SAPM: Assignment 3

Keshav Bhatia, S173F0022

Q1. What is the difference between options and futures? (4 marks)

BASIS FOR FUTURES OPTIONS

COMPARISON

Meaning It is a contract which is a It is the contract in which

binding agreement, for buying
and selling of financial
instruments at a price which
is predetermined at a future
specified date.
the investor gets the right to
buy or sell financial
instruments at a set price,
on or before a certain date,
but without any obligations.

Obligation of Yes, to execute the contract. No, there is no obligation.

buyer

Execution of Yes, On the agreed date. Any time before the expiry
contract of the agreed date.

Risk High Limited

Advance payment No advance payment required Paid in the form of

premiums

Degree of Unlimited profit or loss Unlimited profit and limited

profit/loss loss
Q2. What are swaps? What are the different types of Swaps? Explain how
companies hedge risk and minimize their losses by using swaps. (5 marks)
Swaptions are basically options that give the holder the right but not the obligation to enter into an
underlying swap. A swap is nothing but a derivative contract through which two parties can exchange
financial instruments

Swaps offer great flexibility in designing and structuring contracts based on mutual agreement. This
flexibility generates many swap variations, with each serving a specific purpose.

Interest Rate Swaps

They allow two parties to exchange fixed and floating cash flows on an interest-bearing investment or
loan. Businesses or individuals attempt to secure cost-effective loans but their selected markets may
not offer preferred loan solutions.
For instance, an investor may get a cheaper loan in a floating rate market, but he prefers a fixed rate.
Interest rate swaps enable the investor to switch the cash flows, as desired. They may get interest
rates on loans according to their credit rating. But their analysis shows that either for them floating
rate is best or fixed rate is best. So, they move into agreement.

For Example, Keshav prefers a fixed rate loan and has loans available at floating rate (LIBOR+0.5%) or
at fixed rate (10.75%). Shivam prefers a floating rate loan and has loans available at floating rate
(LIBOR+0.25%) or at fixed rate (10%). Due to a better credit rating, Shivam has the advantage over
Keshav in both the floating rate market (by 0.25%) and in the fixed rate market (by 0.75%). His
advantage is greater in the fixed rate market so he picks up the fixed rate loan. However, since he
prefers the floating rate, he gets into a swap contract with a bank to pay LIBOR and receive a 10%
fixed rate.

Keshav borrows at floating (LIBOR+0.5%), but since he prefers fixed, he enters into swap contract with
the bank to pay fixed 10.10% and receive the floating rate.

Keshav Shivam

The benefit from the scheme is that Keshav pays (LIBOR+0.5%) to the lender and 10.10% to the bank,
and receives LIBOR from the bank. His net payment is 10.6% (fixed). The swap effectively converted his
original floating payment to a fixed rate, getting him the most economical rate. Similarly, Shivam pays
10% to the lender and LIBOR to the bank, and receives 10% from the bank. His net payment is LIBOR
(floating). The swap effectively converted his original fixed payment to the desired floating, getting his
the most economical rate. The bank takes a cut of 0.10% from what it receives from Keshav and pays
to Shivam.
Currency Swaps
The transactional value of capital that changes hands in currency markets surpasses that of all other
markets. Currency swaps offer efficient ways to hedge forex risk.

Assume an Indian company is setting up business in the Japan and needs Yen 10 million.
Assuming Indian/Yen exchange rate at 0.5, the total comes to Rs. 20 million. Similarly, a Japan-based
company wants to set up a plant in India and needs Rs.20 million. The cost of a loan in the Japan is
10% for foreigners and 6% for locals, while in India it's 9% for foreigners and 5% for locals. Apart from
the high loan cost for foreign companies, it might be difficult to get the loan easily due to procedural
difficulties. Both companies have the competitive advantage in their domestic loan markets. The
Indian firm can take a low-cost loan of Rs.20 million in Indian, while the Japanese firm can take a low-
cost loan of Yen.10 million in the Japan. Assume both loans need six monthly repayments.

Both companies then execute a currency swap agreement. At the start, the Indian firm gives Rs 20
million to the Japanese firm and receives Yen 10 million, enabling both firms to start business in their
respective foreign lands. Every six months, the Indian firm pays the Japanese firm the interest
payment for the loan = (notional Yen amount * interest rate * period) = (10 million * 6% * 0.5) = Yen
300,000 while the Japnese firm pays the Indian firm the interest payment for the Japanese loan =
(notional Rs. amount * interest rate * period) = (20 million * 5% * 0.5) = Rs. 500,000. Interest
payments continue until the end of the swap agreement, at which time the original notional forex
amounts will be exchanged back to each other.

Commodity Swaps
Commodity swaps are common among individuals or companies that use raw materials to produce
goods or finished products. Profit from a finished product may suffer if commodity prices vary, as
output prices may not change in sync with commodity prices. A commodity swap allows receipt of
payment linked to the commodity price against a fixed rate.

Assume two parties get into a commodity swap over one million barrels of crude oil. One party agrees
to make six-monthly payments at a fixed price of $60 per barrel and receive the existing (floating)
price. The other party will receive the fixed and pay the floating.

If crude oil rises to $62 at the end of six months, the first party will be liable to pay the fixed ($60 *1
million) = $60 million and receive the variable ($62 * 1 million) = $62 million from the second party.
Net cash flow in this scenario will be $2 million transferred from the second party to the first.
Alternatively, if crude oil drops to $57 in the next six months, the first party will pay $3 million to the
second party.

Credit Default Swaps (CDS)

The credit default swap offers insurance in case of default by a third-party borrower. Assume Shivam
bought a 15-year long bond issued by ABC, Inc. The bond is worth Rs.1,000 and pays annual interest of
Rs.50 (i.e., 5% coupon rate). Shivam worries that ABC, Inc. may default so he executes a credit default
swap contract with Keshav. Under the swap agreement, Shivam (CDS buyer) agrees to pay Rs.15 per
year to Keshav (CDS seller). Keshav trusts ABC, Inc. and is ready to take the default risk on its behalf.
For the Rs.15 receipt per year, Keshav will offer insurance to Shivam for his investment and returns.
If ABC, Inc. defaults, Keshav will pay Shivam Rs.1,000 plus any remaining interest payments. If ABC, Inc.
does not default during the 15-year long bond duration, Keshav benefits by keeping the Rs.15 per year
without any payables to Shivam.
Zero Coupon Swaps (ZCS)
Similar to the interest rate swap, the zero coupon swap offers flexibility to one of the parties in the
swap transaction. In a fixed-to-floating zero coupon swap, the fixed rate cash flows are not paid
periodically, but just once at the end of the maturity of the swap contract. The other party who
pays floating rate keeps making regular periodic payments following the standard swap payment
schedule.

A fixed-fixed zero coupon swap is also available, wherein one party does not make any interim
payments, but the other party keeps paying fixed payments as per the schedule.

Total Return Swaps (TRS)

A total return swap gives an investor the benefits of owning a security, without actual ownership. A
TRS is a contract between a total return payer and total return receiver. The payer usually pays the
total return of an agreed security to the receiver, and receives a fixed/floating rate payment in
exchange. The agreed (or referenced) security can be a bond, index, equity, loan, or commodity. The
total return will include all generated income and capital appreciation.

Assume Keshav (the payer) and Shivam(the receiver) enter into a TRS agreement on a bond issued by
ABC Inc. If ABC Inc.’s share price rises (capital appreciation) and pays a dividend (income generation)
during the swap's duration, Keshav will pay Shivam those benefits. In return, Shivam has to pay Keshav
a pre-determined fixed/floating rate during the duration
 Q3. Assume that you have Rs. 1,00,000 in your savings account. You want to
invest the entire sum in a way that suits your risk appetite (fully risk averse or
moderate risk take or full risk taker). What would your investment strategies be?
Where would you invest (which securities)? What techniques would you make
use of to hedge your risk? (5 marks)
 I will follow moderate risk to risky strategy, I will invest in High Beta Stocks & in futures. When
we operate in futures markets hedging implies taking a position opposite to that in the
physical market, which saves us from market risks.
 Hedging is called the opposite of speculation &we as hedgers try to "win" and make money on
the actual price movements, as well are saved from risk.
 According to me, locking a price today allows for better focus on planning and business
development with minimum exposure to an unwanted risk. This type of approach differs in
complexity from relatively simple "off-setting trades" through to complex derivative
structures.

Key principles in my strategy:

I will follow two principles in my strategy:

 An open hedge: it arises when a futures position is opposite to physical market.

 A closed hedge refers to the case when a futures position is closed when the physical risk is no
longer present.

How these Principles will help in my strategy:

 It will help by naturally strategy of long physical the commodity so to hedge I will normally sell
futures, protecting my profit margin against a price fall.
 It will help by naturally strategy of short physical the commodity, so to hedge I will
normally buy futures, protecting against a rise in prices.

Strategies to Hedge off risk:

 Arbitrage involves taking opposite positions on two markets, in order to hedge physical pricing
on different markets for the same or similar products.

 Averaging is a strategy whereby, instead of hedging against a single price fixed on a single
date, average transactions settle against average prices observed over a certain period of
time.

 Offset is a simple offsetting of the physical market exposure.

 Price Fixing involves taking advantage of the current favourable market levels for the future
physical transactions

 Hedge with Futures

 Hedge with Options

 Long stock, Short Index Futures: To remove risk from fluctuations of the market index, I will
take a long position in a stock plus short position in index. With this strategy, I will hedge my
index exposure.

 Short stock, Long Index Futures: If I will feel that the stock was intrinsically overvalued, then I
will take a short position in the cash market and a long position in the index. This position is
short stock plus long index and will help me to hedge my index exposure.

 Hedging a portfolio with Short Index Futures: In my portfolio of shares I may have a view that
stock prices will fall in the near future. Hence, I may hedge my portfolio by selling index
futures. This strategy makes sense for short periods of time when & if I anticipated a short-
term market volatility.

 Hedging with Long Index Futures: There are situations when I have funds or I may anticipate
funds in the near future and wants to invest in equity shares. However, investing in the stock
market is a time-consuming process as a person, I may need to do equity research and decide
my portfolio. This risk can be hedged by buying index futures. Later, I can fund gradually &
acquire shares and thereby reduce the long index position corresponding. This strategy,
therefore, enables me to choose shares carefully and spend more time in placing aggressive
limit orders.
Q4. Use the data given below to calculate the payoffs and the profits for
investments in each of the following January expiration options, assuming that
the stock price on the expiration date is $125. (6 marks)
a. Call option, Strike Price = $120; available for $7.65 (option premium)

 Since the call price at expiry is greater than strike price we will exercise the option
 Payoff will be $5 (Strike Price- Expiry Price)
 Profit= $ -2.65 (Premium- payoff)

b. Put option, Strike Price = $120; available for $2.53 (option premium)

 Since the put price at expiry is greater than strike price we will not exercise the option
 Payoff will be $0
 Profit= $-2.53 (Premium- payoff)

c. Call option, Strike Price = $125; available for $4.40 (option premium)

 Since the call price at expiry is equal to strike price we will not exercise the option
 Payoff will be $0
 Profit= $-4.40 (Premium- payoff)

d. Put option, Strike Price = $125; available for $4.40 (option premium)

 Since the put price at expiry is equal to strike price we will not exercise the option
 Payoff will be $0
 Profit= $ -4.40 (Premium- payoff)

e. Call option, Strike Price = $130; available for $2.30 (option premium)

 Since the call price at expiry is lesser to strike price we will not exercise the option
 Payoff will be $0
 Profit= $ -2.30 (Premium- payoff)

f. Put option, Strike Price = $130; available for $7.40 (option premium)

 Since the put price at expiry is lesser to strike price we will exercise the option
 Payoff will be $5 (Strike Price- Expiry Price)
 Profit= $ -2.40 (Premium- payoff)