Sapm all chapters

INTRODUCTION OF INVESTMENT
AND
INVESTMENT ALTERNATIVES

Investment is the allocation of monetary resources to
assets that are expected to yield some returns over a period
of time. It involves the commitment of resources which
have been saved with the expectation that some benefits
will accrue in future.
In other words, Investment is a commitment of
funds to derive the future income in the form of
interest, dividend, rent, premium or appreciation in the
value of principal capital .

 Liquidity
 Safety of principal
 Tax benefits
 Income stability
 Purchasing power
 Capital growth

 Minimum comforts
 Future return or income
 Capital appreciation
 Choice of investment

The process on investment involves the following steps:
 Objective specification
 Mix of assets
 Portfolio formulation strategy
 Selection of securities
 Portfolio revision
 Portfolio evaluation

It is considered as an involvement of funds of high risk
and more uncertain expectation of returns. It is basically a
short term phenomenon where people tend to buy assets
with the hope that a profit can be earned from a
subsequent price change. It is based on the expectation
that some change will occur.
The stock brokers may be cited as an
example. Some brokers buy shares with a view to make
quick profit by selling within few days, when the prices of
such shares shoot up.

BASIS SPECULATION INVESTMENT

Contract Type Ownership Creditor

Source of income Change in market price Earning of enterprise

Objective of purchase Tips, Hunches etc. Higher Return

Stability of income Uncertain Stable

Risk involved High Low

Duration Short Long

Acquisition On margin Outright purchase

Attitude Aggressive Conservative

BASIS INVESTOR SPECULATOR
Planning An investor has a relatively longer A speculator has a very short
Horizon planning horizon. planning horizon.
Time His holding period is usually at least His holding period may be a few
one year. days to a few months.
Risk disposition An investor is normally not willing to A speculator is ordinarily willing to
assume more than moderate risk. assume high risk.
Return An investor usually seeks a moderate A speculator looks for a high rate of
expectation rate of return. return.
Basis of An investor attaches greater A speculator relies more on
decisions significance to fundamental factors and technical charts and market
attempts a careful evaluation of the psychology.
prospects of the firm.
Leverage An investor uses his own funds and A speculator normally resorts to
eschews borrowed funds. borrowings, which can be very
substantial, to supplement his
personal resources.

A gamble is a very short term investment in a game of
chance. Gambling involved high risk and the expectations
of high returns. It consists of uncertainty and high stackers
for thrill and excitement.
The example of gambling are horse racing, card
game, lottery etc.

 Compared to investment and speculation, the result of
gambling is known more quickly.
 Rational people gamble for fun, not for income.
 Gambling does not involve a bet on an economic activity.
It is based on risk that is created artificially.

Arbitrage is a planned methods of putting the savings
safely into different investments to get a better return. An
investor can also be an arbitrageur if he buys and sells
securities in more than one stock exchange to take
advantage of the price differentials in such exchanges.
Derivative market is an example of Arbitrage transactions.

 Non – Marketable Financial Assets:-
- Bank Deposits (Savings account, Current account, Fixed
Deposits, Recurring Deposits etc.)
- Post office Savings Accounts.
- Post office Time Deposits.
- Monthly Income Scheme of the Post Office.
- National Savings Certificate (NSC).
- Company Deposits.
- Employee Provident Fund Scheme.
- Public Provident Fund Scheme.

 Money Market Instruments :-
- Treasury Bills
- Certificates of Deposits
- Commercial Paper
- Repos
 Bonds or Debentures and Preference Shares
- Government Securities
- Savings Bonds
- Private Sector Debentures
- Public Sector Undertaking Bonds
- Preference Shares

Equity Shares
Mutual Fund Schemes
Life Insurance
Financial Derivatives

MODULE – 2

INTRODUCTION
OF
FINANCIAL MARKETS
&
FINANCIAL SYSTEM

Financial Market is the place or location to
buy and sell the financial products or
instruments.
Or,
Financial Markets can be referred to as those
center and arrangements which facilitate
buying and selling of financial assets, claims
and services.

Financial Market

Organized Market Unorganized Market

Capital Market Money Market Money Lenders,
Call Money Indigenous,
Market Bankers etc.
Industrial Govt Long term
Securities Securities loan Commercial
Market Market Market Bill Market
Term loan
Market Treasury Bill
Primary Secondary Market
Market Market for
Market
Mortgages
Short Term Loan
Market for Market
Financial
Guarantees

At the time of Independence in 1947, there was no strong
financial institutions mechanism in the country. There are absence
of issuing institutions and non-participation of intermediary
financial institutions. The industrial sector also had no access to
the savings of the community. The capital market was very
primitive and shy. The private as well as the unorganized sector
played a key role in the provision of ‘liquidity’.
With the adoption of the theory of mixed
economy, the development of the financial system took a different
turn so as to fulfill the socio-economic and political objectives.
The government started creating new financial institutions to
supply finance both for agricultural and industrial development
and it also progressively started nationalising some important
financial institutions so that the flow of finance might be in the
right direction.

 The new issues first placed in the new issue market can be disposed of
subsequently in the stock exchange.
 The stock exchange provides the mechanism for regular and continuous
purchase and sale of securities which is of immense utility to potential
investors. The two markets are complimentary.
 Both the markets are connected to each other even at the time of new
issue.
 The company which makes new issue applies for listing shares on a
recognized stock exchange.
 Listing of shares adds prestige to the firm and widens the market for
investors.
 The two markets act and react upon each other in the same direction.
 When the stock prices go up in the market, the new issues increase and
when the stock prices show a downward trend the new issues decline.

 The new issue market is to facilitate transfer of resources
from savers to the users.
 The saver are individuals, commercial banks, insurance
companies etc.
 The users are public companies and the government.
 The new issue market plays an important role of mobilizing
the funds from the savers and transfers them to borrowers
for productive purposes.
 It is not only a platform for raising finance to establish new
enterprises but also for expansion, diversification, and
modernization of existing units.

The various methods which are used in the
floatation of securities in the new issue market
are:-
1. Public Issues
2. Offer for Sale
3. Placement
4. Right Issues

All issues by a new company have to be made at per and for
existing companies the issue price should be justified as per
Malegam Committee’s recommendations which are as
follows:-
The issue price should be justified by:-
1. The earning per share(EPS) for the last three years and
comparison of pre-issue price to earning ratio to the price to
earnings (P/E) of the industry.
2. The latest Net Asset Value (NAV).
3. The minimum return on increased net worth to maintain
pre-issue EPS. A company may also raise funds from the
international markets by issuing Global Depository
Receipts(GDR) and American Depository Receipts (ADR).

The SEBI does not play any role in price fixation. In fact
the issuers in consultation with the Merchant Bankers will
decide the price. However, they are required to give full
disclosures of the parameters which they had considered
while deciding the issue price. In actual practice, there are
two types of issue pricing namely:-
1. In the first type, the company and the lead manager fix
the price which is called fixed price.
2. In the second type, the company and the lead manager
stipulate a floor price or a price band and leave it to
market forces to determine the final price which is called
book building price.

The stock exchange operations at floor level are highly
technical in nature. Non-members are not permitted to enter
into the stock market. Hence, various stages have to be
completed in executing a transaction at a stock exchange.
The steps involved in the methods of trading have been
given below:-
1. Choice of a Broker
2. Placement of Order
3. Execution of Order
4. Preparation of Contract notes
5. Settlement of Transactions

To become a member of a recognized stock exchange, a person
must possess the following qualifications:-
1. He should be a citizen of India.
2. He should not be less than 21 years of age.
3. He should not have been adjudged bankrupt or insolvent.
4. He should not have been convicted for an offence involving
fraud or dishonesty.
5. He should not be engaged in any other business except
dealing in securities.
6. He should not have been declared a defaulter by any other
stock exchange.
Apart from individuals, a company is also
eligible to become a member provided it satisfies the
conditions imposed by the stock exchange concerned.

A clearing house is a financial institution that provides
clearing and settlement services for financial and
commodities derivatives and securities transactions. These
transactions may be executed on a futures exchange or
securities exchange, as well as off-exchange in the over-
the-counter (OTC) market. A clearing house stands
between two clearing firms (also known as member firms
or clearing participants) and its purpose is to reduce the
risk of one (or more) clearing firm failing to honor its trade
settlement obligations.

A company which desires its securities to be listed on a
recognized stock exchange must satisfy the following
conditions:-
1. At least 60% of each class of securities issued must be offered
to the public for subscription and minimum issued capital
should be Rs. 3 crores.
2. The minimum public offer for subscription must be at least
25% of each issue and it must be offered through advertisement
in newspapers at least for a period of 2 days.
3. The company should be of a fair size having broad based
capital structure and public interest in its securities.
4. The existing companies must adhere to the ceiling in
expenditure of public issues.
5. A certificate to the effect that shares from promoter’s quota are
not sold or transferred for a period of 3years must be
submitted.

6. There must be at least 10 public shareholders for every
Rs. 1 lakh share of fresh issue of capital and it is 20 in the
case of subsequent issue of shares. This criteria is different
for investment companies.
7. A company having more than Rs. 5 crore paid up capital
must list its securities on more than one stock exchange.
Listing on the regional stock exchange is compulsory.
8. The company must pay interest on the excess application
money received at the rates ranging between 4% and 15%
depending on the delay beyond 10 weeks from the date of
closure of the subscription list.

9. The Articles of Association of the company must provide for the
following:-
i. A common form of transfer shall be used.
ii. Fully paid shares will be completely free from lien.
iii. Partly paid up shares will be subject to lien only to the extent
of call money due at a fixed time.
iv. Calls in advance carry only interest and not dividend rights.
v. Unclaimed dividends shall not be forfeited before the claim
becomes time barred.
vi. The right to call of shares shall be given only after the
necessary sanction by the general body meeting.
vii. Transfer of shares shall be registered within 30 days of deposit
of request and the balance certificates shall be issued within
the same period.

The Government felt the need for setting up of an apex
body to develop and regulate the stock market in India.
Eventually the SEBI was set up on 12th April, 1988. To
start with, SEBI was set up a non-statutory body.
It took almost 4 years for the government
to bring about a separate legislation in the name of SEBI
Act, 1992 conferring statutory powers. The Act, changed
to SEBI with comprehensive powers over practically all
aspects of capital market operations.

According to the SEBI Act, the primary objective of the SEBI is
to promote healthy and orderly growth of the securities market
and secure investor protection. For this purpose, the SEBI
monitors the activities of not only stock exchanges but also
merchant bankers etc.
The objectives of SEBI are as follows:-
1. To protect the interest of investors so that there is a steady flow
of savings into the capital market.
2. To regulate the securities market and ensure fair practices by
the issuers of securities so that they can raise resources at
minimum cost.
3. To promote efficient services by brokers, merchant bankers and
other intermediaries so that they become competitive and
professional.

Section II of the SEBI Act specifies the functions as follows:-
1. Regulatory Functions:-
i. Regulation of stock exchange and self regulatory organizations.
ii. Registration and regulation of stock brokers, sub-brokers,
registrar to all issue, merchant bankers, underwriters, portfolio
managers and such other intermediaries who are associated
with securities market.
iii. Registration and regulation of the working of collective
investment schemes including mutual funds.
iv. Prohibition of fraudulent and unfair trade practices relating to
securities market.
v. Prohibition of insider trading in securities.
vi. Regulating substantial acquisitions of shares and takeover of
the companies .

2. Developmental Functions:-
i. Promoting investor’s education.
ii. Training of intermediaries.
iii. Conducting research and published information useful
to all market participants.
iv. Promotion of fair practices. Code of conduct for self
regulatory organizations.
v. Promoting self regulatory organizations.

i. Power to call periodical returns from recognized stock exchanges.
ii. Power to call any information or explanation from recognized stock
exchanges on their members.
iii. Power to direct enquiries to be made in relation to affairs of stock
exchanges or their members.
iv. Power to grant approval to bye-laws of recognized stock exchanges.
v. Power to make or amend bye-laws of recognized stock exchanges.
vi. Power to compel listing of securities by public companies.
vii. Power to control and regulate stock exchanges.
viii. Power to grant registration to market intermediaries.
ix. Power to levy fees or other charges for carrying out the purpose of
regulation.
x. Power to declare applicability of section 17 of the Securities Contract
(Regulation) Act is any state or area to grant licenses to dealers in
securities.

Risk refers to the possibility that the actual outcome of an
investment will differ from its expected outcome.
In other words, risk is the possibility of
loss or the probable outcome of all the possible events.
Most investors are concerned about the actual outcome
being less than the expected outcome. The degree of risk
depends upon the features of assets, investment
instruments, mode of investment etc. the wider the range
of possible outcomes, the grater the risk.

RISK

SYSTEMATIC UNSYSTEMATIC

Interest Purchasing Business Financial Credit
Market Risk Rate Risk Power Risk Risk Risk Risk

The Return on an asset or investment for a given
period is the annual income received plus any change
in market price expressed as a percent of opening
market price.
Return is the primary motivating
force that drives investment. It represents the reward
for undertaking investment.

CAPM refer to the way in which the securities are valued in line
with their anticipated risks and returns. A risk averse investor
prefers to invest in risk free securities. A small investor having few
securities in his portfolio has greater risk. To reduce the
unsystematic risk, he must build up a well diversified portfolio of
securities. A diversified and balanced portfolio will bring down the
investor’s systematic risk in the stock market. The systematic risks
of two portfolios remain the same. An individual is assumed to rank
alternatives in the order of his preference. However, due to
constraints he can avail only some of the alternatives. An individual
acts in a way in which he can maximize the return on his investment
under conditions of risk and uncertainty. Thus, CAPM is a linear
relationship in which the required rate of return from an asset is
determined by that asset’s systematic risk.
In the year 1964, William Sharpe published the Capital
Asset Pricing Model. CAPM extended Harry Markowitz’s portfolio
theory to introduce the notions of systematic and specific risk.

The model establishes that the required rate of return of a security
must be related to its contribution. Following are the assumption of
CAP model.
 Investors are risk averse and need diversification to minimize risk.
 The investors can borrow or lend an unlimited amount of funds at
risk free rate of interest.
 No transaction cost are involved.
 Investors prefer to maximize returns and select a portfolio purely on
the basis of risk and return assessment.
 The purchase or sale by a single investor cannot affect the prices of
securities because the market is efficient.
 Investors eliminate the unsystematic risk through diversification. It
is the systematic risk that determines the estimated return.
 The investors have identical estimates of risk and return of all
securities.

The security market line expresses the basic theme of
CAPM i.e, expected return of a security increases linearly
with risk as measured by beta. It is an upward sloping
straight line with an intercept at the risk free return
securities and passes through the market portfolio. The
upward slope line indicates that greater excepted returns
accompany higher levels of beta. In equilibrium, each
security or portfolio lies on the SML. An investor will
come forward to take risk only if the return on investment
also includes risk premium.

Expected SML
Return
-----------------------------------------------------

---------------------------------------
R3
E (Rm) ------------------------------------- Risk Premium

-------------------------------
R2
-------------------- -------------------------
R1

Rf

Risk free return

0 0.5 1.0 1.5
Risk (Beta)

SML is used to find the fair return that a security should
offer according to its beta factor, the risk free return and
the market return. The fair return is compare with the
actual return earned from the security. If the fair return is
less than the actual return, it is an indication that the
security is under priced. On the other hand, if the fair
return is more than the actual return, the security is over
priced. The under pricing or over pricing of a security will
be of immense use to an investor.

The Capital Market Line (CML) defines the relationship between
total risk and expected return for portfolios consisting of the risk
free asset and the market portfolio. If all the investors hold the same
risky portfolio, then in equilibrium it must be the market portfolio.
CML generates a line on which efficient portfolio can lie. Those
which are not efficient will however lie below the line. It is worth
mentioning here the CAPM risk return relationship is separate and
distinct from risk return relationship of individual securities as
represented by CML. An individual security’s expected return and
systematic risk statistics should lie on the CAPM but below CML.
In contrast the risk less end ( R) statistics of all portfolios, even the
inefficient ones should plot on the CAPM. The CML will never
include all points, if efficient portfolios, inefficient portfolio and
individual securities are placed together on one graph. The
individual assets and inefficient portfolios should plot as points
below the CML because their total risk includes diversifiable risk.

Z

Expected ----------------------------------K

----------------------------
Return
E (Rm – R)

R
Defensive Assets Aggressive Assets

Risk
K represents the market portfolio and R represents risk less rate
of return. RKZ line represents preferred investment
strategies, showing alternative combinations of risk and return
obtainable by combining the market portfolio with borrowing or
lending.

CAPM shows the risk and return relationship of an investment in
the formula given below:
E ( R) = Rf + βi (Rm – Rf)
Where,
E ( R) = Expected rate of return on any individual
security or portfolio of securities.
Rf = Risk free rate of return
Rm = Expected rate of return on the market portfolio
Rm – Rf = Risk Premium
βi = Market sensitivity index of individual security or
portfolio of securities.

 Calculation of beta is a tedious and time consuming process as it requires
ample amount of information. Again beta may or may not reflect the
future variability of returns and it cannot be expected to be same all the
time. It will change with time and situation.
 The specified required rate of return can be considered as only
approximation.
 Perfect capital market exists i.e, the market is efficient market.
 Lending and borrowing can take place at risk free rates.
 All investors have the same expectations about return and risk.
 Risk is measured on the basis of historic returns patterns and assumption
is that returns pattern will repeat in the future.
 It also assumes that in the financial markets there are no transaction
costs, no taxes and no limitations on investments.
 The CAPM also assumes that investors are fully diversified. In practice
many investors, particularly small investors, do not hold highly
diversified asset portfolio.

The APT Model states that the security returns are influenced by a number
of factors. These several factors appear to have been identified as being
important such as inflation, interest rate, personal consumption, money
supply, industrial production, demand, population factor or other
economic factor. Some stocks are more sensitive to some factors than
other stocks. For example, the increase in inflation is more than
expected, then the securities which are subject to inflation pressure will
decrease in price and the security which is not sensitive to inflation may
not show change in the price of the security. The sensitivity of the
particular factor is incorporated through ‘â’ for that factor. The random
error ‘e’ represents the unexpected portion of the return on the
security, and which is not explained by other factors. It shows the
unexpected events unique to the security. APT states that the risk
premium on stock should depend on the expected risk premium
associated with each factor and the stock’s sensitivity to each of these
factors. The APT model can be expressed using the following equation:
Ri = λo + λ1b1 + λ2b2 + λ3b3…………..+ λjbj
Where, Ri = Average expected return
bi = beta co-efficient relevant to the particular factor
λ1 = sensitivity of return to bi

MODULE – 4

SECURITY ANALYSIS
AND
VALUATION

Fundamental analysis relates to an examination of the
intrinsic worth of the company, to find out whether the
current market price is fair, overpriced or underpriced.
This is done by studying the various aspects of the
company in the background of the performance of the
industry to which the company belongs and the general
economic and socio-political scenario of the country.
Fundamental analysis is about using real data to evaluate a
security’s value.

Economic information is only as reliable as the raw data
collection and the credibility of its interpretation.
 Gross Domestic Product
 Savings and Investment
 Inflation
 Interest Rates
 Budget
 Tax structure
 Monsoon and Agriculture
 Infrastructure facilities
 Demographic factors

An Industry is a homogenous group of firm that have similar
technological structure of production and produce similar
products. But the industry broadly covers all the economic
activities happening in the country to bring growth.
While analysis industry the main three are:-
a) Technology
b) Competitive pressure
c) Economic and customer activity in a country.

MODULE – 5

PORTFOLIO MANAGEMENT

Portfolio Management is the art and science of making
decisions about investment mix and policy, matching
investments to objectives, asset allocation for individuals
and institution, and balancing risk against performance.
Portfolio Management is all about
strengths, weaknesses, opportunities and threats in the
choice of debt vs. equity, domestic vs.
international, growth vs. safety, and many other tradeoffs
encountered in the attempt to maximize return at a given
appetite for risk.

 Choice of asset mix
 Formulation of portfolio strategy
 Selection of securities
 Portfolio execution
 Portfolio revision
 Performance evaluation

Portfolio Rebalancing:- Portfolio Rebalancing involves
reviewing and revising the portfolio composition (i.e. the
stock – bond mix). There are three basic policies with
respect to portfolio rebalancing –
1. buy and hold policy
2. Constant mix policy
3. Portfolio insurance policy

William F Sharpe has developed a formula in 1966 which
measure the performance of a portfolio. Sharpe’s performance
index gives a single value to be used for the performance
ranking of various funds or portfolios. It is expressed as the
ratio of the excess return per unit of risk where risk is
measured by the standard deviation of the rate of return. It
measures the risk premium of the portfolio relative to the total
amount of risk in the portfolio. The risk premium is the
difference between the portfolio’s average rate of return and
the risk less rate of return.
Sharpe Index (SI) = [Portfolio Average Return (Rp) – Risk
free Rate of Return (Rf) ] Standard deviation of Return (σp)

To understand the Treynor Index, an investor should know
the concept of characteristic line. The relationship between
a given market return and the fund’s return is given by the
characteristic line. The fund performance is measured in
relation to the market performance. The ideal fund’s return
rises at a faster rate than the general market performance
when the market is moving upwards and its rate of return
declines slowly than the market return. A poorly diversified
portfolio could have a higher ranking under the Treynor
measure than for the Sharpe measure. The Treynor measures
the performance of the fund with the help of the
characteristic line.
Treynor Index (TI) = (Rp – Rf) βp

The absolute risk adjusted return measure was developed by
Michael Jensen which is mentioned as a measure of absolute
performance because a definite standard is set and against that the
performance is measures. The standard is based on the manager’s
predictive ability to judge the fund’s performance. The successful
prediction of the stock price enables the manager to earn better
return than the ordinary investor expects to earn in a given level of
risk.
Rp = αp + Rf + β (Rm – Rf)
Where, Rp = Average return on portfolio
Rm = Market return
Rf = Risk free return
αp = Intercept or, αp = (Rp – Rf) – β (Rm – Rf)
β = Measure of systematic risk

According to SEBI, Mutual Fund is a mechanism for
pooling the resources by issuing units to the investors and
investing funds in securities in accordance with objectives
as disclosed in offer document.
A Mutual Fund is a portfolio of
stocks, bonds, or other securities that is collectively
owned by hundreds or thousands of investors and
managed by a professional investment company.

Unit Holder

Sponsors

Trustees AMC

The Mutual Transfer Agent
Fund

Custodian

SEBI

 The Sponsor - A Sponsor is a person who acting alone or
in combination with another body or corporate, establishes
a mutual fund and applies to SEBI for its registration. The
sponsor is also closely associated with the AMC. As per
SEBI regulations, the sponsor has to contribute a
minimum of 40% of the net worth of the AMC.

 The Board of Trustees(BOT) – A person or a group of
persons having an overall supervisory authority over the
fund managers, they ensure that the managers keep to the
trust deed that the unit prices are calculated correctly and
the assets of the funds are held safely.

 The Asset Management Company (AMC) – A company
set up primarily for managing the investment of mutual
funds. It makes investment decisions in accordance with
the scheme objectives, deed of trust and provisions of the
Investment management Agreement.

 The Custodian – Custodian is registered with SEBI, holds
the securities and other assets of various schemes of the
fund in its custody.

 The Unit Holders – A person who holds Unit(s) a Mutual
Fund.

MODULE – 6

NEW DIRECTIONS
IN
INVESTMENT MANAGEMENT

A Derivative is an instrument whose value depends on the
value of some underlying assets. The underlying assets
may be commodity, equity or currency.
Derivative is a modern financial
instrument in hedging risk. The individuals and firms who
wish to avoid or reduce risk can deal with others who are
willing to accept risk for a price.

It is an agreement between buyer and seller to exchange the
commodity or instrument for cash at a predetermined future date
at a certain price agreed today.
For example:-
A farmer growing onions may sell some portion of his crop before
harvest to the buyer at a fixed price, for delivery after harvest. For
the farmer this transaction reduces the risk of selling in the market
after harvest at lower prices. He has locked in a profit by this
operation. This profit would have been more or less if he had
waited until the harvest to sell onions at the spot price then
prevailing in the cash market. Thus farmer has hedged himself
against the risk of a downward movement in onion prices by
entering into a forward contract in the forward market.

Financial swaps are private contractual agreements between two parties
to exchange cash flow in the future according to specified terms and
conditions. They are mutual obligations among the swap parties.
Currency Swaps:- A currency swap is a contract involving exchange of
interest payments on a loan in one currency for fixed or floating interest
payments on equivalent loan in a different principal.
Forward Swaps:- Forward swaps are those swaps in which the
commencement date is set as a future date. Thus, it helps in locking the
swap rates and use them later as and when needed. It is also called as
deferred swaps as the start date of the swap is delayed. It is useful to the
users who do not need funds immediately.
Interest Rate Swaps:- An interest rate swap is a derivative in which one
party exchanges a stream of interest payments for another party’s stream
of cash flows. Interest rate swaps can be used by hedgers to manage their
fixed or floating assets and liabilities.

It is a contract between two parties to contract which
facilitates trading in secondary market. A futures market
can be defined as an agreement to buy or sell a standard
quantity of a specific instrument at a predetermined future
date and at a price agreed between the parties on the floor
of an organized futures exchange.
Future contracts better compare to forward
contract as they are standardized, carry liquidity, traded in
secondary market and safeguards against default.

BASIS FUTURES FORWARDS

Size of contract Standardized contract size No standard size

Valuation Marked to market every day No unique method of
valuation
Place Futures exchange No fixed place

Variation Variation on daily basis No variation

Settlement Made by clearing house Client or bank

Risk Risk is little High risk

Cost of transaction Commission and exchange fees Low cost as contract is
are high direct
Market place Central exchange floor with Over the telephone or
worldwide network direct contact

An Option means choice. An Option in a financial market
is created through a financial contract. This financial
contract gives a right to its holder to enter into a trade at or
before a future specified date.
The underlying assets on options include
stocks, stock indices, foreign currencies and debt
instruments, commodity, and futures contracts. These are
called stock options, index options, commodity options,
currency options, and future options.

 Call Option:- A call option is one which provides the holder the
right to purchase an underlying asset at a specified price. But he
has no obligation to buy a given quantity of the underlying assets.
It gives the right to the buyer to buy a fixed number of shares or
commodities at the exercise price up to the date of expiration of
contract. The buyer has to pay the writer the option price called
premium. The seller of an option is known as writer.
 Put Option:- A put option on the other hand are one which provides
the holder the right to sell an underlying asset at a specified price.
It gives the buyer the right but not the obligation to sell a given
quantity of the underlying asset at a given price on or before a
given date. The put option gives the buyer the right to sell the
underlying asset at the exercise price up to the date of the contract.
The seller of the put option is called the writer. He has no choice
regarding the fulfillment of the obligation under the contract. If the
buyer wants to exercise his put option, the writer must purchase at
the exercise price.

FUTURES OPTIONS

Both seller and buyer are obliged to Only seller is obliged to perform the
perform the contract contract

The holder of the contract is exposed to The buyer’s loss is the risk of losing the
risk and has potential for profit premium

No premium is paid by either party The buyer pays the premium to the seller

The parties to the contract must perform The buyer can exercise the option any
on the settlement date only time before to the expiry date

If we assume that there are two possible stock prices at the
end of each 6 month period, the number of possible end of
year prices increases. As the period is further shortened
(from 6 to 3months or 1 month), we get more frequent
changes in stock price and a wider range of possible end
of year prices. Eventually, we would reach a situation
where prices change more or less continuously, leading to
a continuum of possible prices at the end of the year.
Theoretically, even for this situation we could set up a
portfolio which has a payoff identical to that of a call
option. However, the composition of this portfolio will
have to be change continuously as the year progresses.

Calculating the value of such a portfolio and through that
the value of the callσ option in such a situation appears to
be an unwieldy task, but Black and Scholes developed a
formula that does precisely that. Their formula is:
Co=So N(d1)- E/ert N(d2)
Where Co is the equilibrium value of a call option now, So
is the price of the stock now, E is the exercise price, e is
the base of natural logarithm, r is the annualized
continuously compounded risk free interest rate, t is the
length of time in years to the expiration date and N(d) is
the value of the cumulative normal density function.

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