar-08 18-Mar-08 19-Mar-08 24-Mar-08 25-Mar-08 26-Mar-08 27-Mar-08

Source: www.nseindia.com

Figure 4.7: Relationship between call premiums and time of expiration

41

Interpretation Figure 4.7 gives a relationship between the call premiums and the time remaining for the expiration. We took a 90 days option contract expiring on 27th March 2008. On February 26th, a total of 20 days were remaining for the expiry of the contract and the call premium was Rs.193.65. As the time nears for the expiry from 29th February the call premium values started decreasing and finally became the lowest when there is one day left to Rs 0.5. This shows that as the time for expiration nears the call premium also decreases for any strike prices.

Table: 4.7

Type: Put

Stock: ICICIBANK

Strike: Rs 1020 42

Date 26-Feb-08 27-Feb-08 28-Feb-08 29-Feb-08 29-Feb-08 3-Mar-08 4-Mar-08 5-Mar-08 7-Mar-08 10-Mar-08 11-Mar-08 12-Mar-08 13-Mar-08 14-Mar-08 17-Mar-08 18-Mar-08 19-Mar-08 24-Mar-08 25-Mar-08 26-Mar-08 27-Mar-08

Days remaining for expiration 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0

Put premium(Rs) 73.65 73.65 30 35 35 68 113 65 128.25 153 153 153 153 153 255 250.1 250.1 250.1 250.1 250.1 250.1

Source: www.nseindia.com Figure 4.7: Relationship between put premiums and time to expiration of option contract

Interpretation

43

Figure 4.8 gives a relationship between the put premiums and the time remaining for the expiration. We took the same option contract expiring on 27th March 2008. On February 26th, a total of 20 days were remaining for the expiry of the contract and the put premium was Rs 73.65. As the time nears for the expiry from 29 th February the call premium values started increasing and finally became the lowest when there is one day left to Rs 0.5. This shows that as the time for expiration nears the put premium also increases for any strike prices.

From the above observation we can infer that keeping other pricing factors as constant

With longer time periods before expiration, both call and put prices will be larger. As expiration approaches, both call and put prices will decrease.

FACTOR 4: VOLATILITY

44

Volatility has been one of the most important factors in determining the price of an option. Here there are two types of volatilities used in the market. One approach to this is the calculation of the traditional or the historical volatility, which gives the movement of stock based on the past data. Another is implied volatility which gives the movement of the current stock price i.e., based on the current market price and its movements. As all the call premiums are based upon the implied volatility we are calculating the implied volatility based on the call premiums traded between 25th February 2008 and 14th March 2008. For this study the implied volatility for a stock is calculated by the equation proposed by Corrado and Miller. The volatility calculated is as follows Calculation of the implied volatility using Corrado and Miller equation. Volatility is a factor which is very difficult to measure. However the implied volatility can be measured which gives the volatility of currently trading stock and every investor is interested in this type of volatility rather than the historical volatility. Corrado and Miller equation gives values nearly correct over a reasonable range of moneyness of the option and the equation is as follows.

= 1 x (2 ) x C - S - E er t t S + E er t 2

+ (C - S - E er t )2 -- (S - E er t )2 2

S = Spot price of the underlying stock E = Exercise or the strike price C = call premium t = time remaining for expiry in years r = risk free rate of return of the stock For calculating the implied volatility we took the closing call premium values and closing stock price of the underlying security from www.nseindia.com. Let us work out with an example.

On 25th February 2008, the closing stock price of the underlying security (IFCI) was Rs 63.6 and the call was last traded at Rs 8.5. We assumed the risk free 45

rate of return as 8% and the time remaining for the expiration (27 th March 2008) is 31 days or 0.085 years. The strike price selected is Rs 60. So we have the following data S = 63.6 E = 60 C = 8.5 r = 0.08 t = 0.85 years = 3.14 We substitute the above values in the Corrado and Miller equation to calculate the implied volatility for the day

= 1 x (2*3.14 ) x 8.5 - 63.6 - 60 er t )2 0.085 63.6 + 60 er t 2

+ ( 8.5 - 63.6 - 60 er t )2 -- (63.6 - 60 er t 2 3.14

= 86% We got the implied volatility to be 86% for that day. Similarly using the same procedure implied volatilities for the next days is calculated till the volatility reached a maximum of 100%. We got the following implied volatilities.

Table: 4.8
Date

Stock: IFCI
Call premium (Rs.)

Strike: Rs 60
Spot price (Rs) (%)

Put premium (Rs.)

46

25-Feb-08 26-Feb-08 27-Feb-08 28-Feb-08 29-Feb-08 3-Mar-08 4-Mar-08 5-Mar-08 7-Mar-08 10-Mar-08 11-Mar-08 12-Mar-08 13-Mar-08 14-Mar-08

8.5 8.3 8.55 6.95 9.55 5.95 6.55 3.9 1.9 2 2.25 1.55 0.95 1.15

4.95 4.7 4.4 4.2 2.9 5 5.2 6 9.75 10 7 5.8 12 10.5

63.6 63.3 63.75 62.45 67.05 61.3 58.15 57.4 51.8 52.3 54.75 54.5 48.7 49.9

86 81 89 79 71 82 88 86 94 100 90 78 100 100

Source: www.nseindia.com

Figure 4.8 chart showing the relationship between volatility and the option premiums
120 100 80 V 60 40 20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 C P

Interpretation

47

From table 4.8 we can see that the premium values are not constant for a particular volatility. Though it may look confusing we can observe that, for each higher value of volatility, the premium values are higher comparatively. When the call premium is Rs 8.5 and put premium Rs 4.95 on 25th February 2008, the volatility was 86%. The next day we can see that there is a slight decrease in the volatility which came down to 81%, we can observe that the values of the call and put premium also goes down. Similarly on March 7th the volatility was 94% and the option was traded at Rs 1.9 for a call and Rs 9.75 for a put, the next day the volatility rose to 100% equally increasing the call and put prices Volatility is the single factor which is not constant and its the implied volatility which always gives the investor about the movement of the stock in the market. Though we may not see a regular relationship between the option premiums and the volatilities, we can interpret from the data in hand that, every higher value of volatility increases the option premium vice versa. The higher the volatility of an underlying stock, the greater the likelihood its price can change to move a call or put option in-the-money (or further in-the-money) or, on the other hand, out-of-the-money (or more out-of-the-money). From the above observation we can infer that keeping other pricing factors as constant

As the volatility of the underlying stock increases, both call and put prices increase. As the volatility of the underlying stock decreases, both call and put prices decrease.

APPLYING BLACK SCHOLES EQUATION IN REAL WORLD

48

As we all know that Black-Scholes model is widely used to price the options under assumptions. Let us see how this is used in the real world. Here we have practically calculated the historical volatility by using the historical stock prices. Standard deviation of the historical closing prices multiplied by the yearly factor gives us the volatility of the underlying stock. Once this volatility is estimated, it can be substituted in the Black-Scholes equation to get the premium values. Now let us see the live example. Here we have calculated the historical volatility () of ICICIBANK stock to calculate the corresponding call and put premium values. A contract expiring on 27th March 2008 is taken, and the strike price is Rs. 990. The historical volatility is the annualized volatility of the stock which is calculated by the following procedure. Step 1: In the first step Price Relative for each day using a fraction of years historical 90 days data is calculated. The price relative for a day is the ratio of days closing price to the closing price of the previous day. Step 2: The second step involves finding out the natural logarithms of the price relatives which gives the continuously compounded rate of return per day. The calculations are shown in the following table. The table illustrates the calculation of historical volatility of ICICIBANK stock on February 29th, 2008. For this calculation the 90 days closing price of the stock is taken. Table: 4.9: calculation of historical volatility
DAYS 1 2 3 4 5 6 7 8 9 10 11 12 13 CLOSING PRICE 1102 1099.9 1144.65 1187.5 1240.65 1240.2 1254.05 1298.3 1333.4 1269.85 1241.8 1200.8 1169.05 0.998094374 1.040685517 1.037435024 1.044757895 0.999637287 1.011167554 1.035285674 1.027035354 0.952339883 0.977910777 0.966983411 0.973559294 -0.001907444 0.039879647 0.036751344 0.043785179 -0.000362779 0.011105657 0.034677403 0.026676355 -0.048833288 -0.022336843 -0.033573939 -0.026796548 -0.002058849 0.039728242 0.036599938 0.043633774 -0.000514184 0.010954252 0.034525998 0.02652495 -0.048984693 -0.022488248 -0.033725344 -0.026947953 0.0000423886 0.001578333 0.001339555 0.001903906 0.000119996 0.000119996 0.001192045 0.000703573 0.0023995 0.000505721 0.001137399 0.000726192 PRICE RELATIVE=X LN=X DEVIATION=X- (X-)2

49

14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67

1144.45 1145.35 1173.7 1278.55 1241.65 1220.05 1187.7 1160.45 1106.45 1145.35 1139.4 1156.8 1132.3 1122.9 1161.75 1178.4 1162 1139.7 1164.05 1200.7 1247.6 1271.45 1314.3 1289.9 1242.85 1206.95 1166.25 1137.7 1163.4 1157.5 1205.95 1218.9 1247.25 1226.7 1238.7 1228.75 1267.25 1228.95 1286.3 1362.55 1339.95 1307.95 1356.15 1435 1410 1352.2 1368.3 1322.1 1248.85 1173.2 1124.95 1151.45 1131.85 1261.3

0.978957273 1.000786404 1.024752259 1.089332879 0.971139181 0.982603793 0.973484693 0.977056496 0.953466328 1.035157486 0.994805081 1.015271195 0.978820885 0.991698313 1.034597916 1.014331827 0.986082824 0.98080895 1.021365272 1.031484902 1.039060548 1.019116704 1.033701679 0.981434984 0.963524304 0.971114777 0.966278636 0.975519829 1.022589435 0.994928657 1.041857451 1.010738422 1.023258676 0.983523752 1.009782343 0.991967385 1.031332655 0.969777076 1.046665853 1.059278551 0.983413453 0.976118512 1.036851562 1.058142536 0.982578397 0.959007092 1.011906523 0.966235475 0.944595719 0.93942427 0.958873167 1.023556603 0.982977984 1.114370279

-0.021267281 0.000786095 0.024450885 0.085565471 -0.029285483 -0.017549299 -0.026873178 -0.023210803 -0.047651169 0.034553575 -0.005208459 0.015155764 -0.02140661 -0.008336338 0.034012864 0.014230097 -0.014014928 -0.019377589 0.021140234 0.030999416 0.038316986 0.018936276 0.033146223 -0.018739509 -0.037157567 -0.029310613 -0.034303043 -0.024784793 0.022338072 -0.005084246 0.041005131 0.010681175 0.022992315 -0.016613491 0.009734806 -0.00806505 0.030851806 -0.030689052 0.045609734 0.057588064 -0.016725644 -0.024171274 0.036188777 0.056515046 -0.017575145 -0.041856809 0.011836198 -0.034347712 -0.056998254 -0.06248807 -0.041996468 0.023283427 -0.017168556 0.108289473

-0.021418686 0.00063469 0.02429948 0.085414066 -0.029436888 -0.017700704 -0.027024583 -0.023362208 -0.047802574 0.03440217 -0.005359864 0.015004359 -0.021558015 -0.008487743 0.033861459 0.014078692 -0.014166333 -0.019528994 0.020988829 0.030848011 0.038165581 0.018784871 0.032994818 -0.018890914 -0.037308972 -0.029462018 -0.034454448 -0.024936198 0.022186667 -0.005235651 0.040853726 0.01052977 0.02284091 -0.016764896 0.009583401 -0.008216455 0.030700401 -0.030840457 0.045458329 0.057436659 -0.016877049 -0.024322679 0.036037372 0.056363641 -0.01772655 -0.042008214 0.011684793 -0.034499117 -0.057149659 -0.062639475 -0.042147873 0.023132022 -0.017319961 0.108138068

0.00045876 0.0000402831 0.000590465 0.007295563 0.00086653 0.000313315 0.000730328 0.000545793 0.002285086 0.001183509 0.0000287281 0.000225131 0.000464748 0.0000720418 0.001146598 0.00019821 0.000200685 0.000381382 0.000440531 0.0009516 0.001456612 0.000352871 0.001088658 0.000356867 0.001391959 0.000868011 0.001187109 0.000621814 0.000492248 0.000027412 0.001669027 0.000110876 0.000521707 0.000281062 0.0000918416 0.0000675101 0.000942515 0.000951134 0.00206646 0.00329897 0.000284835 0.000591593 0.001298692 0.00317686 0.000314231 0.00176469 0.000136534 0.001190189 0.003266083 0.003923704 0.001776443 0.00053509 0.000299981 0.011693842

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68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90

1273.95 1220.45 1187.4 1147 1198.15 1212.25 1191.3 1152.05 1106.1 1073.9 1033.85 1067.25 1101.8 1161.85 1190.9 1209.8 1220.2 1168.3 1141.3 1099.8 1107.1 1117.85 1116.95

1.010029335 0.958004631 0.972919825 0.965976082 1.044594595 1.011768143 0.982718086 0.967052799 0.960114578 0.970888708 0.962706025 1.032306427 1.032372921 1.054501724 1.025003228 1.01587035 1.008596462 0.957465989 0.976889498 0.963637957 1.00663757 1.009710053 0.999194883 SUM=X MEAN=

0.009979375 -0.042902667 -0.0274536 -0.034616205 0.043628862 0.011699436 -0.017432989 -0.033502184 -0.040702649 -0.029543433 -0.038007184 0.031795549 0.031859959 0.053068356 0.024695761 0.015745733 0.008559723 -0.043465079 -0.023381737 -0.037039618 0.006615639 0.009663214 -0.000805441 0.013475046 0.000151405

0.00982797 -0.043054072 -0.027605005 -0.03476761 0.043477457 0.011548031 -0.017584394 -0.033653589 -0.040854054 -0.029694838 -0.038158589 0.031644144 0.031708554 0.052916951 0.024544356 0.015594328 0.008408318 -0.043616484 -0.023533142 -0.037191023 0.006464234 0.009511809 -0.000956846 SUM (DEV)2 SUM (DEV)2/n SD 252 Annualized

0.000096589 0.001853653 0.000762036 0.001208787 0.001890289 0.000133357 0.000309211 0.001132564 0.001669054 0.000881783 0.001456078 0.001001352 0.001005432 0.002800204 0.000602425 0.000243183 7.06998E-05 0.001902398 0.000553809 0.001383172 0.0000417863 0.0000904745 0.0000091555 0.076202723 0.000815761 0.028561529 15.87450787 0.453400217

Calculating the mean rate of return,

X n

0.013475046 89

= 0.000151405

The next step involves the calculation of the deviations and the standard deviation The following rule is used to calculate the standard deviation

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 = (X ) 2 n = 0.076202723 89 = 0.028561529

Annualized volatility = 252 = 0.028561529 x 15.87450787 = 0.453400217

Annualized volatility = 45.34%

Hence the historical volatility of ICICIBANK stock on February 29th, 2008, is calculated as 45.34%. Similarly the historical volatility for next few days is calculated following the above procedure and is tabulated in the table as . Now that we have obtained the values of the historical volatility, we can calculate the call and put prices using the Black-Scholes equation.

As we know that the historical volatility on February 29, 2008, is 45.34%, we have calculated the call and put premium of the underlying stock for that date, which is as follows. February 29, 2008 = 45.34 Expiry date: March 27, 2008 E = 990

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S = 1088.5 r = 8%

T = 0.077 years

d1 =

ln (S/E) + (r + 0.5 2) T T

d1 =

ln (1088.5/990) + (0.08 + 0.5* 0.453 * 0.453) 0.077 0.45300 0.077

d1 =

ln (1.099) + (0.08 + 0.102) 0.077 0.1257

d1 =

0.0944 + 0.014 0.1257

d1 = d2 = d1 T

0.8623

d2 = 0.8623 0.1257 d2 = 0.7366

d1 = d2 = N (d1) = 0.5 + 0.3051 N (d2) = 0.5 + 0.2673

0.8623 0.7366 N (-d1) = 0.5 - 0.3051 N (-d2) = 0.5 - 0.2673

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Calculating the call premium

C = SN (d1) E e r T N (d2)

S=1088.5 N (d1) = 0.8051 N (-d1) = 01949

E= 990

T= 0.077

rT=0.006

N (d2) = 0.7673

e= 2.7183

C = 1088.5* 0.8051 990* 2.71830.006 * 0.7673 C = 876.35 990*0.995*0.7673 C = 876.35 755.82 C = 120.52

Calculating the put premium P = E e r t N (d2) SN (d1)

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Here

N (-d1) = 0.1949

N (-d2) = 0.2327

P = 990*0.995*0.2327 1088.5*0.1949 P = 229.22 212.14 P = 17.08

These are the estimated call and put premiums for February 29, 2008, for a stock option of ICICIBANK which expires on March 27, 2008. Using the same procedure, other values of call and put premiums are estimated for the same expiry date. These values are tabulated in the table 4.10 below.

Estimated Table: 4.10: Estimated volatility, call, and put premiums

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Date

Stock price

Time for expiry (years) 0.077 0.066 0.063 0.061 0.055 0.047 0.044 0.041 0.038 0.035 0.027 0.025 0.022 0.008 0.005 0.002

(%) 45.34 48.29 49.88 46.89 50.48 50.60 50.16 50.35 51.48 52.48 52.46 50.80 66.77 59.64 57.4 62.23

Call (Rs) 120.5 44.1 42.19 12.06 8.48 4.74 6.929 2.10 5.48 0.009 0.022 0.23 0.24 0.018 0.001 0

Put (Rs) 17.08 57.8 67.11 103.84 122.28 134.37 113.15 151.31 115.31 227.38 219.68 220.06 186.30 110.38 145.65 155.29

29-Feb 3-Mar 4-Mar 5-Mar 7-Mar 10-Mar 11-Mar 12-Mar 13-Mar 14-Mar 17-Mar 18-Mar 19-Mar 24-Mar 25-Mar 26-Mar

1088.5 971.10 960.15 893.4 871.85 856.65 880.3 837.55 876.95 759.95 768.2 768.2 802.2 878.85 843.95 834.55

Observed Table: 4.11: Observed call and put premium values Date Stock price Time for expiry 29-Feb 3-Mar 4-Mar 5-Mar 1088.5 971.10 960.15 893.4 (years) 0.077 0.066 0.063 0.061 (Rs) 110 110 88.15 52.15 30 45 73 70 (Rs) Call Put

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7-Mar 871.85 10-Mar 856.65 11-Mar 880.3 12-Mar 837.55 13-Mar 876.95 14-Mar 759.95 17-Mar 768.2 18-Mar 768.2 19-Mar 802.2 24-Mar 878.85 25-Mar 843.95 26-Mar 834.55 Source: www.nseindia.com

0.055 0.047 0.044 0.041 0.038 0.035 0.027 0.025 0.022 0.008 0.005 0.002

42.15 52.15 42.3 17.1 10.05 11.1 10 5.4 5 3.3 0.65 0.45

138 129.5 130.5 132.2 156.4 219.45 220.15 189.61 214.21 220 220 220

It can be observed that the estimated values and the observed are not matching instead the shows much variation. Now the question is how long this model of option pricing is valid in pricing of options? Can the investors believe this model to calculate the option prices? These two questions disturb an investor and keep him away from the markets. But this is rarely happening in the market.

Now let us observe two important implications of Black-Scholes model which can be responsible for these discrepancies in the premium values. Assumption 1: The interest rates are constant and are known The Black and Scholes model uses the risk-free rate to represent this constant and known rate. But in reality it is very difficult to know the exact rate of return of a stock and it is not a constant. We assumed in our calculation it to be 8 % which is a constant government bonds risk free rate. This might had a significant affect on the values. Assumption 2: Returns are log normally distributed Black-Scholes assumes that the returns are distributed log normally. This could be one of the significant assumptions which can be taken as the limitation. In reality the

57

stock prices do not follow a strict stationary lognormal process. This may result in change of variances which reflects the volatility factor.

Inference Results using the BlackScholes model differ from real world prices which may be attributed to the simplifying assumptions of the model. One significant limitation is that in reality security prices do not follow a strict stationary log-normal process. All the parameters in the model other than the volatility the time to maturity, the strike price, the risk-free rate, and the current underlying price are unequivocally observable. Furthermore, under normal circumstances the option's theoretical value is a monotonic increasing function of the volatility. This means there is a one-to-one relationship between the option price and the volatility. By computing the implied volatility for traded options with different strikes and maturities, we can test the Black-Scholes model.

INVESTORS PERCEPTION TOWARDS DERIVATIVES

To evaluate the perception of investors towards the derivatives market a survey was conducted for the investors. A questionnaire was administrated to a sample of 50 investors. The following are the observations drawn from the responses. 1. what is your annual income? (in lakhs of Rupees) <2 8 23 12 34 17 45 12 >5 1

58

>5 2% 45 24%

<2 16%

23 24%

34 34%

The annual income of 24% of the investors ranged between Rs.200000 to Rs.300000, 16% of the investors income is less than Rs 200000, 34% of the investors are in the range of Rs 300000 to Rs 400000, and 24% of the respondents come under the range of Rs 400000 to Rs 500000 and 2% are above Rs 500000.

2. What are your annual savings? (In Rupees) a) 0 50000 b) 50000 100000 c) 100000 - 150000

d) 150000 200000 e) Above 200000 Only 11 investors have responded to this question regarding their savings. And rest of the investors doesnt want to disclose their savings. The investors who have responded to this question were also not given exact figure. Of the 11 respondents, 7 investors disclosed the range as Rs.50000 to Rs.100000 and rest of them are in a range of Rs 100000 to Rs 150000.

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3. What are your investment preference areas? a) Bank deposits Shares 52% b) Mutual Funds Mutual funds 28% Gold 8% c) Shares d) Real Estate e) Gold

Others(Real estate and Bank deposits) 12%

Others 12% Gold 8% Shares 52% Mutual funds 28%

According to the responses given 52% of the respondents prefer to invest their savings in shares and 28% in mutual funds. It implies nearly 80% of the investors prefer stock market. Whereas only 8% investors prefer bullion market. 12% of the investors prefer investing as bank deposits and real estate

4. What is your investment objective? Capital appreciation 8 Periodic returns 6 Short term gains 36

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Capital appreciatio n 16% Periodic returns 12%

Short term gains 72%

According to the responses given by the investors it is observed that 72% of the people invest with an objective of short term gain, 16% of then have an investment objective of capital appreciation and only 12% invest to get periodic returns

5. Who plays major role in your investment decisions? Financial advisors 7 Media 29 Friends 6 Relatives 0 Myself 8

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Myself 16% Relatives 0% Friends 12%

Financial advisors 14%

Media 58%

Media has major impact on the investment decision of the investors. 58% of the people rely on the information given by the media for decision making regarding the investment. 14% of the people go with the decision of the brokers. 16% of the investors make their decisions on their own based upon their feel about a particular stock. Nearly 12% of people seek help from their friends while making investment decisions

6. Why do you invest in shares? Higher liquidity Higher return Security Speculation

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12

27

Speculation 16% Security 6%

Higher liquidity 24%

Higher return 54%

Higher returns in stock markets have attracted so many people to invest in it. 54% of the respondents have invested in shares because of the higher returns from shares. 16% of respondents invest in shares to speculate in stock market. Only 24% investors have invested because of high liquidity in shares. And 6% consider it for security.

7. In stock markets, which sector you prefer to invest? a) Banking b) Infrastructure c) IT d) Pharma e) Others____________

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Banking 31

Infrastructure 27

IT 23

Others 19

Others 19%

Banking 31%

IT 23% Infrastructur e 27%

This question has got more than one options in reply. Accordingly they are classified and plotted. Of the given options banking sector stood ahead with 31% of investors preferring to invest in this sector. 27% prefer investing in infrastructure stocks, 23% in IT and 19% in others which include pharma, energy, and FMCG sectors

8. What type of Derivatives you prefer?

64

Futures & Options 97%

Others 3%

Others 3%

F&O 97%

Even this question has 4 options but based on the majority it has been consolidate to two major segments. 97% investors prefer Future and Options as powerful instruments for managing risk. Other derivatives include only 3% and are more common in institutional investors

9. What type of Derivatives strategy you follow the most?

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Speculative 8

Hedging 15

Arbitraging 27

Speculative 16%

Arbitraging 54%

Hedging 30%

This is a very important question and many conclusions can be drawn from this. It was observed that arbitraging strategy still holds the strongest strategy used by the investors as much as 54% of the investors go with it, 30% of the investors go for hedging which is also risk aversing and 16% of the investors go with the speculative strategy.

11. Trading in Derivatives involves more risk when compared to equities.

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Yes 21

No 29

Yes 42% No 58%

Here we can observe that 42% of the respondents feel that derivatives involve more risk when compared to equities whereas 58% of the respondents feel that derivatives involve less risk compared to equities.

12. Do you think that Derivatives are more complex and provide low liquidity when compared to equities?

67

Yes 36

No 14

No 28%

Yes 72%

72% of the people feel that the liquidity in derivatives is very less when compared to equity market.

CHAPTER 5 FINDINGS AND SUGGESTIONS

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FINDINGS The following are the findings made by analyzing the various quantifiable factors: 1) Price of the underlying stock In a bearish market as the stock price decreased the call premium decreased and the put premium increased. In a bullish market as the stock price increased the call premium increased and the put premium decreased. 2) Strike price An increase in the strike price of a stock resulted the call premium values to decrease and the put premium increases. 3) Time remaining to expiration More time remaining for the expiration of an option have higher call premium and lower put premium. As the time for expiration decreases the call premium values decreases and the put premium increases. 4) Volatility It is found that as the volatility of the underlying stock increases both the call and put premiums increased. As the volatility of the stock decreased there was a decrease in the call and put premiums.

It is found that there is a difference in the estimated and observed option prices when calculated by using the Black-Scholes model.

69

 It is found that 60% of the investors, who invest in derivatives, belong to high income category that is between Rs 3 lakhs and Rs 5 lakhs; showing that derivatives are affordable to only one segment of investors.

It is observed that most of the investors use futures and options of several derivatives types.

Many of the investors feel that derivatives are complex and have low liquidity.

It found that a majority of 52% of the investors fell that the derivatives involve low risk.

SUGGESTIONS

70

 The prices of the options are influenced by various parameters like stock price, volatility, time for expiration, strike price. An investor must observe these factors to get more returns.

The pricing estimated by using the Black-Scholes model are not in accordance with the prices observed in real time. This is due to the historical volatility which used in this model does not produce the actual price. Implied volatility which gives the volatility of current stock prices must be considered for calculating the option prices.

60% of the investors belong to high income category. It shows that derivatives are affordable to only one segment of investors. Flexibility is required in this regard so that it is affordable to every type of income group.

As is observed that most of the investors use futures and options of different derivatives types, an attempt was made to know why they dont prefer derivatives other than F&O., it was found that the investors have very less knowledge as they dont have proper awareness regarding these derivative types.

The demand for derivatives is growing tremendously but still 72% investors feel that derivatives are complex and have low liquidity. This misconception is creating a threat to the derivative segment. A proper awareness must be created in this regard.

71

 One of the important finding of this study is that a majority of 52% of the investors fell that the derivatives involve low risk. This removes the myth that derivatives involve high risk.

72

CONCLUSION
As now it is clear that for individual investors, setting reasonable expectations for the price behavior of their option positions reduces surprises in the marketplace; understanding the singular effects of the option pricing factors, helps to do so. But the market is not a simple environment, as all these factors are in play constantly. Getting familiar with option pricing model and its use would be good practice for getting a clearer picture of the dynamic effects of the many pricing factors at once. Before an investor commits his investment to the purchase or sale of an equity option contract he must test his expectations in advance. He must be aware of how changing stock price, passage of time and volatility can possibly affect the options prices at various points in the future. Understanding both ends of the spectrum, positive situations as well as negative ones will help one to evaluate the risk in advance, especially the risk before option expiration.

As options expire they are worth only their intrinsic value if they are in-themoney and have any. As valuable a tool as pricing models are in predicting option values before expiration, individual investors should ultimately be concerned with the potential risk vs. reward of any option position as it expires. Understanding the financial effects of exercise and assignment is a key. Financial derivatives, has gained a lot of importance from the past decade. Though there are many investors investing in the derivatives to avoid their risk, many of them are less aware of the few facts which may help them to gain more profits. This gives an area to educate the investors with various pros and cons related to the investing in the derivates instruments and eliminating the common myths associated with it. Removing these myths would result in more demand for the derivatives market, introducing new investors and helping the existing investors to gain more profits.

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BIBLIOGRAPHY
BOOKS

N.D.Vohra & B.R.Bagri, Futures and Options, 2/e, Tata McGraw Hills Publications, 2004. I.M.Pandey, Financial Management, 9/e, Vikas Publishing, 2004.

WEBSITES

www.nseindia.com www.cboe.com http://www.888options.com/classes/syllabus_options_pricing.jsp http://www.sibson.com/publications/perspectives/Volume_11_Issue_1/e_article00013 7189.cfm

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