Case study- Derivatives and risk management

Ram entered the Indian government service and was working in Tamil Nadu for over 20 years. He held a number of important positions such as the Chairman of Tamil Nadu Corporations. After 20 years of service, he decided to retire from government service and start his own business. Journalism was always his passion and he was looking for an opportunity to enter into journalism. When he visited his brother in the USA, he came across a neighbourhood newspaper that reported various happenings in that neighbourhood as well as the details of the various businesses operating in that neighbourhood. The newspaper was funded by advertisements. This appealed to Ram, and he decided to start a similar venture in Chennai. This venture turned out to be a huge success. Financed through advertisements from the local businesses, this weekly newspaper contained articles highlighting the achievements of local families and children and details of local events. This newspaper was distributed to all the households in that area. With the profits earned through this venture, Ram decided to make investments. Originally, most of his investments were in mutual funds, and when the Indian market was doing well, he was getting a high return on these investments. He was not satisfied with this investment performance and decided to trade in derivatives. Since options sounded very complicated, he went on to trade in futures. Even though he did not know much about futures, he formulated a simple rule. He would take a long position in the futures on a single stock, which he believed would increase in price. Then he would close the position if the future prices move up, so that he can make at least INR 1,000 and take the profits. In case the price does not increase as expected, he would close the position after two days and take whatever be the result, even if it is a loss. From 2004 to 2007, this worked when the market was doing well and most stocks were increasing in prices. However, when the market started doing poorly from the middle of 2008, this strategy resulted in huge losses, and at one point of time, he had lost more than INR 1.5 million in a month. In early 2009, Rams brother Raj, who lives in the USA and is a professor of finance, visited Ram. When Ram explained his predicament, Raj told Ram that he should have gone into options rather than futures, as futures were comparatively more risky and can lead to huge losses. Ram had a number of questions for Raj, and Raj told him that all these questions can be easily answered by his students who take his course on derivatives.

Discussion Questions 1. Why is trading in futures more risky when compared to trading in options? 2. If I buy a November futures contract on the ICICI Bank at INR 1,250, I agree to buy ICICI Bank shares at INR 1,250. The contract size for ICICI futures and options is 350. However, when I look at the option, there are a number of options trading in the market, some are called call options and some are called put options, and their prices are very low. For example, the November call at INR 1,250 is selling for INR 70 and the November put at INR 1,250 is selling for INR 140. The contract size for ICICI futures and options is 350 shares. What do these mean? What will be the price at which I can buy the ICICI Bank shares? At what price can I sell them? 3. In the case of futures, I need to post a margin. Do I need to post a margin in the case of options? 4. In the case of futures, I have a strategy of closing the position whenever I make INR 1,000. Can I also do the same with options? 5. I enter into a long November futures contract at INR 1,250. I also enter into an options contract to buy ICICI Bank shares at INR 1,250. The option price is INR 70. On November 28, ICICI Bank shares sell at INR 1,300. What will be my gain or loss from futures? What will be my gain or loss from options? 6. In case the ICICI Bank announces a stock split of 5:2, that is, for every two shares currently owned, five new shares will be issued. Will the options contract remain the same or will it change? How will the option terms change?