Unit-1

Introduction & Evolution of Derivative Market

Derivatives are tradable products whose price is based upon another market. Derivatives are
security, whose value based upon other more basic underlying variables. In recent years,
derivative security has become increasingly important in the finance field.

When commodity futures were first introduced on the Chicago Board of Trade in 1865,
policymakers and regulators in these markets are concerned about the impact of futures on the
underlying cash market. One of the reasons for this concern is the belief that futures' trading
attracts speculators who then destabilize spot prices.

The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the
launch of index futures on June 12, 2000. The futures contracts are based on the popular
benchmark Nifty 50 Index. The Exchange introduced trading in Index Options (also based on
Nifty 50) on June 4, 2001

Futures & Options are now actively traded on many different exchanges. Forward contracts,
swaps and many different types of options are regularly traded outside the exchanges by
financial institutions and their corporate clients in over-the-counter markets. Other more
specialized derivative securities often form part of a bond or stock issue.

Meaning of Derivatives:
A derivative is an instrument whose value depends on the values of other more basic
underlying variables.

Derivative Securities are also known as contingent claims. Generally, the variables underlying
derivative securities are the prices of traded securities.

For example, a stock option is a derivative security whose value is contingent on the price of
the stock.
 Types of Derivatives Contracts:

There are several derivatives markets and each containing thousands of

individual derivatives which can be traded.

1. Forward Contracts
2. Futures Contracts
3. Options Contracts
Forward Contracts:

A forward contract is a customized contract between two entities, where settlement takes
place on a specific date in the future at today's preagreed price.

A forward contract is a simple derivative security. It is an agreement to buy or sell an asset at a

certain time for a certain price.

This contract is usually between two financial institutions or between the financial institution
and one of its corporate clients. Generally, it is not traded on an exchange.
In a forward contract, one of the parties to be assuming a long position and agrees to buy the
underlying asset on the certain specified future date for a certain specified price.

The other party assumes a short position and agrees to sell the asset on the same date for the
same price. A forward contract is settled at maturity.

The specified price in a forward contract will be referred to as the delivery price. At the time
when parties entered into the contract, the delivery price is chosen so that the value of the
forward contract to both parties is zero.

The holder of the short position delivers the asset to the holder of the long position in return
for a cash amount equal to the delivery price.

Key variable determines the value of a forward contract is the market price of the asset. Value
of a forward contract is zero when parties enter into the contract.

Futures Contracts:

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. Futures contracts are special types of forward contracts in the
sense that the former are standardized exchange-traded contracts.

A future contract is like a forward contract. It is an agreement between two parties to buy or
sell an asset at a certain time in the future for a certain price.

Futures contracts are generally traded on the exchange. The largest exchanges on which futures
contracts are traded are the Chicago Board of Trade (CBOT) and the Chicago Mercantile
Exchange (CME).

One way in which a futures contract is different from a forward contract is the exact delivery
date is not usually specified.

Futures contracts are generally referred by its delivery month, and the exchange specifies the
period during the month when delivery must be made.

For Example: In case of the bullion commodities future contract, the delivery period is 5 trading
days after the expiry of the contract.
We can understand it by one example- there is an August – 2017 future contract of Gold, this
contract will expire on end of the month i.e. 31st July (Monday) so the delivery period will be
1st to 4th August (Tuesday to Friday). Ideally delivery period should be 1st to 5th Aug. but 5th Aug
is Saturday (no Trading day) so this date has to be excluded from the delivery period and it will
remain for four days.

Options Contracts:

Options on stocks were first traded on an organized exchange in 1973. Since then, there has
been a dramatic growth in the options market. Nowadays options are traded on many different
exchanges across the world.

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.

Types of Options:

There are two basic types of options – Call Option and Put option.

Call Option:

A call option is a security, which gives the owner the right to buy the underlying asset at a
certain price by a certain date.

The “certain price” is called the ‘Strike Price’, and “certain date” is called “expiration date”.

Put Option

A put option is a security that one buys when you think the price of a Stock or Index is going to
go down. A put option is a right to sell shares of stock or index at a certain price by a certain
date.

The “certain price” is called the ‘Strike Price’, and “certain date” is called “expiration date”.

The underlying assets include stocks, stock indices, foreign currencies, debt instruments,
commodities, and future contracts.
Warrants: Options generally have lives of up to 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 up to three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is
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. Rather than have calls and
puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is
an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and
receive floating.

Forward Markets Commission (FMC) in India:

The Forward Markets Commission (FMC) was the chief regulator of commodity futures
markets in India. As of July 2014, it regulated Rs 17 trillion worth of commodity trades in India.
It is headquartered in Mumbai and this financial regulatory agency is overseen by the Ministry
of Finance. The Commission allows commodity trading in 22 exchanges in India, of which 6 are
national.
On 28 September 2015 the FMC was merged with the Securities and Exchange Board of
India (SEBI).
FMC is the chief regulator of forward and futures markets in India. FMC comes under the
Ministry of Consumer Affairs, Food and Public Distribution because futures traded in India
are traditionally in food commodities.
FMC is a legal body set up under Forward Contracts (Regulation) Act 1952. The Act provides
that the Commission should consist of minimum two and maximum four members appointed
by the Central Government. The chairman of the FMC is nominated by the central
government.

At present five national exchanges, viz. Multi Commodity Exchange, National Commodity and
Derivatives Exchange, National Multi Commodity Exchange, Indian Commodity Exchange Ltd
and ACE Derivatives and Commodity Exchange, regulate forward trading in 113 commodities.
Besides, there are 16 commodity specific exchanges recognized for regulating trade in
various commodities approved by FMC under the Forward Contracts (Regulation) Act, 1952.

Commodities traded on these exchanges comprise:

 Edible oilseeds: Groundnut, mustard seed, cotton seed, sunflower, rice bran oil, soy oil,
etc.
 Food grains: Wheat, gram, dals, bajra, maize etc.
 Metals: Gold, silver, copper, zinc etc.
 Spices: Turmeric, pepper, jeera etc.
 Fibres: Cotton, jute, etc.
 Others: Gur, rubber, natural gas, crude oil etc.

Functions of FMC
 To advise the central government in respect of the recognition or the withdrawal of
recognition from any association.
 To advise the central government in respect of issues arising out of the administration
of the Forward Contracts (Regulation) Act 1952.
 To keep forward markets under observation and to take such action in relation to them,
as it may consider necessary, in exercise of the powers assigned to it under the Act.
 To collect and whenever the Commission thinks it necessary, to publish information
regarding the trading conditions in respect of goods to which any of the provisions of
the Act is made applicable, including information regarding supply, demand and prices,
and to submit to the central government, periodical reports on the working of forward
markets relating to such goods.
 To make recommendations to improve the organization and working of forward
markets;
 To undertake the inspection of accounts and other documents of any recognized
association, registered association or any member of such association whenever it
considers it necessary.

It allows futures trading in 23 fibers and manufacturers, 15 spices, 44 edible oils, 6 pulses, 4
energy products, single vegetable, 20 metal futures and 33 other futures.
FMC has powers of deemed civil court for
 Summoning and enforcing the attendance of any person and examining him on oath.
 Requiring the discovery and production of any document.
 Receiving evidence on affidavits.
 Requisitioning any public record from any office.

Participants in a derivative market:

Participants in a derivative market can be segregated into four sets based on their trading
motives.

 Hedgers
 Speculators
 Margin Traders
 Arbitrageurs

Hedgers face risk associated with the price of an asset. They use futures or options markets to
reduce or eliminate this risk. 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 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.

Forward Market transaction

Forward Exchange Contracts

A Forward Exchange Contract is a contract between Bank and the person where the Bank
agrees to BUY from Person, or SELL to Person, foreign currency on a fixed future date, at a fixed
rate of exchange. Person undertakes to pay the Bank, the overseas currency in terms of the
contract in exchange for the settlement currency, which would usually be Dollars.

The Bank can provide a Forward Exchange Contract in most overseas currencies, for the
protection of Exporters and Importers who are subject to exchange risks in the course of their
international transactions.

Forward Exchange Contracts can be used to cover Person exchange risk between an overseas
currency and dollars or between two overseas currencies. The contract may be entered into at
anytime and can be used to cover both trade and non-trade transactions.
Hedge & Hedging:

A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally,
a hedge consists of taking an offsetting position in a related security, such as a futures contract.
And the process is known as Hedging. Hedging risky transactions can help the person to avoid
heavy losses in financial markets. Hedging against investment risk means strategically using
instruments in the market to offset the risk of any adverse price movements.

Hedging with forward Market:

Forward market hedging is a means by which to protect exposure in forward currency, interest
rate, commodities and financial assets market. The Forward market, engaging in large
contracts, is dominated by government, institutional & corporate entities. Forward Market
Hedging is a large scale maneuver for a corporation, Government or institutional entity to
protect a position in financial instrument or asset markets. For Example, if a corporation
expects a weakening of a foreign currency that contribute sales revenue, the corporation might
protect profits by securing a forward contract for a currency instrument at a Profit-compatible
fixed price for a delivery at a fixed future rate.
Hedging is an investment strategy whereby various maneuvers may be employed to protect investment
value. In financial Instrument markets, hedging may take the form of investing in hard currency
securities.

Forward market hedging is a maneuver to protect against loss in the event of a drop in or weakening of
assets ,interest rates or currency, but hedging is not without risk as an entity in the forward market may
find they have over –hedged (Creating a liability, or debt) or under hedged ( thus accruing profit loss).
Characteristics of Derivatives:

1. Derivatives have the characteristic of Leverage or Gearing. With a small initial outlay of
funds (a small percentage of the entire contract value) one can deal big volumes.

2. Pricing and trading in derivatives are complex and a thorough understanding of the price

behaviour and product structure of the underlying is an essential pre-requisite before

one can venture into dealing in these products.

3. Derivatives, by themselves, have no independent value. Their value is derived out of the
underlying instruments.

Functions of Derivatives:

1. Derivatives shift the risk from the buyer of the derivative product to the seller and as
such are very effective risk management tools.

2. Derivatives improve the liquidity of the underlying instrument. Derivatives perform an

important economic function viz. price discovery. They provide better avenues for
raising money. They contribute substantially to increasing the depth of the markets.
 Unit-2
Difference between Forward Contract & Futures Contract:
Basis for
Comparison Forward Contract Futures Contract
Meaning Forward Contract is an A contract in which the parties
agreement between parties to agree to exchange the asset for cash
buy and sell the underlying at a fixed price and at a future
asset at a specified date and specified date, is known as future
agreed rate in future. contract.

What is it? It is a tailor made contract. It is a standardized contract.

Traded on Over the counter, i.e. there is Organized stock exchange.

no secondary market.

Settlement On maturity date. On a daily basis.

Risk High Low

Default As they are private agreement, No such probability.

the chances of default are
relatively high.

Size of Depends on the contract Fixed

contract terms.

Collateral Not required Initial margin required.

Maturity As per the terms of contract. Predetermined date

Regulation Self regulated By stock exchange

Liquidity Low High

Features of Forward Contract:

Key features of forward contracts are:

 Highly customized - Counterparties can determine and define the terms and features to
fit their specific needs, including when delivery will take place and the exact identity of
the underlying asset.
 All parties are exposed to counterparty default risk - This is the risk that the other party
may not make the required delivery or payment.
 Transactions take place in large, private and largely unregulated markets consisting of
banks, investment banks, government and corporations.
 Underlying assets can be stocks, bonds, foreign currencies, commodities or some
combination thereof. The underlying asset could even be interest rates.
 They tend to be held to maturity and have little or no market liquidity.
 Any commitment between two parties to trade an asset in the future is a forward
contract.

Features of Future Contract

A futures contract can also be deliverable or cash settled. Because a futures contract is traded
on an exchange. Key features of futures contracts are:

1. Futures contracts are traded on an exchange while forward contracts are privately
traded.
2. Since they are traded on exchange, futures contracts are highly standardized. Forward
contracts, on the other hand, are customized as per the requirements of the
counterparties.
3. A single clearinghouse acts as the counterparty for all futures contracts. This means that
the clearinghouse is the buyer for every seller and seller for every buyer. This eliminates
the risk of default, and also allows traders to reverse their positions at a future date.
4. Futures contracts require a margin to be posted at the contract initiation, which
fluctuates as the futures prices fluctuate. There is no such margin requirement in a
forward contract.
5. The government regulates futures market while the forward market is not regulated.
A futures contract is a type of derivative or financial contract in which two parties agree to
make a certain transaction on a specified future date at a specified current price. Trading
futures contracts are also known as margin trading.
Margin trading gives a leverage of capital as only a margin needed, usually 5 to 10% of the total
value of the contract to trade.
Futures have been gaining popularity throughout the recent years as investors and traders are
searching for alternatives for better return of investments and with that popularity, arises
different types of futures contract.
Futures contract are classified into two big categories -financial futures and commodities
futures.

Types of Financial Futures

Eurodollar Futures
Eurodollar futures are U.S. dollars that are deposited outside the country in commercial banks
mainly in Europe which are known to settle international transactions. They are not guaranteed
by any government but only by the obligation of the bank that is holding them.

U.S. Treasury Futures

Because U.S. Dollars is the reserved currency for most countries, the stability of the dollars
allows for treasury futures market and instruments such as treasury bonds and treasury bills.

Foreign Government Debt Futures

Most Government Issue debt that are corresponded to the futures markets that are listed
around the world.

Swap Futures
This is generally agreements that are between two parties to exchange periodic interest
payments.

Forex Futures
This type of futures is to manage the risks and take advantage of related forex exchange rate
fluctuations.

Single Stock Futures

Most popular futures contracts are related to the equity markets, they are also known as
security futures. There are about 10 companies in Malaysia that offer single stock futures. They
are Bursa Malaysia Bhd, Air Asia Bhd, AMMB Holdings Bhd, Berjaya Sports Toto Bhd, Genting
Bhd, IOI Corporation Bhd, Maxis Communications Bhd, RHB Capital Bhd, Scomi Group Bhd and
Telekom Malaysia Bhd.

Index Futures
Futures that are based on the stock index. In the case of the Kuala Lumpur Composite Index,
the index futures will be the FTSE Bursa Malaysia KLCI Futures (FKLI).

Types of Commodities Futures

Metals
Major metals traded with futures contracts include copper, gold, platinum, palladium and
silver, which are listed on the New York Mercantile Exchange which has merged with
the Chicago Mercantile Exchange.

Energy
The most popular energy futures contracts are crude oil, heating oil and natural gas. They have
become an important indicator of world economic and political developments and are very
much influenced by producing nations such as Malaysia.

Grains & Oil Seeds

Grains such as soybeans and oil seeds are essential to food and feed supplies, and prices are
sensitive to the weather conditions, and also to economic conditions that affect demand.
Because corn is integral to the increasing popularity of ethanol fuel, the grain markets also are
affected by the energy markets and the demand for fuel.

Livestock
Commodity futures on live cattle, feeder cattle, lean hogs and pork bellies are commodities
traded at CME Group Inc and prices are affected by consumer demand, competing protein
sources, price of feed, and factors that influence the number of animals born and sent to
market, such as disease and weather.

Food and Fiber

The food and fiber category for futures trading includes cocoa, coffee, cotton and sugar. In
addition to consumer demand globally, factors such as disease, insect’s infestation and drought
affect prices of these commodities.
 Currency future

A currency future, also known as an FX future or a foreign exchange future, is a futures

contract to exchange one currency for another at a specified date in the future at a price
(exchange rate) that is fixed on the purchase date; see Foreign exchange derivative.
Typically, one of the currencies is the US dollar. The price of a future is then in terms of
US dollars per unit of other currency. This can be different from the standard way of
quoting in the spot foreign exchange markets. The trade unit of each contract is then a
certain amount of other currency, for instance €125,000. Most contracts have physical
delivery, so for those held at the end of the last trading day, actual payments are made
in each currency. However, most contracts are closed out before that. Investors can
close out the contract at any time prior to the contract's delivery date.

Currency futures are a transferable futures contract that specifies the price, in one currency, at
which another currency can be bought or sold at a future date. Currency futures contracts are
legally binding and counterparties that are still holding the contracts on the expiration
date must deliver the currency amount at the specified price on the specified delivery date.
Currency futures can be used to hedge other trades or currency risks, or to speculate on price
movements in currencies.

Currency futures contracts are marked-to-market daily. This means traders are responsible for
having enough capital in their account to cover margins and losses which result after taking the
position. Futures traders can exit their obligation to buy or sell the currency prior to the
contract's delivery date. This is done by closing out the position.
The price of currency futures are determined when the trade is initiated. For example, buying a
Euro FX future on the US exchange at 1.20 means the buyer is agreeing to buy euros at $1.20
US. If they let the contract expire, they are responsible for buying 125,000 euros at $1.20 USD.
Each Euro FX future on the Chicago Mercantile Exchange (CME) is 125,000 euro, which is why
the buyer would need to buy this much. On the flip side, the seller of the contract would need
to deliver the euros and would receive US dollars.

Most participants in the futures markets are speculators who close out their positions before
futures expiry date. They do not end up delivering the physical currency. Rather, they make or
lose money based on the price change in the futures contracts themselves.

Currency futures were first created in 1970 at the International Commercial Exchange in New
York. But the contracts did not "take off" because the Bretton Woods system was still in effect.
On 15 August 1971, President Richard Nixon abandoned both the gold standardand the system
of fixed exchange rates. Some commodity traders at the Chicago Mercantile Exchange (CME)
did not have access to the inter-bank exchange markets in the early 1970s, when they believed
that significant changes were about to take place in the currency market. The CME established
the International Monetary Market (IMM) and launched trading in seven currency futures on
May 16, 1972.

The CME actually now gives credit to the International Commercial Exchange (not to be
confused with ICE) for creating the currency contract, and state that they came up with the idea
independently of the International Commercial Exchange. Today, the IMM is a division of CME.
In the fourth quarter of 2009, CME Group FX volume averaged 754,000 contracts per day,
reflecting average daily notional value of approximately $100 billion. Currently most of these
are traded electronically.
Other futures exchanges that trade currency futures are Euronext.liffe, Tokyo Financial
Exchange and Intercontinental Exchange .
 Unit-3

Hedging in Currency Futures:

Hedging
Hedging is an act of protecting or guarding the investment against an undesired price
movement.
Investors use these futures contracts to hedge against foreign exchange risk. If an investor will
receive a cash flow denominated in a foreign currency on some future date, that investor can
lock in the current exchange rate by entering into an offsetting currency futures position that
expires on the date of the cash flow.
For example, Jane is a US-based investor who will receive €1,000,000 on December 1. The
current exchange rate implied by the futures is $1.2/€. She can lock in this exchange rate by
selling €1,000,000 worth of futures contracts expiring on December 1. That way, she is
guaranteed an exchange rate of $1.2/€ regardless of exchange rate fluctuations in the
meantime.

Forex Hedge
A forex hedge is a transaction implemented by a forex trader or investor to protect an existing
or anticipated position from an unwanted move in exchange rates. By using a forex hedge
properly, a trader who is long a foreign currency pair, or expecting to be in the future via a
transaction can be protected from downside risk, while the trader who is short a foreign
currency pair can protect against upside risk.
It is important to remember that a hedge is not a money making strategy.

The primary methods of hedging currency trades for the retail forex trader is through spot
contracts and foreign currency options. Spot contracts are the run-of-the-mill trades made by
retail forex traders. Because spot contracts have a very short-term delivery date (two days),
they are not the most effective currency hedging vehicle. In fact, regular spot contracts are
often why a hedge is needed.

Foreign currency options are one of the most popular methods of currency hedging. As with
options on other types of securities, foreign currency options give the purchaser the right, but
not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in
the future. Regular options strategies can be employed, such as long straddles, long strangles,
and bull or bear spreads, to limit the loss potential of a given trade.

Arbitrage in Currency Futures:

Forex Arbitrage

Forex arbitrage is the simultaneous purchase and sale of currency in two different markets.
Arbitrage in itself is a trade that profits by exploiting the price differences of identical or similar
financial instruments on different markets or in various forms. So, with forex arbitrage, foreign
exchange traders acquire currency pairs to exploit any short-term pricing inefficiency between
them. However, prices tend to move toward equilibrium across markets, so it may be difficult
to find such price discrepancies.

Forex arbitrage can occur, for example, when a trader at one bank offers to sell a currency at a
lower price than a trader at another bank is offering to buy it. A forex arbitrage trade profits by
simultaneously purchasing the currency from the one seller, and selling it to the buyer.
However, there is the hazard of execution risk if the price should change or re-quote, which
could reduce the profit or generate a loss.

Electronic trading, which is high-frequency trading using algorithms and dedicated computer
networks, has shortened the timeframe for forex arbitrage trades. Previously, price
discrepancies would last several seconds. Now they may remain for only a second or less,
before reaching equilibrium. However, volatile markets and price quote errors or staleness can
still provide arbitrage opportunities.
Other forex arbitrage includes:

 Currency arbitrage involves the exploitation of the differences in quotes rather than
movements in the exchange rates of the currencies in the currency pair.
 A cross-currency transaction is one that consists of a pair of currencies traded
in forex that does not include the U.S. dollar. Ordinary cross currency rates involve the
Japanese yen. Arbitrage seeks to exploit pricing between the currency pairs, or the cross
rates of different currency pairs.
 In covered interest rate arbitrages the practice of using favorable interest rate
differentials to invest in a higher-yielding currency, and hedging the exchange risk
through a forward currency contract.
 An uncovered interest rate arbitrage involves changing a domestic currency which
carries a lower interest rate to a foreign currency that offers a higher rate of interest on
deposits.
 Spot-future arbitrage involves taking positions in the same currency in the spot and
futures markets. For example, a trader would buy currency on the spot market and sell
the same currency in the futures market if there is a beneficial pricing discrepancy.

Arbitrage involves the simultaneous buying and selling of an asset in order to profit from small
differences in price. Often, arbitrageurs buy stock on one market (for example, a financial
market in the United States like the NYSE) while simultaneously selling the same stock on a
different market (such as the London Stock Exchange). In the United States, the stock would be
traded in US dollars, while in London; the stock would be traded in pounds.
As each market for the same stock moves, market inefficiencies, pricing mismatches and even
dollar/pound exchange rates can affect the prices temporarily. Arbitrage is not limited to
identical instruments; arbitrageurs can also take advantage of predictable relationships
between similar financial instruments, such as gold futures and the underlying price of physical
gold.

Since arbitrage involves the simultaneous buying and selling of an asset, it is essentially a type
of hedge and involves limited risk, when executed properly. Arbitrageurs typically enter large
positions since they are attempting to profit from very small differences in price.

Speculation in Currency Futures

Speculation
Currency futures can also be used to speculate and, by incurring a risk, attempt to profit from
rising or falling exchange rates.
For example, Peter buys 10 September CME Euro FX Futures for $1,250,000 (each contract
worth $125,000), at $1.2713/€. At the end of the day, the futures close at $1.2784/€. The
change in price is $0.0071/€. As each contract is over €125,000, and he has 10 contracts, his
profit is $8,875. As with any future, this is paid to him immediately.
More generally, each change of $0.0001/€ (the minimum Commodity tick size), is a profit or
loss of $12.50 per contract.

Speculation, on the other hand, is a type financial strategy that involves a significant amount of
risk. Financial speculation can involve the trading of instruments such as bonds, commodities,
currencies and derivatives. Speculators attempt to profit from rising and falling prices. A trader,
for example, may open a long (buy) position in a stock index futures contract with the
expectation of profiting from rising prices. If the value of the index rises, the trader may close
the trade for a profit. Conversely, if the value of the index falls, the trade might be closed for a
loss.

Speculators may also attempt to profit from a falling market by shorting (selling short, or simply
"selling") the instrument. If prices drop, the position will be profitable. If prices rise, however,
the trade may be closed at a loss.
Market Index

A market index is a weighted average of several stocks or other investment vehicles from a
section of the stock market, and it is calculated from the price of the selected stocks. Market
indexes are intended to represent an entire stock market and track the market's changes over
time.

Index values help investors track changes in market values over long periods of time. For
example, the widely used Standard and Poor's 500 Index is computed by combining 500 large-
cap U.S. stocks into one index value. Investors can track changes in the index's value over time
and use it as a benchmark for their own portfolio returns.

Market indices measure the value of groups of stocks. If an index goes up one level, or 1%, this
means a group of stocks has, correspondingly, increased its value by one level also
and become more attractive to investors. The Dow Jones Industrial Average (DJIA), Nasdaq
Composite index and the S&P 500 are examples of market indices.
Application of Market Indexes:

 Economists and statisticians use stock-market indexes to study long-term growth

patterns in the economy.

 To analyze and forecast business-cycle patterns.

 To relate stock indexes to other time- series measures of economic activity.

 To use the market index as a benchmark against which to evaluate the performance of

their own or institutional portfolios.

 Market technicians in many cases base their decisions to buy and sell on the patterns

that appear in the time series of the market indexes. The final use of the market index is

in portfolio analysis.
Index Futures in the Stock Market

In finance, a stock market index future is a cash-settled futures contract on the value of

a particular stock market index, such as the S&P 500. The turnover for the global market

in exchange-traded equity index futures is notionally valued, for 2008, by the Bank for

International Settlements at USD 130 trillion.

A stock index is a composition of select securities traded on an exchange, e.g. Sensex is a

composition of 30 blue- chip securities being traded on BSE. Therefore, a stock index

futures contract is simply a futures contract where the underlying variable is a stock

index such as BSE Sensex, S&P CNX, NIFTY etc.

The value of stock index futures derives its value from a stock index value. Theoretically,

an investor who buys a stock index futures contract agrees to buy the entire stock index

and the seller agrees to sell the entire stock index. The SEBI has taken a landmark

decision permitting the use of derivatives based on L.C. Gupta Committee Report. The

SEBI has suggested phased introduction of derivatives starting with Stock Index Futures

to be followed by Stock Index Options.

Application of Stock Index Futures:

Stock index futures are used for hedging, trading, and investments. Index futures are also used
as leading indicators to determine market sentiment.[2] Hedging using stock index futures could
involve hedging against a portfolio of shares or equity index options. Trading using stock index
futures could involve, for instance, volatility trading (The greater the volatility, the greater the
likelihood of profit taking – usually taking relatively small but regular profits). Investing via the
use of stock index futures could involve exposure to a market or sector without having to
actually purchase shares directly.
There are cases of equity hedging with index futures. One case is where a portfolio 'exactly'
reflects the index (this is unlikely) so that the portfolio is perfectly hedged via the index future.
Another case is where a portfolio does not entirely reflect the index (this is more likely to be the
case). Here, the degree of correlation between the underlying asset and the hedge is not high.
So, your portfolio is unlikely to be 'fully hedged'.
Equity index futures and index options tend to be in liquid markets for close to delivery
contracts. They trade for cash delivery, usually based on a multiple of the underlying index on
which they are defined (for example £10 per index point).
OTC products are usually for longer maturities, and are usually a form of options product. For
example, the right but not the obligation to cash delivery based on the difference between the
designated strike price, and the value of the designated index at the expiration date. These are
traded in the wholesale market, but are often used as the basis of guaranteed equity products,
which offer retail buyers a participation if the equity index rises over time, but which provides
guaranteed return of capital if the index falls. Sometimes these products can take the form
of exotic options (for example Asian options or Quanto options).

Indian Derivatives Market:

Derivatives markets in India have been in existence in one form or the other for a long time. In
the area of commodities, the Bombay Cotton Trade Association started futures trading way
back in 1875. In 1952, the Government of India banned cash settlement and options trading.
Derivatives trading shifted to informal forwards markets. In recent years, government policy
has shifted in favour of an increased role of market-based pricing and less suspicious derivatives
trading. The first step towards introduction of financial derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995. It provided for withdrawal
of prohibition on options in securities. The last decade, beginning the year 2000, saw lifting of
ban on futures trading in many commodities. Around the same period, national electronic
commodity exchanges were also set up. Derivatives trading commenced in India in June 2000
after SEBI granted the final approval to this effect in May 2001 on the recommendation of L. C
Gupta committee. Securities and Exchange Board of India (SEBI) permitted the derivative
segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to
commence trading and settlement in approved derivatives contracts. Initially, SEBI approved
trading in index futures contracts based on various stock market indices such as, S&P CNX, Nifty
and Sensex. Subsequently, index-based trading was permitted in options as well as individual
securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in
options on individual securities commenced in July 2001. Futures contracts on individual stocks
were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX
Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001
and trading in options on individual securities commenced on July 2, 2001. Single stock futures
were launched on November 9, 2001. The index futures and options contract on NSE are based
on S&P CNX. In June 2003, NSE introduced Interest Rate Futures which were subsequently
banned due to pricing issue.

Bombay Stock Exchange (BSE), which is Asia's Oldest Broking House, was established in 1875 in
Mumbai. It is also called as Dalal Street. The BSE Index, called the Sensex, is calculated by Free
Float Method by including scrips of top 30 companies selected on the market capitalization
criterion.

BSE created history on June 9, 2000 by launching the first Exchange-traded Index Derivative
Contract in India i.e. futures on the capital market benchmark index - the BSE Sensex. The
inauguration of trading was done by Prof. J.R. Varma, member of SEBI and Chairman of the
committee which formulated the risk containment measures for the derivatives market.

In sequence of product innovation, BSE commenced trading in Index Options on Sensex on June
1, 2001, Stock Options were introduced on 31 stocks on July 9, 2001 and Single Stock Futures
were launched on November 9, 2002.

Long Dated Options:

BSE also introduced 'Long Dated Options' on its flagship index - Sensex® -on February 29, 2008,
whereby the Members can trade in Sensex Options contracts with an expiry of up to 5 years.

Currency Derivatives:
Going ahead, on October 1, 2008 BSE launched its currency derivatives segment in dollar-rupee
currency futures as the exchange traded currency futures contracts facilitate easy access,
increased transparency, efficient price discovery, better counterparty credit risk management,
wider participation and reduced transaction costs.

Futures on BOLT
BSE re-launched its Derivatives Segment by enabling trading of Index and Stock Futures on its
BOLT Terminal. The change was in response to requests from trading members for a common
front end from which equities and equity derivatives could be traded. The change will enable a
trader to trade in cash Securities and futures products through BOLT TWS/ IML while Option
products would continue to trade through the DTSS TWS/DIML. The risk management and
settlement of futures and option trades will continue to take place on DTSS.
Why SENSEX Futures:
There are many reasons why SENSEX® futures makes sense:
 SENSEX® as compared with other indices shows less volatility and at the same time gives
returns equivalent to the returns given by the other indices.
 SENSEX® is widely used to describe the mood in the Indian stock market. Because of its
long history and wide acceptance, no other index matches the BSE SENSEX® in reflecting
market movements and sentiments and it makes an attractive underlying for index-based
products like Index Funds, Futures & Options and Exchange Traded Funds.
 SENSEX® is truly investible as it is the only broad based index in India that is "free float
market capitalization weighted", which reflects the market trends more rationally and
takes into consideration only those shares that are available for trading in the market.

It may be noted that in addition to the SENSEX®, five sectoral indices belonging to the 90/FF
series are also available for trading in the Futures and Options Segment of BSE Limited. The
term '90 /FF' means that the indices cover 90% of the market capitalization of the sector to
which the index belongs and is thus well representative of that sector. Also, FF stands for free
float - i.e. the indices are based on the globally followed standard of free float market
capitalization methodology.

The five sectoral indices that are presently available for F&O are BSE TECK, BSE FMCG, BSE
Metal, BSE Bankex and BSE Oil & Gas.

The National Stock Exchange (NSE), located in Bombay is the first screen based automated
stock exchange. It was set up in 1993 to encourage stock exchange reform through system
modernization and competition. It opened for trading in mid1994 and today accounts for 99%
market shares of derivatives trading in India.

The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the
launch of index futures on June 12, 2000. The futures contracts are based on the popular
benchmark Nifty 50 Index.

The Exchange introduced trading in Index Options (also based on Nifty 50) on June 4, 2001. NSE
also became the first exchange to launch trading in options on individual securities from July 2,
2001. Futures on individual securities were introduced on November 9, 2001. Futures and
Options on individual securities are available on 175 securities stipulated by SEBI.
The Exchange has also introduced trading in Futures and Options contracts based on Nifty IT,
Nifty Bank, and Nifty Midcap 50, Nifty Infrastructure, Nifty PSE, Nifty CPSE indices.
This section provides you with an insight into the derivatives segment of NSE. Real-time quotes
and information regarding derivative products, trading systems & processes, clearing and
settlement, risk management, statistics etc. are available here.
 Unit-4

Currency Option

A currency option is a contract that gives the buyer the right, but not the obligation, to buy or
sell a certain currency at a specified exchange rate on or before a specified date. For this right, a
premium is paid to the seller, the amount of which varies depending on the number of
contracts if the option is bought on an exchange or on the nominal amount of the option if it is
done on the over-the-counter market. Currency options are one of the most common ways for
corporations, individuals or financial institutions to hedge against adverse movements in
exchange rates.

Foreign Currency Option:

A Foreign Currency or Foreign Exchange Option is a contract through which a seller offers a
buyer the possibility – not the obligation – to purchase or sell a specific currency at a defined
exchange rate on or before a fixed date.

When the option involves a currency purchase it is known as a Put Option. But when the option
holder wants to sell a currency is known as a Call Option.
There are a few key components in a foreign currency option.

 The Premium: is the price that the option buyer pays for the right to buy or sell that currency at
a fixed rate on or before a specific maturity date.
 The Strike Price: is the exchange rate at which the currency will be bought or sold before that
maturity date.

Hedging with currency options:

Investors can hedge against foreign currency risk by purchasing a currency put or call. There are
two main types of options, calls and puts:

Call options provide the holder the right (but not the obligation) to purchase an underlying
asset at a specified price (the strike price), for a certain period of time. If the stock fails to meet
the strike price before the expiration date, the option expires and becomes worthless. Investors
buy calls when they think the share price of the underlying security will rise or sell a call if they
think it will fall. Selling an option is also referred to as ''writing'' an option.

Put options give the holder the right to sell an underlying asset at a specified price (the strike
price). The seller (or writer) of the put option is obligated to buy the stock at the strike price.
Put options can be exercised at any time before the option expires. Investors buy puts if they
think the share price of the underlying stock will fall, or sell one if they think it will rise. Put
buyers - those who hold a "long" - put are either speculative buyers looking for leverage or
"insurance" buyers who want to protect their long positions in a stock for the period of time
covered by the option. Put sellers hold a "short" expecting the market to move upward (or at
least stay stable) A worst-case scenario for a put seller is a downward market turn. The
maximum profit is limited to the put premium received and is achieved when the price of the
underlying is at or above the option's strike price at expiration. The maximum loss is unlimited
for an uncovered put writer

Forex Hedge

A forex hedge is a transaction implemented by a forex trader or investor to protect an existing

or anticipated position from an unwanted move in exchange rates. By using a forex hedge
properly, a trader who is long a foreign currency pair, or expecting to be in the future via a
transaction can be protected from downside risk, while the trader who is short a foreign
currency pair can protect against upside risk.

It is important to remember that a hedge is not a money making strategy.

The primary methods of hedging currency trades for the retail forex trader is through spot
contracts and foreign currency options. Spot contracts are the run-of-the-mill trades made by
retail forex traders. Because spot contracts have a very short-term delivery date (two days),
they are not the most effective currency hedging vehicle. In fact, regular spot contracts are
often why a hedge is needed.

Foreign currency options are one of the most popular methods of currency hedging. As with
options on other types of securities, foreign currency options give the purchaser the right, but
not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in
the future. Regular options strategies can be employed, such as long straddles, long strangles,
and bull or bear spreads, to limit the loss potential of a given trade.

Arbitrage with Options:

Options arbitrage
Options arbitrage trades are commonly performed in the options market to earn small profits
with very little or zero risk.
Traders perform conversions when options are relatively overpriced by purchasing stock and
selling the equivalent options position. When the options are relatively underpriced, traders
will do reverse conversions or reversals. In practice, actionable option arbitrage opportunities
have decreased with the advent of automated trading strategies.
 Currency Arbitrage
A currency arbitrage is a forex strategy in which a currency trader takes advantage of different
spreads offered by brokers for a particular currency pair by making trades. Different spreads for
a currency pair imply disparities between the bid and ask prices. Currency arbitrage involves
buying and selling currency pairs from different brokers to take advantage of the miss priced
rates.

Currency arbitrage involves the exploitation of the differences in quotes rather than
movements in the exchange rates of the currencies in the currency pair. Forex traders typically
practice two-currency arbitrage, in which the differences between the spreads of two
currencies are exploited. Traders can also practice three-currency arbitrage, also known as
triangular arbitrage, which is a more complex strategy. Due to the use of computers and high-
speed trading systems, large traders often catch differences in currency pair quotes and close
the gap quickly.

Currency Arbitrage Example

For example, two different banks (Bank A and Bank B) offer quotes for the US/EUR currency
pair. Bank A sets the rate at 3/2 dollars per euro, and Bank B sets its rate at 4/3 dollars per
euro. In currency arbitrage, the trader would take one euro, convert that into dollars with Bank
A and then back into euros with Bank B. The result is that the trader who started with one euro
now has 9/8 euro. The trader has made a 1/8 euro profit if trading fees are not taken into
account.

By definition, currency arbitrage requires the buying and selling of the two or more currencies
to happen instantaneously, because an arbitrage is something that is risk free. With the advent
of online portals and algorithmic trading, arbitrage has become much less common. With price
discovery high, the ability to benefit from arbitrage falls.

Speculation with Options

As a quick summary, options are financial derivatives that give their holders the right to buy or
sell a specific asset by a specific time at a given price (strike price). There are two types of
options: calls and puts. Call options refer to options that enable the option holder to buy an
asset whereas put options enable the holder to sell an asset.

Speculation, by definition, requires a trader to take a position in a market, where he is

anticipating whether the price of a security or asset will increase or decrease. Speculators try to
profit big, and one way to do this is by using derivatives that use large amounts of leverage.
This is where options come into play.
Options in Operation

Options provide a source of leverage because they can be quite a bit cheaper to purchase in
comparison to the actual stock. This allows a trader to control a larger position in options,
compared with owning the underlying stock. For example, suppose a trader has $2,000 to
invest, and an XYZ stock costs $50 and an XYZ call option (with a strike price of $50 that expires
in six months) costs $2 each. If the trader only buys stock, then he will have a position with 40
shares ($2,000/$50). But if he takes a position with only options ($2,000/$2), he effectively
controls a position of 1,000 shares. In these cases, all gains and losses will be magnified by the
usage of the options. In this example, if the XYZ stock drops to $49 in six months, in the all stock
scenario, the trader's position is $1,960, whereas in the all option situation his total value will
be $0. All the options would be worthless then, because no one would exercise the option to
buy at a price that is greater than the current market value.

The speculator's anticipation on the asset's situation will determine what sort of options
strategy that he or she will take. If the speculator believes that an asset will increase in value,
he or she should purchase call options that have a strike price that is lower than the
anticipated price level. In the event that the speculator's belief is correct and the asset's price
does indeed go up substantially, the speculator will be able to close out his or her position and
realize the gain (by selling the call option for the price that will be equal to the difference
between the strike price and the market value).

On the other hand, if the speculator believes that an asset will fall in value, he or she can
purchase put options with a strike price that is higher than the anticipated price level. If the
price of the asset does fall below the put option's strike price, the speculator can sell the put
options for a price that is equal to the difference between the strike price and the market price
in order to realize any applicable gains.

Options Pricing/ Pricing Options: Option pricing refers to the amount per share at which
an option is traded. Options are derivative contracts that give the holder (the "buyer") the right,

but not the obligation, to buy or sell the underlying instrument at an agreed-upon price on or

before a specified future date.

Although the holder of the option is not obligated to exercise the option, the option writer (the
"seller") has an obligation to buy or sell the underlying instrument if the option is exercised.

Depending on the strategy, options trading can provide a variety of benefits, including the
security of limited risk and the advantage of leverage. Another benefit is that options
can protect or enhance your portfolio in rising, falling and neutral markets. Regardless of why
you trade options – or the strategy you use – it's important to understand how options are
priced. In this tutorial, we'll take a look at various factors that influence options pricing, as well
as several popular options-pricing models that are used to determine the theoretical value of
options.

Black-Scholes Option pricing model

Black-Scholes is a pricing model used to determine the fair price or theoretical value for a call or
a put option based on six variables such as volatility, type of option, underlying stock price,
time, strike price, and risk-free rate. The quantum of speculation is more in case of stock
market derivatives, and hence proper pricing of options eliminates the opportunity for any
arbitrage. There are two important models for option pricing – Binomial Model and Black-
Scholes Model. The model is used to determine the price of a European call option, which
simply means that the option can only be exercised on the expiration date.

The Option Pricing Model is a formula that is used to determine a fair price for a call or put
option based on factors such as underlying stock volatility, days to expiration, and others. The
calculation is generally accepted and used on Wall Street and by option traders and has stood
the test of time since its publication in 1973. It was the first formula that became popular and
almost universally accepted by the option traders to determine what the theoretical price of an
option should be based on a handful of variables.

Option traders generally rely on the Black Scholes formula to buy options that are priced under
the formula calculated value, and sell options that are priced higher than the Black Schole
calculated value. This type of arbitrage trading quickly pushes option prices back towards the
Model's calculated value. The Model generally works, but there are a few key instances where
the model fails.

Description: Black-Scholes pricing model is largely used by option traders who buy options that
are priced under the formula calculated value, and sell options that are priced higher than the
Black-Schole calculated value (1).

The formula for computing option price is as under (2):

Call Option Premium C = SN(d1) - Xe- rt N(d2)

Put Option Premium P = Xe–rT N (–d2) – S0 N (-d1)

d1 = [Ln (S / X) + (r + s2 / 2) X t] -------------------------------------- s Öt d2 = [Ln (S / X) + (r - s 2 / 2) X

t] --------------------------------------- s Öt
Here,

C = price of a call option

P = price of a put option

S = price of the underlying asset

X = strike price of the option

r = rate of interest

t = time to expiration

s = volatility of the underlying

N represents a standard normal distribution with mean = 0 and standard deviation = 1

The Model or Formula calculates an theoretical value of an option based on 6 variables. These
variables are:

 Whether the option is a call or a put

 The current underlying stock price
 The time left until the option's expiration date
 The strike price of the option
 The risk-free interest rate
 The volatility of the stock

General Principles of Option Pricing

 Minimum values of calls and puts
 Maximum values of calls and puts
 Values of calls and puts at expiration
 Effect of Exercise Price, Time to Maturity, Interest Rates, Volatility
 American versus European Style Options
 Put-Call Parity
Index Option:
Definition: index options are financial derivatives that draw their value from an
underlying asset. In this case, index options are derived from the value of an underlying
stock index. Like an option, the holder of an index option has the right to buy or sell an index
or basket of stocks, such as the S&P 500 or NASDAQ, at a predetermined price and date.
Investors generate profits from an expected move in the market or mitigate the risk of holding
the underlying instrument in particular indexed funds.
All the options that have an index as underlying are known as Index Options. The two most
basic and popular index options are Call Option and Put Option. Further, they may be American
Options or European Options.

A Call Option gives the buyer a right to buy a specified quantity of an underlying index at a pre-
decided price. For this privilege, the buyer of the Call Option pays an upfront premium to the
seller or writer. A Put Option gives the buyer the right to sell a specified quantity of an
underlying index at a pre-decided price; for this privilege the buyer of the Put Option pays an
upfront premium to the Put Option seller or writer.

An American Option may be exercised anytime before the expiry of the contract whereas a
European Option can be exercised only on the day of expiry.

However, unlike Index Futures, the buyer of Index Option Contracts has only the right but not
the obligation to buy / sell the underlying index on expiry. Index Option Contracts are generally
European Style options i.e. they can be exercised / assigned only on the expiry date.
Index Options Market in Indian Stock Market
In NSE there 11 indices or index are available in which derivative trading or option trading occur
for which underlying asset would be spot market price of this index.
In this indices NIFTY and BANK NIFTY are the most popular index that represents respectively
the performance of top 50 share of NSE and BANK NIFTY that represent the performance of
banking share.

1) INDIA VIX
2) Nifty CPSE
3) Nifty 50
4) Nifty IT
5) Nifty Bank
6) Nifty Midcap 50
7) Nifty PSE
8) Nifty Infrastructure
9) Dow Jones Industry Average
10) S&P 500
11) FTSE 100

Use of different option strategies to mitigate the risk

Risk mitigation is defined as taking steps to reduce adverse effects. There are four types of risk
mitigation strategies that hold unique to Business Continuity and Disaster Recovery. It’s
important to develop a strategy that closely relates to and matches your company’s profile.

Risk Acceptance: Risk acceptance does not reduce any effects however it is still considered a
strategy. This strategy is a common option when the cost of other risk management options
such as avoidance or limitation may outweigh the cost of the risk itself. A company
that doesn’t want to spend a lot of money on avoiding risks that do not have a high possibility
of occurring will use the risk acceptance strategy.
Risk Avoidance: Risk avoidance is the opposite of risk acceptance. It is the action that avoids
any exposure to the risk whatsoever. Risk avoidance is usually the most expensive of all
risk mitigation options.
Risk Limitation: Risk limitation is the most common risk management strategy used by
businesses. This strategy limits a company’s exposure by taking some action. It is a strategy
employing a bit of risk acceptance along with a bit of risk avoidance or an average of both. An
example of risk limitation would be a company accepting that a disk drive may fail and avoiding
a long period of failure by having backups.
Risk Transference: Risk transference is the involvement of handing risk off to a willing third
party. For example, numerous companies outsource certain operations such as customer
service, payroll services, etc. This can be beneficial for a company if a transferred risk is not a
core competency of that company. It can also be used so a company can focus more on their
core competencies.
Option strategies are the simultaneous, and often mixed, buying or selling of one or
more options that differ in one or more of the options' variables. Call options, simply known as
calls, give the buyer a right to buy a particular stock at that option's strike price. Conversely, put
options, simply known as puts, give the buyer the right to sell a particular stock at the option's
strike price. This is often done to gain exposure to a specific type of opportunity or risk while
eliminating other risks as part of a trading strategy. A very straightforward strategy might
simply be the buying or selling of a single option, however option strategies often refer to
a combination of simultaneous buying and or selling of options.
Options strategies allow traders to profit from movements in the underlying assets based
on market sentiment (i.e., bullish, bearish or neutral). In the case of neutral strategies, they can
be further classified into those that are bullish on volatility, measured by the lowercase Greek
letter sigma (σ), and those that are bearish on volatility. Traders can also profit off time decay,
measured by the uppercase Greek letter theta (Θ), when the stock market has low volatility.
The option positions used can be long and/or short positions in calls and puts.

Bullish options strategies

Bullish options strategies are employed when the options trader expects the underlying stock
price to move upwards. They can also use Theta (time decay) with a bullish/Bearish combo
called a Calendar Spread and not even rely on stock movement. The trader can also just assess
how high the stock price can go and the time frame in which the rally will occur in order to
select the optimum trading strategy for just buying a bullish option.
The most bullish of options trading strategies is simply buying a call option used by most
options traders.
The stock market is always moving somewhere or somehow. It's up to the stock trader to figure
what strategy fits the markets for that time period. Moderately bullish options traders usually
set a target price for the Bull Run and utilize bull spreads to reduce cost or eliminate risk
altogether. There is limited risk when trading options by using the appropriate strategy. While
maximum profit is capped for some of these strategies, they usually cost less to employ for a
given nominal amount of exposure. There are options that have unlimited potential to the up or
down side with limited risk if done correctly. The bull call spread and the bull put spread are
common examples of moderately bullish strategies.
Mildly bullish trading strategies are options that make money as long as the underlying stock
price does not go down by the option’s expiration date. These strategies may provide downside
protection as well. Writing out-of-the-money covered calls is a good example of such a strategy.
However, Covered Calls usually require the trader to buy actual stock in the end which needs to
be taken into account for margin. This is why it's called a covered call. The trader is buying an
option to cover the stock you have already purchased. This is how traders hedge a stock that
they own when it has gone against them for a period of time. The stock market is much more
than ups and downs, buying, selling, calls, and puts. Options give the trader flexibility to really
make a change and career out of what some call a dangerous or rigid market or profession.
Bearish options strategies
Bearish options strategies are employed when the options trader expects the underlying stock
price to move downwards. It is necessary to assess how low the stock price can go and the time
frame in which the decline will happen in order to select the optimum trading strategy. Selling a
Bearish option is also another type of strategy that gives the trader a "credit". This does require
a margin account.
The most bearish of options trading strategies is the simple put buying or selling strategy
utilized by most options traders.
Stock can make steep downward moves. Moderately bearish options traders usually set a
target price for the expected decline and utilize bear spreads to reduce cost. This strategy can
have unlimited amount of profit and limited risk when done correctly. The bear call spread and
the bear put spread are common examples of moderately bearish strategies.
Mildly bearish trading strategies are options strategies that make money as long as the
underlying stock price does not go up by the options expiration date. However, you can add
more options to the current position and move to a more advance position that relies on Time
Decay "Theta". These strategies may provide a small upside protection as well. In general,
bearish strategies yield profit with less risk of loss.
Neutral strategies
Neutral strategies in options trading are employed when the options trader does not know
whether the underlying stock price will rise or fall. Also known as non-directional strategies,
they are so named because the potential to profit does not depend on whether the underlying
stock price will go upwards. Rather, the correct neutral strategy to employ depends on the
expected volatility of the underlying stock price.
Examples of neutral strategies are:

 Guts - buy (long gut) or sell (short gut) a pair of ITM (in the money) put and call
（compared to a strangle where OTM puts and calls are traded);
 Butterfly - a neutral option strategy combining bull and bear spreads. Long butterfly
spreads use four option contracts with the same expiration but three different strike prices
to create a range of prices the strategy can profit from.[1]
 Straddle - an options strategy in which the investor holds a position in both a call and put
with the same strike price and expiration date, paying both premiums (long straddle)[2]
 Strangle - where you buy a put below the stock and a call above the stock, with profit if the
stock moves outside of either strike price (long strangle).[3]
 Risk reversal - simulates the motion of an underlying so sometimes these are referred as
synthetic long or synthetic short positions depending on which position you are shorting;
 Collar - buy the underlying and then simultaneous buying of a put option below current
price (floor) and selling a call option above the current price (cap);
 Fence - buy the underlying then simultaneous buying of options either side of the price to
limit the range of possible returns;
 Iron butterfly - sell two overlapping credit vertical spreads but one of the verticals is on the
call side and one is on the put side;
 Iron condor - the simultaneous buying of a put spread and a call spread with the same
expiration and four different strikes. An iron condor can be thought of as selling a strangle
instead of buying and also limiting your risk on both the call side and put side by building a
bull put vertical spread and a bear call vertical spread;
 Jade Lizard - a bull vertical spread created using call options, with the addition of a put
option sold at a strike price lower than the strike prices of the call spread in the same
expiration cycle;
 Calendar spread - the purchase of an option in one month and the simultaneous sale of an
option at the same strike price (and underlying) in an earlier month, for a debit.

Speculation and Arbitrage with Index Options:

Index Arbitrage

The index arbitrage strategy attempts to profit from the differences between actual and
theoretical prices of a stock market index. This is done by simultaneously buying, or selling, a
stock index futures contract while selling or buying, the stocks in that index.

The actual component of this trading strategy is most often a futures contract with
the Standard & Poor's 500 being the most popular underlying index. The S&P 500 index
arbitrage is often called basis trading. The basis is the spread between the cash and futures
market prices.

The theoretical price represents the prices of all the stocks in the index inputted into the
specific index calculation, such as capitalization-weighted.

Index arbitrage is at the heart of program trading, where computers monitor both actual and
theoretical prices and automatically enter buy or sell orders to exploit the differences. It is a
high-speed, electronic trading process. Since major financial institutions actively pursue this
strategy, the opportunities are often fleeting and razor-thin.

Big institutions can execute large trades and still make money on such small differences. The more
components of the index, the greater the chances of some of them being mis-priced, and the greater
the opportunities for arbitrage. Therefore, arbitrage on an index of just a few stocks is less likely to
provide significant opportunities.

Traders can also use arbitrage strategies on exchange-traded funds (ETFs) in the same way.
Because most ETFs do not trade as actively as major stock index futures, chances for arbitrage
are plentiful. ETFs are sometimes subject to major market dislocations, even though the prices
of the underlying component stocks remain stable.

Trading activity on August, 24, 2015 offered an extreme case where a large drop in the stock
market caused erratic bid and ask prices for many stocks, including ETF components. The lack
of liquidity and delays to the start of trading for these stocks was problematic for the exact
calculation of ETF prices. This delay created extreme gyrations and arbitrage opportunities.

The Role of Arbitrage:

All markets function to bring buyers and sellers together in order to set prices. This action is
known as price discovery. Arbitrage might connote unsavory dealings used to exploit the
market but it actually serves to keep the market in line. For example, some bit of news creates
demand for a futures contract but short-term traders overplay it. The basket of underlying
stocks, the index, does not move; therefore the futures contract becomes overvalued.
Arbitrageurs quickly sell the futures and buy the cash to bring their relationship back in line.

Arbitrage is not an exclusive activity of the financial markets. Retailers can also find lots of
goods offered at low prices by a supplier and turn around to sell them to customers. Here, the
supplier may have an overstock or loss of storage space requiring the discounted sale.
However, the term arbitrage is indeed mostly associated with trading of securities and relates
assets.

Speculation Index:

The speculation index is the ratio of trading volume on the American Stock Exchange, now
known as the NYSE American, to that of the New York Stock Exchange. A high index may signal
increased speculation among traders since the American Exchange lists smaller, riskier stocks.

The speculation index is an analytic measure of overall speculative trading activity in U.S.
equities markets. Speculation is trading activity in which a high risk of loss is offset by the
promise of large low-probability gains. Such activity takes place across all markets from real
estate to foreign currency exchanges. The line between speculation and longer-term
investment has become less clear in recent years due to practices like high-frequency
trading (HFT) and the co-mingling of once-distinct sectors across exchanges.

Historically, the speculation index was calculated by dividing total trading volume on the
American Stock Exchange (AMEX), now known as the NYSE American equities exchange, by the
same volume on the New York Stock Exchange (NYSE). Many analysts believe that a high
speculation index is a sign of overall bullishness among investors. An unusually high speculation
index can suggest the end of an upward trend and an impending decline in market
performance. The speculation index is of particular use to traders looking for predictive
indicators of stock activity. As such, the speculation index is known as one of a small number of
leading indicators of market activity.

Hedging with index Options:

Institutions and mutual funds are the biggest customers for index options. To manage large
diversified stock portfolios, it is easier to purchase puts on an index or sector rather than doing
hundreds of trades on each individual stock. When analyzing how to hedge their risk, they must
balance the cost of the strategy against their opinion of the market.

The objective of the index option purchase is to limit or insure against portfolio losses. But
index puts are not cheap. So why are managers willing to risk underperforming the market by
3% or so during a 90-day period (approximately a 13.2% annual rate)?

Some try to keep a little protection on no matter what the current market conditions are like.
But it is only natural that they are more willing to take that risk if they have a bearish
view. They hope to beat the market by profiting from the index puts.

The technique of hedging a portfolio is straightforward. The first step is to find the index with
the composition that most closely resembles your own portfolio. You then purchase out-of-the-
money protective puts.

An alternative to selling index futures to hedge a portfolio is to sell index calls while
simultaneously buying an equal number of index puts. Doing so will lock in the value of the
portfolio to guard against any adverse market movements. This strategy is also known as a
protective index collar.
The idea behind the index collar is to finance the purchase of the protective index puts using
the premium collected from selling the index calls. However, as a result of selling the index
calls, in the event that the fund manager's expectation of a falling market is wrong, his portfolio
will not benefit from the rising market.
 Unit-5

Financial Swaps

A Financial swap is a derivative contract through which two parties exchange financial
instruments. These instruments can be almost anything, but most swaps involve cash flows
based on a notional principal amount that both parties agree to. Usually, the principal does not
change hands. Each cash flow comprises one leg of the swap. One cash flow is generally
fixed while the other is variable, which is based on a benchmark interest rate, floating currency
exchange rate, or index price.

The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and
retail investors do not generally engage in swaps. Rather, swaps are over-the-counter contracts
primarily between businesses or financial institutions.

Types of swaps

The five generic types of swaps, in order of their quantitative importance, are: interest rate
swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also many
other types of swaps.

Interest rate swaps

The most common type of swap is an interest rate swap. Some companies may have
comparative advantage in fixed rate markets, while other companies have a comparative
advantage in floating rate markets. When companies want to borrow, they look for cheap
borrowing, i.e. from the market where they have comparative advantage. However, this may
lead to a company borrowing fixed when it wants floating or borrowing floating when it wants
fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan
into a floating rate loan or vice versa.

For example, party B makes periodic interest payments to party A based on a variable interest
rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a
fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate is
called variable because it is reset at the beginning of each interest calculation period to the
then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is
slightly lower due to a bank taking a spread.

Currency swaps

A currency swap involves exchanging principal and fixed rate interest payments on a loan in one
currency for principal and fixed rate interest payments on an equal loan in another currency.
Just like interest rate swaps, the currency swaps are also motivated by comparative advantage.
Currency swaps 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. It is
also a very crucial uniform pattern in individuals and customers.

Commodity swaps

A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged
for a fixed price over a specified period. The vast majority of commodity swaps involve crude
oil.

Subordinated risk swaps

A subordinated risk swap (SRS), or equity risk swap, is a contract in which the buyer (or equity
holder) pays a premium to the seller (or silent holder) for the option to transfer certain risks.
These can include any form of equity, management or legal risk of the underlying (for example
a company). Through execution the equity holder can (for example) transfer shares,
management responsibilities or else. Thus, general and special entrepreneurial risks can be
managed, assigned or prematurely hedged. Those instruments are traded over-the-counter
(OTC) and there are only a few specialized investors worldwide.

Debt-equity swaps

A debt-equity swap involves the exchange of debt for equity; in the case of a publicly traded
company, this would mean bonds for stocks. It is a way for companies to refinance their debt or
re-allocate their capital structure.

Total return swaps

In a total return swap, the total return from an asset is exchanged for a fixed interest rate. This
gives the party paying the fixed rate exposure to the underlying asset—a stock or an index, for
example—without having to expend the capital to hold it

Interest rate exposure

The amount of financial loss a company or individual could be incurred as a result of adverse
changes in interest rates. A risk common to both businesses and individuals involves refinancing
debt in an increasing interest rate environment.

Interest rate risk is the risk to income or capital arising from fluctuating interest rates.

The interest rate risk when viewed from these two perspectives is known as ‘earnings
perspective’ and ‘economic value’ perspective, respectively.
Managing interest rate risk

Management of interest rate risk aims at capturing the risks arising from the maturity and
repricing mismatches and is measured both from the earnings and economic value perspective.

(a) Earnings perspective involves analysing the impact of changes in interest rates on
accrual or reported earnings in the near term. This is measured by measuring the
changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the difference
between the total interest income and the total interest expense.

(b) Economic Value perspective involves analysing the changes of impact og interest on
the expected cash flows on assets minus the expected cash flows on liabilities plus the
net cash flows on off-balance sheet items. It focuses on the risk to networth arising from
all repricing mismatches and other interest rate sensitive positions. The economic value
perspective identifies risk arising from long-term interest rate gaps.

1. The Diversifier

“If there’s someone who looks at fixed income as ballast to their portfolio, ballast against
equities, they may not want to reduce interest-rate risk at all.

To many, fixed income is a diversifier to equity exposure, and a lot of that diversification benefit
comes from the interest-rate risk that bonds have.

“A typical investor who is investing in a fund such as the Bond may want to hold on to that
investment, because even in a rising-rate environment, they are going to get the diversification
benefits of that exposure. “Timing a rising-rate environment is very difficult,” “For the investor
who is long-term-minded and looks at fixed income as a diversifier, they should be comfortable
leaving that allocation as it is.

2. The Safe-Haven Seeker

Investors who want to make an adjustment to their exposure because they have a particularly
strong conviction that rates will rise might want to reduce interest-rate risk.

“The most common solution here is to move into shorter-maturity, fixed-income vehicles that
offer less interest-rate risk, and are less impacted by rising rates,”

3. The One Who Wants It All

There are investors who want to take some interest-rate risk off the table but they still want to
participate, or “benefit,” when the Fed does begin to raise interest rates. For these folks, the
most appealing category of fixed-income bond is those comprising floating-rate securities.
Floating-rate bonds have a coupon payment that resets regularly, and are often linked to the
Libor, which in turn is tied to the fed funds rate.

“What you will see is that if the Fed raises interest rates, the actual coupon and yields from the
fund will increase along with rising rates,” . “That’s a way of not only being defensive against
rising rates, but benefiting from when rates do move higher in the short end.”

4. The Bond Ladder-er

Many fixed-income investors like to own actual individual bonds rather than bond funds. They
do so to have certainty about their time horizon and the yields coming from their investment.

“Investors are drawn to bond ladders in the context of a rising-rate environment because when
you buy a bond, you buy it at a yield,”

5. The Hedger

Finally, there’s an emerging tool in the Crporate investor fixed-income kit that’s quickly
gathering a following: interest-rate-hedged funds.

Managing interest rate risk

Interest rate risk can be mitigated by reducing the exposure of the government’s portfolio to
floating rates, either by issuing new fixed rate debt or by modifying the characteristics of
outstanding floating rate debt.However, it is important to note that this is only beneficial to
borrowers in a scenario when current forward rates end up below the actual rates in the future.
In other words, governments benefit from fixing their floating rates only when actual rates
increase faster than the forwards were projecting at the time of fixing.
The decision to fix the interest rate should be based on a cost-risk analysis as part of
a robust debt management strategy set by the government.Sound debt management practices
help governments reduce exposure to financial risks.
As part of their debt management strategies, many governments establish targets or ranges for
key risk indicators to guide borrowing activities and other debt transactions.
For example,
a country may set a target of holding 60% of the total debt in the sovereign debt portfolio in
fixed rate. Reducing exposure to interest rate risk by issuing new debt may take more time
compared to a derivatives solution. However, many developing country borrowers have limited
access to derivatives, especially sub-national borrowers and State-Owned Enterprises. One way
that a country can achieve the target mix of fixed versus floating rate debt is by fixing the
interest rate on its IBRD loans.
Forward Rate Agreements (FRAs): An FRA is based on the idea of a forward contract,
where the determinant of gain or loss is an interest rate. Under this agreement, one party pays
a fixed interest rate and receives a floating interest rate equal to a reference rate. The actual
payments are calculated based on a notional principal amount and paid at intervals determined
by the parties. Only a net payment is made – the loser pays the winner, so to speak. FRAs are
always settled in cash.

FRA users are typically borrowers or lenders with a single future date on which they are
exposed to interest rate risk. A series of FRAs is similar to a swap (discussed below); however, in
a swap all payments are at the same rate. Each FRA in a series is priced at a different rate,
unless the term structure is flat.

Interest rate future

An interest rate future is a futures contract with an underlying instrument that pays interest. An
interest rate future is a contract between the buyer and seller agreeing to the future delivery of
any interest-bearing asset. The interest rate future allows the buyer and seller to lock in the
price of the interest-bearing asset for a future date.

An interest rate future is a financial derivative (a futures contract) with an interest-bearing

instrument as the underlying asset. It is a particular type of interest rate derivative.
Examples include Treasury-bill futures, Treasury-bond futures and Eurodollar futures.
Uses of Interest rate future:
Interest rate futures are used to hedge against the risk that interest rates will move in an
adverse direction, causing a cost to the company.
For example, borrowers face the risk of interest rates rising. Futures use the inverse
relationship between interest rates and bond prices to hedge against the risk of rising interest
rates. A borrower will enter to sell a future today. Then if interest rates rise in the future, the
value of the future will fall (as it is linked to the underlying asset, bond prices), and hence a
profit can be made when closing out of the future (i.e. buying the future).
Treasury futures are contracts sold on the Globex market for March, June, September and
December contracts. As pressure to raise interest rates rises, futures contracts will reflect that
speculation as a decline in price. Price and yield will always be in an inversely correlated
relationship.
It is important to note that interest rate futures are not directly correlated with the market
interest rates. When one enters into an interest rate futures contract (like a bond future), the
trader has ability to eventually take delivery of the underlying asset. In the case of notes and
bonds this means the trader could potentially take delivery of a bunch of bonds if the contract
is not cash settled. The bonds which the seller can deliver vary depending on the futures
contract. The seller can choose to deliver a variety of bonds to the buyer that fit the definitions
laid out in the contract. The futures contract price takes this into account, therefore prices have
less to do with current market interest rates, and more to do with what existing bonds in the
market are cheapest to deliver to the buyer