MBA 4006 E (F1)

M.B.A DEGREE EXAMINATION, MAY 2013

Fourth Semester
FINANCIAL DERIVATIVES

Time: 3 Hours Max Marks: 60

Part-A and Part-C are compulsory
Answer One Question from each unit of Part-B

PART-A
5 x 2 = 10 Marks
Answer any FIVE questions from the following
a. Weather Derivatives
Weather derivatives are financial instruments that can be used by organizations or
individuals as part of a risk management strategy to reduce risk associated with adverse
or unexpected weather conditions. The difference from other derivatives is that the
underlying asset (rain/temperature/snow) has no direct value to price the weather
derivative.

b. Causes of Volatility
 Markets
 Company specific issues
 Credit risk
 Interest rate changes
 Liquidity
 Changes in the value of the Australian dollar
 Derivatives
 Gearing
 Short selling
 Counterparties
 Agency risk

c. Index Options
A financial derivative that gives the holder the right, but not the obligation, to buy or sell a
basket of stocks, such as the S&P 500, at an agreed-upon price and before a certain date.
An index option is similar to other options contracts, the difference being the underlying
instruments are indexes. Options contracts, including index options, allow investors to
profit from an expected market move or to reduce the risk of holding the underlying

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instrument.

d. Badla Trading
Badla was an indigenous carry-forward system invented on the Bombay Stock
Exchange as a solution to the perpetual lack of liquidity in the secondary
market. Badla were banned by the Securities and Exchange Board of India or SEBI in
1993, amid complaints from foreign investors, with the expectation that it would be
replaced by a futures-and-options exchange.

e. Spreads
The difference between the bid and the ask price of a security or asset. An options
position established by purchasing one option and selling another option of the same
class but of a different series.

f. Commodity Futures
An agreement to buy or sell a set amount of a commodity at a predetermined price and
date. Buyers use these to avoid the risks associated with the price fluctuations of the
product or raw material, while sellers try to lock in a price for their products. Like in all
financial markets, others use such contracts to gamble on price movements.

g. Financial Derivatives
Derivatives are the financial instruments whose value is derived from the value of
underlying assets. They generally take the form of contracts under which the parties agree
to payments between them based upon the value of underlying asset on other data at a
particular point in time. The main types of derivatives are futures, forwards, options and
swaps.

h. Advantages of Rolling Settlement

Rolling Settlement is a mechanism of settling trades done on T i.e trade day plus 'x' days,
where x could be 3 or 5 days. In India, , the settlement of majority of trades is being done
on Account Period basis, where trades done in a trading cycle of T +2 days are
consolidated and netted and settlement of such netted trades take place on a single day.
However, in Rolling Settlements, trades done on a single day are settled separately from
the trades of other day on Trade days. The netting of trades is done only for the day and
not for multiple days. In Rolling Settlement, settlement is carried out on a daily basis.

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 PART-B
UNIT-I
5 x 8 =40 M
1. Explain about the pricing of forwards and futures contracts. 8M

 Defining Forwards & Futures 2 Marks

 Factors impacting the pricing 3 Marks
 Explaining the pricing methods 3 Marks

Pricing of forwards and future contracts

1) Assuming the asset does not pay any income before the delivery date Fo =Poe^r n

Where Fo, represents the forward price of the asset on the day zero ie today itself
 Po denotes the spot price of the asset on day zero
 r denotes the carrying cost ie risk free interest rate.
 t denotes life of the forward contrast
 e continuous compounding exponential constant

2)Suppose if Fo>Poe^r n then the arbitrageurs can buy the asset in the cheap market ie
the spot market and will short/sell in the forward market which will lead to guaranteed
profits equal to Fo-Poe^r n these are known as cash and carry arbitrage

3)Suppose if Fo<Poe^r n, then the arbitrageurs will buy the asset in the cheap market ie
the forward market and will sell in the spot market which will lead to guaranteed profits
equal to Poe^rn-Fo. This is also known as reverse cash and carry arbitrage.

Determining Forward and Futures Prices

• In a well functioning market, the forward price of carry-type commodities (stocks & stock
indexes, debt securities, currencies, & gold) must preclude the possibility of arbitrage.
• That is, at any time ‘t’:
F = S + CC – CR
where:
F = THEORETICAL Futures Price at time t
S = Spot Price at time t
CC = Carrying Costs from time t to time T
CR = Carry Returns from time t to time T

Note: the above concept can be award marks, if answered in full wordings without using
any formulae.

(OR)

2. Briefly explain the regulation of financial derivatives in India. 8M

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  Explaining the emergence of Financial Derivatives in India 4 Marks
 Explaining regulation in Indian market 4 Marks

History of derivatives in India

Derivatives are definitely not modern invention. They were known and were used from
the ancient times. Bernstein (1992) attributes the first option transaction to the Greek
philosopher. Thales from Miletus who was adept at forecasting the harvest of the olives in
the ensuring season. The first organized futures market came up in 1875 with the
establishment of “Bombay Cotton Trade Association Ltd.”Later Bombay cotton exchange
ltd in 1893 and in 1900 Gujarathi Vyapari Mandali etc were established.

After the country attained independence, derivative markets came through full circle.
The chronology of the events is presented below;

 Enchantment of the forward contracts (regulation act)

 Setting up of the forward markets commission
 Enchantment of SCRA
 1969-- Prohibition of all forms of forward trading under sec 16 of SCRA
 Informal carry forward trades between 2 settlement cycles began on BSE
 1980 -- Khuso committee recommends reintroduction of futures in most
commodities
 1983 – Govt. amends bye laws of exchanges of Bombay, Calcutta, Ahmedabad
and introduced carry forward trading in specified shares
 1992 – Enchantment of the SEBI act
 1993 – SEBI prohibits carry forward transactions
 1994 – Kabra committee recommends futures trading in nine commodities;
 2000 – Trading in index futures began on BSE and NSE
 2001 – trading in options on index and stocks commenced trading on BSE and
NSE
 2002 – Trading on single stock futures on NSE
 2003 – Introduction of interest rate futures on NSE
 2007- Introduction of rupee of options, Futures trading in permitted on almost all
commodities but options on commodities still prohibited.
 2008-Commencement of NCDEX and MCX commodity exchanges

Regulatory framework of derivatives markets in India?

With the amendment in the definition of ''securities'' under SC(R)A (to include derivative
contracts in the definition of securities), derivatives trading takes place under the
provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and
Exchange Board of India Act, 1992.

Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework

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for derivative trading in India. SEBI has also framed suggestive bye-law for Derivative
Exchanges/Segments and their Clearing Corporation/House which lays down the
provisions for trading and settlement of derivative contracts. The Rules, Bye-laws &
Regulations of the Derivative Segment of the Exchanges and their Clearing
Corporation/House have to be framed in line with the suggestive Bye-laws. SEBI has also
laid the eligibility conditions for Derivative Exchange/Segment and its Clearing
Corporation/House. The eligibility conditions have been framed to ensure that Derivative
Exchange/Segment & Clearing Corporation/House provide a transparent trading
environment, safety & integrity and provide facilities for redressal of investor grievances.
Some of the important eligibility conditions are –

1.Derivative trading to take place through an online screen based Trading System.
2.The Derivatives Exchange/Segment shall have online surveillance capability to monitor
positions, prices, and volumes on a real time basis to deter market manipulation.
3.The Derivatives Exchange/ Segment should have arrangements for dissemination of
information about trades, quantities and quotes on a real time basis through atleast two
information vending networks, which are easily accessible to investors across the
country.
4.The Derivatives Exchange/Segment should have arbitration and investor grievances
redressal mechanism operative from all the four areas / regions of the country.
5.The Derivatives Exchange/Segment should have satisfactory system of monitoring
investor complaints and preventing irregularities in trading.
6.The Derivative Segment of the Exchange would have a separate Investor Protection
Fund.
7.The Clearing Corporation/House shall perform full novation, i.e. the Clearing
Corporation/House shall interpose itself between both legs of every trade, becoming the
legal counterparty to both or alternatively should provide an unconditional guarantee for
settlement of all trades.
8.The Clearing Corporation/House shall have the capacity to monitor the overall position
of Members across both derivatives market and the underlying securities market for those
Members who are participating in both.
9.The level of initial margin on Index Futures Contracts shall be related to the risk of loss
on the position. The concept of value-at-risk shall be used in calculating required level of
initial margins. The initial margins should be large enough to cover the one-day loss that
can be encountered on the position on 99% of the days.
10.The Clearing Corporation/House shall establish facilities for electronic funds transfer
(EFT) for swift movement of margin payments.
11.In the event of a Member defaulting in meeting its liabilities, the Clearing
Corporation/House shall transfer client positions and assets to another solvent Member or
close-out all open positions.

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12.The Clearing Corporation/House should have capabilities to segregate initial margins
deposited by Clearing Members for trades on their own account and on account of his
client. The Clearing Corporation/House shall hold the clients' margin money in trust for
the client purposes only and should not allow its diversion for any other purpose.
13.The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the
trades executed on Derivative Exchange / Segment.

UNIT-II
3. Differentiate between Call and Put options. What are the rights and obligations of
the holders or long and short position in them? 8M
 Option Definition 1 Mark
 Defining Call option Put option 2 Marks
 Defining the rights and obligation of holders 5 Marks
Option is a legal contract in which the writer of the contract grants to the buyer, the right
to purchase from or to sell to the writer a designated instrument or a scrip at a specified
price within a specified period of time.

The right to purchase a specified stock is called the call option, while the right to sell a
specified stock is called a put option.

An options contract has four essential ingredients:

1. The name of the company on whose stock the option contract has been
derived.
2. The quantity of the stock required to be delivered in the case of exercise of the
option.
3. The price, at which the stock would be delivered, or the exercise price or the
strike price.
4. The date when the contract expires, called the expiration date.

CALL OPTIONS

A call option gives the buyer the right to purchase a specified number of shares of a
particular company from the option writer (seller) at a specified price (called the
exercise price) up to the expiry of the option. In other words, the option buyer gets a
right to call upon the option seller to deliver the contracted shares any time up to the
expiry of the option. The contract, thus, is only one-way obligation, i.e. the seller is
obligated to deliver the contracted shares while the buyer has the choice to exercise
the option or let the contract lapse. The buyer is not obligated to perform

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PUT OPTION
A put option gives a buyer the right to sell a specified number of shares of a particular
stock to the option writer at a specified price (called the exercise price) any time during
the currency of the option.

WHO CAN WRITE AN OPTION?

Anyone eligible to enter into contract as per the Law of Contract can write an option
irrespective of the fact whether one owns the underlying stock or not.

If the writer of a call option owns the stock that he is obliged to deliver upon exercise of
the call he has written, he is called a covered call writer.

On the other, if the writer of the call option does not own the stock he has written the
option for, he is called an uncovered or naked call writer and the option is called an
uncovered or naked call option.

OBLIGATION OF THE OPTION WRITER AND BUYER

The writer is legally obligated to perform according to the terms of the option. On the
other hand, the buyer of the option has bought a write to exercise the option and is under

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no obligation to exercise the option. He can conveniently let the option lapse on the date
of expiration of the option.

(OR)
4. Show graphically the Call and Put Option pricing: 8M
(i) at expiration 3 Marks
(ii) before expiration indicating clearly the intrinsic and time value components of
the option value 5Marks

Option Pricing

Before venturing into the world of trading options, investors should have a good
understanding of the factors that determine the value of an option. These include the
current stock price, the intrinsic value, time to expiration or the time
value, volatility, interest rates and cash dividends paid. (If you don't know about these
building blocks, check out our Option Basics and Options Pricing tutorials.)

There are several options pricing models that use these parameters to determine the fair
market value of the option. Of these, the Black-Scholes model is the most widely used. In
many ways, options are just like any other investment in that you need to understand
what determines their price in order to use them to take advantage of moves the market.

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Main Drivers of an Option's Price

Let's start with the primary drivers of the price of an option: current stock price, intrinsic
value, time to expiration or time value, and volatility. The current stock price is fairly
obvious. The movement of the price of the stock up or down has a direct - although not
equal - effect on the price of the option. As the price of a stock rises, the more likely the
price of a call option will rise and the price of a put option will fall. If the stock price
goes down, then the reverse will most likely happen to the price of the calls and puts.

Intrinsic Value

Intrinsic value is the value that any given option would have if it were exercised today.
Basically, the intrinsic value is the amount by which the strike price of an option is in the
money. It is the portion of an option's price that is not lost due to the passage of time. The
following equations can be used to calculate the intrinsic value of a call or put option:

Call Option Intrinsic Value = Underlying Stock\'s Current

Price – Call Strike Price

Put Option Intrinsic Value = Put Strike Price – Underlying

Stock\'s Current Price

The intrinsic value of an option reflects the effective financial advantage that would result
from the immediate exercise of that option. Basically, it is an option's minimum value.
Options trading at the money or out of the money have no intrinsic value.

Time Value
The time value of options is the amount by which the price of any option exceeds the
intrinsic value. It is directly related to how much time an option has until it expires as
well as the volatility of the stock. The formula for calculating the time value of an option
is:

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 Time Value = Option Price – Intrinsic Value

The more time an option has until it expires, the greater the chance it will end up in the
money. The time component of an option decays exponentially. The actual derivation of
the time value of an option is a fairly complex equation. As a general rule, an option will
lose one-third of its value during the first half of its life and two-thirds during the second
half of its life. This is an important concept for securities investors because the closer you
get to expiration, the more of a move in the underlying security is needed to impact the
price of the option. Time value is often referred to as extrinsic value.

UNIT-III
5. Explain the different strategies that involve options. 8M
 Any 4 option strategies from following strategies can be given 2 marks each.
BULLISH STRATEGIES
 LONG CALLS
For aggressive investors who are bullish about the short-term prospects for a stock,
buying calls can be an excellent way to capture the upside potential with limited inside
risk.

 COVERED CALLS
For conservative investors, selling calls against a long stock position can be an excellent
way to generate income without assuming the risks associated with uncovered calls. In
this case, investors would sell one call contract for each 100 shares of stock they own.

 PROTECTIVE PUT
For investors who want to protect the stocks in their portfolio from falling prices,
protective puts provide a relatively low-cost form of portfolio insurance. In this case,
investors would purchase one put contract for each 100 shares of stock they own.

 BULL CALL SPREAD

For bullish investors who want to a nice low risk, limited return strategy without buying
or selling the underlying stock, bull call spreads are a great alternative. This strategy
involves buying and selling the same number of calls at different strike prices to
minimize both the cash outlay and the overall risk.

 BULL PUT SPREAD

For bullish investors who want a nice low risk, limited return strategy, bull put spreads
are another alternative. Like the bull call spread, the bull put spread involves buying and
selling the same number of put options at different strike prices. Since puts with the
higher strike are sold, the trade is initiated for a credit.

 CALL BACK SPREAD

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For bullish investors who expect big moves in already volatile stocks, call back spreads
are a great limited risk, unlimited reward strategy. The trade itself involves selling a call
(or calls) at a lower strike and buying a greater number of calls at a higher strike price.

 NAKED PUT
For bullish investors who are interested in buying a stock at a price below the current
market price, selling naked puts can be an excellent strategy. In this case, however, the
risk is substantial because the writer of the option is obligated to purchase the stock at the
strike price regardless of where the stock is trading.

BEARISH STRATEGIES
 LONG PUT
For aggressive investors who have a strong feeling that a particular stock is about to
move lower, long puts are an excellent low risk, high reward strategy. Rather than
opening yourself to enormous risk of short selling stock, you could buy puts (the right to
sell the stock). While risk is limited to the initial investment, the profit potential is
unlimited.

 NAKED PUT
Selling naked calls is a very risky strategy which should be utilized with extreme caution.
By selling calls without owning the underlying stock, you collect the option premium and
hope the stock either stays steady or declines in value. If the stock increases in value this
strategy has unlimited risk.

 PUT BACKSPREAD
For aggressive investors who expect big downward moves in already volatile stocks,
backspreads are great strategies. The trade itself involves selling a put at a higher strike
and buying a greater number of puts at a lower strike price. As the stock price moves
lower, the profit potential is unlimited.

 BEAR CALL SPREAD

For investors who maintain a generally negative feeling about a stock, bear spreads are a
nice low risk, low reward strategies. This trade involves selling a lower strike call,
usually at or near the current stock price, and buying a higher strike, out-of-the-money
call. This spread profits when the stock price decreases and both calls expire worthless.

 BEAR PUT SPREAD

For investors who maintain a generally negative feeling about a stock, bear spreads are
another nice low risk, low reward strategy. This trade involves buying a put at a higher
strike and selling another put at a lower strike. Like bear call spreads, bear put spreads
profit when the price of the underlying stock decreases.

NEUTRAL STRATEGIES
 REVERSAL

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Primarily used by professional traders, a reversal is an arbitrage strategy that allows
traders to profit when options are underpriced. To put on a reversal, a trader would sell
stock and use options to buy an equivalent position that offsets the short stock.

 CONVERSION
Primarily used by professional traders, a conversion is an arbitrage strategy that allows
traders to profit when options are overpriced. To put on a conversion, a trader would
buy stock and use options to sell an equivalent position that offsets the long stock.

 COLLAR
For bullish investors who want to nice low risk, limited return strategy to use in
conjunction with a long stock position, collars are a great alternative. In this case, the
collar is created by combining covered calls protective puts.

 LONG STRADDLE
For aggressive investors who expect short-term volatility yet have no bias up or down
(i.e., a neutral bias), the long straddle is an excellent strategy. This position involves
buying both a put and a call with the same strike price, expiration, and underlying. The
potential loss is limited to the initial investment. The potential profit is unlimited as the
stock moves up or down.

 SHORT STRADDLE
For aggressive investors who don't expect much short-term volatility, the short straddle
can be a risky, but profitable strategy. This strategy involves selling a put and a call with
the same strike price, expiration, and underlying. In this case, the profit is limited to the
initial credit received by selling options. The potential loss is unlimited as the market
moves up or down.

 LONG STRANGLE
For aggressive investors who expect short-term volatility yet have no bias up or down
(i.e., a neutral bias), the long strangle is another excellent strategy. This strategy typically
involves buying out-of-the-money calls and puts with the same strike price, expiration,
and underlying. The potential loss is limited to the initial investment while the potential
profit is unlimited as the market moves up or down.

 SHORT STRANGLE
For aggressive investors who don't expect much short-term volatility, the short strangle
can be a risky, but profitable strategy. This strategy typically involves selling out-of-the-
money puts and calls with the same strike price, expiration, and underlying. The profit is
limited to the credit received by selling options. The potential loss is unlimited as the
market moves up or down.
 BUTTERFLY
Ideal for investors who prefer limited risk, limited reward strategies. When investors
expect stable prices, they can buy the butterfly by selling two options at the middle strike
and buying one option at the higher and lower strikes. The options, which must be all
calls or all puts, must also have the same expiration and underlying.

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  RATIO SPREAD
For aggressive investors who don't expect much short-term volatility, ratio spreads are a
limited reward, unlimited risk strategy. Put ratio spreads, which involve buying puts at a
higher strike and selling a greater number of puts at a lower strike, are neutral in the sense
that they are hurt by market movement.

 CONDOR
Ideal for investors who prefer limited risk, limited reward strategies. The condor takes the
body of the butterfly - two options at the middle strike - and splits between two middle
strikes. In this sense, the condor is basically a butterfly stretched over four strike prices
instead of three.

 CALENDAR SPREAD
Calendar spreads are also known as time or horizontal spreads because they involve
options with different expiration months. Because they are not exceptionally profitable on
their own, calendar spreads are often used by traders who maintain large positions.
Typically, a long calendar spread involves buying an option with a long-term expiration
and selling an option with the same strike price and a short-term expiration.

(OR)
6. Explain the following hedging strategies. 8M
(i) Short Stock long call
(ii) Long Stock long put
(iii) Long stock short call
(iv) Short stock short put
Note 2 Marks each

Short Stock: The sale of a borrowed security, commodity or currency with the expectation
that the asset will fall in value. In the context of options, it is the sale (also known as
"writing") of an options contract. Its just Opposite of "long (or long position)."

The long call option strategy is the most basic option trading strategy whereby the options
trader buy call options with the belief that the price of the underlying security will rise
significantly beyond the strike price before the option expiration date.

Long put An options strategy in which a put option is purchased as a speculative play on
a downturn in the price of the underlying equity or index. In a long put trade, a put option
is purchased on the open exchange with the hope that the underling stock falls in price,
thereby increasing the value of the options, which are "held long" in the portfolio.

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The options can either be sold prior to expiration (for a profit or loss) or held to
expiration, at which time the investor must purchase the stock at market prices, then sell
the stock at the stated exercise price. The buying of a security such as a stock, commodity
or currency, with the expectation that the asset will rise in value. In the context of
options, the buying of an options contract. Its just the opposite of "short" (or short
position).

A short call is simply the sale of one call option. Selling options is also known as
"writing" an option. A short is also known as a Naked Call. Naked calls are considered
very risky positions because your risk is unlimited. A short put is simply the sale of a put
option. Like the Short Call Option, selling naked puts can be a very risky strategy as your
losses are unlimited in a falling market.

Although selling puts carries the potential for unlimited losses on the downside they are a
great way to position yourself to buy stock when it becomes "cheap". Selling a put option
is another way of saying "I would buy this stock for [strike] price if it were to trade there
by [expiration] date."A short put locks in the purchase price of a stock at the strike price.
Plus you will keep any premium received as a result of the trade.

UNIT-IV
7. Discuss how risks of options can be managed? How is volatility estimated? 8M

 Explanation on managing risk 5marks

 Explaining the volatility estimation 3 marks
HEDGING
Thus far, we have overviewed the logistics of the market maker’s business model
and have seen how it functions to both serve the trading public and the market maker
simultaneously. Now we will consider how market makers work to secure their edge
against the ongoing risks presented to their many positions.

An investor who chooses to invest in a particular market is exposed to the risks that are
inherent in that market. The specific risk is high if the investor concentrates on one
security only. The more a portfolio is diversified, the lesser the specific risk.

Hedging is the most basic strategy that an investor can use in order to guard against loss.
A hedge position is taken with the specific intent of lowering risk. As we have learned,
option positions are susceptible to more than just simple directional price risks, and
therefore, a trader must be concerned with more than simple delta neutral trading. There
is risk associated with each of the variables that determine an option’s value (from
interest rates to time until expiration).

In order to minimize the effect of these risks to an option’s value, a trader will
establish a position with offsetting characteristics. Just as you hedge a bet by betting
against your original bet too a lesser degree, market makers try to take on complementary
positions (in stock or options) with characteristics that can potentially buffer against

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exposure to loss. A hedge, then, is a position that is established for the sole purpose of
protecting an existing position.

Determining what risks an option position might be exposed to is one of the first
steps towards determining how best to hedge risk. We have learned that six risks are
associated with an option position:

Directional risk (delta risk) is the risk that an option’s value will change as the
underlying asset changes in value. All other factors aside, as the price of an underlying
asset decreases, the value of a call will decrease while the price of the put will increase.
Conversely, as the underlying asset increases in value, a call will increases in value as the
put decreases in value. Delta risk can easily be offset through the purchase or sale of an
option or stock with opposing directional characteristics. Directional hedges are
illustrated in the following Delta Effects

When the Underlying

Security…
The Long Call will….
The Short Call will….
The Long Put will….
The Short Put will….
Increase in Value
Increase in Value
Decrease in Value
Decrease in Value
Increase in Value
Decrease in Value
Decrease in Value
Increase in Value
Increase in Value
Decrease in Value

Position Hedges

Option Position Hedge Position

Long Call – Increases in value as the Short Underlying
underlying increases in value Short Call
Long Put
Short Call – Decreases in value as the Long Underlying
underlying increases in value Long Call
Short Put
Long Put – Decreases in value as the Long Underlying
underlying increases in value Short Put
Long Call
Short Put – Increases in value as the Short Underlying
underlying decreases in value Long Put
Short Call

Gamma risk is the risk that the delta of an option will change. The holder of options is
long gamma (backspreader) and the seller of options is short gamma (frontspreader).
Sometimes referred to as curvature, gamma can be offset through the purchase or sale of
options with opposing gammas.

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Volatility risk (vega risk) is the risk that the volatility assumption used in pricing the
options will change. If the option volatility rises, the value of the calls and puts will
increase. The holder of any options might benefit from an increase in volatility whereas
the seller might incur a loss. This risk can be offset through the purchase or sale of option
contracts that have an opposing vega value. For example, we know that options decrease
in value as volatility decreases. Therefore, selling options (that benefit as volatility
decreases) might be the best hedge for a trader who is looking to offset vega risk.

Time decay (theta risk) is a positions exposure to the effects of a change in the amount of
time remaining to expiration. We know that time moves forward and as it does, the time
value of an option decreases. This exposure can be offset through the purchase or sale of
options with opposite theta characteristics. The effects of time decay on an options value
in the Effects of Theta

As Time Moves Forward…

Underlying Security Value remains constant
Long Call Decrease in Value
Short Call Increase in Value
Long Put Decrease in Value
Short Put Increase in Value

Interest rate risk (rho risk) is negligible to most traders. Its impact can be substantial if a
position contains a large amount of long or short stock or long-term options. Decreasing
the stock position, replacing stock with options is the most efficient way to reduce rho
risk. Remember, longer-term options are more interest rate sensitive.

Dividend risk can be offset through the purchase or sale of options or the underlying
stock. An increase in the dividend will make the call decrease in value because the holder
of the call does not receive the dividend. In this situation, it is more advantageous to own
the underlying asset over owning the call. Conversely, the put will increase in value when
the dividend is increased because the short stock seller must pay the dividend to the
lender of the stock, which makes owning the put more desirable than shorting the
underlying asset, changing input variables on an option’s theoretical value.

Varying Market Conditions

As market Rise in
conditions price of the Interest Volatility Passage of Dividends
change the underlying rates Rise… Rise… time… Rise…
values of… …
Long
Increase No effect No effect No effect Increase
Underlying

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 Short
Decrease No effect No effect No effect Decrease
Underlying
Long Call Increase Increase Increase Decrease Decrease
Short Call Decrease Decrease Decrease Increase Increase
Long Put Decrease Decrease Increase Decrease Increase
Short Put Increase Increase Decrease Increase Decrease

Knowing the risks involved with options trading is the first step to successful trading
while hedging these risks to create a profitable position is the second step. We have
learned that there are different ways to hedge each trade, providing a market maker with
the important task of determining the best hedge possible for each trade he or she
executes. Determining which hedge is the best is based on knowing not only the risks of
the original trade but also the corresponding risk of the hedge. Observing actual positions
under a multitude of conditions is by far the best way to learn the complex nuances of
options. The next two chapters will guide the reader through the fundamentals of the
marketplace and setting up a trading station, giving the investor the ability to begin
trading on his or her own.

Estimating Volatility:
In a real options analysis the value of the option will depend crucially on the volatility of
the underlying project or asset. Under the assumption that a stock follows a lognormal
random variable the volatility is the  characterizing the stock’s lognormal price random
variable. Most experts believe that the best way to estimate volatility of say, an Internet
startup or a biotech drug is to look at the volatility the market has placed on companies in
a similar line of business. It is therefore important to understand how to estimate the
volatility of a stock. Basically there are two approaches to estimating volatility:
 Estimate volatility based on historical data.
 Look at a traded option and estimate volatility as the value of sigma that makes
the actual option price match the predicted Black-Scholes price. This approach is
called implied volatility estimation.

Most experts prefer to estimate volatility via the implied volatility approach. The
reason is, of course, that the implied volatility approach is forward-looking and the
historical approach is based on the past. We illustrate both approaches.

(OR)
8. Discuss the procedures for calculating the value of a Call Option as per Black-
Scholes model. 8M
 Explaining the components of Black-Scholes formula 5 marks
 Explaining the component of Black-Scholes Call Option formula 3 marks

 d1= In (S/X) + (r +o2 /2) x t

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 o . √t
 d2= d1- o . √t
 C = S . N(d1) – X . e-rt . N(d2)
 In (spot price/expiry price)
 r- annual risk free rate of returns
 t-time to expiry
 o annual volatility

UNIT-V
9. Explain about Caps and Floors. Explain how Swaps are similar but different from
forwards contracts? 8M

 Defining Caps 2 Marks

 Defining Floors 2 Marks
 Defining SWAPS and Forwards and explaining their differences 4 Marks

An interest rate cap is a derivative in which the buyer receives payments at the end of
each period in which the interest rate exceeds the agreed strike price. An example of a
cap would be an agreement to receive a payment for each month the LIBOR rate exceeds
2.5%.
Similarly an interest rate floor is a derivative contract in which the buyer receives
payments at the end of each period in which the interest rate is below the agreed strike
price.
Caps and floors can be used to hedge against interest rate fluctuations. For example a
borrower who is paying the LIBOR rate on a loan can protect himself against a rise in
rates by buying a cap at 2.5%. If the interest rate exceeds 2.5% in a given period the
payment received from the derivative can be used to help make the interest payment for
that period, thus the interest payments are effectively "capped" at 2.5% from the
borrowers point of view.

A swap is one of the most simple and successful forms of OTC-traded derivatives. It is a
cash-settled contract between two parties to exchange (or "swap") cash flow streams. As
long as the present value of the streams is equal, swaps can entail almost any type of
future cash flow. They are most often used to change the character of an asset or liability
without actually having to liquidate that asset or liability. For example, an investor
holding common stock can exchange the returns from that investment for lower risk fixed
income cash flows - without having to liquidate his equity position. The difference
between the both is the series of payments that take place in swaps, where as it just one
time payment in forwards or

A forward contract requires delivery or taking delivery of some commodity or security at

some specified time in the future at some price specified at the time of origination. In a
swap, each party promises to deliver and/or receive a pre-specified series of payments at

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specific intervals over some specified time horizon. In this way, a swap can be
considered to be the same as a series of forward contracts.

(OR)
10. What do you mean by SWAPS? Give the different types of SWAPS along with
components of swaps price. 8M

 Defining SWAPS and explaining the swap concept 4 marks

 Explaining different types of swaps 2 marks
 Explaining different components of swaps 2 marks

In finance, a swap is a derivative in which counterparties exchange cash flows of one

party's financial instrument for those of the other party's financial instrument. The
benefits in question depend on the type of financial instruments involved. For example, in
the case of a swap involving two bonds, the benefits in question can be the periodic
interest (or coupon) payments associated with the bonds. Specifically, the two
counterparties agree to exchange one stream of cash flows against another stream. These
streams are called the legs of the swap. The swap agreement defines the dates when the
cash flows are to be paid and the way they are calculated. [1] Usually at the time when the
contract is initiated at least one of these series of cash flows is determined by a random or
uncertain variable such as an interest rate, foreign exchange rate, equity price or
commodity price.[1]
The cash flows are calculated over a notional principal amount. Contrary to a future,
a forward or an option, the notional amount is usually not exchanged between
counterparties. Consequently, swaps can be in cash or collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on
changes in the expected direction of underlying prices.

Types of Swaps
Equity Swaps, Interest Rate Swaps, Currency Swaps, Commodity Swaps and Credit
Swaps are the five different types.

An equity swap can be comprised of a basket of stocks or a single stock or a stock index.
In terms of commodity swaps, the underlying asset is usually crude oil even though it
really includes all types of goods. Currency swaps and Interest Rate swaps are motivated
by comparative advantage. During the recession of 2008, a phrase that came into
prominence was the credit default swap (CDS). It can be a difficult concept to grasp.
Basically, if the bond or a loan is defaulted, the buyer of the CDS stands to benefit by
getting a big payoff.

Equity Swap

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An equity swap is a type of Delta One product. This is really great for meeting an
investor’s diversification goals because it combines several underlying securities and
therefore the owner has a simple approach to use a single product to get the exposure of a
basket of securities. Equity swaps are great investment tools to offer an investor leverage
like derivative products. Lets look at an example to illustrate how great they can be. If X
owns 100 shares of a Technology Company and believes that he will see a drop in the
share price of that firm, he could utilize an equity swap to mitigate risk. He does this so
that he doesn’t lose any voting rights he has on the board and at the same time does not
get affected by any returns on the stock.

Interest Rate Swap

Interest rate swaps are great for speculating and hedging and the two parties involved will
now exchange cash flows on the interest rate. There are different types and they can be
for different currencies as well. Fixed-for-floating rate swaps, floating-for-floating rate
swaps and fixed-for-fixed rate swaps are all done with this derivative instrument. Interest
rate swaps are great for arbitrage as well.

Currency Swap

The idea of comparative advantage is what fuels a currency swap which has two primary
uses. One is to get inexpensive debt by borrowing at the best rate in the market
irrespective of currency and then exchanging for debt in the currency that an investor
wants. The second use is to lessen the exposure to movements in the exchange rate which
is also a way to hedge.

Commodity Swap

A commodity swap is a great way to capitalize on the market price of a commodity by

getting some fixed payments after paying a fixed price to a financial institution. This is
how a user of a commodity would invest in this type of swap but there is also a way for a
producer to receive fixed income for the commodity by compensating the market price to
a financial institution. Oil is the commodity that is mostly used.

Credit Default Swap

Although, credit default swaps have been given a lot of coverage, they are definitely the
easiest type of swap for me to understand. I really want to go into more detail with this in
another post and with other different types of swaps that I have mentioned here. For now,
just wanted to let you know that this was how John Paulson was able to make $3.5 billion

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 PART-C
10 M
Analyze the following CASE in not exceeding four pages

The price of a stock is Rs 250/- per share and its volatility is 25%. The risk free
interest rate is 7%. A call option with an exercise price of Rs 235 has a expiration in
one year. Using Black-Scholes option pricing models (BSOPM). Calculate the price
of call option.

 3 Marks for the correct formula

 3 Marks for d1 calculation
 1 mark for d2 calculation
 3 marks for calculation call option of BSOPM

 d1= In (S/X) + (r +o2 /2) x t

o . √t
 d2= d1- o . √t

 C = S . N(d1) – X . e-rt . N(d2)

= In(250/235) + (0.07 + (0.252 /2)) x 1

0.25

= 0.0619 + 0.10125 / 0.25

Therefore d1 = 0.6528

d2= 0.3472

N(d1)= 0.2442 and N(d2)= 0.1331

Call Option formula

C = S . N(d1) – X . e-rt . N(d2)

= 250 (0.2442) – 235 (0.9324) (0.1331)

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Price of a Call option is 41.95

Note: ± 2.5 to 41.95 can be awarded full marks.

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