Educational policy Essay

On Tuesday May eleventh, 2010 David Cameron became the British Prime Minister after forming a Conservative and Liberal Democrat coalition. This followed five days of negotiation as the general election had produced a hung parliament. While the Conservatives were the largest party, they held an inadequate number of seats to meet the threshold for majority rule, and so formed a coalition with the Liberal Democrats, (guardian.co.uk, 2010). Even prior to becoming Prime Minister, David Cameron spoke at length on the Conservatives’ education election manifesto by announcing plans to attract the most educated professional teachers into the classroom. Central to his party’s focus on education was his party’s desires to improve the standard of teacher’s education, he said, â€Å"The most important thing that will determine if a child succeeds is not their background, the curricula, the type of school or the amount of funding, it’s the teacher,† (daily mail.co.uk, 2010). This paper intends to examine the evolution of the Academy school system under the current coalition government, make a comparison between the current the education policy under the coalition government and the tripartite system of the 1944 Butler Education Act. It will examine the effects of both systems on the pupils within them, whether in fact pupils will benefit from the Academy and free school systems or is it the case that there are also be some pupils who are disadvantaged by this  system. There will also be an examination of what will happen to pupils who are not educated in either the academy or free school systems and the influence that market forces will have on the establishment and success of schools. Education is the delivery of knowledge, skills and information from teachers to students; the process of becoming an educated person, (Carr & Kemmis, 1986). Education promotes the abilities to perceive accurately, think critically and act effectively to achieve self-sele cted goals and aspirations, (Gelber Cannon, 2011). It allows individuals to map their experiences and provides a variety of reliable routes for individual’s to return to optimal states when they find themselves facing difficult decisions and life events. Crucially in modern era, education itself is seen as a vital resource for global economies, in fact most first world economies are characterised as ‘learning economies’, (Tze-Chang, 2011). It is the acquisition and retention of knowledge that drives global economies which, in previous generations, were based entirely on pure market forces, (Avis, 1996). Consequently an economy based exclusively on market forces would be unable sustain learning and innovation, (Morgan, 1997). For modern economies to flourish they must develop a combination of a ‘learning economy’ with market forces, (Beckett & Hager, 2002). It is for these reasons that successive governments have recognised the essential value of a higher educated population and have improve the way in which the population is taught from school age right throughout life, (Wolf & Evans, 2011). Even Prior to the Coalition Government taking power, there had been a move towards Neoliberal ideology from the previo us two governments. From 1997 New Labour brought about changes within educational policies that Tony Blair stated were part of the ‘Third Way’. This was intended to evolve social democratic ideals into encompassing the Neo-liberalism that had been prevalent for the decade under Thatcher’s Government, (Hill,2001). Neo-liberalism attempts to evolve away from social democratic principles such, redistributive policy, taxing the very wealthy, defending equal opportunities with a strongly proactive sense of achieving more equal outcomes, relying on the high standard qualifications of professional groups (such as teachers) and regulating these professionals in the interests of equal opportunities. Neo-liberalism focuses on the continuation of the national curriculum which has had a strong influence from central government. So for instance, Margaret Thatcher insisted that events of the previous twenty years had not to be included in history lessons, (Thatcher, 1980). Even today many teachers believe the national curriculum prevents them encouraging creativity and innovation, focusing on a narrow curriculum and a strict testing regime, (McCormick & Burn, 2011). Neo-liberalism encourages the competition of schooling through supporting market forces with the spread of selective `specialist schools’, (Hursh, 2005). New Labour called these ‘Modernising’ comprehensive education’ by encouraging ‘selection and diversity’, (Kassem et al, 2006). One important area of neo-liberal ideology is marrying of private organisations with public services such as education; New Labour termed these `creating new partnerships’, (Clarke et al, 2000). These ideologies question of `standards’ achieved in school tests expecting that education focus on achieving good test results and making these a requirement for entry into Higher Education, (Rowden, 2011). There are concerns that neo-liberal education policies increase in inequalities in terms of social class, (Hill, 2003). In many ways the new school systems will create winners, those who attend new inspiring buildings that are full to the brim with facilities and opportunities for the pupils, however there will also be losers, those who continue to attend buildings possibly built in the 1950’s with teachers who are not amongst the highly paid or highly educated, (Griffiths, 2007). Investment by the private sector, (which is prone to the nuances of market forces) and reduction in public spending on education is considered `increased public expenditure’, from a neoliberal approach, (Goodwin, 2011). The Importance of Teaching, The Schools White Paper 2010, was published 24th November 2010, its intention was to improve the standard of education for teachers and allowing head teachers to recruit and set pay for the highest educated teachers. Following this the Coalition formulated their plans for the future of education in the UK. This would in some respects follow on from New Labour’s neo liberalistic approach of including private organisations in the creation of new ‘Academy Schools’, (Gunter & Forrester, 2008). The first academies were introduced under the Labour government in 2002, (Higher Standards, 2005). Academy schools are independent from local  education authorities and are state funded with assistance from external organisations; these can include businesses, charities or other governmental bodies. The idea followed the inception of charter schools in USA, (Budde, 1988). They were also influenced in part by the Swedish School system. Charter schools are American schools which are independent from their ‘public school system’, (Finn et al, 2000). They were intended to allow the schools themselves more freedom to be more innovative, while being accountable to local education boards for improved student achievement. Charter schools were meant to create partnerships between educators, parents and students. Many Charter Schools began in the 1990’s; however there has been widespread criticism of the Charter school system. One criticism is that funding has in fact not followed the schools, which were often built within deprived areas. This in fact has meant that many have actually lost funding and have gone into administration, (Buckley & Schneider, 2007). Kunskapsskolan schools were established in Sweden in 1999, it translates into ‘Knowledge School’s and currently operates 30 secondary schools in Sweden. Kunskapsskolan schools are privately managed, non-selective and non-fee paying, with funding for these schools provided by the Swedish government, (Eiken, 2011). The Kunskapsskolan model in Sweden has produced higher than average results and is currently the model behind a number of the UK academy schools. The Kunskapsskolan model was based on personalised learning with every student following a long-term learning and attainment plan which is formulated between the student and the student’s Personal Tutor and their parents. The learning plan was designed to ensure that every student achieves the very best results that he or she is capable of. Kunskapsskolan students are offered the opportunity to work at their own pace, using their own learning style to achieve their own goals and those set by accrediting bodies. Parents are encouraged to actively engage in their children’s education, participate in setting goals and are able to monitor their child’s progress through online reporting systems, (Ball, 2008). New Labour intended that the establishment of academies would drive up standards by replacing failing schools in struggling education authorities, (Chitty, 2009). Under New Labour’s guidelines the academy schools could be established only if they held a sp onsor and could raise two  million pounds in independent funding. The government would then contribute  £25 million, (Pennell & West, 2007). The academy would then run the school outside of the local education authority’s (LEA) funding control, but still operate within all the national requirements for curriculum and standards, (Griggs ,2010). The Coalition Government has greatly expanded the number of Academy schools. The Secretary of State for Education, Michael Gove, initially asked every head teacher in England if they would be interested in achieving academy status. By 31st August 2010, 170 mainstream schools had made an application to convert to academy status and as of 1st April 2012 there are 1776 academies in the UK, (education.gov.uk, 2012). The Academies Bill opened up the possibility of applying for Academy status to all schools and no longer required these schools to hold sponsorships or raise the initial  £2 million, (Wilson, 2011). All other schools, irrespective of their ‘Ofsted’ rating, were also able to apply to become academies if they are part of a group which includes a high performing school or if they join an existing successful academy trust. For the first time since its inception primary schools are also permitted to apply for Academy school status, (Bassett et al, 2012). Ofsted refers to the acronym used for the Office for Standards in Education. It monitors and is the overall regulatory body for the provision childminding, child day care, children’s centres, children’s social care, state schools, independent schools (including Academy schools) and teacher training providers, colleges and learning and skills providers in England, (ofsted.gov.uk, 2012). It also monitors the work of the Independent Schools Inspectorate. Following this, The Coalition Government introduced The Education Bill into the House of Commons on Wednesday 26th January 2011 and received Royal Assent on 15th November 2011, (legislation.gov.uk, 2011). The Education Act specified that from now on all new maintained schools must be setup as either an academy or ‘free schools’. So in effect there will be no new state schools, (Needham et al, 2006). Prior to this they launched a new initiative to introduce what they termed ‘Free School’s into the education arena. Free schools are proposed and governed by local community groups such as groups of parents, faith groups or other interested parties. They are free at source to parents and are all-ability state-funded schools set up in response by local people to meet the needs of local communities and in order to improve education for children in their community, (Leo et al, 2010). The first Free Schools opened in September 2011. Alongside Academies and Free schools, The Government also proposed other types of secondary educational settings governed by local community groups such as the University Technical Colleges and Studio Schools were launched. The process of creating a free school begins with the Secretary of State entering into an Academy Arrangement with a person, group of people, or an organisation. These arrangements usually take the form of an â€Å"Academy Agreement†. In this agreement, the government agrees to provide funds for the school in exchange for certain undertakings, including that the school provides provision for children with special educational needs and different abilities. that the curriculum is balanced and broadly based, that in the case of secondary schools, they provide an emphasis in a particular subject such as sport, science or the arts, and that the pupils are drawn wholly or mainly from the area in which the school is located, (Gunter, 2011). One concern voiced is the claim that Academy schools will be completely outside of the control of not only education authorities but national overarching governmental control, (Woods, 2011). However even the regular state schools have increasingly less control by local education authorities and it is certainly the case that successive reforms over the past two decades have given all schools much greater autonomy, (Bangs et al, 2010). Most legislation that governs schools is currently derived from national government or national bodies, such as the national curriculum or Standard Assessment Tests, Ofsted, or government legislation on issues such as safeguarding or Every Child Matters, (Field, 2010). Local education authorities, in fact have increasingly less control over individual schools. LEA’s continue to be responsible for the provision of school places, sitting appeals when a child does not gain a place at their chosen school and taking responsibility when a school fails, (Bradley & Taylor, 2010). LEA’s also continue to have responsibility for the provision of educational psychologists and special educational needs support. Nonetheless, Academy schools system does provide an increasing  amount of freedom not only for head teachers and teachers, in what they teach, how they are structured, pay structures, freedom to adapt the national curriculum and the freedom to vary the length of the school day and how the school sets its holidays, (Bassett et al, 2010) They also offer freedom to pupils in the sorts of the subjects they study and even in fact the kinds of examinations they gain, for instance, the English baccalaureate, (Taylor, 2010) When asked by the BBC’s Mike Baker in 2010, â€Å"what exactly makes an academy different?† The Former Schools Commissioner, Sir Bruce Liddington, stated that they are more, â€Å"a state of mind more than anything else†, (bbc.co.uk, 2010). Sir Bruce Liddington is the director-general of E-Act (formerly Edutrust Academies Charitable Trust), which is responsible 14 academies and free schools which aim to target the education of children in Britainâ⠂¬â„¢s most deprived areas. However critics have voiced concerns in regards to E-Act’s expansion plans in that they wish to create a â€Å"super-chain† of 250 academy and free schools within five years. There has also been criticism of how these schools will be run and the way market practices will influence the teaching, such as buying and selling of intellectual property, (guardian.co.uk, 2011). The Education Secretary, Michael Gove has stated that â€Å"outstanding† schools may possibly no longer have to undergo the Ofsted inspection, freeing them to concentrate solely on education and not preparing for audits. He has also made the link between â€Å"outstanding† schools and Academy schools, by allowing all â€Å"outstanding† schools to automatically achieve Academy status. Clearly this equates academies with quality, (Dept. of Education, 2010). New academy schools will not be able to select purely on ability, however Grammar schools which have converted to Academy status c an continue to do so, (Miller, 2011). Nonetheless Academies can and do select according to the behaviour of the child, (Sales et al, 2010). Much available research points to there being an increase in challenging behaviours amongst children and young people who come from deprived backgrounds, (Wickham, 2011). Michael Gove himself stated, in a speech at Durand Academy in London, ‘There is a direct line to deprivation which begins when children are failed in primary because their behaviour is not policed with proper boundaries and they are not taught how to read properly. When these young people arrive in  secondary school they cannot follow the curriculum and cover up their failure with a show of bravado, acting up in class’, (politics.co.uk, 2011). Michael Gove also made the link between children who have no positive male role model in their lives and, ‘the Educational underclass’, who he believed would ultimately continue on to become, ‘NEETS’ (not in education, employment or training), again making the links between behaviour and social and economic deprivation, (Attewell & Newman, 2011). The attempt to bring children out of poverty and encourage participation in education has been a central theme for the Neo-liberalism policies of the Coalition Government and the previous New Labour Government, (Hall, 2011). However it was the Coalition Government alone who expanded on the idea of the Academy Schools to Include ‘Free Schools’ and the thinking behind such proposals as the University Technical Colleges and Studio Schools. Free Schools are a recent concept introduced by the Coalition Government, making it possible for the first time parents, teachers, faith groups, charities and businesses to set up their own schools, (Morris, 2011). They are non-fee paying and supported by government. Free schools are subject to the School Admissions Code of Practice, other than that they are permitted to accept only those children they chose. The government has stated that Free Schools must meet the same admissions criteria as the National Admissions Code, however they will have the flexibility to select based on their own criteria. These types of schools are an extension of the existing Academies Programme. Free schools are expected to offer a broad and balanced curriculum. They are still su bject to Ofsted inspections and are expected to comply with standard performance measures, (education.gov.uk, 2011) The first 24 free schools opened in autumn 2011. They represent the most overtly market-oriented policy as part of the neo-liberal Coalition government’s school reform policies in England. There is some degree controversy, as these schools are led by market forces and again to achieve success will be motivated to accept only children from a particular group (for instance those of a particular faith). This could lead to some democratic discrimination if they are not made to be fully accountable in terms of the application process, the governance of free schools, and their effect on local authorities, (Hatcher, 2011). There are also some concerns that some free schools will be run for profit. So for example, it was reported in The  Guardian Newspaper,(guardian.co.uk, 2012), that the head of News Corporation, Rupert Murdoch; who is currently being investigated on charges of telephone hacking had had secret meetings with The Education Secretary Michael Gove expressed an interest in applying to set up a free school, (guardian.co.uk, 2012). One example of a free school will be the Phoenix Free School in Oldham which was conceived by Tom Burkard, a former teacher and military instructor. The school itself will be run by ex-military staff and will have a focus on discipline. Burkard says the school will teach children between the ages of 11years and 18years, and will encourage high standards of behaviour, literacy and numeracy, (localschoolsnetwork.org.uk, 2012). University Technical Colleges are described as a new concept in education which offers secondary age pupils from age 14years to 19years olds vocational courses at specialist colleges. There initially proposed by New Labour but had cross party support. The former education secretary, Lord Kenneth Baker proposed them as a means to promote the concept prepare younger people for work. He said, â€Å"We want to forge a partnership between vocational education and universities, further education colleges and employers.† Each university technical college (UTC) will be sponsored by a university or college of further education. They will develop their own specialism, usually to reflect the university’s a rea of excellence. The colleges are intended to be small, with numbers no more than 800 students. Funding is intended to come from sponsorship and from government. The university will not be required to provide funds; however, their assistance is needed for curriculum development, teaching support and guiding student’s education progression. These sorts of courses are intended to reflect a normal weekday and the students will embark on high quality vocational courses rather than purely academic ones. However, there is a requirement that the pupils continue have a background in academic study. Following post sixteen education, the pupils can progress onto apprenticeships utilising support from local employers for day placements with the most up to date equipment. This enhances the employment experience of students and is intended to encourage the development of a work ethic. Pupils can progress on to study for diplomas, A-levels other related qualifications, (edge.co.uk, 2012). There have been  some concerns voiced about the UTCs. For instance, John Bangs who is the head of education at the National Union of Teachers, fears this could lead to reintroducing widespread selection at 14, â€Å"Academies and UTCs are predicators of the kind of pessimism that kids are forever destined for one or other route. It sorts the sheep from the goats, which I’m very opposed to†, (guardian.co.uk, 2010). But Professor Alison Halstead, who is heading a UTC sponsored by Aston University, due to open in 2012, says fears are unfounded. â€Å"Nobody wants academic selection. This type of technical institution is not going to be suitable for all youngsters, and, if it’s not, there are 76 other schools in this area to choose from†. However the Department of Education has strict selection criteria which currently allow UTC’s to select only 10% of pupil admissions based on their aptitude and states that all of new the new school types must comply with the School Admissions Code, (Clegg, 2011). The Studio School is a yet another new concept in education, which seeks to address the growing gap between the skills, and knowledge that young people require to succeed, and those that the current education system provides. Studio Schools are designed for 14-19 year olds of all abilities. They are small schools for 300 students; and with year-round opening and a 9-5 working day, the emphasis will be on creating an environment more like a workplace than a school, (Fuller & Unwin, 2011). Working closely with local employers, Studio Schools will offer a range of academic and vocational qualifications including GCSEs in English, Maths and Science, as well as paid work placements linked directly to employment opportunities in the local area. Students will gain a broad range of employability and life skills through the skills framework, and will have the option to go on to university, further training, and into employment. There are also the concerns that these sorts of education facilities, like the free schools could have influence from market forces, (Bonell et al, 2011). Evidence in the past has suggested that this has a negative effect on children’s education and reduces their life choices in later life, (Gorard, 1997). As mentioned previously, many of the Charter Schools in USA have since failed many because they failed to attract the investment of businesses. The reasons for this are diverse, however some commentators highlight that many were developed within deprived inner city areas. Business ventures did initially contribute funding to set these  schools up but ultimately withdrew support as the area’s the schools were built in, were not in positions to sustain market involvement. It appeared that many were unlikely to become self-sustaining without on-going support from philanthropic communities, (Minow, 2000). It is the frailty of involving market forces into education that causes concerns for many. There are also issues as regards future life choice, for example, would a child whose school was funding entirely by a bank and who experienced the full weight of that bank’s marketing focuses, make another choice as regards their banking when they reached adulthood, (Adkins, 1999)? With all these new types of education structures there appears to be central themes of freedom and flexibility for teachers and head teachers with new opportunities for children, however alongside this there are concerns that these schools will create divisions within the education system. Also what of the children who will not get the opportunity to attend one of these new types of schools? Will they ‘suffer’ from attending less prestigious schools? What of teachers who do not hold prestigious qualifications? Although the new schools are not able to select purely on intellect, they can make some selections which state schools cannot, they can also select out children who have behaviou ral problems. As has been discussed earlier, this does tend to discriminate against children from deprived backgrounds and these were part of the criticisms that the ‘tripartite system of education’ was charged with in the 1960’s In 1944 The Butler Act brought about radical changes for the British Education System with the basic aim was to give every pupil an equal opportunity to develop his or her talents and abilities to the full, within a free system of state education, (Dent ,1948). For the first time the structure of Education in England and Wales was divided into three stages; Primary schools which taught children from 5years old up to the age of 11years, secondary from the age of 11years until 15years (This was increased to 16years from 1973) and then finally optional post-16yrs education in either an academic setting and on to Higher education or vocational qualifications via the further education route. The most important aspect of this was that for the first time, free secondary education became compulsory for all. At the time the Butler Education Act received cross party support, (Boyle, 1972). The Butler Act proposed three  different types of schools; grammar schools (which were intended for the most academic of children), secondary technical schools (which were intended for children who were gifted in the arts, technology or crafts) and secondary modern schools (For everyone else). This became known as the tripartite system. The tripartite system did allow for a small number of schools to combine all three types of school into one ‘Comprehensive system’, however in reality this did not happen, (Francis, 1995). Pupils were assessed by a tests called ‘the eleven plus’ which was administered to them at age 11years. This was a once only test after their 11th birthday. The system was intended to allocate pupils to the schools best suited to their â€Å"abilities and aptitudes†. However increasingly there were many criticisms directed at this system. For instance, the once only test decided a child’s future, the late developers, or children who were ill on the day, children with dyslexia or social problems were expected to achieve the same as any other child. It was almost certainly true that the test which was given by more or less exclusively middle class teachers was biased towards middle class children, for example it might ask a question which related to classical composers, something a middle class child would be more likely to answer right than a working class child, (Moore,1996). The intention had been that there would be parity of esteem between the three types of school, with none holding a more prestigious position than the other two. However, there were often only two types of school available in practice, those pupils classed as ‘Technical’ were denied the opportunity to attend Secondary Technical schools as very few were built. As a result Technical children went to Secondary Modern schools, (Elder, 1965). It was official policy to mark down female scores, so girls on the borderline of the academic threshold were denied a Grammar school education just because of their gender which resulted in them going to Secondary Moderns, (Deem, 1981). In effect, these meant that it became a one opportunity to pass or fail the eleven plus. Those who passed were granted the opportunity to attend Grammar schools, those who failed would be forced to attend Secondary Moderns, (Hendrick, 1997). Ultimately the result that vast majority of children went to Seco ndary Modern schools, (around seventy percent), and only about five percent were accepted into Secondary Technical schools. Consequently the majority of children were automatically considered to have  Ã¢â‚¬Ëœfailed’ the eleven plus, (Simon, 1986). Middle class children certainly derived the most benefit out of the tripartite system, and this was directly at the expense of the working class. Children from middle class homes were more likely to be focused to achieve within education, (Tomlinson, 1991). Middle class children were taught and tested by mostly middle class teachers which asked questions about experiences they were familiar with, (Welford, 1968). Working class children, in particular experienced the democratic prejudice that has more recently been a major criticism of the New Academy school system. For instance the eleven plus was seen as culturally biased towards the middle class; questions related to table place settings for example, something a middle class child would be more likely to be aware of than a working class child, (Marwick, 2003). Children attending the Secondary modern schools were not intended to achieve academic success or enter into the professions. Curriculums were developed out of the interests of local employers, such as manufacturers and agriculture and consequently taught subjects with a practical dimension. As there was no external examinations to be taken at the end of the pupil’s education and pupils were not under pressure to achieve, (Heath, 1984). There was a possibility of staying on for a further year and in the 1950s there was a growing tendency to do so. Those who continued into the 5th year could sit the General Certificate of Education (GCE) and a very small number did continue on to Higher education and the professions, (Little & Westergaard 1964). However this system did change things for many school children. It ensured secondary education was free for all and one of the results of the Act was to educate and mobilise women and the working class for the first time ever (Thompson, 2000). The Tripartite System was abolished by the new Labour government of 1974 and The 1976 Education Act finally ended any selection of pupils by ability thus officially ending the Tripartite System, (Aldrich, 2002). Although certainly there are a small number of Grammar schools who continue to operate and continue to select based entirely on ability. This is in part due to The Thatcher government allowing selection once again in 1979, and it was used increasingly by individual schools eager to choose  the best pupils, (Chitty, 1989). In 1986 the first City Technology Colleges were proposed, arguably inspired by the Technical schools. Although currently there have no further attempts made to restore the Tripartite System, the perceived failure of the Comprehensive System gave New Labour and currently the Coalition Government the impetus to propose â€Å"Beacon Schools†, â€Å"Advanced Schools† and an â€Å"escalator† or â€Å"ladder† of schools, (Brighouse, 2003). So will the new school systems create disparity? Certainly for pupils attending Academies do appear to gain much more from their state school counterparts; often built in brand new or newly renovated buildings, with smart new uniforms, lots of facilities and the best, most engaged and most highly paid teachers, (Gewirtz, 2009). As was discussed earlier, there has been a move by the Coalition Government to increase professional standing amongst teachers, by only allowing those with a first class honours degree to even enter the profession, (education.gov.uk, 2012). As a consequence these young teachers will obviously be sought after and will be attracted to the schools that pay the most, (Avis, 2011). Clearly Academy Schools, who can set their own pay scales, are more likely to attract the best educated teachers, (Lupton, 2011). So what of the rest? Michael Gove has often made the link between non-academy schools and ‘failure’. Immediately thrusting these children in a position of being ‘written off’ as ‘no hopers’ and failures; destined to a life of being a NEET or ending up in youth custody, (politics.co.uk, 212). Will these children in the future, become ‘the rest’ who under the tri-partite system ended up in secondary modern schools, those who were never quite good enough to meet the standards for a grammar school education? In April 2012, the National Association of Schoolmasters Union of Women Teachers’ union (NASUWT) meeting for its annual conference voiced concerns that academies will be used to dismantle national teacher’s pay agreements and will attack the stability of existing state schools, (bbc.co.uk, 2012). Michael Gove has also suggested that organisations of individuals who oppose the changes in the school systems are, â€Å"happy with failure†, (bbc.co.uk, 2012). However in fact, the Academy school system itself has not produced the outstanding educational results expected, (Barker,2012 ). Barker (2012) stated that the changes in the school system  were more likely to, ‘provoke a crisis than to sustain the last government’s drive for improved effectiveness’. There have also been other anxieties voiced by individuals, such as the celebrity chef, Jamie Oliver who accused the Government of attempting to make profits from school children by de-regulating school meals and allowing schools to utilise private companies and his biggest worry, fast food outlets to provide meals for school children, (bbc.co.uk, 2010). For British society to compete in the Global market place, it has to continue to educate its young people. The United Kingdom (UK) can no longer rely on its manufacturing base or the products of commonwealth nations. In the future the UK’s most saleable commodity will be its knowledge. Any Government will need to invest in its young people, encouraging in them a desire to learn and stimulate participation. The UK’s current market is dominated by financial services, especially in banking and insurance. For these services to continue to maintain the prestigious place they hold globally they must supported by continued inn ovation from information technology, architecture, science and the arts. However education is vital not just for the contributions the next generation will provide in creating wealth but as a part of human life in of itself. The importance of education to children and to British life is beyond question. It therefore should continue to attract the highest levels of investment from Government. Government’s led by individuals who most understand what it means to teach children; teachers. Teachers should be the ones to set standards, not big businesses. Children should be encouraged to participate because school is a place where they can feel valued and happy. Schools should ensure safety, not just within buildings or against school bullies but free from the influence of market forces. Governments should encourage parity across all schools and not attempt to make links between certain types of school and failure. The tripartite system benefitted one group of children with the exclusion all others. Modern education policies should not continue to do the same, because as Ghandi said, ‘You must be the Change you wish to see in the world’. 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A Study on Futures and Potions

A STUDY ON FUTURES AND POTIONS Project submitted in partial fulfillment for the award of the degree of MASTER OF BUSINESS ADMINISTRATION DECLARATION I hereby declare that this Project Report titled, â€Å"A STUDY ON THE DERIVATIVES† submitted by me to the Department OF BUSINESS ADMINISTRATION, XXXX and is a bonafide work under taken by me and it is not submitted to any other University or Institution for the award of any degree diploma / certificate or published any time before. Name and Address of the StudentSignature of the student Date : ACKNOWLEDGEMENTI wish to express my sincere deep sense of gratitude and also thank my guide XXX, Faculty of Finance for his significant suggestions and help in every aspect to accomplish the project work. His persisting encouragement, everlasting patience and keen interest in discussions have benefited me to the extent that cannot be spanned by words. I take my pleasure to acknowledge XXXX for the facilities provided and constant encouragem ent. Finally I express bows to everyone who are involved with this project. CONTENTS INTRODUCTION METHODOLOGY 1 FUTURES 2 OPTIONS ANALYSIS OF THE STUDYSUMMARY AND CONCLUSIONS BIBLIOGRAPHY INTRODUCTION Nature of the problem: The turnover of the stock exchanges has been tremendously increasing from last 10 years. The number of trades and the number of investors, who are participating, have increased. The investors are willing to reduce their risk, so they are seeking for the risk management tools. Prior to SEBI abolishing the BADLA system, the investors had this system as a source of reducing the risk, as it has many problems like no strong margining system, unclear expiration date and generating counter party risk.In view of this problem SEBI abolished the BADLA system. After the abolition of the BADLA system, the investors are seeking for a hedging system, which could reduce their portfolio risk. SEBI thought the introduction of the derivatives trading, as a first step it has set up a 24 member committee under the chairmanship of Dr. L. C. Gupta to develop the appropriate regulatory framework for derivative trading in India, SEBI accepted the recommendations of the committee on May 11, 1998 and approved the phased introduction of the derivatives trading beginning with stock index futures.There are many investors who are willing to trade in the derivative segment, because of its advantages like limited loss and unlimited profit by paying the small premiums. IMPORTANCE OF THE STUDY: To evaluate the profit/loss position of option holder and option writer. OBJECTIVES OF THE STUDY: ? To analyze the derivatives market in India. ? To analyze the operations of futures and options. ? To find out the profit/loss position of the option writer and option holder. ? To study about risk management with the help of derivatives. SCOPE OF THE STUDY:The study is limited to â€Å"Derivatives† with special reference to futures and options in the Indian context and the Hyder abad stock exchange has been taken as a representative sample for the study. The study can’t be said as totally perfect. Any alteration may come. The study has only made a humble attempt at evaluating derivatives market only in Indian context. The study is not based on the international perspective of derivatives markets, which exists in NASDAQ, NYSE etc. LIMITATIONS OF THE STUDY: The following are the limitations of this study. The scrip chosen for analysis is STATE BANK OF INDIA and the contract taken is March 2005 ending one-month contract. ? The data collected is completely restricted to the STATE BANK OF INDIA of March 2005; hence this analysis cannot be taken as universal. METHODOLOGY 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 ma rkets 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. Derivatives are risk management instruments, which derive their value from an underlying asset.The underlying asset can be bullion, index, share, bonds, currency, interest etc. Banks, securities firms, companies and investors to hedge risks, to gain access to cheaper money and to make profit, use derivatives. Derivatives are likely to grow even at a faster rate in future. DEFINITION: Derivative is a product whose value is derived from the value of an underlying asset in a contractual manner. The underlying a sset can be equity, forex, commodity or any other asset. Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines â€Å"derivative† to include – 1.A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. PARTICIPANTS: The following three broad categories of participants in the derivatives market. HEDGERS: Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. SPECULATORS: Speculators wish to bet on future movements in the price of an asset.Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. ARBITRAGEURS: Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. FUNCTIONS OF DERIVATIVES MARKET: The following are the various functions that are performed by the derivatives markets.They are: ? Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. ? Derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. ? Derivative trading acts as a catalyst for new entrepreneurial activity. ? Derivatives markets help increase savings and investment in the long run. Types of derivatives: the following are the various types of derivatives. They are: Forwards:A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the futu re at today’s pre-agreed price. Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Options: Options are of two types – calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give 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.Warrants: Options generally have lives of upto one year; the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset i s usually a moving average of a basket of assets. Equity index options are a form of basket options. Swaps:Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. _ Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite Direction. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options.Thus a swaption is an option on a forward swap. RATIONALE BEHIND THE DEVELOPMENT OF DERIVATIVES: Holding portfolio of securities is associated with the risk of the possibility that the investor may realize his returns, which would be much lesser than what he expected to get. There are various factors, which affect the returns: 1. Price or dividend (interest). 2. Some are internal to the firm like – ? Industrial policy ? Management capabilities ? Consumer’s preference ? Labor strike, etc. These forces are to a large extent controllable and are termed as non Systematic risks.An investor can easily manage such non-systematic by having a well – diversified portfolio spread across the companies, industries and groups so that a loss in one may easily be compensated with a gain in other. There are yet other types of influences which are external to the firm, cannot be controlled and affect large number of securities. They are termed as systematic risk. They are: 1. Economic 2. Political 3. Sociological changes are sources of systematic risk. For instance, inflation, interest rate, etc. their effect is to cause prices of nearly all individual stocks to move together in the same manner.We therefore quite often find s tock prices falling from time to time in spite of company’s earnings rising and vice versa. Rationale behind the development of derivatives market is to manage this systematic risk, liquidity and liquidity in the sense of being able to buy and sell relatively large amounts quickly without substantial price concessions. In debt market, a large position of the total risk of securities is systematic. Debt instruments are also finite life securities with limited marketability due to their small size relative to many common stocks.Those factors favour for the purpose of both portfolio hedging and speculation, the introduction of a derivative security that is on some broader market rather than an individual security. India has vibrant securities market with strong retail participation that has rolled over the years. It was until recently basically cash market with a facility to carry forward positions in actively traded ‘A’ group scrips from one settlement to another b y paying the required margins and borrowing some money and securities in a separate carry forward session held for this purpose.However, a need was felt to introduce financial products like in other financial markets world over which are characterized with high degree of derivative products in India. Derivative products allow the user to transfer this price risk by looking in the asset price there by minimizing the impact of fluctuations in the asset price on his balance sheet and have assured cash flows. Derivatives are risk management instruments, which derive their value from an underlying asset. The underlying asset can be bullion, index, shares, bonds, currency etc.DERIVATIVE SEGMENT AT NATIONAL STOCK EXCHANGE: The derivatives segment on the exchange commenced with S&P CNX Nifty Index futures on June 12, 20007. The F&O segment of NSE provides trading facilities for the following derivative segment: 1. Index Based Futures 2. Index Based Options 3. Individual Stock Options 4. Ind ividual Stock Futures |COMPANY NAME |CODE |LOT SIZE | |ABB Ltd. ABB |200 | |Associated Cement Co. Ltd. |ACC |750 | |Allahabad Bank |ALBK |2450 | |Andhra Bank |ANDHRABANK |2300 | |Arvind Mills Ltd. ARVINDMILL |2150 | |Ashok Leyland Ltd |ASHOKLEY |9550 | |Bajaj Auto Ltd. |BAJAJAUTO |200 | |Bank of Baroda |BANKBARODA |1400 | |Bank of India |BANKINDIA |1900 | |Bharat Electronics Ltd. BEL |550 | |Bharat Forge Co Ltd |BHARATFORG |200 | |Bharti Tele-Ventures Ltd |BHARTI |1000 | |Bharat Heavy Electricals Ltd. |BHEL |300 | |Bharat Petroleum Corporation Ltd. |BPCL |550 | |Cadila Healthcare Limited |CADILAHC 500 | |Canara Bank |CANBK |1600 | |Century Textiles Ltd |CENTURYTEX |850 | |Chennai Petroleum Corp Ltd. |CHENNPETRO |950 | |Cipla Ltd. |CIPLA |1000 | |Kochi Refineries Ltd |COCHINREFN |1300 | |Colgate Palmolive (I) Ltd. COLGATE |1050 | |Dabur India Ltd. |DABUR |1800 | |GAIL (India) Ltd. |GAIL |1500 | |Great Eastern Shipping Co. Ltd. |GESHIPPING |1350 | |Glaxosmithkline Pharma Ltd. |GLAXO |300 | |Grasim Industries Ltd. |GRASIM |175 | |Gujarat Ambuja Cement Ltd. GUJAMBCEM |550 | |HCL Technologies Ltd. |HCLTECH |650 | |Housing Development Finance Corporation Ltd. |HDFC |300 | |HDFC Bank Ltd. |HDFCBANK |400 | |Hero Honda Motors Ltd. |HEROHONDA |400 | |Hindalco Industries Ltd. |HINDALC0 |150 | |Hindustan Lever Ltd. HINDLEVER |2000 | |Hindustan Petroleum Corporation Ltd. |HINDPETRO |650 | |ICICI Bank Ltd. |ICICIBANK |700 | |Industrial development bank of India Ltd. |IDBI |2400 | |Indian Hotels Co. Ltd. |INDHOTEL |350 | |Indian Rayon And Industries Ltd | INDRAYON |500 | |Infosys Technologies Ltd. INFOSYSTCH |100 | |Indian Overseas Bank |IOB |2950 | |Indian Oil Corporation Ltd. |IOC |600 | |ITC Ltd. |ITC |150 | |Jet Airways (India) Ltd. |JETAIRWAYS |200 | |Jindal Steel & Power Ltd |JINDALSTEL |250 | |Jaiprakash Hydro-Power Ltd. JPHYDRO |6250 | |Cummins India Ltd |KIRLOSKCUM |1900 | |LIC Housing Finance Ltd |LICHSGFIN |850 | |Mahindra & Mahindra Ltd. |M&M |625 | |Matrix La boratories Ltd. |MATRIXLABS |1250 | |Mangalore Refinery and Petrochemicals Ltd. MRPL |4450 | |Mahanagar Telephone Nigam Ltd. |MTNL |1600 | |National Aluminium Co. Ltd. |NATIONALUM |1150 | |Neyveli Lignite Corporation Ltd. |NEYVELILIG |2950 | |Nicolas Piramal India Ltd |NICOLASPIR |950 | |National Thermal Power Corporation Ltd. NTPC |3250 | |Oil & Natural Gas Corp. Ltd. |ONGC |300 | |Oriental Bank of Commerce |ORIENTBANK |600 | |Patni Computer System Ltd |PATNI |650 | |Punjab National Bank |PNB |600 | |Ranbaxy Laboratories Ltd. RANBAXY |200 | |Reliance Energy Ltd. |REL |550 | |Reliance Capital Ltd |RELCAPITAL |1100 | |Reliance Industries Ltd. |RELIANCE |600 | |Satyam Computer Services Ltd. SATYAMCOMP |600 | |State Bank of India |SBIN |500 | |Shipping Corporation of India Ltd. |SCI |1600 | |Siemens Ltd |SIEMENS |150 | |Sterlite Industries (I) Ltd |STER |350 | |Sun Pharmaceuticals India Ltd. SUNPHARMA |450 | |Syndicate Bank |SYNDIBANK |3800 | |Tata Chemicals Ltd |TATACHEM |1350 | |Tata Consultancy Services Ltd |TCS |250 | |Tata Power Co.Ltd. |TATAPOWER |800 | |Tata Tea Ltd. |TATATEA |550 | |Tata Motors Ltd. |TATAMOTORS |825 | |Tata Iron and Steel Co. Ltd. |TISCO |675 | |Union Bank of India |UNIONBANK |2100 | |UTI Bank Ltd. UTIBANK |900 | |Vijaya Bank |VIJAYABANK |3450 | |Videsh Sanchar Nigam Ltd |VSNL |1050 | |Wipro Ltd. |WIPRO |300 | |Wockhardt Ltd. |WOCKPHARMA |600 | REGULATORY FRAMEWORK:The trading of derivatives is governed by the provisions contained in the SC ( R ) A, the SEBI Act, the and the regulations framed there under the rules and byelaws of stock exchanges. Regulation for Derivative Trading: SEBI set up a 24 member committed under Chairmanship of Dr. L. C. Gupta develop the appropriate regulatory framework for derivative trading in India. The committee submitted its report in March 1998. On May 11, 1998 SEBI accepted the recommendations of the committee and approved the phased introduction of Derivatives trading in India beginning with Stock Index F utures.SEBI also approved he â€Å"Suggestive bye-laws† recommended by the committee for regulation and control of trading and settlement of Derivatives contracts. The provisions in the SC (R) A govern the trading in the securities. The amendment of the SC (R) A to include â€Å"DERIVATIVES† within the ambit of ‘Securities’ in the SC (R ) A made trading in Derivatives possible within the framework of the Act. 1. Any exchange fulfilling the eligibility criteria as prescribed in the L. C. Gupta committee report may apply to SEBI for grant of recognition under Section 4 of the SC (R) A, 1956 to start Derivatives Trading.The derivatives exchange/segment should have a separate governing council and representation of trading / clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange shall regulate the sales practices of its members and will obtain approval of SEBI before start of Trading in any derivative co ntract. 2. The exchange shall have minimum 50 members. 3. The members of an existing segment of the exchange will not automatically become the members of the derivative segment. The members of the derivative segment need to fulfill the eligibility conditions as lay down by the L.C. Gupta Committee. 4. The clearing and settlement of derivates trades shall be through a SEBI approved Clearing Corporation / Clearing house. Clearing Corporation / Clearing House complying with the eligibility conditions as lay down By the committee have to apply to SEBI for grant of approval. 5. Derivatives broker/dealers and Clearing members are required to seek registration from SEBI. 6. The Minimum contract value shall not be less than Rs. 2 Lakh. Exchanges should also submit details of the futures contract they purpose to introduce. 7.The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI. FUTURES DEFINITION: A Futur es contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. To facilitate liquidity in the futures contract, the exchange specifies certain standard features of the contract. The standardized items on a futures contract are: ? Quantity of the underlying ? Quality of the underlying ? The date and the month of delivery ? The units of price quotations and minimum price change ? Locations of settlementTYPES OF FUTURES: On the basis of the underlying asset they derive, the futures are divided into two types: ? Stock futures: The stock futures are the futures that have the underlying asset as the individual securities. The settlement of the stock futures is of cash settlement and the settlement price of the future is the closing price of the underlying security. ? Index futures: Index futures are the futures, which have the underlying asset as an Index. The Index futures are also cash settled. The settlement price of the Inde x futures shall be the closing value of the underlying index on the expiry date of the contract.Parties in the Futures Contract: There are two parties in a future contract, the Buyer and the Seller. The buyer of the futures contract is one who is LONG on the futures contract and the seller of the futures contract is one who is SHORT on the futures contract. The pay off for the buyer and the seller of the futures contract are as follows. PAYOFF FOR A BUYER OF FUTURES: [pic] CASE 1: The buyer bought the future contract at (F); if the futures price goes to E1 then the buyer gets the profit of (FP). CASE 2: The buyer gets loss when the future price goes less than (F), if the futures price goes to E2 then the buyer gets the loss of (FL).PAYOFF FOR A SELLER OF FUTURES: [pic] F – FUTURES PRICE E1, E2 – SETTLEMENT PRICE. CASE 1: The Seller sold the future contract at (f); if the futures price goes to E1 then the Seller gets the profit of (FP). CASE 2: The Seller gets loss when the future price goes greater than (F), if the futures price goes to E2 then the Seller gets the loss of (FL). MARGINS: Margins are the deposits, which reduce counter party risk, arise in a futures contract. These margins are collected in order to eliminate the counter party risk. There are three types of margins: Initial Margin:Whenever a futures contract is signed, both buyer and seller are required to post initial margin. Both buyer and seller are required to make security deposits that are intended to guarantee that they will infact be able to fulfill their obligation. These deposits are Initial margins and they are often referred as performance margins. The amount of margin is roughly 5% to 15% of total purchase price of futures contract. Marking to Market Margin: The process of adjusting the equity in an investor’s account in order to reflect the change in the settlement price of futures contract is known as MTM Margin.Maintenance margin: The investor must keep the fut ures account equity equal to or greater than certain percentage of the amount deposited as Initial Margin. If the equity goes less than that percentage of Initial margin, then the investor receives a call for an additional deposit of cash known as Maintenance Margin to bring the equity up to the Initial margin. Role of Margins: The role of margins in the futures contract is explained in the following example. S sold a Satyam February futures contract to B at Rs. 300; the following table shows the effect of margins on the contract.The contract size of Satyam is 1200. The initial margin amount is say Rs. 20000, the maintenance margin is 65% of Initial margin. |DAY |PRICE OF SATYAM |EFFECT ON BUYER (B) |EFFECT ON SELLER (S) |REMARKS | | | |MTM |MTM | | | | |P/L |P/L | | | | |Bal. in Margin |Bal. n Margin | | | | | | | | |1 | | | | | | | | | |Contract is entered and| | |300. 00 | | |initial margin is | | | | | |deposited. |2 | | | | | | | | | | | | | |+13,200 | | | | | | |-13,200 |B got profit and S got | | |311(price increased) | |+13,200 |loss, S deposited | |3 | | | |maintenance margin. | | | | | | | | | | | |B got loss and | | | | | |deposited maintenance | |4 | |-28,800 | |margin. | | |+15,400 |+28,800 | | | | | | | | | |287 | | |B got profit, S got | | | | | |loss. Contract settled| | | | | |at 305, totally B got | | | |+21,600 | |profit and S got loss. | | | |-21,600 | | | | | | | | | |305 | | | | Pricing the Futures: The fair value of the futures contract is derived from a model known as the Cost of Carry model. This model gives the fair value of the futures contract. Cost of Carry Model: F=S (1+r-q) t Where F – Futures Price S – Spot price of the Underlying r – Cost of Financing q – Expected Dividend Yield T – Holding Period. FUTURES TERMINOLOGY: Spot price: The price at which an asset trades in the spot market. Futures price: The price at which the futures contract trades in the futures market.Contract cycle: The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. Expiry date: It is the date specified in the futures contract. This is the last day on which the contract will be traded, at the end of which it will cease to exist. Contract size:The amount of asset that has to be delivered under one contract. For instance, the contract size on NSE’s futures market is 200 Nifties. Basis: In the context of financial futures, basis can be defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. Cost of carry: The relationship between futures prices and spot prices can be summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Open Interest:Total outstanding long or short positions in the market at any specific time. As total long positions for market would be equal to short positions, for calculation of open interest, only one side of the contract is counted. OPTIONS DEFINITION: Option is a type of contract between two persons where one grants the other the right to buy a specific asset at a specific price within a specified time period. Alternatively the contract may grant the other person the right to sell a specific asset at a specific price within a specific time period. In order to have this right, the option buyer has to pay the seller of the option premium. The assets on which optio ns can be derived are stocks, commodities, indexes etc.If the underlying asset is the financial asset, then the options are financial options like stock options, currency options, index options etc, and if the underlying asset is the non-financial asset the options are non-financial options like commodity options. PROPERTIES OF OPTIONS: Options have several unique properties that set them apart from other securities. The following are the properties of options: ? Limited Loss ? High Leverage Potential ? Limited Life PARTIES IN AN OPTION CONTRACT: 1. Buyer of the Option: The buyer of an option is one who by paying option premium buys the right but not the obligation to exercise his option on seller/writer. . Writer/Seller of the Option: The writer of a call/put options is the one who receives the option premium and is there by obligated to sell/buy the asset if the buyer exercises the option on him. . TYPES OF OPTIONS: The options are classified into various types on the basis of var ious variables. The following are the various types of options: I) On the basis of the Underlying asset: On the basis of the underlying asset the options are divided into two types: ? INDEX OPTIONS: The Index options have the underlying asset as the index. ? STOCK OPTIONS: A stock option gives the buyer of the option the right to buy/sell stock at a specified price.Stock options are options on the individual stocks, there are currently more than 50 stocks are trading in this segment. II. On the basis of the market movement: On the basis of the market movement the options are divided into two types. They are: ? CALL OPTION: A call options is bought by an investor when he seems that the stock price moves upwards. A call option gives the holder of the option the right but not the obligation to buy an asset by a certain date for a certain price. ? PUT OPTION: A put option is bought by an investor when he seems that the stock price moves downwards. A put option gives the holder of the op tion right but not the obligation to sell an asset by a certain date for a certain price. III. On the basis of exercise of Option:On the basis of the exercising of the option, the options are classified into two categories. ? AMERICAN OPTION: American options are options that can be exercised at any time up to the expiration date, most exchange-traded options are American. ? EUROPEAN OPTION: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options. PAY-OFF PROFILE FOR BUYER OF A CALL OPTION: The pay-off of a buyer options depends on the spot price of the underlying asset. The following graph shows the pay-off of buyer of a call option: S-Strike priceOTM – Out of the Money SP -Premium/LossATM – At the MoneyE1 – Spot price 1 ITM – In The Money E2 – Spot price 2 SR – profit at spot price E1 CASE 1: (Spot price > Strike Price) As the spot price (E1) of the underlying asset is more than strike price (S). The buyer gets the profit of (SR), if price increases more than E1 than profit also increase more than SR. CASE 2: (Sport price < Strike Price) As the spot price (E2) of the underlying asset is less than strike price (s). The buyer gets loss of (SP), if price goes down less than E2 than also his loss is limited to his premium (SP). PAY – OFF PROFILE FOR SELLER OF A CALL OPTION:The pay-off of seller of the call option depends on the spot price of the underlying asset. The following graph shows the pay-off of seller of a call option: [pic] S-Strike priceITM – In the Money SP – Premium/profitATM – At the Money E1-Spot price 1OTM – Out of The Money E2 -Spot price 2 SR-profit at spot price E1 CASE 1: (Spot price < Strike price) As the spot price (E1) of the underlying asset is less than strike price (S). The seller gets the profit of (SP), if the price decreases less than E1 than also profit of the seller does not exceed (SP). CASE 2: (Spot price > Strike price) As the spot price (E2) of the underlying asset is more than strike price (S).The seller gets loss of (SR), if price goes more less than E2 than the loss of the seller also increase more than (SR). PAY-OFF PROFILE FOR BUYER OF A PUT OPTION: The payoff of buyer of the option depends on the spot price of the underlying asset. The following graph shows the pay off of the buyer of a call option: [pic] S-Strike priceITM-In The Money SP-Premium/profitOTM-Out of The Money E1-Spot price 1ATM-At The Money E2-Spot price 2 SR-profit at spot price E1 CASE 1: (Spot price < Strike price) As the spot price (E1) of the underlying asset is less than strike price (S). The buyer gets the profit of (SR), if price decreases less than E1 than the profit also increases more than (SR). CASE 2: (Spot price > Strike price)As the spot price (E2) of the underlying asset is more than strike price (s), the buyer gets loss of (SP), if price goes more than E2 than the loss of the buyer is limited to his premium (SP). PAY-OFF PROFILE FOR SELLER OF A PUT OPTION: The pay off of seller of the option depends on the spot price of the underlying asset. The following graph shows the pay-off of seller of a put option: [pic] S-Strike priceITM-In The Money SP-Premium/profitATM-At The Money E1-Spot price 1OTM-Out of The Money E2-Spot price 2 SR-profit at spot price E1 CASE 1: (Spot price < Strike price) As the spot price (E1) of the underlying asset is less than strike price (S), the seller gets the loss of (SR), if price decreases less than E1 than the loss also increases more than (SR). CASE 2: (Spot price > Strike price)As the spot price (E2) of the underlying asset is more than strike price (S), the seller gets profit of (SP), if price goes more than E2 than the profit of the seller is limited to his premium (SP). FACTORS AFFECTING THE PRICE OF AN OPTION: The following are the various factors that affect the price of an option. They are: Stoc k price: The pay-off from a call option is the amount by which the stock price exceeds the strike price. Call options therefore become more valuable as the stock price increases and vice versa. The pay-off from a put option is the amount; by which the strike price exceeds the stock price. Put options therefore become more valuable as the stock price increases and vice versa. Strike price:In the case of a call, as the strike price increases, the stock price has to make a larger upward move for the option to go in-the –money. Therefore, for a call, as the strike price increases, options become less valuable and as strike price decreases, options become more valuable. Time to expiration: Both Put and Call American options become more valuable as the time to expiration increases. Volatility: The volatility of n a stock price is a measure of uncertain about future stock price movements. As volatility increases, the chance that the stock will do very well or very poor increases. Th e value of both Calls and Puts therefore increase as volatility increase.Risk-free interest rate: The put option prices decline as the risk – free rate increases where as the prices of calls always increase as the risk – free interest rate increases. Dividends: Dividends have the effect of reducing the stock price on the ex dividend date. This has a negative effect on the value of call options and a positive affect on the value of put options. PRICING OPTIONS The Black Scholes formulas for the prices of European Calls and puts on a non-dividend paying stock are: CALL OPTION: C = SN (D1)-Xe-rtN(D2) PUT OPTION: P = Xe-rtN(-D2)-SN (-D2) C – VALUE OF CALL OPTION S – SPOT PRICE OF STOCK X – STRIKE PRICE r – ANNUAL RISK FREE RETURN – CONTRACT CYCLE D1 – (ln(s/x) +(r+ )/2) t)/ D2 – D1- Options Terminology: Strike Price: The price specified in the options contract is known as the Strike price or Exercise price. Option Premium: O ption premium is the price paid by the option buyer to the option seller. Expiration Date: The date specified in the options contract is known as the expiration date. In-The-Money Option: An in the money option is an option that would lead to a positive cash inflow to the holder if it is exercised immediately. At-The-Money Option: An at the money option is an option that would lead to zero cash flow if it is exercised immediately. Out-Of-The-Money Option:An out of the money option is an option that would lead to a negative cash flow if it is exercised immediately. Intrinsic Value of an Option: The intrinsic value of an option is ITM, if option is ITM. If the option is OTM, its intrinsic value is ZERO. Time Value of an Option: The time value of an option is the difference between its premium and its intrinsic value. DESCRIPTION OF THE METHOD: The following are the steps involved in the study. 1. Selection of the scrip: The scrip selection is done on a random basis and the scrip selec ted is RELIANCE COMMUNICATIONS. The lot size of the scrip is 500. Profitability position of the option holder and option writer is studied. 2. Data collection:The data of the RELIANCE COMMUNICATIONS has been collected from the â€Å"The Economic Times† and the internet. The data consists of the March contract and the period of data collection is from 30th December 2008 to 31st January 2008. 3. Analysis: The analysis consists of the tabulation of the data assessing the profitability positions of the option holder and the option writer, representing the data with graphs and making the interpretations using the data. ANALYSIS ANALYSIS The objective of this analysis is to evaluate the profit/loss position of option holder and option writer. This analysis is based on the sample data, taken RELIANCE COMMUNICATIONS scrip. This analysis considered the March ending contract of the SBI.The lot size of SBI is 500. The time period in which this analysis is done is from 30/12/2007 To 31/0 1/2008 Price of SBI in the Cash Market. |DATE |MARKET PRICE | | | | |30-Dec-07 |685. 1 | |31-Dec-07 |714. 65 | |1-Jan-08 |695. 6 | |2-Jan-08 |706. 4 | |3-Jan-08 |717. 1 | |4-Jan-08 |713. 45 | |7-Jan-08 |726. 6 | |8-Jan-08 |724. 05 | |9-Jan-08 |720. 85 | |10-Jan-08 |742. 1 | |11-Jan-08 |736. | |14-jan-08 |734. 1 | |15-Jan-08 |731. 75 | |16-Jan-08 |728 | |17-Jan-08 |726. 2 | |18-Jan-08 | | | |727. 8 | | | | |21-Jan-08 |722. 7 | |22-Jan-08 |693. 25 | |23-Jan-08 |657. 7 | |24-Jan-08 |664. 4 | |28-Mar-08 |665. 6 | |29-Jan-08 |641. 7 | |30-Jan-08 |661. 05 | |31-Jan-08 |654. 8 | pic] The closing price of SBI at the end of the contract period is 654. 80 and this is considered as settlement price. The following table explains the amount of transaction between option holder and option writer. ? The first column explains the trading date. ? The second column explains the market price in cash segment on that date. ? The call column explains the call/put options which are considered. Every call/ put has three sub columns. ? The first column consists of the premium value per share of the contracts, second column consists of the volume of the contract, and the third column consists of total premium value paid by the buyer. ?NET PAYOFF FOR CALL OPTION HOLDERS AND WRITERS |MARKET PRICE |CALLS |VOLUME (‘000) |PREMIUM (‘000) |PROFIT TO HOLDER|NET PROFIT TO |NET PROFIT TO | | | | | |(‘000) |HOLDER (‘000) |BUYER (‘000) | | | | | | | | | |654. 8 |640 |199. 5 |3634. 15 |2952. 6 |-681. 55 |681. 55 | |654. 8 |660 |1463 |21600. 35 |0 |-21600. 35 |21600. 35 | |654. |680 |2008 |51831. 53 |0 |-51831. 525 |51831. 525 | |654. 8 |700 |3297 |85603. 45 |0 |-85603. 45 |85603. 45 | |654. 8 |720 |3796. 5 |74881. 93 |0 |-74881. 925 |74881. 925 | |654. 8 |740 |2309. 5 |30208. 4 |0 |-30208. 4 |30208. 4 | OBSERVATIONS AND FINDINGS: ? Six call options are considered with six different strike prices. ? The current market price on the expiry date is Rs. 654. 80 and this is c onsidered as final settlement price. The premium paid by the option holders whose strike price is far and greater than the current market price have paid high amounts of premium than those who are near to the current market price. ? The call option holders whose strike price is less than the current market price are said to be In-The-Money. The calls with strike price 640 are said to be In-The-Money, since, if they exercise they will get profits. ? The call option holders whose strike price is less than the current market price are said to be Out-Of-The-Money. The calls with strike price of 660, 680,700,720,740 are said to be Out-Of-The-Money, since, if they exercise, they will get losses. [pic] FINDINGS:The premium of the options with strike price of 700 and 720 is high, since most of the period of the contract the cash market is moving around 700 mark. [pic] FINDINGS: ? The contracts with strike price 660, 680, 700, 720, 740 get no profit, since their strike price is more than the settlement price. ? The contract with strike price 640 gets the profit. NET PAY OFF OF PUT OPTION HOLDERS AND WRITERS. |MARKET PRICE |PUTS |VOLUME (‘000) |PREMIUM (‘000) |PROFIT TO HOLDER |NET PROFIT TO HOLDER |NET PROFIT TO WRITER| | | | | |(‘000) |(‘000) |(‘000) | | | | | | | | | |654. |600 |25 |47. 625 |0 |-47. 625 |47. 625 | |654. 8 |640 |323. 5 |993. 5 |0 |-993. 5 |993. 5 | |654. 8 |660 |1239. 5 |9506. 575 |6445. 4 |-3061. 175 |3061. 175 | |654. 8 |680 |1399. 5 |21894 |35267. 4 |13373. 4 |-13373. 4 | |654. 8 |700 |1858 |30871. 28 |83981. 6 |53110. 325 |-53110. 325 | |654. |720 |1468. 5 |23727. 83 |95746. 2 |72018. 375 |-72018. 375 | | | | | | | | | OBSERVATIONS AND FINDINGS: ? Six put options are considered with six different strike prices. ? The current market price on the expiry date is Rs. 654. 80 and this is considered as the final settlement price. ? The premium paid by the option holders whose strike price is far and greater than the current market price have paid high amount of premium than those who are near to the current market price. The put option holders whose strike price is more than the current market price are said to be In-The-Money. The puts with strike price 660,680,700,720 are said to be In-The-Money, since, if they exercise they will get profits. ? The put option holders whose strike price is less than the current market price are said to be Out-Of-The-Money. The puts with strike price of 600,640 are said to be Out-Of-The-Money, since, if they exercise their puts, they will get losses. [pic] FINDINGS: ? The premium of the option with strike price 700 is higher when compared to other strike prices. This is because of the movement of the cash market price of the SBI between 640 and 720. [pic] FINDINGS: The put option holders whose strike price is more than the settlement price are In-The-Money. ? The put options whose strike price is less than the settlement price are Out-Of-The-Money. DATA OF SBI THE FUT URES OF THE JANUARY MONTH |DATE |FUTURES CLOSING PRICE (Rs. ) |CASH CLOSING PRICE (Rs. ) | | | | | |30-Dec-07 |689. 6 |685. 1 | |31-Dec-07 |720. 65 |714. 65 | |1-Jan-08 |700. 5 |695. 6 | |2-Jan-08 |710. 9 |706. 4 | |3-Jan-08 |720. 85 |717. 1 | |4-Jan-08 |716. 85 |713. 45 | |7-Jan-08 |729. 2 |726. 6 | |8-Jan-08 |728. 25 |724. 05 | |9-Jan-08 |723. 35 |720. 5 | |10-Jan-08 |745. 3 |742. 1 | |11-Jan-08 |741. 35 |736. 9 | |14-Jan-08 |738. 95 |734. 1 | |15-Jan-08 |735. 7 |731. 75 | |16-Jan-08 |733. 15 |728 | |17-Jan-08 |730. 75 |726. 2 | |18-Jan-08 |732. |727. 8 | |21-Jan-08 |725. 25 |722. 7 | |22-Jan-08 |695 |693. 25 | |23-Jan-08 |660. 1 |657. 7 | |24-Jan-08 |666. 7 |664. 4 | |28-Jan-08 |667. 75 |665. 6 | |29-Jan-08 |642. 7 |641. 7 | |30-Jan-08 |662. 5 |661. 05 | |31-Jan-08 |655. 95 |654. 8 | [pic] OBSERVATIONS AND FINDINGS: The cash market price of the SBI is moving along with the futures price. ? If the buy price of the futures is less than the settlement price, then the buyer of the f utures get profit. ? If the selling price of the futures is less than the settlement price, then the seller incur losses. SUMMARY, CONCLUSIONS AND RECOMMENDATINONS SUMMARY ? Derivatives market is an innovation to cash market. Approximately its daily turnover reaches to the equal stage of cash market. Presently the available scrips in futures are 89 and in options segment are 62. ? In cash market the profit/loss of the investor depends on the market price of the underlying asset. The investor may incur huge profits or he may incur huge losses. But in derivatives segment the investor enjoys huge profits with limited downside. ? In cash market the investor has to pay the total money, but in derivatives the investor has to pay premiums or margins, which are some percentage of total money. ? Derivatives are mostly used for hedging purpose. ? In derivative segment the profit/loss of the option holder/option writer is purely depended on the fluctuations of the underlying asset. CONCLUSIONS In bullish market the call option writer incurs more losses so the investor is suggested to go for a call option to hold, where as the put option holder suffers in a bullish market, so he is suggested to write a put option. ? In bearish market the call option holder will incur more losses so the investor is suggested to go for a call option to write, where as the put option writer will get more losses, so he is suggested to hold a put option. ? In the above analysis the market price of State Bank of India is having low volatility, so the call option writers enjoy more profits to holders. RECOMMENDATIONS ? The derivative market is newly started in India and it is not known by every investor, so SEBI has to take steps to create awareness among the investors about the derivative segment. In order to increase the derivatives market in India, SEBI should revise some of their regulations like contract size, participation of FII in the derivatives market. ? Contract size should be minimiz ed because small investors cannot afford this much of huge premiums. ? SEBI has to take further steps in the risk management mechanism. ? SEBI has to take measures to use effectively the derivatives segment as a tool of hedging. BIBLIOGRAPHY BIBLIOGRAPHY BOOKS: FUTURES AND OPTIONS – N. D. VOHRA, B. R. BAGRI DERIVATIVES CORE MODULE WORKBOOK – NCFM MATERIAL FUTURES AND OPTIONS – R. MAHAJAN WEBSITES: www. nseindia. com www. equitymaster. com www. peninsularonline. com NEWS EDITIONS: THE ECONOMIC TIMES BUSINESS LINE

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