Risk from an individual’s Perception

• If Ganesh, an investor invests in equity:

Possible out comes:

• Matches fairly with his expectation

• Gets a super profit
• Manages a positive return, which is below his
expectation.
• Suffers a negative return

Thus, We have a set of probable outcomes, where it is not

certain as to which one of them will happen. Such a
situation is called a situation of Risk
• Concept of Risk – SD/basic assumption normal dist
• Approaches to risk mgt – risk transfer/risk retention/risk
avoidance/diver/loss control
• Cash mkt/F&O seg
• Clearing and settlement/ margin system
• Role of exchange/net cash settlement
• Forwards/futures- specifications- counter party risk
• Futures pricing – cost of carry model
• Option – concept – call/put
• Basic option potation LC/SC/LP/SP
• Option payoffs
• Factors influencing the option price
• Hedging using futures
• Introduction to swaps
Risk from an individual’s Perception

• If Risk is a situation where there are a number of

specific, probable outcomes, but is not certain as to
which one of them will occur,…

• If Ganesh decides to invest in 6 year FD with ICICI Bank

@ 10.5% p.a., he now leaves no doubts about the
outcomes of his investment. This may be called a
situation of Certainty and…

• If he decides to invest in a small cap company with an

gambling intention, where probable outcomes are
unknown, becomes a situation of Uncertainty.
Personal risk implies

• Risk on Earnings -Death/Disability/Aging/Unemployment

• Risk on Health -Medical Expenses
• Liability -Loans
• Physical Assets -Real Estates/Motor vehicles/related
• Financial -Stocks/bonds/deposits
Assets
• Longevity.
Risk from an corporate Perception

The complexity of Risk and Risk management is much

complex for business entities, because of the complex
set of internal and external environment of business.

Government

Management Competition
Consumer
Behaviour Labour

Business Entity
Cost of Capital

Machinery Global Markets

Inward supply

Economy
Sources of Risk
Profits of a business entity are at risk from different
sources like: -
• Interest Rate Risk
• Exchange Risk
• Default Risk
• Liquidity Risk
• Business Risk
• Financial Risk
• Market Risk
• Marketability Risk
Involvement of multiple currency and risk
implication

Assume AAA Ltd invests Rs 100,000,00 in 9% US

Bond on 1 Dec 06 @ a spot rate of 45/$
maturing on 1 Dec 07. The spot rate then be
41/$.

222222
242221
9931101
Business Risk - Explained
Business Risk may generate from the Internal
Environment or External Environment.
Internal Factors like

• Stock Out / Buffer Stock

• Short Term Liquidity / Higher Working Capital
• Credit Risk / Credit Policy
• Death of Key Personnel / Key Man Insurance
• Machinery Breakdown / Spares level (VED)
Business Risk – Influenced by External Variables Like
• Governmental and legal Decisions
• Competition
• Demography and consumer
• Natures Play
• Economy

The external environment is generally uncontrollable and

we can only have strategic stands against these
Environment. Thus the generic approaches would
• Risk avoidance / not taking activity on that entails risk
• Loss Control / balancing inflow/outflow
• Diversification
• Risk Transfer / Factoring/Hedging/Insurance
• Risk Retention / Cost benefit
• Risk Sharing
• Risk avoidance is a conscious decision not to
expose oneself or the one’s firm to a particular risk
of loss.
• Loss Control– When a particular risk cannot be
avoided, actions may often be taken to reduce the
losses associated with them. This method of
dealing with risk is known as loss control.

• Risk Retention - - assumes the risk and hope to

get rewarded.
• Risk Transfer – involves payment by one party
(the transferor) to another (the transferee, or the
risk bearer), where the transferee agree to
assume a risk that the transferor desires to
escape. Example Vehicle insurance/ Health
insurance, derivative contract etc.
How does implied risk reflect on a
company?

• Net worth of Apollo Tyres Rs 630 Cr

• Assume AT gets a contract on which a fairly

expected PAT of Rs 45 Cr in one year.

• Thus, the year end expected networth of AT

would stand around Rs 670 to 675Cr.

• Or in other words this would be reflected in the

share price. i.e. 352 moving up to 363. (45/3.83)
Reinsurance

• Reinsurance may be defined as the shifting by a

primary insurer, called the ceding company, of
a part of the risk it assumes to another company,
called reinsurer.

• The portion of the risk kept by the ceding

company is know as the line, or retention and
the portion reinsured is called cession.

• The process by which a reinsurer passes on risk

to another reinsurer is known as retrocession.
Contingent business income insurance
• If a firm is forced to suffer a loss, not because an
exposure to peril occurred and damages happened, but
because a peril forced the shutdown of a plant belonging
to a supplier or to an important customer on whom the
firm depends.

• To meet such situations, contingent business income

insurance has been devised.

• The regular business income policy will not cover the

losses described above because the insured peril did not
cause any damage directly.

• Insurable value for contingent business income

insurance is calculated in the same manner as it is for
business income insurance.
Derivatives and Risk Management
• A derivative is a financial instrument whose value depends on
the value of other (called an underlying asset), such as a
commodity, forex, shares etc.

• For Example
– Nifty cash 10,892/- Nifty Futures 10,959/-

Thus a derivative security can be defined as a security whose

value depends on the values of other underlying variables.
Very often, the variables underlying the derivative securities
are the prices of traded securities.
Types of Derivatives and Futures
Basically three types of Derivatives and
Futures are found:-

• Futures and Forwards

• Options
• Swaps
Forward Contract
• A forward contract is the simplest mode of a derivative
transaction. It is an agreement to buy or sell an asset (of
a specified quantity) at a certain future time for a certain
price. No cash is exchanged when the contract is
entered into.

• Illustration 1
• Shyam wants to buy a TV, which costs Rs 10,000 but he
has no cash to buy it outright. He can only buy it 3
months hence. He, however, fears that prices of
televisions will rise 3 months from now. So in order to
protect himself from the rise in prices Shyam enters into
a contract with the TV dealer that 3 months from now he
will buy the TV for Rs 10,000. What Shyam is doing is
that he is locking the current price of a TV for a forward
contract. The forward contract is settled at maturity. The
dealer will deliver the asset to Shyam at the end of three
months and Shyam in turn will pay cash equivalent to the
TV price on delivery.
Mr. Lal wants to buy 100 g of gold for her
daughters marriage in May 2016. The spot
price of gold is Rs 2500 per g.

However he is worried that by May the gold

prices would go up.

Since he did not want to hold the gold with

him for the next six months, he approaches
a jewellery.
• The jewellery merchant agrees that he
would deliver him 100 g of gold by May
2016.

• What should be the contract price?

• R = 10% pa.
• Great India Ltd is a sw developer. They have agreed to develop a mobile
app for a client in US. The product was agreed to be delivered by May
2019 end @ $ 10000.
• The treasury dept of GIL forecast that INR/USD will be 78/1 if a stable govt
is comes to power in May 2019 or else will be 60/1.
• The Management feels it is 75% likely that a stable govt will come to power
in May 2019.
• Which risk faced by GIL for the above situation can be transferred using a
forward contract. How? Who will be an ideal counter party to a forward
contract with GIL.
Futures Contract
• Futures contracts can be defined as an agreement ,
regulated by a exchange, to buy or sell a standard
quantity of a specific instrument at a predetermined
future date and a price.

• Thus, in Index futures the underlying is the stock index

(Nifty or Sensex)

• In India we have index futures contracts based on S&P

CNX Nifty and the BSE Sensex and near 3 months
duration contracts are available at all times. Each
contract expires on the last Thursday of the expiry month
and simultaneously a new contract is introduced for
trading after expiry of a contract.
How is futures Price arrived?

• The relationship between the cash price and the

futures price of any commodity can be
expresses as follows:

Ft,T =Ct + [Ct x Ir x ((T-t)/365)]

Where,
Ft,T = The futures price at time t, which is to be delivered at
time period T
Ct = Cash Price at time t
Ir = Annualized interest rate on borrowings
T-t = Time period
Futures Markets V Forwards Markets

• Location - Exchange/No Fixed Location

• Size of Contract Standard/Customized

• Maturity Standard/Customized

• Margins Marked to market/None

• Credit Risk None/Possible

• Settlement Clearing House/Customized

• Liquidation Usually offsetting/Delivery

Margins in futures Markets
• Margins The margining system is based on the JR Verma
Committee recommendations. The actual margining happens on a
daily basis while online position monitoring is done on an intra-day
basis.

Daily margining is of two types:

• 1. Initial margins
• 2. Mark-to-market profit/loss

Let us take a hypothetical trading activity where a client purchases 200

units of FUTIDX NIFTY 29JUN2001 at Rs 1500.

• The initial margin payable as calculated by VaR is 15%.

• Total long position = Rs 3,00,000 (200*1500)
• Initial margin (15%) = Rs 45,000
Popular Types of futures
• Stock Index Futures
Index futures are all futures contracts where the underlying is the
stock index (Nifty or Sensex) and helps a trader to take a view on
the market as a whole.

• Interest Rate Futures

• An Interest Rate Future is a futures contract with an interest-
bearing instrument as the underlying asset.
• Examples include Treasury-bill futures, Treasury-bond futures and
Eurodollar futures.

• Currency Futures
A currency future, also forex 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 last trading date

• Commodity Futures
Stock Index Futures

• The stock index futures were introduced in

USA in 1982 with the Commodity Futures
Trading Commission (CFTC) approving
the Kansas Board of Trade proposal.

• In India, the beginning of financial futures

was made with the introduction of stock
index futures by the NSE of India Ltd and
the BSE Ltd in June 2000.
Valuation of Stock Index Futures

• Usually the financial forwards and futures contracts are

priced using the cost of carry model.

• The carry pricing model stipulates that the forward or

futures price defined as the value of one unit of the asset
underlying the contract, is equal to the sum of the spot
price and the carrying costs incurred by buying and
holding on to the deliverable asset, less the carry return
if any.

• Thus, forward or futures price

= Spot Price + Carry Cost – Carry Return
Valuation Concepts

• Continuous Compounding: usually the

compounding is done annually/ half yearly/
quarterly/ or on a daily basis. However in
practice, for valuation of futures,
continuous compounding is adopted
where the time period between successive
is near to zero.
Valuation of Stock Index Futures
(when securities included in the index are not expected to pay dividends during the life of the
contract)

Calculate the value of a futures contract using the following

date:

• Spot value of index (S0)= 3090

• Time to expiration =76 days
• Contract multiplier =100
• Risk free rate of return (r)= 8%

• Thus F = S0ert
• =3090 e (76/365)(0.08) = 3139.92

• Thus value of the contract = 3139.92 x 100 =313992

Valuation of Stock Index Futures
(when securities included in the index are expected to pay dividends during the life
of the contract)

• Consider a three month futures contract on NSE

50. Assume that the spot value of the index is
1090, the continuously compounded risk free
rate of return is 12 per cent pa, and the
continuously compounded yield on shares
underlying the NSE 50 index is 4 per cent pa.

• Find the value of a 3 m futures contract,

assuming the multiplier to be 200.
Valuation of Stock Index Futures…cont
(when securities included in the index are expected to pay dividends during the life
of the contract)

• FP = S0e(r –y)t
• FP = 1090 e (0.12 – 0.04)(0.25)
= 1112.02

With a multiplier of 200, the value of futures

contract is 200 x 1112.02 = 2,22,404.
Valuation of Stock Index Futures
(when securities included in the index are expected to pay dividends during the life
of the contract)

• On Dec 15, the spot Price of S&P 500 index was

1295. What will be the theoretical price of a
futures contract which is expected to declare a
dividend of 1 percent per share and which will
mature on Dec 31 The three month annual T-
Bill rate is 9.66%

• FP = 1295 + 1295 x (0.0966 - .010)x15/356

= 1299.58
Valuation of Stock Index Futures
(when securities included in the index are expected to pay dividends during the life
of the contract)
• The current value of sensex is 4500 and the annualized
dividend yield on the index is 4%.
•
• A three-month futures contract on the sensex can be
purchased for a price of 4600, the risk free rate of return
being 10%.

• Can an investor earn an abnormal (risk free) return by

resorting to stock index arbitrage.

• Assume 50% of the stocks included in the index will pay

dividends during the next three months.
•
• Ignore margin requirements, transactions and taxes.
Valuation of Stock Index Futures
(when securities included in the index are expected to pay dividends during the life
of the contract)

• The fair value of the futures contract =

• 4500 + (4500 x.10 x 3/12) – (4500 x 0.04 x .05)
• =4522.5
Currency Futures

• Currency futures can be defined as “a binding obligation

to buy or sell a particular currency against another at a
designated rate of exchange on a specified future date”.

• The basic advantage of using currency futures is that it

provides a means to hedge the trader’s position or
anybody who wishes to lock in exchange rates on future
currency transactions.

• In other words, by purchasing (long hedge) or selling

(short hedge) forex futures, a trader can fix the incoming
and outgoing cash flows in one currency with respect to
another currency.
Currency Futures

• Assume that a US exporter is exporting goods to

his German Client. On Sep 14, the exporter got
confirmation from the German importer that the
payment of DM 625,000 will be madeo n Nov 1.

• Here the US exporter is exposed to the risk due

to currency flucation …if the DM depreciates
there will be loss on his dollar receivables.

• To cover this risk the exporter can sell DM

futures contract.
Currency Futures…cont
• On Sep 14, the exporter gets confirmation of receivables
equal to DM 625,000 on Nov 1.

• The spot rate on Sep 14 is $/DM:0.4407.

• Thus expected cash in flow are @ $275,437.5 (i.e.,

625000 x 0.4407)

• But he cannot confirm it since he did not receive the DM

yet and also is not certain about the exchange rate on
Nov1.

• However the exporter can get into a futures contracts to

confirm in cash inflows (if he is not interested in
speculative profits.)
Currency Futures…cont

• Sell five Dec DM futures contract (since each

DM contract is 125000) @ which is prevailing in
the market.

• Say he sold five Dec DM futures @ $/DM:

0.4442 on Sep 14

• Hence the equivalent notional amount in USD

will be $ 277,625 (i.e., 0.4442 x 625000)
Currency Futures…cont
• Now on Nov 1 let $/DM be 0.43908

• Now, the dollar value of DM 625,000 = 274,425 (625000

x 0.43908)

• So loss on Spot Market position = 275437.5 -274,425 =

$1,012.5

• On Nov 1 he Buys five Dec DM futures contracts. The

qty of futures bought should be the same as that sold on
Sep 14. Let the futures rate be 0.44258. This gives the
exporter the notional right to buy DM 625,000 by paying
$ 276,612.5 (i.e., 625000 x .44258 )
(Design) Specifications of a Futures
contract

• The Asset (if commodity – grade must be

specified)
• The price
• The contract size
• Delivery arrangements
• Tick size (minimum price fluctuation)
• Trading unit (lot size)
• Daily price limits
Risk Management using derivatives…Hedging
• The activity of trading in futures to control or reduce risk is called
Hedging
• Assume the following:
– In Dec you need 20,00,000 bales of cotton and you expect a price
hike of cotton by then.

– Currently in NYCE Jan cotton futures are trading at 57 cents per

lot.

– You entered into a futures contract for 20,00,000 bales (thus your
out flow is locked @ 2280)

– Now, assume in Dec, the cash price of cotton is 58.55 cents per
lot, you will have to pay supplier $2342.

– However the extra cost of 1.55 cents per lot (or $62) will be offset
by a profit of 1.55 cents per lot when the futures contract bought
@ 57 cents is sold at 58.55.
• MRF requires 1000 q of rubber in March.
• The current prices of rubber are Rs
120000/q
• Based on the current prices MRF
estimates the cost of production and
further on the selling price to its contract
clients abroad.
• Other cost of sales amount to Rs 50000/q.
MRF targets 20% NP margin.

• How can MRF approach the risk on

material price hikes?
Long Hedging and Short Hedging
• Short hedging is also known as selling hedge
and it happens when the futures are sold in
order to hedge the cash commodity against
declining prices.

• Long hedging is also known as buying hedge

and it happens when the futures are purchased
to hedge against the increase in the prices of a
commodity to be acquired either in the spot or
future market.
Factors to be considered while hedging

• Hedging is for controlling risk and not for

speculative profits
• Beta Management

• While using index futures as a hedging tool, the

following should be noted:
– If you are long on a stock, your hedging strategy
would be to go short on index futures.
– If you are short on a stock, your hedging strategy
would be to go long on index futures. s
Options
• An option is a contract, which gives the buyer
the right, but not the obligation to buy or sell
shares of the underlying security at a specific
price on or before a specific date.

• ‘Option’, as the word suggests, is a choice given

to the investor to either honour the contract; or if
he chooses not to walk away from the contract.

• However, if you decides use your privilege not to

honour the contract, you may have to pay a
amount called Option Premium to the counter
party.
Options - types
Options are classified into two as
• Call Option and Put Options
• A call option gives the investor the right to
purchase shares of a particular stock at a fixed
price until a specific date.

• A put option gives an investor the right to sell

shares of a particular stock at a fixed price until
a specific date.

• Both puts and calls gives the investor the right

but not an obligation
Call option explained

• Raj purchases 1 NTPC Aug Call –150 @ 8

• This contract allows Raj to buy 100 shares

of NTPC at Rs 150 per share at any time
between the current date and the end of
next Aug. For this privilege, Raj pays a fee
of Rs 800 (Rs eight a share for 100
shares). Thus Rs 800 is option Premium.
Call Option illustrated
• Sam purchases a Sail Aug call at Rs 40 for a premium of
Rs 15. That is he has purchased the right to buy that
share for Rs 40 in Aug. If the stock rises above Rs 55
(40+15) he will break even and he will start making a
profit. Suppose the stock does not rise and instead falls
he will choose not to exercise the option and forego the
premium of Rs 15 and thus limiting his loss to Rs 15.
Put Option Explained

• Sam purchases 1 INFTEC (Infosys Technologies) Aug

3500 Put --Premium 200

• This contract allows Sam to sell 100 shares INFTEC at

Rs 3500 per share at any time between the current date
and the end of Aug. To have this privilege, Sam pays a
premium of Rs 20,000 (Rs 200 a share for 100 shares).
Put option illustrated
• Raj is of the view that the a stock is overpriced and will fall in
future, but he does not want to take the risk in the event of
price rising so purchases a put option at Rs 70 on ‘X’. By
purchasing the put option Raj has the right to sell the stock at
Rs 70 but he has to pay a fee of Rs 15 (premium).
• So he will breakeven only after the stock falls below Rs 55 (70-
15) and will start making profit if the stock falls below Rs 55.
Commodity Futures
• Commodity trading is nothing but trading in commodity
derivatives (futures or options). In other words, if you are
keen at taking a buy/sell position based on the future
performance of commodities like gold, silver, agricultural
commodities, metals, crude etc; then you could do so by
trading in commodity derivatives.
This is called Commodity Futures Trading.
•
Commodity derivatives are traded at the commodity
exchanges. There are currently 2 major commodity
exchanges NCDEX (National Commodity and Derivative
Exchange) and MCX (Multi-Commodity Exchange).

• Gold, Silver, Agri-commodities including grains, pulses,

spices, oils and oilseeds, mentha oil, metals and crude
are some of the commodities that the exchanges deal in.
 Option Value and Option Pricing Models

Intrinsic value is the difference between the exercise price of

the option (strike price, K) and the current value of the
underlying instrument (spot price), Sf).

If the option does not have positive monetary value, it is

referred to as out-of the-money. If an option is out-of the-
money at expiration, its holder will simply "abandon the
option" and it will expire worthless.

– For a call option: value = Max [ (S – K), 0 ]

– For a put option: value = Max [ (K – S), 0 ]
Option pricing
• In Real markets option values are a
function of the price of the underlying
asset, strike price and the time until
expiration.

• The range of prices, which the option can

take during a particular period is called as
the boundary space of an option.
Binomial Option Pricing Model
by Cox, Ross and Rubinstein 1979

• This model is based on the construction of

a ‘binomial tree’ which represents the
possible paths followed by the underlying
asset’s price over the life of the option.

• Binomial option pricing model is used to

estimate the fair value of call or put option.
Binomial Model - illustrated
• Assume current strike price of a stock is Rs. 100/- and
will either increase to Rs. 110/- or decrease to Rs. 90/-
by the end of one year from now.

• Assume riskless interest rate to be 8%

• Now, to value the call option, we need to construct a

portfolio that ensures the owner of the portfolio receives
zero return after one year, whether the stock sells at Rs.
90/- or Rs.110/-

• Thus to construct a zero pay –off portfolio, we need to

long n stocks and short calls in such a way that the pay –
off from the portfolio of call and stock will be the same
irrespective of the value of stock price after 1 year.
Binomial Model - illustration
Portfolio Flows at t = 0 Flows at t = 1 year

• S1= 90 S1=110
Write 2 Calls +2C 0 -20
Buy 1 Stock -100 +90 +110
Net Revenue 90 90
Borrow Rs 83.34 -90 -90
0 0
i.e., we borrow an amount equal to the PV of the exercise price

The above portfolio is constructed in such a way that the portfolio investor
receives no return at the end of year one, whether the stock price moves up
or down, there fore, the investment required for this portfolio should be zero.
Thus 2C – 100 + 83.34 = 0 or C = 8.33
Black Scholes Model …illustrated

• Consider an investor buys an European call

option on a stock which currently trades at Rs 50
with strike price Rs. 55.
•
• The option will expire in the next 3 months. The
stock’s volatility is 25%.

• The risks free rate is 7% pa.

• What will be the price of the option bought by

the investor using Black –Schole’s model?
Black Scholes Model …illustrated

• C = SN(d1) –Xe –r (T-t) N(d2)

• C = Call option Price
• S = Spot Price
• X = Strike Price
• r = Risk free rate
• T-t = Time to expiration in years
• N(d) cumulative standard normal
distribution
• e = 2.71838
 Black Scholes Model …illustrated

• C = SN(d1) –Xe –r (T-t) N(d2)

• d1 = In (S/X) + (r+(σ2/2)) (T-t)

σ√(T-t)
In = Natural Log
σ = standard deviation of returns on the underlying asset. (volatility
measure)

= In (50/55) + .07 +(.252/2) (.25) = -0.6850 and N(6850) = 0.2467

.25 √.25

d2 = d1 - σ√(T-t) = -.6850 -0.12 = -0.8100 and N(.8100)=0.2090

C = 50(.2467) – 55e -.07 x.25 (.2090) = Rs. 1.0394
Black Scholes Model …illustrated

• To calculate the value of theput option we have

to calculate the value of N (-d1) and N (-d2) and
use the formula

• P = Xe –r (T-t) N(-d2) – SN (-d1)

• 5.085
Portfolio Insurance

• Portfolio Insurance is an investment strategy where

various financial instruments like equities and debts and
derivatives (like options and futures etc.,) are combined
in such a way that degradation of portfolio value is
protected.

• Swaption

• An swaption is an option on a swap where the buyer of

the swaption (like the option holder) is entitled to perform
a specific swap deal for a defined period of time
Exotic Options

• Options which are more complicated than

the standard European or American
options are referred to as exotic options
Factors affecting option Prices

• The current stock price

• The strike price
• The time to expiration
• The volatility of the stock price
• The risk free interest rate
• The dividends expected during the life of
the option.
Upper and Lower Bonds for Options Prices

• An American or European call option gives the

holder the right to buy one share of a stock for a
certain price. No matter what happens, the
option can never be worth more than the stock.
Hence, the stock price is an upper bond to the
option price.

• If these relationships are not true, an arbitrageur

can easily make a risk less profit by buying the
stock and selling the call option.
Upper and Lower Bonds for Options Prices

• An American or European put option gives

the holder the right to sell one share of a
stock for X. No matter how low the stock
price becomes, the option can never be
worth more than X.
• Hence the selling price of the stock is the
upper bond for a put option.
 Lower bonds – calls
• Consider an European call option on a non
dividend paying stock when the stock price
is $ 51, the exercise price is $ 50, the time
to maturity is 6 months and the risk free
rate is 12% pa.

S – Xe –r(T-t)
= 51-50e -.12x0.5 = $3.91
Put -Call Parity p156

• Factors affecting option prices

– The current stock price
– The strike price
– Time to expiration
– Volatility of the stock price
– Risk free rate
– Dividends expected during the life of option.
Put -Call Parity

• Put – Call parity is the relationship among

the put price, call price, stock price,
exercise price, time to expiration and risk
free rate.
Illustration – Put Call Parity
• The following information are available for stock Zenith
Ltd.
Call Put
• Time to expiration 3 3
• Risk free Rate 10% 10%
• Exercise Price Rs.50 Rs.50
• Stock Price Rs.60 Rs.60
• Price Rs.16 Rs.2

• Determine if Put call parity is working?

Illustration – Put Call Parity
• C + D+Xe-r(T-t) = p+S
• Where
• c =value of call option to buy one share
• X = Strike price of option
• r = risk free rate of return
• T = Time of expiration of option
• t = current time
• p = value of put option to sell one share
• S = Current stock price
• D dividend
Illustration – Put Call Parity
• S = Rs.60
• X = Rs.50
• r = 10%
• T = 3 months
• c = Rs 16 and
• p = Rs 2.

• p + s = Rs. 62
• C +Xe-r(T-t) = Rs 64.756.
• Thus, there is arbitrage opportunity.
Calculation of Futures price

• A Three month futures contract on S$P 500 is trading @

400, and the stocks underlying the index provide a
dividend yield of 3% p.a.. If the risk free return is 8%,
what is the futures price of the index?
• F = Se (r-q) (T-t)
• S= current price
• r = risk free rate
• T –t time left to maturity.

= 400e0.05 x 0.25 = 405.03

What quantity to hedge?

• A company wishes to hedge a proftolio worth $

2,100,000 using an S&P 500 index futures
contract with four months to maturity. The
current futures price is 300 and beta of the
portfolio is 1.5. The value of one futures
contract is 300 x 500 = $ 150,000. What is the
correct number of futures contract to short to
make a perfect hedge?

• 1.5 x 2,100,000 =21

150,000
What is a straddle?

• Straddle involves buying a call and put

with the same strike price and expiration
date. A straddle is appropriate when an
investor is expecting a large move in a
stock price but does not know in which
direction the move will be.
Straddle – illustrated
• Consider an investor who feels that the price of a certain stock,
currently valued at Rs 69, will move in either direction in next three
months.

• He creates a straddle by buying both a put and a call with a strike

price of Rs 70.

• Suppose that the call costs Rs 4 and Put costs Rs 3.

• Now, if the stock price stays @ Rs 70 on expiration, he will loose Rs

7.

• However, he makes profit, if the closing price moves up or down

severely, say Rs 90 or Rs 50.
Strips, Straps and Strangles

• Strips: A strip consists of a long position in one

call and two puts with the same strike price and
expiration date

• Strap: A strap consists of a long position in two

calls and one put with same strike price and
expiration date.

• Strangles: Here an investor buys a put and a call

with same expiration date and different strike
price.
Swaps
• In finance, a swap is a derivative, where two
counterparties exchange one stream of cash
flows against another stream. These streams
are called the legs of the swap. The cash flows
are calculated over a notional principal amount.

• The most common swaps are:-

– Interest rate swaps
– Currency swaps and cross currency interest rate
swaps
Interest rate Swaps
• An interest rate swap is defined as an agreement
between two or more parties who agree to exchange
interest payments over a specific time period on a
notional principal and agreed terms. Simple interest rate
swaps are popularly known as plain vanilla swaps.

• Interest rate Swaps

• A currency swap is a foreign exchange agreement
between two parties to exchange a given amount of one
currency for another and, after a specified period of time,
to give back the original amounts swapped

• Practically, a currency swap is a contract involving exchange of interest

payments on a loan in one currency for a fixed or floating interest payments
on equivalent loan in a different currency.
Motives for swaps

• Quality spreads (lower financing costs)

• Currency Risk Management
• Interest Risk Management
Swaps - illustration
• Assume two parties X and Y who are interested in raising funds

• Firm Y can raise funds in fixed and floating markets at 10% and
LIBOR + 0.25% respectively

• Firm X can raise funds in fixed and floating markets at 10.75%

and LIBOR +0.50% respectively.

• These rates are applicable for a 100m borrowing for 2 years.

• While both x and y can borrow in fixed and floating rates, firm X
is interested in borrowing fixed rates and firm Y is interested in
borrowing in floating rates.
Cost analysis …interest rate Swaps
Firm Objective Fixed Interest Floating interest rate

X Fixed rate 10.75% LIBOR + 0.50%

Y Floating Rate 10.00% LIBOR + 0.25%

Note that the cost of borrowing for Y is lower than X in both markets. This difference
is called Quality Spread, which can be quantified for both fixed and floating rate markets
as follows:-

Fixed Market 10.75% -10% = 0.75%

Floating market LIBOR +0.50% - LIBOR+0.25% = 0.25%

Thus, we say that Firm Y has an absolute advantage in both markets. However, Firm Y
has a comparative advantage in floating rate market.

Thus, being X has a comparative advantage, it is possible to reduce the cost of funds to
both X and Y if they borrow in the markets where they enjoy comparative advantage.
In economics, the law of comparative
advantage refers to the ability of a party to
produce a particular good or service at a lower
marginal and opportunity cost over another.
Even if one country is more efficient in the
production of all goods (absolute advantage in
all goods) than the other, both countries will
still gain by trading with each other, as long as
they have different relative efficiencies.
Benefit analysis…interest rate Swaps
Thus, based on the comparative advantage theory, if each firm
borrows in the markets where they have a comparative advantage
Y – borrows funds in fixed rate market and lends to X
X - borrows funds in floating rate markets and lends to Y
Assume X lends to Y at LIBOR and Y lends to X at 10%.

Firm Int Paid to Int Received Int Paid Net Savings

counterparty to mkt Cost
Y LIBOR 10% 10% LIBOR LIBOR -
0.25% -
LIBOR
X 10% LIBOR LIBOR+ 10.50% 10.75% -
0.50% 10.50%
Option Strategies

• An option strategy refers to a combination one

or more option positions and zero or more
underlying positions.

• The option positions used can be long and/or

short positions in calls and/or puts at various
strikes.

• Options trading strategies can could be either:

bullish, bearish or neutral.
Option Strategies in bullish Market

• Bullish options strategies are employed when

the options trader expects the underlying stock
price to move upwards.

• The most bullish of options trading strategies is

the simple call buying strategy used by most
novice options traders.

• The most bullish of options trading strategies is

the simple call buying strategy used by most
novice options traders.
Simple long call strategy in bull market

• Here, Person A receives a privilege or a right to

opt either to but not to buy wipro from person B
at Rs 625.

• Thus, buyer of the option receives a privilege for

which he pays a premium. The seller accepts an
obligation for which he receives a fee.

• Here Person A is the option buyer and person B

is the option seller or option writer.
Long Call Option illustrated (bullish
market)
• Sam purchases a Mar call option at Rs 40 for a premium of Rs
15.

• Total Cost = 40 =15 =55

• Profit =MP- EP- Premium
• Max Loss = premium =Rs 15
Simple Short Puts in bullish markets

• An investor with a bullish market outlook can also go

short on a put option (i.e., sell a put option).

• A put writer profits (in form of the premium he receives),

if the price of the underlying increases and the buyer of
the put does not exercise the option to sell.

• The most bullish of options trading strategies is the

simple call buying strategy used by most novice options
traders.
Puts in bullish markets cont…

• Suppose A Sells a March Put option on 1000 Wipro

@650 to B on recipt of a premium of Rs 20 per share.

(where by B gets the right to sell 1000 wipro shares to A

@650 on or before March end)

• Thus, if on or before or march if the Wipro goes down

below 650 , the buyer i.e., person B will exercise the
option.

• However, if the seller, person A’s prediction comes

correct and if wipro prices moves up, then the buyer will
leave the option unexercised, where by person A the
seller will get the premium he has received as his profit.
Call Spread Strategies in Bull Market

• To buy a call spread is to purchase (long) a call

with a lower exercise price and to write (sell) a
call with a higher exercise price. The trader
pays a net premium for the position.

• An investor with a bullish market outlook should

buy a call spread, which allows him to participate
to a limited extent in the bull market, while at the
same time limiting risk exposure.
Assume that cash price of a scrip is Rs 100 and you buy a Mar call
option with a strike price of Rs 90 and pay a premium of Rs 14.

At the same time you sell another Mar call option on a scrip with a
strike price of Rs 110 and receive a premium of Rs 4.
This would result in a net outflow of Rs 10 as premium.

Max Profit = Higher SP-

Lower SP – Net Premium
110-90-10= 10

Max Loss = Net Premium

Different option Spreads used in developing
option Strategies
• Options spreads are the basic building blocks of many options
trading strategies. A spread position is entered by buying and selling
equal number of options of the same class on the same underlying
security but with different strike prices and/or expiration dates.
• The three main classes of spreads are

• Vertical spreads, or money spreads, are spreads involving options of

the same underlying security, same expiration month, but at different
strike prices.

• Horizontal, calendar spreads, or time spreads are created using

options of the same underlying security, same strike prices but with
different expiration dates.

• Diagonal spreads are constructed using options of the same

underlying security but different strike prices and expiration dates.
They are called diagonal spreads because they are a combination of
vertical and horizontal spreads.
Synthetic option
• A synthetic option is created by a
combination of two options or an option
and shares. It is "synthetic" because the
two instruments being "synthesized" - put
together - have the same effect as a
different investment.
 Accounting for Derivatives
• In India no standard has been prescribed for
accounting of derivative contracts in the books of
accounts.

• At present, banks are disclosing their exposure

in derivative transactions as off-balance-sheet
items, which include currency and interest rate
swaps, rupee options and forward contracts. The
exposure in the financial instruments
(derivatives) is disclosed in the Notes to
Accounts.
Accounting for Derivatives

• The Financial Accounting Standard Board

(US) has issued FASB 133, Accounting for
Derivative Instruments and Hedging
Activities.

• FASB 133 specifies recognition of all

derivative instruments in the balance sheet
as assets or liabilities measured at fair
value.
Accounting for Derivatives
The following underlying principles are observed in
the new standards: -
• Derivative instruments are assets and liabilities

• For reporting purpose only the fair value of

derivative instruments are to be considered.

• Only true asses and liabilities are reported as

such and not the gains or losses arising from
derivative instruments.
• IAS 39 and FASB 133 require all derivatives, including
hedges, to be recognised on the balance-sheet at their
fair value.

• Internationally, fair value is considered to be the most

relevant measure for financial instruments and the only
relevant measure for derivative instruments.

• Fair value can be defined as: "Value at which an asset

could be exchanged or a liability settled, between
knowledgeable, willing parties in an arm's length
transaction."
• The accounting for changes in fair value of
a derivative contract is depended on the
intended use of such contract. Broadly,
derivative contract is classified into
hedging and speculation.
Firm Objective Fixed Interest Floating interest rate

X Fixed rate 10.75% LIBOR + 0.50%

Y Floating Rate 10.00% LIBOR + 0.25%

Firm Int Paid to Int Received Int Paid Net Cost Savings
counterparty to mkt
Y LIBOR 10% 10% LIBOR LIBOR -
0.23% -
LIBOR
X 10% LIBOR LIBOR+ 10.50% 10.75% -
0.50% 10.50%