All you wanted to know about yuan revaluation

September 28, 2005, www.rediff.com, Co-author-Vivek Kaul

China's move to revalue the Yuan on July 21, 2005, was hailed as a surprise. But its revaluation by 2.1% was definitely not surprising!
China once again proved its mettle by taking action on its own terms. It pegged the Yuan against a basket of currencies of China's major trading partners but refused to reveal the constituents of the basket.
Finally, the Chinese authorities revealed, almost a month after the revaluation, that the basket consisted of the US Dollar, the Yen, the Korean Won and the Euro.
On Thursday, July 21, 2005, the day Yuan was revalued, it closed at 8.11 Yuans per dollar. On that day, the Chinese officials announced that the Yuan will now be allowed to float against the dollar within a band of plus or minus 0.3% of the previous day's closing.
The band of 0.3% within which the Yuan is allowed to float against the dollar is too narrow and a 2.1% revaluation is just a drop in the ocean given that Yuan is said to be undervalued by as much as 40%.
Beijing made a move which will hardly have an effect on its exports and at the same time has managed to shut up Washington for some time.
Later, a band of 1.5% was announced for non-dollar currencies. On Friday, September 23, 2005, once again this band was widened further to 3% per day for non-dollar currencies. This means that now Yuan is allowed to float within a band of plus or minus 3% of the previous day's closing against non-dollar currencies and 0.3% against the dollar.
The different bands for dollar and non-dollar currencies will prove a difficult act to balance for the People's Bank of China as both these currencies are also trading against each other.
The Chinese pegging of the Yuan has been in the line of fire for a long time now. Yuan was pegged to the US dollar in 1994 at 8.28 Yuans per dollar. This has been a source of grief for most of the industrialised nations (G7 members), particularly the United States (US).
Nearly 10% of the huge current account deficit of the United States, which was a staggering $164.7 billion in the third quarter of last year, was on account of China alone.
People's Bank of China Governor, Zhou Xiaochuan, claims that China needs time to reform its financial sector. But the industrialised nations are becoming more and more desperate as they are getting increasingly aware of the fact that poorer countries are financing the current account deficits of industrialised nations.
The current accounts of all the G7 countries taken together are in a deficit. On the other hand, China had a trade surplus of $31.98 billion in 2004.
The move to revalue Yuan by China was seen as a way to ease the growing tension between the US and China, before the impending visit of the Chinese President Hu Jintao to Washington in September 2005. It is definitely not expected to make any significant improvement to the trade deficits of US with China or the fiscal deficit of US.
Heads I win. . .
Recently, the Hong Kong-based, China National Offshore Oil Corporation (CNOOC), a publicly listed company in which the Chinese government has a 71% stake, made a bid to buy Unocal, America's eighth biggest oil company, for an all cash deal of $18.5 billion.
CNOOC outbid Chevron, the American oil company which made a bid of $17 billion for Unocal. Even though the deal did not go through, this bid to acquire Unocal (and similar bids to acquire other foreign companies) signals that China is now following an aggressive policy of investing overseas to utilise its huge forex reserves.
For the Chinese government such deals make a lot of sense. These deals will help China to reduce the monetary impact of keeping its currency, the Yuan, undervalued. Since the dollars, spend in acquiring the overseas assets need not be exchanged for Yuan, this will lead to a real contraction in money supply.

If the Chinese are able to successfully execute this strategy then even without revaluing the Yuan to a great extent, China can prevent its internal economy from overheating.
This can become a thorn in the neck of Alan Greenspan and Co who have been relying on the consistent purchase of the American Treasuries at low interest rates by China and other Asian nations to finance America's burgeoning fiscal and current account deficit at extremely low interest rates.
This has also helped in keeping the inflation low. China is sitting on top of $700 billion of forex reserves of which $230 billion has been invested in American Government securities.
Now with Chinese companies actually prowling for overseas assets China's investment in American treasuries can go down. This might lead to increased interest rates in America.
So basically, now that the pressure to revalue the Yuan will be taken off China's back for sometime, China can relax and not go for any further revaluations and still be at a comfortable level.
. . . tails you lose
On the other hand, even if China goes for more revaluations of Yuan in the future, being a developing economy with a large and growing manufacturing sector, China's import demand is going to be continuously high in the coming years and the importers are going to benefit from a stronger Yuan.
Also, China is a net oil importing country with demand for oil expected to go up as China progresses, once again a stronger Yuan will benefit China, as the US dollar is the currency in which oil is traded.
The Chinese executives and analysts believe that the Chinese exporters will remain competitive even if the yuan appreciates, say by as much as 25%. It will still not make much difference to the Chinese businesses.
The competitive advantage of the Chinese firms goes much beyond just cheap labor and an undervalued currency. The Chinese firms have mastered the art of building plants and factories at much lower costs than it's possible in the Western countries.
Too early to celebrate
Malaysia has already dropped its peg to the US dollar just after the Chinese announcement and moved to a managed float against a basket of currencies. Those Asian countries which were not letting their currencies appreciate by resorting to sterilisation so that their exports maintain their competitiveness vis-a vis the Chinese, have let their currencies strengthen considerably since the revaluation announcement.

Is this just the beginning? We do not think so. It is the beginning of a very long wait. It may be too early to laud the People's Bank of China's move wholeheartedly. The Bush administration may see the revaluation as a victory, but the real victory will be if China continues to revalue the Yuan at regular intervals to bring it to its intrinsic value.

And this as of now seems too farfetched. It should not be forgotten that China has taken ten long years to make the small change that it did on July 21, 2005. From the comments of the Chinese officials in the past, it was clear that eventually the Yuan would be let free, but when that would be done was the question. And we are no closer to the answer now than we were earlier!

Whats wrong with everyone?

I am a kid. My parents remind me daily to study hard so that when I grow up, I earn a lot of money. I go to school. My teachers tell me that if I talk in the class, I will not be able to do anything in life. I will never make it "Big". I am growing up. Not "Big" though.

I do everything I want to do, slyly though. As my parents will not approve of me playing cricket when I ought to be in the tuition class. They will not approve of me reading Enid Blyton when I should be reading the basic concepts of Physics. I will not make it to the IIT's if I do what I want to do, according to them.

So I do everything I want to do, but I don't tell them. I know for sure that even if I do everything they want me to do, I will still not make it to the IITs.
I grow up. A loser in the eyes of my parents as I did not make it to any of the top ranked Engineering colleges.

A loser in the eyes of all my relatives and teachers. I have learnt to live with it. I have learnt to turn a deaf ear to all of them. They keep complaining and comparing though. Why do they do it? Who is listening to them? Who is getting affected by it? No One. Not me atleast. I am happy. I am happy to do what I want to do. Stare out of the window and think about nothing. Cry and laugh whenever I want to. I have no intellectual image to maintain. No baggage to carry.
I am an engineer. Like everyone does now days, I end up working for a Software giant.

And suddenly, I am a hero. Suddenly people start recalling incidences which never happened, but nevertheless they prove that I was always a very good student, a very good child, a very promising fellow, since my childhood. Revelations for me. I remember everything that was said about me in the past, they do not. Their perception has changed, I remain the same. The software giant has a huge appetite. It makes me work endless hours. I do. And I get handsomely paid for it.

But, I have no time to look out of the window. I have no time to cry and laugh. I have no time to do what I want to do. I am doing everything the software giant wants me to do, my parents want me to do, my relatives want me to do. But I am not doing what I want to do.

I leave the job and take up an assignment with a smaller firm, which allows me to do as much work as I want to do and pays accordingly. This means, I have taken a huge paycut. And this also means that perceptions have changed again. Once again, I am a loser. And once again, I have turned a deaf ear to all the advices I get from my well wishers. I am happy. What else do my well wishers want for me? I do not want anything else. I just want happiness.

I just want the time to gaze at the stars, to read books, to watch movies, to walk in the rain, to paint, to listen to music. What more do my well wishers possibly want for me? Money? But what will that money buy me? Time? If it cannot buy me time, if it cannot buy me happiness, I do not want it. What’s wrong with everyone? Why can't they understand these simple theories of my life? Why do they want me to lead my life the way they want me to lead it? Alas, there's no answer to these questions and I am afraid, some things never change, and my well wishers are amongst those things.

This is the story of all of us born after the early 1970's. In a race to make it Big, we forget the happiness that smaller things in life could provide. We keep running after things till we no longer know what we are running for. We forget to enjoy life and then a day will come when we would leave this world without knowing what life was.

Our own Daphne Du Maurier

After a long long time, I have come across a book, which is not a murder mystery or does not classify to be a thriller, which I was not able to put down. And no, it is not because of the story, it is because of the writing style. Well, that should not undermine the story which must be given the credit for being unique too.
We have had many authors of Indian origin doing well in the international literary circles. Inspite of their achievements, the writing style would be uniquely Indian. Take for example R.K.Narayan or V.S.Naipaul. The settings, the characters, the stories mostly revolve around India or Indians or people who reflect the Indian mindset.

Over the years I had begun to believe that Indians cannot write like Gabriel García Márquez or Daphne Du Maurier and why should they?
That Summer in Paris by Abha Dawesar was a pleasant surprise which changed the notion that authors of Indian origin cannot paint with words. I was struck by the beauty of words used by the author. I had not experienced such urge to keep on reading a book just to find out how is the author going to construct her next sentence since I read Rebecca by Du Maurier.

Read this: "The spoken word was more fluid than the written; it could be modified with new words and adapt itself to the situation". This sentence made me rethink my belief that writing down once's feelings is more appropriate than speaking them. Spoken words are definitely more fluid, hence may be more expressive. Some expressions cannot be written about.

On the other hand this senence: "...the yin and yang of my life, the occident and orient, have really been about whether to devour all your books swiftly-for the pleasure of the moment, or to abstain-so that a new one and its promises are always on the horizon"...is exactly the way I used to feel when I was reading "Shantaram" by Gregory David Roberts. I don't think anyone else could have put it so beautifully.

I had started associating with Shantaram so much that I did not want the story to ever get over. Everyday I would deliberately restrain myself from reading too many pages so that I could keep on reading the book for more number of days. And the day I finished reading the book, I felt a kind of emptiness. I felt a kind of loss which is difficult to write down, reinstating the authors words that "The spoken word was more fluid than the written".That Summer in Paris is not the first book by Abha Dawesar.

Her previous work "Babyji" was also critically acclaimed and recieved many awards. Though, I must admit that Babyji gave me the impression of another one of those Indian authors trying to get recognition by overtly using sex and desire as the theme. I found it a grotesque narration of a confused, zealous, curious and perhaps a perverted girl.

But, with her latest book, Abha Dawesar has taken a leap which puts her in the same league as Du Maurier, Gabriel García Márquez or Lord Byron, in my eyes. In some of the places, her sentences reminded me of "She Walks in Beauty" by Lord Byron. Read this: "The point at which it diverges from reality is exactly where it becomes true. Its so strange. By being so unreal, it creates reality". Please don't get me wrong.

What I mean is that the creation of her sentences struck me just like the creation of Lord Byron's sentences. Ofcourse Ms. Dawesar is only three books old (have not read her first book Miniplanner) and has a long way to go. It might be too early to shower so much praise on her. But then I am only talking about this one book. And That Summer in Paris is worth all the praise.

To admit or not to admit…That is the Question!

More than six years, more than 1200 episodes, more television awards than any other soap on the Indian television, more number of characters than you care to remember, more drama than ever seen on Indian television before, more generations than can ever come together in reality….thats Kyunki Saas Bhi Kabhi Bahu Thi (KSBKBT).

Produced by Balaji Telefilms, the brainchild of Ekta Kapoor, who is the celebrated daughter of our own jumping jack of yesteryears, Jitendra, KSBKBT has been a subject of ridicule with the so called generation ‘X’. Well, actually it can be generalized to all the entire genre of the lovey-dovey-weepy-villainy soaps.

Why do people fall in love, why do they break up, why do they have extra marital affairs, why do they turn villainous, why and how do they scheme and plot so many things against each other, and above all, why do the ladies of the house keep crying all the time, is beyond the understanding of my generation people.

Making fun of those who watch such soaps and ridiculing everything about the characters, from the twentyish looking grandmother to the always overdressed Bahu’s, was something I considered to be my birthright, till fate took a 180 degree turn and hurled me on to the opposite camp!

It all started about two months back with giving company to a few others while they watched the episodes of KSBKBT religiously. Initially I spent all my time either reading a book or making fun of those watching the serial. Slowly, I was watching more of the serial and reading less. Then I stopped reading completely and started to discuss the serial with others who watched, and then a time came when I waited for the serial to start at 10.30 every night.

I am ashamed to admit that I have started watching the serial. Me? How can I watch a serial like this? I, who appreciates documentaries and art movies, how can I like meaningless stuff like KSBKBT? Well, the reality hits hard. The fact is that I have started enjoying the serial. It’s like a friend of mine once said, whether you like to admit or not, you get hooked on to Himesh Reshammia songs. ‘There is something about the nasal twang’, he said.

Similarly, there is something about KSKBT. From the background music of “Ram Ram Jai Raja Ram, Ram Ram Jai Sita Ram” to the dialogues of Tulsi, the episodes catch the imagination of the viewers. Will Tulsi come back to the palatial Virani house? Will she accept Mihir again? When they finally meet, for good, will Ekta Kapoor show that scene with Mihir sprinkling red color on Tulsi accidentally (the way it always happens when they meet)? Well when you are caught with such important questions, how can you stop watching the soap?

I guess the easy thing would be to just admit that it’s okay to watch such serials as long as you like them and are happy watching them. Wow, that’s some journey, from writing hard core finance articles to writing about KSBKBT. I guess the two can go hand in hand and I am definitely more at peace after admitting to the fact that I am addicted to the soap, just like I am addicted to the movement of the SENSEX.

There is peril as well as profit in riding the leverage tiger

DNA, 24th May 2006

It has happened before, and it's happening again. Futures markets were widely blamed for the Black Monday crash in the US in October 1987 - even though research has shown that futures cannot be blamed for the unfortunate turn of events then. Similarly, futures are being blamed now for the falling indices in India. Let us examine how trading in futures has an impact on the cash markets.

Let us take, for example, the Reliance Industries share for the past one month.On April 24, 2006, the share closed at Rs 977 in the spot market and Rs 988 in the futures market. Buoyed by the positive market sentiment, investors bought into the Reliance stock futures in the hope that its price will rise in the future, and then they can offset or close their positions in the futures market by selling.

People prefer to take a long position in the futures market as they have to pay only a small margin for the contracts rather than the entire amount. For example, an investor can buy one lot of Reliance futures consisting of 600 units by paying a margin of around 28% on the total contract value.

The total contract value would amount to Rs 5,92,800 (Rs 988 x 600 = Rs 5,92,800). The investor, though, needs to pay only Rs 1,65,984 (5,92,800 x 0.28). To buy the same number of shares in the spot market, the investor would have had to pay Rs 5,86,200 (977 x 600) on the same day.

Now, say, an investor has bought in one lot of Reliance futures contracts by paying a margin of Rs 1,65,984. He is of the view that the price of the futures contracts will keep rising. And indeed they do, till May 12, 2006, after which they start falling. The investor thinks that it is just a temporary downward move and does not square off his position.

But the markets continue to fall. On May 22, 2006, all hell broke lose and the Sensex lost more than 1,000 points during intra-day trading. The Reliance futures price also took a heavy beating and closed the day at Rs 928. On account of the daily mark-to-market system in the derivatives segment, the investor receives margin calls as the value of his investment falls.

Mark-to-market essentially is a term used for adjusting the value of an investor's investment on a daily basis. Here, the difference between the settlement price (the closing price of the futures contract) of the previous day and the settlement price of today is settled in cash daily. So if the price of the futures is falling, the investor needs to deposit cash with his broker, who, in turn, needs to deposit it with the clearing house.

Now, the investor has three choices. If he has the cash to meet the margin call, he pays the money to the broker who will then deposit it with the clearing house. Second, he can square off his position by selling one lot of futures contracts and can book a loss on his position (loss of (Rs 988-Rs 928) x 600=Rs 36,000).

Thirdly, if he holds Reliance shares or any other shares in the spot market, he can sell them and raise the money to meet the margin call. Most of the investors fall in the second and the third category. They either square off their positions on their own or the brokers do it compulsorily if the investor fails to deposit the margin call or they sell shares in the spot market to meet the margin call in the futures market.

In both the circumstances, there is selling pressure on the spot market. When an investor squares off his futures position by selling futures contracts, there is a drop in the futures price due to selling pressure on the futures contracts. If the futures prices drop, and they start selling at a price which is lower than the cash market, the market players will start buying in the futures market and selling in the spot market. This will create a selling pressure on the cash market, sending the prices down.

Similarly, there is selling pressure on the cash market if investors start selling their shares in the spot market to raise cash in order to meet the margin calls in the futures market. And so, futures market influence the spot market.

Note: Stock and futures prices have been rounded of.

Lamhe

Choti choti baatein, ban jaati hain yaadein
Bhooli bisri yaadein, ban jaatey hain saharey.
Saharon se guzarish hai, kabhi na hona fanaa.
Jeevan ke har lamhe thaam kar meri baahein dena mujhe panaah.
Woh har lamha jo beet gaya hai
Usse yeh arja hai meri samaye rahna dil me meri, dhadkanon ki tarah.
Jo kabhi juda huey mujhse, meri saanse bhi saath le jaana.

All about commodity derivatives

May 05, 2005, www.rediff.com, Co-author-Vivek Kaul

Trading in derivatives first started to protect farmers from the risk of the value of their crop going below the cost price of their produce. Derivative contracts were offered on various agricultural products like cotton, rice, coffee, wheat, pepper, et cetera.
The first organised exchange, the Chicago Board of Trade (CBOT) -- with standardised contracts on various commodities -- was established in 1848. In 1874, the Chicago Produce Exchange -- which is now known as Chicago Mercantile Exchange -- was formed (CME).
CBOT and CME are two of the largest commodity derivatives exchanges in the world.
The Indian scenario

Commodity derivatives have had a long and a chequered presence in India. The commodity derivative market has been functioning in India since the nineteenth century with organised trading in cotton through the establishment of Cotton Trade Association in 1875. Over the years, there have been various bans, suspensions and regulatory dogmas on various contracts.

There are 25 commodity derivative exchanges in India as of now and derivative contracts on nearly 100 commodities are available for trade. The overall turnover is expected to touch Rs 5 lakh crore (Rs 5 trillion) by the end of 2004-2005.
National Commodity and Derivatives Exchange (NCDEX) is the largest commodity derivatives exchange with a turnover of around Rs 3,000 crore (Rs 30 billion) every fortnight.

It is only in the last decade that commodity derivatives exchanges have been actively encouraged. But, the markets have suffered from poor liquidity and have not grown to any significant level, till recently.
However, in the year 2003, four national commodity exchanges became operational; National Multi-Commodity Exchange of India (NMCE), National Board of Trade (NBOT), National Commodity and Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX).

The onset of these exchanges and the introduction of futures contracts on new commodities by the Forwards Market Commission have triggered significant levels of trade. Now the commodities futures trading in India is all set to match the volumes on the capital markets.

Investing in commodity derivatives
Commodity derivatives, which were traditionally developed for risk management purposes, are now growing in popularity as an investment tool. Most of the trading in the commodity derivatives market is being done by people who have no need for the commodity itself.

They just speculate on the direction of the price of these commodities, hoping to make money if the price moves in their favour.
The commodity derivatives market is a direct way to invest in commodities rather than investing in the companies that trade in those commodities.

For example, an investor can invest directly in a steel derivative rather than investing in the shares of Tata Steel. It is easier to forecast the price of commodities based on their demand and supply forecasts as compared to forecasting the price of the shares of a company -- which depend on many other factors than just the demand -- and supply of the products they manufacture and sell or trade in.

Also, derivatives are much cheaper to trade in as only a small sum of money is required to buy a derivative contract.
Let us assume that an investor buys a tonne of soybean for Rs 8,700 in anticipation that the prices will rise to Rs 9,000 by June 30, 2005. He will be able to make a profit of Rs 300 on his investment, which is 3.4%. Compare this to the scenario if the investor had decided to buy soybean futures instead.

Before we look into how investment in a derivative contract works, we must familiarise ourselves with the buyer and the seller of a derivative contract. A buyer of a derivative contract is a person who pays an initial margin to buy the right to buy or sell a commodity at a certain price and a certain date in the future.

On the other hand, the seller accepts the margin and agrees to fulfil the agreed terms of the contract by buying or selling the commodity at the agreed price on the maturity date of the contract.
Now let us say the investor buys soybean futures contract to buy one tonne of soybean for Rs 8,700 (exercise price) on June 30, 2005. The contract is available by paying an initial margin of 10%, i.e. Rs 870. Note that the investor needs to invest only Rs 870 here.

On June 30, 2005, the price of soybean in the market is, say, Rs 9,000 (known as Spot Price -- Spot Price is the current market price of the commodity at any point in time).

The investor can take the delivery of one tonne of soybean at Rs 8,700 and immediately sell it in the market for Rs 9,000, making a profit of Rs 300. So the return on the investment of Rs 870 is 34.5%. On the contrary, if the price of soybean drops to Rs 8,400 the investor will end up making a loss of 34.5%.
If the investor wants, instead of taking the delivery of the commodity upon maturity of the contract, an option to settle the contract in cash also exists. Cash settlement comprises exchange of the difference in the spot price of the commodity and the exercise price as per the futures contract.

At present, the option of cash settlement lies only with the seller of the contract. If the seller decides to make or take delivery upon maturity, the buyer of the contract has to fulfil his obligation by either taking or making delivery of the commodity, depending on the specifications of the contract.

In the above example, if the seller decides to go for cash settlement, the contract can be settled by the seller paying Rs 300 to the buyer, which is the difference in the spot price of the commodity and the exercise price. Once again, the return on the investment of Rs 870 is 34.5%.

The above example shows that with very little investment, the commodity futures market offers scope to make big bucks. However, trading in derivatives is highly risky because just as there are high returns to be earned if prices move in favour of the investors, an unfavourable move results in huge losses.

The most critical function in a commodity derivatives exchange is the settlement and clearing of trades. Commodity derivatives can involve the exchange of funds and goods. The exchanges have a separate body to handle all the settlements, known as the clearing house.

For example, the seller of a futures contract to buy soybean might choose to take delivery of soyabean rather than closing his position before maturity. The function of the clearing house or clearing organisation, in such a case, is to take care of possible problems of default by the other party involved by standardising and simplifying transaction processing between participants and the organisation.

In spite of the surge in the turnover of the commodity exchanges in recent years, a lot of work in terms of policy liberalisation, setting up the right legal system, creating the necessary infrastructure, large-scale training programs, et cetera still needs to be done in order to catch up with the developed commodity derivative markets.

Also, trading in commodity options is prohibited in India. The regulators should look towards introducing new contracts in the Indian market in order to provide the investors with choice, plus provide the farmers and commodity traders with more tools to hedge their risks.

A Short History of Nearly Everything-Bill Bryson

If someone knows of a better book which talks about the evolution of the Universe, explains important discoveries in physics, chemistry, geology and palaeontology more lucidly than this book, please let me know. I am not a science person.

This is the first time I am hooked on to a book on science. Newton, Einstein, Marie Curie, Charles Darwin...names that I had forgotten soon after the 10+2 exams, are once again intriguing me. Questions like the mass of the Earth, the age of the Earth, the size of the Earth, how did it come into existence...how about our Solar System? How big is it? How far are the planets from the Earth? What if the planets collide with each other? Will they in the first place? And many more such Questions, have been answered much before the so called revolution in technology and the age of computers.

The dedication with which many of the names who find mention in the book used to work is amazing. Probably its because for many of them finding answers to these questions was a hobby rather than a job. And their hobbies became their passion. This once again reinforces my point that in order to make a difference, we must do things that make us happy rather than working just for money.

Kabhi kabhi mere dil me khayal aata hai

Which is my favorite colour? It was red yesterday, its black today. What is my favorite food? It was North Indian yesterday, its Chinese today. What is my favorite passtime? It was writing poetries yesterday, its painting today. Which is my favorite movie? Many movies are my favorite, but the composition of these basket of movies also change very often.

Kabhi kabhi mere dil me khayal aata hai ki kya mein bahut moody hoon? Is it being fickle? Or is it just changing with times? There is a lot of difference in the way different people look at it. Some call it flexibility and adaptability, which is basically saying that this moodiness is good.

Most are not able to comprehend these changes in my likes and dislikes and call me very-very moody, which is basically saying that its a negative trait. Even though I would like to go with the first group of people, kabhi kabhi mere dil me khayal aata hai ki what if the second group of people are right? Am I really that moody? Do I hurt people when they assume that I like paav bhaji and then I tell them that its no longer my favorite dish? I guess I do.

So now I have stopped telling people what I like and what I don't. I just go by what they think I am, what they think my likes and dislikes are. Which means, I am not revealing my feelings to anyone. But then, thats the best I can do to not hurt people. I am sure I am not alone.

There are many like me who face the same problem. I don't know how they deal with it. May be they are more straight forward and express themselves. I cannot. But basically, the point that I am trying to make is that why has everything in this world become so defined? Why do all of us want to know everything about everyone else? And once we do know a few things, why do we assume that those things are for eternity? When the winds of change are rocking the entire world, businesses, economies, relationships, why is it that if we change our likes and dislikes often (according to our state of mind) its termed as something negative?

Good employees = great company

March 22, 2006, http://www.rediff.com/

The importance of human capital can no longer be ignored. India is slated to be the hub of Knowledge Process Outsourcing in the coming decade.

Already, many of the multi-national giants have shifted their R&D operations to India due to the availability of the vast pool of professionals in the country.

Human capital or intellectual capital has long been recognised as an important asset by knowledge intensive industries like bio-technology and information technology. However, its valuation has grabbed most of the attention of the academicians, researchers and practitioners. But, what about the risks faced by the companies due to the intangible nature of this asset?

It is said that a company is as good as its employees. Once a company recognises human capital as an asset, the identification, evaluation and management of the risks associated with this asset becomes pertinent for the company. There is a deep correlation between the risks faced by employees and the risk faced by the company, especially in knowledge intensive industries.

The greater the risk faced by the employee greater is the risk to the company. If an employee has problems in his personal life then he will not be able to deliver his true potential, which will be detrimental for the survival of the company. We can break these correlated risks into three categories based on the number of parties exposed to risk.

• Individual risk
• Group risk
• Company risk

Individual risks: these are the risk that an individual faces and these have no relevance for the company. For example: the risk of automation in the company, which might reduce the work force. This will be risk for the employee only and not for the company, as the company will be benefited from automation that will result in cost savings.

Group risk: This is the risk that a group of individuals face. These risks are much correlated i.e. the effect of risk exposure on one individual affects the risk exposure of the other people working with him. For example change in the location of company may hinder a group of employees.

Company risk: These risks are highly correlated with the above risks. Any dispute among the employees will directly hinder the operations of the company. Hence, while evaluating this risk one needs to cover the above risks first. The company must dissect the various factors, which have an effect on each of the individuals or a group of individuals.

A few such risks are:

Lack of continuing education: An outdated degree, without training to keep the workforce up to date with the latest breakthroughs in the industry, will result in insecurity amongst the individual employees. This will result in loss of productivity. To minimise this risk, it is in the benefit of the company to facilitate ongoing continuing education and training for the employees.

Health related risks: Employees can give more than their 100 per cent to the company only if they are physically and mentally healthy to do so. Mere intention will not be enough. Mental bell being of an employee is also dependent on the well being of the family of the employee. Healthcare benefits and plans for the employee and her family are key to mitigate these risks to a large extent.

Cultural and behavioral risks: Boundaries have literally disappeared today. For an individual who is employable and wishes to be employed, globe is the playing field. In such circumstances, people from various backgrounds, ethnicity, and countries, often have to work together as a team towards the common goal of the company.

This can be challenging, to say the least. Personal differences can result in loss of time, productivity and profits. Providing enough platforms for all the employees to get to know each other and understand each other is important and the task lies with the management of the company.

There can be many other risks associated with human capital. Detailed above, are just a few important ones. Once the company takes care of these risks it is left with little exposure to unknown risks. Now the company can map the factors, which are essential to maintain the human capital risk at the desired level and it can find out the net worth of its entire workforce.

Net worth: As the age of an individual increases his financial strength increases while his physical strength decreases. Although the physical wealth of a person can't be quantified, we can take some metrics to represent it over a period of time. We find that the net worth of an individual increases to a certain point in life and then again decreases (See figure 1).

The company needs to draw out the strategy to continuously enhance the net worth of its human capital asset in order to survive in these times when knowledge and people are the key to the success of any venture.

Does India need a single financial regulator?

February 13, 2006, www.rediff.com, Co-author-S Subramanian

Recently, at a seminar, Union Agriculture and Food Minister Sharad Pawar announced that he would take up the issue of banks, mutual funds and foreign institutional investors entering into the commodities derivative market with the Reserve Bank of India and the finance ministry. On the same platform he went on to rule out the possibility of merging Forward Markets Commission with the market regulator Securities Exchange board of India.
It looked a bit contradictory as it once again raised the question whether it is required to have different regulators for various markets when it is clear that the participants of the markets are the same entities.
The origin of this debate dates back to eighties when the abolition of Glass-Stegall Act in the United States resulted in the blurring of differences between various financial service providers like commercial banks, investment banks, insurance companies and securities brokerage firms. The regulatory environment for these converged functional entities however remained different. This resulted in overlap of functions between the regulators.
A need was felt for a single unified regulator who can oversee the entire financial services markets. The initiative for such a unified financial regulator came from the Scandinavian countries.
Norway was the first country to establish an integrated regulatory agency in 1986 followed by Denmark in 1988 and Sweden in 1991. East Asian countries like Japan and South Korea followed suit in the nineties. The most famous move towards a single regulatory authority was that of United Kingdom where a single regulator called Financial Services Authority was formed by merging nine regulators. It was a gradual process that spread over a period of five years.
In India also there are many regulators -- namely the Reserve Bank of India, SEBI, FMC, Insurance Regulatory and Development Authority -- who supervise various financial markets. Another regulator for pension funds Pension Fund Regulatory and Development Authority is waiting in the wings. These regulators, as in other countries, have an obvious overlap between their functions.
Hence one section of experts is in favour of moving towards a unified regulatory regime with strong supportive arguments. But, we need to look into the suitability and benefits over costs of such a move in the Indian context.
Single regulator mirrors market environment
The main argument is that a single financial regulator is superior as it mirrors the nature of modern financial markets where old distinctions between different sectors and different products have broken down. But the applicability of this concept in India may not hold good.
Though some financial firms have spread their wings across the spectrum of products, most others are still focused on their core area. Besides, the market is also dominated by firms which are specialising in the particular business. For example, the life insurance business is dominated by the Life Insurance Corporation of India whose main focus is insurance.
In securities brokerage business, the market share of the brokerage firms which are subsidiaries of banks is still in single digit.
In such an environment the concentration of regulatory responsibility will result in loss of regulatory diversity and valuable sector-specific knowledge and expertise. The benefits of a single regulator may not compensate for these losses.
Single regulator is efficient
Another argument in favour of a single regulator is that it will be more efficient in allocating resources. A single regulator's position allows it to look across the entire financial industry and devote regulatory resources (both human as well as financial resources) to where they are most needed.
However, the main challenge lies in the formation of the single regulator. Typically, single regulators are formed by simply merging the regulatory functions of many regulators and they continued to be plagued by bureaucratic and government interventions.
The UK's FSA is an exception as traditionally the financial market there were operating without much of government intervention. Secondly, though FSA was formed by merging regulators, later it got synchronised with a unification act.
The experiences of various nations (except the UK) show that even after the merger the regulatory authorities for various divisions continued to work as separate divisions and there were Chinese walls separating them.
The same fate can be foreseen for India as the regulatory environment here is not mature enough to be liberated from government interventions. Hence merger may not result in automatic synchronization and efficiency among the various regulatory functions.
Commonality of knowledge
The commonality of knowledge required in regulating markets gives the single regulator the benefit of economies of scale.
For example, for both commodities market and securities market, the basic issues of trading, clearing and settlement are very similar. Hence when a regulator develops the expertise in preventing fraud and protecting systemic integrity, it will be more effective and ideally placed to select the optimal regulatory responses to any situation.
But, in a developing economy like India, unlike the matured markets, the objectives and focus of various markets are different.
For example, the primary focus of futures commodity market is price discovery and hedging for price risk, while that of the securities market is capital formation. Further, as the regulatory environment is not mature, it is better to have a healthy competition among regulators which will automatically push them towards efficient and effective regulatory practices.
Clarity of accountability
The supporters of 'single market regulator' system further argue that in the case of single market regulator, the responsibility and accountability is clear. The single regulator cannot transfer the blame of any failure to another regulatory body.
In India itself we have seen in some instances the regulators passing the buck to another regulator. During the banking scam of 2001, which was a part of the Ketan Parekh scam, the then chief of Sebi D R Metha, in an interview commented that Sebi cannot be held responsible for what happened in the banking system. The business press observed that he actually passing on the buck to the RBI.
But in countries like India the regulators have the responsibility of developing the market along with regulation. For instance, IRDA has the responsibility to develop a healthy insurance market by educating the public about the need for insurance.
Similarly, the FMC has the responsibility to bring in more farmers directly to the futures market to benefit from price discovery. A single regulator may have well defined accountability in terms of regulations but not in terms of development.
Hence India needs multiple regulators who can develop the market as well.
Information sharing
Yet another argument in favour of a single regulator is Information sharing. Single regulators will have advantage in sharing information among various regulating division, which will help a lot in preventing fraud as well as in handling crisis. Multiple regulators have problem in sharing information on time.
The previous market crises in India like the CRB scam have shown that the Information flow between RBI and Sebi is not very smooth.
This problem can be overcome by strengthening the High Level Committee on Capital Markets (HLC) which was formed as per the suggestion of the Joint Parliament Committee that enquired the 1992 stock market scam.
HLC is chaired by RBI Governor and has Union Finance secretary and chairmen of Sebi and IRDA as members. It may also have a representation from FMC and the Pensions Authority as and when it is formed.
HLC can play a very important role in facilitating information sharing between the multiple regulators.
Conclusion
A single market regulator clearly has its own advantages over multiple regulators. But it is more suitable for well-developed and mature markets which are smaller in size, like the UK. Even the United States, which is supposed to have the most mature financial markets in the world, has multiple regulators.
Indian markets are not mature yet and still have a long way to go. Different sectors are in different stages of development. In this environment it is better to have multiple regulators which are flexible and sensitive to the needs of the market or the sector they are regulating.

Why is risk management important?

December 27, 2005, www.rediff.com

Corporations operate in a dynamic environment. Hence the future remains uncertain to a large extent, allowing for fate to play a part in the results that are achieved by the companies.
However, the role of fate has reduced considerably over the years. With the help of probability theory and careful evaluation of the environment, companies are now able to predict, to some extent, the various risks that may have a critical impact on their business.
The primary objective of any company is to maximise shareholders' wealth. The shareholders appoint agents (read managers) who take various investing and financing decisions to achieve the firm's objectives. The main criteria are to maximise returns and minimise risks related to any decision.
The point of discussion in this article is the part of decision-making that deals with minimising risk. Ignorance or mismanagement of risk will result in loss of shareholders' wealth and loss of reputation apart from other undesirable consequences.
A number of cases have occurred in the recent past which very well brings to light the lack of foresight and pro-activity on the part of the management in managing risk.
'Risk management' therefore is an integral part of managing a business. From the recent devastation in the United States, we have come to realise that companies like Wal-Mart and Home Depot, which have active risk management programmes in place were much better poised to deal with hurricane Katrina than the government or other companies who have not yet embraced the advantages of risk management.
Companies face various types of risks. Some may be external in nature, which are not under the direct control of the management, like the political environment, the changes in exchange rates or the changes in interest rates. The others may be internal in nature which the management can control to a great extent, for example risks associated with non-compliance in financial reporting or non-compliance with labor laws.
A company would need to identify the risks that it faces in trying to achieve the objectives of the firm. Once these risks are identified, the risk manager would need to evaluate these risks to see which of them will have critical impact on the firm and which of them are not significant enough to deserve further attention.
The critical risks that could have adverse impact on the firm's business are then given maximum importance and strategies are formulated to deal with them or hedge against them.
The entire process of identifying, evaluating, controlling and reviewing risks, to make sure that the organisation is exposed to only those risks that it needs to take to achieve its primary objectives, is known as 'risk management.'
Risk management is a proactive process, not reactive. The best example is Shell Oil which has many offices in the New Orleans region but dealt with hurricane Katrina rather well due to the rigorous risk management procedures that it has in place.
Risk cannot be eliminated. However, it can be:
Transferred to another party, who is willing to take risk, say by buying an insurance policy or entering into a forward contract;
Reduced, by having good internal controls;
Avoided, by not entering into risky businesses;
Retained, to either avoid the cost of trying to reduce risk or in anticipation of higher profits by taking on more risk, and;
Shared, by following a middle path between retaining and transferring risk.
There are various tools available to the management to manage risks. Some of them being, derivative products like Forwards, Futures, Options and Swaps. The others involve having better internal controls in place, due diligence exercises, compliance with rules and regulations, etc.
Reserve Bank of India Governor Dr Y V Reddy has been stressing the need to disclose the risk management practices followed by the companies for sometime now and rightly so. It is very important for the investors to know if the companies in which they are investing are managing the risks as efficiently as they claim to maximise returns.
Infosys, for example, gives a detailed outline of the various risks facing their business, the policies of the company regarding each of them, the measures that are taken to deal with these risks, the implementation of strategies to manage risks and finally their review process.
However, there are large numbers of companies which are still ignorant or chose to ignore the importance of risk management and deal with situations as and when they arise. It is time the management of such companies sits up and takes note of the risks that their company faces.

The woes of US airlines

October 04, 2005, www.rediff.com

Seems like just yesterday when I was pacing the corridors of the Detroit airport early this year, waiting for the connecting flight to Syracuse, New York. Every other plane taking off from the runway was the trademark silver and red Northwest carrier, with dozens more standing in a row on a side.
Then comes the shocking news on September 14, that the carrier which made its presence felt in almost every city of the eastern coast of United States has filed for bankruptcy. Coincidentally, Delta Air Lines, third largest airline in America filed for bankruptcy on the same day.
The woes of America's airlines seem never-ending. On the one hand, the airlines of the emerging nations are growing by leaps and bounds with open skies treaties, more routes being covered and more players coming in into the market. On the other, the airlines industry of some of the developed economies, especially America, has been facing exceedingly difficult times since the start of this century.
Airline companies are a symbol of national pride for many countries. So, the government in many cases tries to bail out the troubled company. But, despite that, names like Swiss Air and Sabena of Belgium became history during the first round of crisis post September 11 attacks on the World Trade Center twin towers, which sent the insurance costs soaring for the airlines.
In the US, the government put together an aid of $15 billion (all taxpayers' money) to help the ailing industry then. United and US Airways filed for bankruptcy soon after the terrorist attacks. United Airlines is still under the chapter 11 proceedings and US Airways closed its merger plans with America West Airlines a week back (September 27) to emerge from the second round of its bankruptcy.
The other reasons that were blamed then were the downturn in the US economy, the foot-and-mouth disease, SARs epidemic, and the gaining importance of the low cost carriers like Ryanair and Jet Blue. What followed were fierce job cuts, cost cutting measures and restructuring.
The second round, now, is more worrisome. The trouble this time around is soaring oil prices. Fuel being the major expense for airline companies, cost of jet fuel at an average of $110 per barrel, post Katrina and Rita, is scary. Around 18% of the refineries (in terms of capacity) in US had to shut down due to the hurricanes.
This time around, even low-cost carriers like Jet Blue, Independence Air and Southwest are being hit very hard as the fuel costs remain same for them too. Jet Blue, a profitable company, has recently announced that this quarter it will lose money. Independence Air announced on September 30 that it will lay off 600 employees, 18% of its workforce. It is also resorting to cutting down flight schedules to cut costs.
Southwest Airlines, the most profitable airline company in US, however has hedged its position by entering into very long term contracts to purchase fuel.
American Airlines, the number one carrier in US, had to cancel a number of flights temporarily after a failed attempt to pass on some of the high fuel costs to the customers. Continental Airlines has announced that it will also increase the fares and many other airlines might have to follow suit.
Surprisingly, the US airlines industry is not undergoing any consolidation. It seemed imminent in 2001-2002, but nothing major happened. In this second phase too nothing major is in view. The only know proposed merger, that of US Airways and America West Airlines, is still under the lens. It is to be seen if the merger can successfully turn around US Airways which carries the burden of being in the midst of the worst-ever times for the airlines industry and the highest-ever cost of fuel.
Philip Baggaley, a senior airline credit analyst with Standard & Poor's, puts it rightly, "Airline mergers are very difficult. They require a lot of cooperation from labor, management attention and financing. All those things are in short supply when you're just struggling to survive."
Three out of the five major airlines in US are under chapter 11 bankruptcy code. What is to be seen is whether the industry will see a major overhaul and consolidation or will the government be willing to bail out the industry from the rising fuel prices.
In any case, the whole industry needs to spread its wings for prayers to tide over the difficult times.

All you want to know about bonds

June 28, 2005, www.rediff.com, Co-author-Vivek Kaul

Individuals have surplus funds in the form of savings which they want to invest. Companies need funds to undertake good projects with high returns. Companies provide individuals with instruments to invest their savings in.
One such instrument is corporate bonds. Similarly, governments also need funds for various developmental projects. Further, the government also needs to raise money to finance the fiscal deficit. They too tap the savings by issuing various kinds of bonds.
Characteristics of a bond
A bond, whether issued by a government or a corporation, has a specific maturity date, which can range from a few days to 20-30 years or even more. Based on the maturity period, bonds are referred to as bills or short-term bonds and long-term bonds.
Bonds have a fixed face value, which is the amount to be returned to the investor upon maturity of the bond. During this period, the investors receive a regular payment of interest, semi-annually or annually, which is calculated as a certain percentage of the face value and know as a 'coupon payment.'
A story goes that in the old days, bond certificates used to come with coupons to claim interest from the issuer of the bond; hence, the name coupon payments. However, nowadays, with paperless issues of scrips (demat), coupons are no longer in use, but the name has stuck and the interest payments are still known as coupon payments.
Issuing a bond
The government, public sector units and corporates are the dominant issuers in the bond market. The central government raises funds through the issue of dated securities (securities with maturity period ranging from two years to 30 years, long-term) and treasury bills (securities with maturity periods of 91 or 364 days, short-term).
The central government securities are issued for a minimum amount of Rs 10, 000 (face value). Thereafter they are issued in multiples of Rs 10,000. They are issued through an auction carried out by the Reserve Bank of India.
State governments go about raising money through state development loans. Local bodies of various states like municipalities also tap the bond market from time to time. Bonds are also issued by public sector banks and PSUs. Corporates on the other hands raise funds by issuing commercial paper (short-term) and bonds (long-term).
Bonds can be issued at par, which means that the price at which one unit of the bond is being sold is same as the face value. Alternatively, they can be issued at a discount (less than the face value) or a premium (more than the face value).
For example, a bond with a face value of Rs 100, if issued at Rs 100, is said to be issued at par. If it is issued at, say, Rs 95, it will be said to have been issued at a discount and conversely, if issued for, say, Rs 110, at a premium.
Investors
Banks are the largest investors in the bond market. In the low-interest scenario that prevailed, it made more sense for banks to invest in government bonds than to give out loans. Mutual funds, in order capitalise on low interest rates, started a good number of debt funds that mobilised a significant amount of money from the investors.
Thus, mutual funds emerged as important players in the bond markets. However, in the recent past with the interest rates on their way up, the performance of debt funds has not been good and so the presence of mutual funds in the bond market has been limited.
Foreign institutional investors are also allowed to invest in the bond market, though within certain limits. Also, regulations mandate provident funds and pension funds to invest a significant proportion of their funds mobilised in government securities and PSU bonds.
Hence, they continue to remain large investors in the bond market in India. The same holds true for charitable institutions, societies and trusts.
Since January 2002, individuals categorised by RBI as retail investors can participate in the auction carried out by RBI. They can submit bids through banks or primary dealers to invest in these securities on a non-competitive basis.
The minimum bid has to be for an amount of Rs 10,000 (and there on in multiples of Rs 10,000) and a single bid cannot exceed Rs 1 crore (Rs 10 million).
Secondary market
Bonds issued by corporates and the Government of India can be traded in the secondary market. Most of the secondary market trading in government bonds happens on the negotiated dealing system (an electronic platform provided by the RBI for facilitating trading in government securities) and the wholesale debt market (WDM) segment of the National Stock Exchange.
Corporate bonds and PSU bonds can also be traded on the WDM. The secondary market transactions in the bond market for the year 2003-04 was Rs 27,21,470.6 crore (Rs 272,147.06 billion), an increase of 36.6 per cent over the previous year.
Of this, government securities accounted for 98.4 per cent of the total turnover. The number of retail trades in the year 2003-04 formed an insignificant 73 per cent of the total number of trades (189,518) in the secondary market.
Returns from the bond
The return on investment into bonds is in the form of coupon payments, as already mentioned before, and through capital gains. Capital gain occurs when the bond is bought at a discount. Bonds bought at a premium would result in capital loss.
And bonds bought at par would have no capital gain or loss. Together, the total return is known as the Yield from the bond. Let us explain this with the help of an example. Let's say, that an investor buys one unit of a Long-term bond issued by a Company X Ltd for Rs 95 (i.e at a discount).
The face value of the bond is Rs 100. The coupon is 5 per cent per annum, paid annually, and the maturity period of the bond is two years.
This means, that the investor will get a payment of Rs 5 every year (calculated as 5 per cent of the face value) and at the end of the second year, he will receive Rs 100, the face value. The yield on this long-term bond can be calculated by solving for r in the equation below.
95 = 5/(1 + r) + 5/(1 + r)2 + 100/(1 + r)2
We get r=7.8%
If we notice, in the above equation, the coupon payments are fixed, the face value is fixed; the maturity of the bond is fixed. Hence the yield from the bond effectively depends on the price of the bond.
The price of the bond is determined by the issuer, by taking the market forces into account. For example, if the price of a similar bond is Rs 94 in the market (all other characteristics being same) no one will be willing to pay Rs 95 for the bond being issued by company X (assuming similar risk as well).
Hence, company X must ensure that the price, at which they are offering their Bond, is competitive with similar bonds in the market, and should provide similar yield to the investors.
Interest rate risk
Price and Yield share an inverse relationship. When price is high, yield is lower and when price is low, yield is higher (As can be seen in the way equation 1 would work). This brings us to the problem of Interest rate risk faced by bonds.
If the government suddenly decides to raise the prevailing interest rates, the expected yield from bonds held by the investors would go up. This would result in a drop in the price of the bonds. And if the investor wants to sell the bond for some reason, instead of holding it till maturity, he will have to suffer a capital loss.
On the contrary, if the interest rates are falling, the price of the bonds will rise and the investors can sell their bonds at higher prices in the secondary market than the price at which they bought the bond initially.
The reason for this inverse relationship is that, when interest rates are raised, the newer bonds issued by the government and the corporates, other investments like fixed deposits, post office savings schemes, et cetera offer greater return, with more or less the same kind of risk.
So an existing bond becomes less attractive. Investors want to sell off their existing investment in bonds and switch to other more attractive investments. The selling pressure in the bond market causes the prices of the bonds to drop. Similarly, when interest rates are dropped, price of bonds increases due to increase in demand.
Over the last few years the treasury departments of banks in India have been responsible for a substantial part of profits made by banks. Between July 1997 and Oct 2003, as interest rates fell, the yield on 10-year government bonds fell, from 13 per cent to 4.9 per cent. With yields falling, the banks made huge profits on their bond portfolios.
Conclusion
As the reader must have realised by now, bonds are not really a retail investor friendly type of investment. In our next article we will take a look at what is probably the friendliest form of investment for the retail investor, the mutual fund.

All you want to know about financial options

May 23, 2005, www.rediff.com. Co-author-Vivek Kaul

Options are the most popular class of derivatives around the world. But, surprisingly, options are not very popular in India. At present option contracts are available on 108 individual stocks and the Nifty and CNXIT Indices.

The index options and stock options together account for just 12 per cent of the derivatives market segment on National Stock Exchange. In this article, we will try and explain the trading mechanism of options contract in a simple manner.

Introduction

Options are contracts which give the holder or the buyer of the contract the right to buy (Call option) or sell (Put option) the underlying at a certain price (strike or exercise price) at a certain date (expiry date) or within a certain period in future. (For details, see All you wanted to know about derivatives).

However, the holder is not obligated to buy or sell the underlying. Thus, an option gives the holder a cushion from any unfavourable price movements in the underlying and also allows the holder of the contract to take advantage of any favorable price movements.

This flexibility of course comes at a premium. The buyer of the option is required to pay a premium to the seller of the option in order to acquire this option.

There are two major types of options. These are American Options and European Options. American options allow the holder the flexibility to exercise the option at any time before the expiry.
On the other hand, European Options allow the holder to exercise the option only upon expiry. Needless to say, American Options give more flexibility to the holder.

The underlying in case of financial options can be either an index or the stock of an individual company. An option contract, whose underlying is the stock of an individual company, is known as stock option.

Similarly, if the underlying is a stock market index, the contract is known as an Index options contract. On the National Stock Exchange, the index options are European in nature i.e. they can be exercised only upon expiry, where as the stock options are American in style, i.e. they can be exercised any time before the expiry.

The seller of the option contract is known as the writer of the contract. He receives the premium from the buyer, and that is his maximum profit in all circumstances as we will see later.
But the losses can be unlimited for a person who is writing an option. Lets see understand all this with the help of an example.

Call Options

Let us look at an investor (say, Mr Bull) who believes that the share price of Infosys is going to rise. So on May 13, 2005, he decides to buy 100 shares of Infosys which are selling for say Rs 2,040. His investment will be Rs 204,000. The person sells the shares on May 26, 2005 when the share price is Rs 2,100.
The profit for Mr Bull, will be 100*(2,100-2040) = Rs 6,000 on an investment of Rs2,04,000. This implies a return of 2.9 per cent.

Now instead, lets say Mr Bull buys Infosys Call options at a premium of Rs 40 per option (100 is the minimum contract size for stock options on NSE, although the contract size varies from stock to stock) from an investor (say, Mr Bear) who expects the price of the Infosys stock to fall. The premium paid by Mr Bull to Mr Bear is Rs 4,000 (Rs 40*100).

The Call options give Mr Bull the right to buy 100 shares of Infosys at Rs 2,040 (strike price) each from Mr Bear, upon expiration on May 26, 2005. The value of the contract stands at Rs 204,000 (Rs 2040*100).

Now, if the price of an Infosys share is Rs 2,100 each (spot price) on the expiry date, the holder of the option contract, i.e. Mr Bull will exercise his option. Mr Bear will have to hand over 100 shares of Infosys to Mr Bull at the strike price, i.e. Rs 2,040.
Mr Bull can then sell these shares in the market for Rs 2,100 and make a profit of Rs 6,000 (as he makes a profit of Rs 60 per share). But since all the financial derivative contracts on NSE are settled in cash, no delivery of the underlying is made.
Hence, the contract will be settled by the seller of the option paying an amount of Rs 6,000 to the buyer of the contract. The Rs 6,000 is calculated as the difference between the spot and the strike price, multiplied by the number of options.
The net profit of the buyer will be Rs6,000 less the premium paid (Rs 4,000), i.e. Rs 2,000. Mr Bull makes a profit of Rs2,000 on an investment of Rs 4,000, i.e. return of 50 per cent.
Mr Bull, the buyer of the option will exercise his option in two cases: a) when he makes a profit (As has been clearly shown in the above example) b) when he can minimize his loss.
Lets say on May 26, 2005 (the expiry date), the spot price of Infosys is Rs 2,070 (instead of Rs 2,100 in the earlier example). Mr Bull exercises his option. Mr Bear pays Mr Bull Rs 3,000 [(Rs.2070-Rs.2040)*100].

But Mr Bull has already paid Mr Bear a premium of Rs 4,000.So he makes a loss of Rs 1,000. But if he had not exercised his option he would have made a loss of Rs 4,000. So even though he ended up making an overall loss it made more sense for him to exercise the option.

Given this, it always makes sense for the buyer of the Call option to exercise the option as long as the spot price (on the expiry date) is greater than the strike price. Since the stock option traded on NSE are American options, Mr Bull can exercise the option on any day before expiry.

On the other hand, if the spot price of Infosys on the expiry date, is less than the strike price, lets say Rs 2,000, the investor will not exercise the option and let it expire.

In this case, his maximum loss is Rs 4,000; the amount of premium that he had paid. Thus, the loss is limited to the premium paid, and gain can be unlimited, depending on how much greater the spot price of the share on the date of the expiry of the option is vis a vis the strike price.

The position will be reversed for the seller of the option. The seller of the option is obligated to buy or sell the underlying if the buyer decides to exercise the option.

So the loss for the seller of the option is unlimited (The greater the spot price is vis a vis the strike price, the greater the loss for the seller of the Call option). Also, the seller will have to pay an initial margin to the exchange. This is because the seller of the contract can have unlimited losses.

So to prevent any default from the seller, the exchange takes this margin, which is refunded upon the expiry of the contract. Just like in the futures contracts, the seller's account is marked to market (MTM) on a daily basis.

The seller is liable to pay to the exchange on a daily basis any loss due to the change in the price of the contract and receives any gains. (For details, see All about financial futures).

In the above example, the seller will sell the option for a premium of Rs 4,000. Plus he will have to pay an initial margin of say 10 per cent of the contract value to the exchange, which will be Rs 20,400 (10% of Rs 204,000, the value of the contract). This is of course refunded when the contract expires.
On final settlement, the seller will have to pay the buyer the difference between the exercise price (Rs 2,040) and the market price of the share(Rs 2,100), multiplied by the number of options (Rs 100), i.e. Rs 6,000 (Rs 60*100).
But, his maximum profit can only be the amount of premium received, i.e. Rs 4,000. In spite of this, the seller sells the option because he thinks that the price of Infosys will fall and the buyer will not exercise the option, thus he can easily pocket the Rs 4,000 premium received.

Put Options

Put option is bought by an investor who believes that the share price of a company is going to fall. The counterparty is a person who believes that the share price of the same company is going to rise, hence he writes a Put option.
The Put option works exactly opposite to the Call option. The buyer of the Put option will exercise the option if the share price drops below the exercise price. His profit will be the difference between the exercise price and the spot price at maturity, less the premium paid for the option.

For the writer of the Put, the maximum profit is once again only the premium received, but the loss is equal to the difference between the exercise price and the spot price, multiplied by the number of options. Call options in India are more popular than Put options.
Conclusion
There are various combinations of Options, which are used to make money in different circumstances. But the fact remains that derivatives in general and options in particular are fairly risky investments (As our examples have shown).
Investors should invest in them if and only if they have a fairly good understanding of the stock market, the economy and the instrument itself. Happy investing.