Stock index futures began trading on NSE on the 12th June 2000. Stock futures were launched on 9th November 2001. The volumes and open interest on this market has been steadily growing. Looking at the futures prices on NSE's market, have you ever felt the need to know whether the quoted prices are a true reflection of the price of the underlying index/stock? Have you wondered whether you could make risk-less profits by arbitraging between the underlying and futures markets? If so, you need to know the cost-of-carry to understand the dynamics of pricing that constitute the estimation of fair value of futures. A futures contract on the stock market index gives its owner the right and obligation to buy or sell the portfolio of stocks characterized by the index. Stock index futures are cash settled; there is no delivery of the underlying stocks. In their short history of trading, index futures have had a great impact on the world's securities markets. Indeed, index futures trading has been accused of making the world's stock markets more volatile than ever before. The critics claim that individual investors have been driven out to the equity markets because the actions of institutional traders in both the spot and futures markets cause stock values to gyrate with no links to their fundamental values. Whether stock index futures trading is a blessing or a curse is debatable. It is certainly true, however, that its existence has revolutionized the art and science of institutional equity portfolio management.
[...] Most books on derivatives use continuous compounding for pricing futures too. However, we have used discrete compounding as it is more intuitive and simpler to work with. Had we to use the concept of continuous compounding, the above equation would have been expressed as: Where: r Cost of financing(using continuously compounded interest rate) T Time till expiration and e Pricing futures contracts on commodities Let us take an example of a futures contract on a commodity and work out the price of the contract. [...]
[...] Table 5.2 gives the premiums for one month calls and puts with different strikes. Given that there are a number of one-month calls trading, each with a different strike price, the obvious question is: which strike should you choose? Let us take a look at call options with different strike prices. Assume that the current index level is 1250, risk-free rate is 12% per year and index volatility is 30%. You could write the following options: 1. A one month call on the Nifty with a strike of A one month call on the Nifty with a strike of A one month call on the Nifty with a strike of A one month call on the Nifty with a strike of A one month call on the Nifty with a strike of 1300. [...]
[...] While options enable speculators to take leveraged positions on stocks, the losses incurred by the buyer of the option are limited to the extent of premium paid, but the losses suffered by the seller/writer of the option are potentially unlimited Combination positions using stock futures and stock options With the availability of a range of basic derivative products for trading, it is possible to create speculative/hedged positions using a combination of these. Given a clear understanding and imagination, a wide range of interesting payoffs/trading strategies can be generated using futures and options. [...]
[...] We take T = S=1150, X=1180, r=ln ( 1.12 and σ = Substituting these values in the formula, we get the call price as Rs The put price on an option with the same strike works out to be Pricing stock options Much of what was discussed about index options also applies to stock options. But before learning how to price stock options, we shall have a quick look at the factors which affect option prices. Factors affecting option price Various factors affect the price of options on stocks. [...]
[...] We shall first try to get an intuitive understanding of the topic assuming for the time being that there is just one single futures price. If the basis happens to be incorrect, there can be arbitrage opportunities. Exploiting this mispricing involves the following trades. When the spread between the two futures contracts narrows, buy the far month contract and sell the near month one. Why do we buy the far month and sell the near month? Because we know that if the fair spread between two contracts is 10, but the one observed on the market watch is the far month contract is under priced and the near month is overpriced. [...]
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