Professional Documents
Culture Documents
OF FINANCIAL
DERIVATIVES
FUNDAMENTALS OF FINANCIAL
DERIVATIVES
N.R. Parasuraman
SDM-IMD
SDM Institute for Management Development
Mysore
PREFACE
Few topics in Finance have undergone the type of change that Derivatives have over the
last few years. Dealers and Corporate practitioners have discovered several new uses to
Derivatives, resulting in lowering risk and optimizing return. Many students of Financial
Management and practitioners find the basic tenets of these Derivatives difficult to
understand in the beginning. Standard text books give answers to their queries but since
these are embedded in a cluster of applicable theory, exceptions and mathematical
notations, the beginner is often confounded.
The principal objective behind attempting this work is to help the newcomer to the world
of Derivatives get a grip on various facets in a simple manner. The attempt has been to
dwell on the most important characteristics of these instruments, without going into too
much of mathematical analysis. Let me hasten to add that in the process the work cannot
be a substitute for an advanced text book on the topic. What it seeks to accomplish is to
give the reader a quick and easy approach to understand the basic complexities in day-
to-day situations. Once comfortable with the basics, the reader is advised to get a deeper
understanding of various sub-topics with the help of text books that cover the full
mathematical application.
Thanks are also due to my father N.P.Ramaswamy who was a source of inspiration and
encouragement and to my wife Prema, who spent long hours checking the drafts and
helping me in data entry. I also thank my colleagues at SDM-IMD for all their support. I wish
to make particular mention of the support of Mr.M.V.Sunil, Mr.M. Rangaswamy,
Ms.Madhura .S. Narayan and Ms.R. Gayithri in completing the final transcript of the book.
N.R.PARASURAMAN
FUNDAMENTALS OF FINANCIAL DERIVATIVES
BRIEF CONTENTS
Module 1............................................................................................ 8
FUTURES AND FORWARDS ......................................................... 8
1 Introduction to Derivatives Markets......................................... 9
2 Forwards and Futures a quick look...................................... 17
3 Hedging with Futures .............................................................. 28
4 Pricing of Futures and arbitrage conditions ........................... 41
5 Stock Index Futures ................................................................. 54
Module 2 ....................................................................................... 69
INTRODUCTION TO OPTIONS................................................... 69
1 Types of Options ....................................................................... 70
2 Pay off of various Options ........................................................ 79
3 Special applications of Options................................................ 91
4 Options bounds- Calls............................................................. 104
5 Options bounds -Puts ............................................................. 113
Module 3........................................................................................ 121
ADVANCED TOPICS ON OPTIONS .......................................... 121
1 Option combinations............................................................... 122
2 Principles of Option Pricing Put call parity....................... 141
3 The Binomial model for pricing of Options ........................... 153
4 The Black-Scholes model........................................................ 163
5 Volatility and Implied Volatility from the Black-Scholes model
172
Module 4........................................................................................ 180
OTHER DERIVATIVES AND RISK MANAGMENT................. 180
1 Introduction to Options Greeks and Basic Delta Hedging... 181
2 Interest Rate Derivatives and Eurodollar Derivatives......... 191
3 Swaps ...................................................................................... 203
4 Credit Derivatives................................................................... 216
5 Risk Management with Derivatives...................................... 225
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Module 1............................................................................................ 8
......................................................................................................... 1
FUTURES AND FORWARDS ...................................................... 11
1 Introduction to Derivatives Markets ......................................... 12
1.1 Objectives ................................................................................................. 12
1.2 Introduction ............................................................................................. 12
1.3 Derivatives meaning and definition .................................................... 12
1.4 Types of Derivatives ................................................................................ 13
1.5 Uses of Derivatives .................................................................................. 16
1.6 Derivatives in India ................................................................................. 18
1.7 Summary .................................................................................................. 19
1.8 Key words ................................................................................................. 20
1.9 Questions for Self- study ......................................................................... 20
2 Forwards and Futures a quick look ........................................ 21
2.1 Objectives ................................................................................................. 21
2.2 Introduction to Forwards and Futures ................................................... 21
2.3 Basic hedging practices ........................................................................... 24
2.4 Cost of carry ............................................................................................. 29
2.5 Differences between Forwards and Futures .......................................... 31
2.6 Summary .................................................................................................. 32
2.7 Key words ................................................................................................. 33
2.8 Questions for Self- study ......................................................................... 34
3 Hedging with Futures ................................................................ 34
3.1 Objectives ................................................................................................. 34
3.2 Introduction ............................................................................................. 34
3.3 Long hedge and Short hedge ................................................................... 36
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Module 1
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1.1 Objectives
The objectives of this unit are to
1.2 Introduction
As financial instruments, Derivatives have become very popular over the last
two decades. While the practice of using Derivatives instruments has been
there for even centuries, the formal application of these instruments in
everyday financial management came about only recently. With the
development of appropriate markets for these securities, a lot of academic
research has also been carried out in their various facets. Understanding their
applications, uses and misuses constitutes an important part of the study of
Financial Management
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contract is also firmed up. There are several other aspects to Forwards and
Futures which will be discussed in detail in a later section
Options
Option contracts are a step ahead of the Forwards/Futures contract in that they
result in a right being created without a corresponding obligation. The buyer
of an option contract gets the right without the obligation to either buy or sell
the underlying asset. There is a time frame and a price fixed for the contract.
For the privilege of going ahead with the contract as per her desire, the option
buyer has to pay the seller a premium up front. If, ultimately prices do not
allow the Options to be exercised, then the premium is the only loss incurred
by the buyer of the Option contract. All the detailed aspects of an Options
contract are covered in a later Module.
Swaps
In a swap transaction the two parties thereto exchange their obligations on
predetermined terms. In its simplest version, two companies having different
obligations of interest payments (with one Company obliged to pay a fixed rate
of interest to its bankers and the other Company having to pay a floating rate
of interest), enter into a contract whereby they exchange their obligations. This
exchange of their obligations results in one Company getting the fixed interest
from the other Company to be used for satisfying its obligation. In exchange
this Company passes on a floating rate of interest to the counterparty Company
to satisfy the latters floating interest obligation. The principal amount to be
reckoned for the purpose of calculating the two interests (called the Notional
principal), and the benchmark interest rate to be used for the purpose of
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determining the floating rate are decided at the time of entering into the
contract. Swaps are dealt with in detail in a later module
Commodity Derivatives
The most common intuitive use of Derivatives will be in the commodity
segment, where operators fear price rise/fall based on natural weather
conditions. To safeguard their interests these operators can enter into a
buy/sell contract for the required amount of commodity Derivatives. Typically,
like all Derivatives, this does not directly result in the underlying commodity
being traded. Instead, a right or an obligation is established with respect to
the underlying commodity. This type of derivative is also used by
manufacturers and exporters who want to ensure a specified amount of
commodities to meet their business obligations. The principles involved in
these Derivatives are the same as those governing general Options.
Interest rate Derivatives
Here the parties to a transaction fear a rise or fall in interest rates in the future
and enter into a derivative transaction by which one counterparty compensates
the other when interest rises beyond the agreed rate. Sometimes these
transactions are entered into for getting compensation for interest rate
declines. The notional principal, the benchmark interest rate and the time of
reckoning all are decided at the time of entering into the contract. Interest
Rate Derivatives are covered in a later Module.
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Credit Derivatives
Bankers and lenders use Credit Derivatives to safeguard themselves against
credit defaults. There are many varieties of these Derivatives involving
sometimes the creation of a third body called a Special Purpose Vehicle. Credit
Derivatives constitute an area of great development in recent years and many
new sophisticated instruments are getting developed by the day. An
introduction to some common Credit Derivatives is given in a later module.
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Stock markets find Derivative instruments very useful and portfolio managers
find a number of uses from these for protecting and enhancing their stock
holdings. The rising volumes of Index-based and individual securities are an
indication of their growing popularity. The fact remains, however, that most
of the deals are speculative in nature and are not necessarily for risk
management. But this by itself need not be taken as an adverse factor, since
in most world markets initial uses of derivative instruments have been
basically speculative. Besides, the existence of a large number of speculators
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enables the genuine risk manager to put through his deals comfortably and
volumes will not suffer.
The regulation of the Derivatives segments has been handled by the Securities
& Exchange Board of India and the stock exchanges. Strict margins and
deposits are taken from the trading members to avoid defaults and payment
problems.
1.7 Summary
The study of Derivatives involves an approach different from the customary.
In conventional analysis, trading involves buying and selling an asset. In the
Derivatives segment, trading involves not the selling and buying of the asset
itself, but a right on the asset. This right does not carry with it any obligation
and comes at a price called the premium. There are many types of derivative
instruments, the most notable among them being Forwards and Futures,
Options and Swaps. In addition, Interest Rate Derivatives and Credit
Derivatives have become very popular in the US and other countries in recent
years. Derivatives are useful for managing the risk of an organization. Usually
companies develop a strategy for active risk management using Derivatives.
The stock-based Derivatives have become very popular in India and result in
great trading volumes. In India, Forwards and Futures are in great use in the
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2.1 Objectives
The objectives of this unit are
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commodity at Rs.50 per kg. He expects the price to be steady at this level even
after 3 months when the crop will be ready, but fears that some adverse
movements in other sectors might result in a fall in the price. To safeguard
himself he enters into a Forward contract for the quantity at around Rs.50 per
kg. The contract in effect means that he is obliged to surrender 500 kgs of the
commodity after 3 months in exchange of getting Rs.25000 (500 multiplied by
Rs.50). Now, if as feared, the prices fall to a level less than Rs.50, the farmer
will still get Rs.25000 calculated at Rs.50 per kg, because that is the agreed
rate. However, if the price rises above Rs.50 to say Rs.60 per kg. the farmer
loses on the opportunity profits, since he is obliged to fulfill his Forward
contract at Rs.50 per kg. and will not be able to participate in the higher profits.
Thus, in a Forward/ Futures contracts, one of the parties to the contract is
likely to lose out on the deal in the final analysis.
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contract will stand to gain more in the final analysis, but what it ensures at
the time of entering into the contract is that the risk element is eliminated.
To take the opposite situation, an importer of goods from the US has to pay
$75000 after 3 months. The invoicing is in $ and so the importer is exposed to
exchange rate risk. The importer is apprehensive that the amount to be paid
may become more in terms of the Indian rupees because of adverse movements
in the foreign exchange market. To ensure that the amount is frozen, the
importer can enter into a Forward agreement to buy $ at a predetermined
price. At the expiry of the period, the importer pays the agreed amount in
Rupees for getting $75000. The amount to be paid in Indian Rupees does not
vary with the then prevailing exchange rate. Even if the exchange rate
movement is adverse, the importer is not affected since the amount to be paid
in exchange has been firmed up in advance. However, like the contract for
selling foreign currency seen earlier, here again one of the parties would lose
opportunity gains in the final analysis depending upon the exchange rates at
the time of expiry, but it ensures that the risk is eliminated at the time of
entering into the contract.
Futures contracts work in exactly the same way as the Forwards, except that
they are better regulated. The quantity of the underlying asset that is to be
contracted is in specified lots and the time of expiry is also pre-fixed. For
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instance if the importer wants to sell Rs.50000 worth Forward for a period of 3
months, she has to sell this in an exchange contracts corresponding as nearly
as possible to the amount and the horizon needed. Thus if a standard Futures
contract is for say Rs.10000, 5 such contracts have to be sold and if the
contracts expire in 2 months or 6 months, the former is chosen being the
nearest to the horizon needed. There are other structural differences in
Futures as well like the margin requirement, mark-to-market rules and
settlement. These are dealt with in detail later in the Module.
A trader in the same area is prepared to get into an agreement with the farmer
to buy the harvest from him at a rate of Rs.2.90 per kg., provided the farmer
commits to the quantity and price today. In other words, the farmer would be
obliged to sell 10000 kgs of the commodity after 3 months at a price of Rs.2.90
per kg. and the trader would be obliged to buy the quantity at the price. This
will be regardless of what the final price of the commodity is to be at the end of
3 months.
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If he accepts this offer today, the farmer is able to make sure that he gets
Rs.2.90 per kg and he can stop worrying about any possible fall in prices in the
interim. However, he has to continue to worry about obtaining the harvest of
10000 kgs In case the harvest is not as successful as anticipated and he ends
up having only less than 10000 kgs. ready, he will be forced to buy from the
market the difference in quantity and meet his obligation to the trader.
As far as the trader is concerned he has ensured that he will get a supply of
10000 kgs. of the commodity at a pre-determined price, and he does not now
have to worry either about changes in prices in the interim, nor about the
availability of the quantity.
This is an example of a short hedge as far as the farmer is concerned and a long
hedge as far as the trader is concerned. In a short hedge the individual is
concerned about fall in prices and sells the commodity in advance at a
predetermined price. In a long hedge the individual is concerned about the rise
in prices and ensures the price by buying the commodity at the predetermined
price. In either case the quantity is frozen.
The short hedge has enabled the farmer to reduce his anxiety about the prices.
Now regardless of the actual movement of prices in the market the farmer will
get Rs.2.90 per kg. If the price at the end turns out to be Rs.2.40 say, he can
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congratulate himself for having entered into the Forward agreement, enabling
him to force the counterparty to buy from him at 2.90 per kg. On the other
hand, if the price rises beyond 2.90 to say Rs.3.20 per kg. the farmer might feel
let down in that he would have been better off without the Forward contract
and would then have been able to sell at Rs.3.20 per kg. The Forward would
force him to sell at Rs.2.90, even though the actual rate at that time is Rs.3.20.
This is the price he pays for ensuring a minimum amount. He will not be able
to participate in upward movement of prices
The long hedge has enabled the trader to reduce his anxiety about prices. Now
regardless of the actual movement of prices in the market the trader will have
to pay only Rs.2.90 per kg. If the price at the end turns out to be Rs.3.20 say,
he can congratulate himself for having entered into the Forward agreement,
enabling him to force the counterparty to sell to him at 2.90 per kg. On the
other hand, if the price falls to say Rs.2.40 per kg. the trader might feel that he
would have been better off without the Forward contract and would then have
been able to buy from the market at Rs.2.40 per kg. The Forward would force
him to buy at 2.90, even though the actual price at that time is Rs.2.40. This
is the price he pays for ensuring a Forward amount. He will not be able to take
the benefit from downward movement of prices.
In the following example the possible payoff from a short hedge can be seen.
The situation involves selling Forward at Rs.101.51 for 3-month duration. If
the price ends up at Rs.95, he will gain Rs.6.51 on the Futures, but will be able
to sell in the market at Rs.95, making totally Rs.101.51.
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If the price is Rs.103, he will lose Rs.1.49 on the Futures, but can sell at Rs.103
in the market, thereby making a total of Rs.101.51.
95 6.51 101.51
96 5.51 101.51
97 4.51 101.51
98 3.51 101.51
99 2.51 101.51
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Taking the same situation the position in respect of a long hedge is shown
below. Here again the long hedge has been made at Rs.101.51 for 3-month
duration:
If the price ends up at Rs.97, the long hedge would have to suffer a loss of
Rs.4.51 on the Futures contract, but can get the product at Rs.97 from the
market; thereby the total cost will be Rs.101.51. If the price ends up at Rs.103,
he gains Rs.1.49 on the Futures contract, but has to buy from the market at
Rs.103, resulting in a net position of Rs.101.51.
97 -4.51 101.51
98 -3.51 101.51
99 -2.51 101.51
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The theoretical correct price for a Forward contract which has 3 months to go
on a spot price of Rs.40 and an interest rate of 5% can be calculated using the
formula given below:
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If the price is greater than 40.50 say Rs.40.75, then an alert operator will sell
the Forward at 40.75 and buy the spot asset at 40. The spot asset will be
bought using borrowed funds which will necessitate an interest payment of
Rs.0.50 for the 3 month period. (Interest is calculated on a principal of Rs.40
for a period of 3 months at an interest rate of 5%, using the continuous
compounding method). On the expiry of the period, the operator will sell the
asset (which he had bought originally in the spot market using borrowed funds)
at Rs.40.75 based on the Forward contract. He will repay Rs.40.50 for the loan
(Rs.40 principal and Rs.0.50 interest) and pocket the difference of Rs.0.25 as
risk-free profit. As more and more operators do this the price will come back
to its equilibrium level of Rs.40.50 for the Forward contract.
If the price is less than Rs.40.50 say Rs.40.25, then an alert operator will sell
the asset in the spot market at Rs.40 and buy the Forward at Rs.40. 25. The
amount got out of selling the spot asset (Rs.40) will be invested in risk-free
securities earning an interest of 5% for 3 months. i.e. Rs.0.50 (The interest is
calculated on a principal of Rs.40 for a period of 3 months at an interest rate of
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5%, using the continuous compounding method). On the expiry of the period,
the operator will buy the asset based on his Forward contract by paying
Rs.40.25. He will receive Rs.40.50 from his investment (Rs.40 he got out of sale
of the spot asset plus the interest of Rs.0.50 for the 3-month period), thereby
resulting in a net gain of Rs.0.25. As more and more operators seize on this
risk-free opportunity, the prices will reach back the equilibrium level of
Rs.40.50 for the Forward contract.
More aspects of the cost of carry principle and the risk-free arbitrage are
covered in a later unit.
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3. A Futures contract will entail a margin for avoidance of default and this
amount has to be remitted from time to time to the exchange based on
extant regulations. In a Forward contract, there is no standardized
margin but this can also be incorporated as a condition to the contract
by the parties concerned.
4. A Futures contract is monitored on a regular basis by the regulating
authority and hence entails a mark-to-market margin. Thus, if a trader
has bought a Forward contract of 3 months for a commodity at Rs.50 and
if the price is Rs.40 after a week of entering into the contract, the
exchange may require him to pay up the difference of Rs.10 on each
contract. This is because the adverse price movement might result in
ultimate default and the mark-to-market enables the contract to be
scaled up or down to the current market levels. Mark-tomarket margins
are generally not insisted upon in a Forward contract.
5. A Futures contract is cash settled. This means that that the final price
of the underlying is compared to the rate agreed upon and the difference
either paid or received from the parties concerned. Actual delivery of
the underlying is not done. A Forward contract, on the other hand, can
be of cash settled or based on physical delivery.
2.6 Summary
Forwards and Futures constitute the simplest of derivative instruments. They
are in wide use for risk management. A Forward contract facilitates the buying
or selling of an underlying asset at a pre-determined price after a specified
period. A Futures is similar in operation to Forwards except for structural
variations on account of contractual specifications, margins and mark-to
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market. A long Forward contract obliges the buying of the underlying asset
and a short Forward contract obliges the selling of the underlying asset.
Forwards and Futures are used widely in the hedging of price risks. While the
practice of hedging enables the avoidance of price risk, traders find that
occasionally they lose out on opportunity gains because of price movements
which turn out to be more favorable than expected.
The pricing of Forwards and Futures follow the cost of carry principle.
According to this, the price at the time of its inception has a definite
relationship with the spot price and is generally represented by the interest for
the period involved. If the price does not conform to this pattern it is possible
to enter to arbitrage and make risk-free profits. That fact that a number of
operators will embark upon this arbitrage will result in the prices once again
coming to the equilibrium levels.
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3.1 Objectives
The objectives of this unit are:
3.2 Introduction
The basic hedging model was introduced in the previous unit. Hedging is an
important requirement for all mangers. Based on price fluctuations and
market behavior, managers will tend to hedge their exposures short or long.
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entered into by those fearing price rises. By buying the Forward, they
seek to freeze the prices upper limit. A short hedge is used by those
fearing price falls. A short hedge signifies selling of the Forward or
Futures. By selling the Forward or Futures they seek to freeze the prices
at a level.
2. Hedging is a double-edged sword. While the hedge does offer protection,
it would also mean that if the prices do not move in the direction feared,
one might lose a chance for bonanza profits. Thus in a long hedge if the
price ends up well below the level expected, the hedge would force the
operator to the Forward/Futures price, resulting in an opportunity loss.
In the same way, if the price is greater than anticipated then the short
hedger suffers an opportunity loss. However, in both the cases, the
operators would have frozen upon a level of prices which is acceptable to
them. It is only the opportunity of higher gains that they lose in the
process.
3. Hedging is a part of the strategic process of companies. They generally
have a policy as to how much of their exposure to hedge and the price
bands at which these should be carried out. Companies tend to leave a
portion of their exposure open. The farmer expects to produce 10000 kgs
in 3 months might decide to hedge only 6000 kgs and leave the
remaining 4000 kgs unprotected.
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Let us assume that the actual price of the commodity has gone up to Rs.290 per
unit after three months. This was what the exporter had feared. However, since
he had the foresight to go in for a Futures contract his interests are protected.
Now he gets delivery of the commodity at Rs.256 per unit which is the agreed
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price under the Futures contract. The actual price of Rs.290 does not affect
him.
If, however, the price in the spot market ends up at Rs.240 per unit, the
exporter loses Rs.16 on the Futures contract (Rs.256 per unit which is his
contracted price minus the actual spot price of Rs.240). In such a case the
exporter is not able to take advantage of the fall in the prices and still ends up
paying Rs.256 per unit. As we have seen this is the sacrifice he makes for
seeking a hedge using Forwards or Futures.
To take an example a Company fears that the price of its output will come
down. It expects 5000 units of output by the end of next 3 months. The current
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output price is Rs.50 per unit. The Futures for the output asset are currently
going at Rs.54 per unit for a 3 month contract. Again the reader would have
noticed that the Futures price does not strictly conform to the cost of carry
principle. This will be looked at in detail in the next unit.
Similarly, in a short hedge the operator can use Futures by selling the Futures
today. As we have seen the Futures will conform more or less to the cost of
carry principle. After the specified period of contract he will be able to get the
difference between the price at which he sold the Futures, from the commodity
exchange and the actual price in the spot market. If, however, the spot price in
the end happens to be higher than the price at which he sold the Futures, he
will have to pay the difference to the exchange.
Fearing a decline in prices our Company goes for a short hedge by selling the 3
months Futures at Rs.54 per unit for the required quantity. After 3 months if
the final price is say Rs.40 the Company is protected by the Futures contract.
The cash settlement from the Futures contract will give the Company Rs.14
per unit (Rs.54 contracted in the Futures minus the end spot price of Rs.40)
.The Company will sell the commodity in the market atRs.40 and along with
the Rs.14 got from the Futures exchange will be able to pocket Rs.54 per unit.
Here again the procedural difference between a Forward contract and a
Futures contract may be noticed. In the Forward contract the Company would
have been able to sell to the counter party the quantity contracted at Rs.54
directly. In the Futures contract because it is cash settled only the difference
between the Futures contracted price and the actual price in the end is handed
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over to the Company. The actual buying of the commodity has to be done by
the Company through the regular market.
Continuing the example if it so happens that the final price were Rs.70 per unit
the Company will not be able to take advantage of the increase in prices.
Although it will still be able to sell the output at Rs.70 per unit to the market,
it will suffer a loss of Rs.16 (final price of Rs.70 minus contracted price of Rs.54)
in the Futures market resulting in a net inflow of only Rs.54 per unit. This is
the sacrifice for freezing a price using Forwards or Futures.
In order to ensure that the parties entering into a Futures contract meet the
stringent requirements of payment, stock exchanges insist on margins.
Margins are amounts required to be paid by dealers in respect of their Futures
positions. There will be initial margins, some special margins imposed from
time to time and mark to market margins.
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Mark to market margins result in the dealer having to pay margins specially
for meeting the adverse movement in underlying positions as a result of
changes in spot prices. Some exchanges insist on maintenance margins which
mean that the trader is required to pay additional margin when the mark to
market position falls below a trigger point.
1
Example adapted from Derivatives Valuation and Risk Management, by Dubofski and Miller, Oxford
Press
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On 5th Nov when the contract was entered into the price was Rs.285. The
trader had taken a short position in Futures and has paid an initial margin of
Rs.1000. On 6th Nov the price fell to Rs.286.40 resulting in his effective margin
amount falling to Rs.860, as shown under column Equity. The next day the
spot price was Rs.288.80 resulting in a further depletion of Rs.240. As shown
under the Equity column the margin now is only Rs.620. Since the
maintenance margin is Rs.750 and the Equity has fallen below that level the
trader is required to replenish the margin to the original level of Rs.1000. This
entails a payment of Rs.380 from his side as shown under the column
Maintenance margin. This procedure goes on till the end of the contract. The
last two columns show the effective Equity position and the margin position
from time to time.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Basis refers to the difference between the Spot price of the asset and the
Futures price of the asset. Let us work with the following symbols
S1 = Spot at time t1 S2
= Spot at time t2
F1 = Futures at time t1
F2 = Futures at time t2
B1 = Basis at time t1
B2 = Basis at time t2
Suppose the spot price of an asset at inception was Rs.2.50 and the Futures
price at that time was Rs.2.20. After 3 months, the spot price becomes 2.00
and the Futures price at that time is Rs.1.90. Here the basis at the beginning
(B1) is - 0.30 and the basis at the end (B2) is - 0.10
When the spot increases by more than the Futures, Basis strengthens
When the Futures increases by more than the Spot the Basis weakens
In a hedge the final price =
S2 + F 1 F 2
This is equal to F1 + B2
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
F1 is known at inception
If we can correctly estimate B2, the hedge can be perfect
The above situation can be elaborated a little more. At the time when the
contract is entered into there is a spot price for the asset and a corresponding
Futures price. Normally, the Futures will conform to the cost of carry principle
and can be determined fairly accurately. But the actual Futures price may not
sometimes conform to the cost of carry rule for various reasons discussed in the
next unit. The difference between the spot and the Futures price at the start is
the basis at the beginning. As time goes on, the spot price changes and the
Futures price also changes. At the expiry time, which is the next crucial
juncture, the Spot and the Futures are at another level of difference between
each other. Occasionally, the difference levels will remain identical.
Sometimes the differences go up or come down. When the difference goes up
(Spot Futures goes up), the basis is said to have strengthened. When the
difference comes down (Spot-Futures comes down) the basis is said to have
weakened.
A short hedger expects prices to come down and hence has sold the Futures.
At expiry, he settles his position with the Futures price at the end. If the
Futures price at the end is in line with the Spot at the end in exactly the same
level as the difference at the beginning, the basis is the same. In such a case,
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
the hedge will be perfect. He will realize exactly what he sought out to do. For
instance, the spot at the beginning was Rs.100, and the Futures were 102. He
had sold Futures at Rs.102. At the end the spot is Rs.85 and the
Futures is Rs.87. Now he realizes Rs.15 (the difference between 102 and 87).
Suppose the basis had strengthened, the Futures price would have been less
than Rs.87, say Rs.86. the basis at the beginning was (-2) and it has now
become (-1). The (-2) difference has become (-1). The hedger would make Rs.16
(difference between 102 and 86). Here the short hedger has benefited from the
basis strengthening.
On the other hand, if the basis had weakened and if the final Futures price is
88, the hedger would have made only Rs.14 (102-88). He would have lost out
of the basis weakening. The basis originally was (-2) and it has become (-3).
The converse is true of a long hedge. Here the hedger had bought the Futures.
If the spot initially was Rs.200 and the corresponding Futures was
Rs.203 at inception. At expiry the spot is Rs.240 and the Futures Rs.243. Here
the basis remains the same at the start and at the end. So there is no gain or
loss from basis risk. The hedger would get Rs.40 (243-203) from the long hedge.
If the basis had strengthened the Futures would be Rs.242 for instance. The
basis originally was -3 and it has become -2. Here the hedger would get only
Rs.39 (242-203). He has lost on the basis strengthening. If, the basis had
weakened and the Futures price at the end was say 244, he would have gained
Rs.41 (244-203). Here the original basis was (-3) and the final basis was (-4),
so the basis had weakened.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Basis risk arises because the hedge position cannot possibly go on up to the last
date desired. If the horizon required by the hedger exactly conforms to the
horizon of the Futures contract then there will be only negligible basis risks.
The principle of convergence which avoids basis risks is discussed in detail in
the next unit.
A change in basis can result from a change in the risk free rate of interest,
change in floating funds, change in the availability position of the assets and a
phenomenon called convenience yield.
Cross hedges have greater basis risks because the underlying assets are
different.
Even though basis risk is a very real factor, the fact that un-hedged positions
carry greater risks means that former can be ignored as a factor in hedging.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
In such cases the Company has to identify another asset which is covered by
going Forward/Futures contracts. Having identified the asset which is similar
in nature to the asset on which the Company wants a hedge, the extent of the
relationship should be estimated. There is no hard and fast rule for this
estimation.
To take an example a farmer expects 500 kgs of onion in the next three months.
He would be happy to be able to sell the output at around the price of Rs.15
prevalent today. Unfortunately for him there is no Forward/Futures contract
which would have enabled him to go in for a short hedge. He however, notices
that there are running contracts of Forwards/Futures in respect of potatoes.
Based upon his past experience he feels that the price movements of potatoes
and onions are perfectly co related. In other words a Re 1 increase in the price
of onion is generally concurrent with a Re.1 increase in the price of potato. So
he performs his short hedge using his Futures potato contracts. He will short
hedge by selling 500 kgs of potatoes in the Futures market at Rs.15 per kg. If
after 3 months the price of potatoes falls to say Rs.12 he will be able to enforce
his Forward/Futures contract by being able to get a selling price of Rs.15 per
kg. What this effectively means is he will be able to buy from the spot market
at Rs.12 per kg then and sell it at Rs.15 to Forward/Futures market at Rs.15
per kg thereby making a gain of Rs.3 per kg. Corresponding to the decline in
potato prices the onion price would have also be fallen to around Rs.12 per kg.
But the farmer is protected in the sense that he will be able to sell the onions
at Rs 12 per kg in the market and get Rs.3 per kg as gains from the potato
future contract. Effectively he is able to get Rs.15 per kg which was what he
wanted in the first place.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The practice of hedging with a different asset to the asset of interest to the
hedger is called cross hedging. The following aspects may be noted in respect
of cross hedges.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
3.7 Summary
Hedging constitutes the most important use of Futures. Hedges are either long
or short. In a long hedge a Futures contract is bought and in a short hedge a
Futures contract is sold. Hedging is a double-edged sword. It offers protection
for adverse movement of prices but prevents the hedger from participating in
extreme favorable movements.
When a Futures contract is not available for a specific underlying asset it may
become necessary to hedge with another asset similar in nature to the desired
underlying. This is called cross hedge. Here the hedger will have to estimate
the extent of change likely to occur in the second asset for a change in the
underlying asset. Accordingly the desired number of contracts is entered into
on the second asset - either as a short hedge or a long edge. If the estimated
movements of the two assets are in conformity with expectations, a cross hedge
will perform as efficiently as a regular hedge.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Mark-to-market
4.1 Objectives
The objectives of this unit are:
4.2 Introduction
The basic principle of cost of carry and its application in Forward/Futures
pricing was introduced in an earlier unit. Operators in a stock exchange should
be well-versed with principles governing the pricing of Derivatives, to enable
them to use these in the right manner. These postulates in pricing are
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
intricately connected to basis risk and other economic imbalances that might
be existent.
In case a specific dividend is expected from the asset during the period of the
contract, the formula has to be modified as follows:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The impact of the time and rate of interest on the cost of carry can be seen with
an example.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Assuming the asset price today is Rs.200, the time to expiry of the Futures
contract is 3 months and the interest rate to be 6% p.a, the Futures price should
be Rs.203.02, based on the cost of carry principle. This is calculated as
The time has been taken as 0.25 (3 months), and the rate of interest in decimals
is 0.06.
The impact of changes in interest rates and time to expiry on the Futures
contract is shown in the following table:
The table shows the relative impact of interest rates and the time to expiry
(both expressed in decimals). As the interest rates go up, keeping the time
constant, the Futures price goes up. This is intuitive in that a greater rate of
interest results in greater cost of carry. Similarly, as time goes up, keeping the
interest rate constant, the cost of carry goes up. This again is intuitive in that
the greater the time period, the greater the carry element.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
In Futures contracts, the cost of carry has to factor in the possible margins and
the interest thereon into the calculations.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Suppose the price is only Rs.101, operators will seize the opportunity to buy
Futures at 101 and sell the spot asset at Rs.100. In 3 months they will earn
an interest of Rs.0.51 on the sale proceeds of the spot asset, and use Rs.101 of
this to buy back the asset. The difference of Rs.0.51 is their risk-free profit.
There will be a gain regardless of the final price of the asset. This is shown in
the following table:
Table I.4.2 Arbitrage when actual Futures is less than theoretical price
If final gain on gain on total net gain
interest
price is spot Futures gain
-2 1 -1 1.51 0.51
99 1 -2 -1 1.51 0.51
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
As more and more operators take this opportunity, the price of the Futures will
get automatically adjusted to the theoretical level of Rs.101.51.
In the same way, if the final price is Rs.102 (greater than the theoretical level),
alert operators will sell Futures and buy the asset in the spot market at Rs.100.
They will borrow Rs.100 for buying the asset spot. They will incur an interest
of Rs.1.51 over the 3-month period for the borrowed money. They will, however,
realize Rs.102 from the sale of The Futures. This will be available to them
after 3 months, and they will use Rs.101.51 of that for repaying the interest
and principal of the loan, thereby pocketing the difference as risk-free profits.
The risk-free profits will be available to them regardless of the final spot price,
as shown in the following table:
Table I.4.3 Arbitrage when actual Futures is greater than theoretical price
End gain net gain
gain F tot gain int. loss
spot spot
99 -1 3 2 1.511306 0.49
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
As more and more operators take this opportunity, the price of the Futures will
get automatically adjusted to the theoretical level of Rs.101.51.
While the possibility of arbitrage ought to restore the Futures prices to their
correct theoretical position, the following factors need to be considered:
1. For arbitrage to be possible, the information regarding Futures prices
should be constantly available to all possible dealers. In India, stock
markets work on an online real-time basis andhence the information will
be readily available. In the commodity segment and the foreign
exchange segment, information may not be that easily available and this
factor will create the difficulty for arbitrage.
2. When the actual Futures prices are greater than the theoretical level,
the dealer will seek to sell Futures and buy the Spot. For buying the
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
A typical study on the behavior of Futures prices to changing spot prices would
look at spot rates at various dates and compare these with the corresponding
Futures rates. Over a period of time, the interest rate taken by the market can
be intuitively understood. When this rate is steady over a period of time, we
can gather that the cost of carry principle holds and that the interest rate
attributed is rigid. However, studies of this nature have found the cost of carry
varying from week to week and sometimes even day to day.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Let us take the case of a trader wanting a long hedge for a period of 6 months.
He fears that the prices will go up for the commodity in 6 months and wants to
lock in the price at a level. He understands that a Futures contract on the
commodity will be the ideal answer to his problem. However, he finds that
Futures contracts exist only for a 3-month horizon, while his requirement is for
6 months.
In such a case, he can go in for rolling the hedge forward. We can look at this
phenomenon through an example (all figures in Rs.):
The rolling of the hedge forward involves first taking Futures of a suitable
duration and just before its expiry, squaring it off and going in for a new
Futures contract. If the horizon is not met even after the second set of Futures,
the process is repeated as many number of times as makes the horizon match.
In the above example it would not have mattered if the Spot price at the end of
3 months had actually been less than the original. The square off will be done
at the spot price at end of 3 months ( the Futures will be very near this spot
price near expiry because of the principle of convergence and low cost of carry)
and the new Futures will be taken up at around the same price.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Risk-free rate of
interest
6%
After 3 months
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
After 6 months
Sometimes tracking errors can occur and there could be resultant differences
in the prices of square off and new Futures. So the gains listed above may not
always occur accurately. But hedging is all about approximation and the
trader will continue to be covered by and large.
One great disadvantage of rolling the hedge forward is the high amount of
transaction costs that are likely to be incurred in the process. Ultimately, like
a single-period hedge, a rolling of hedge is also a double-edged sword. If the
price movements are not as anticipated, the potential for participation in these
will be foregone. However, the rolling process can be reviewed at the end of
each interval.
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4.7 Summary
The principles of hedging for Forwards and Futures are substantially the same.
In Futures, we also have to reckon the question of margins. A long hedge
involves going in for buying the Futures contract fearing a price rise. A short
hedge involves going in for selling the Futures contract fearing a price fall. In
either case, the hedge is based on the going Futures prices, which, in turn is
expected to conform to the cost of carry principle.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
level. However, there are certain economic factors which may prevent perfect
arbitrage. These could also be sometimes regulatory in nature. In such cases
the Futures prices will not conform to the cost of carry principle and what is
more, may sometimes go into backwardation.
Empirical evidence on these prices has not established that cost of carry as a
principle will always hold good. In fact, the evidence has been weighed in favor
of its not holding most of the time.
When the horizon of the hedger does not match the horizon of a Futures
contract, the hedge can be rolled forward. This involves taking a Futures
shorter than the required horizon at first and then shifting this to other
Futures on the expiry of the first. By and large this will result in a perfect
hedge. However, high transaction costs and occasional tracking errors might
result in some losses. Like a regular hedge the rolling hedge will also be able
to ensure around the agreed price regardless of the movement of spot prices.
By the same token, any unforeseen profits cannot be participated in because a
Futures contract is a commitment at a particular level.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
5.1 Objectives
The objectives of this unit are:
5.2 Introduction
Several years after Futures trading got into full swing in both the NSE and the
BSE, the investing community in India does not appear to be fully aware of all
the possibilities that these offer. This unit attempts to draw attention to
common uses and certain possibilities of sophisticated uses of Index Futures.
At a given point of time, there are three Futures being traded in each exchange
one expiring on the last Thursday of the third month from the date of the
trade, another expiring on the last Thursday of the second month from the date
of the trade and yet another one expiring on the last Thursday of the month
succeeding the date of the trade. The 3-month Futures of today will thus
become the 2-month Futures after one-month and a 1-month Futures after 2
months. The permitted lot size of S&P CNX Nifty Futures contracts is 200 and
multiples thereof. The spot price at the expiry of the last trading day will be
reckoned as the converged Futures price for settlement purposes. In other
words, this means that as on the last date of trading of the Index Futures, the
Futures price will equal the spot price. For instance, if Futures are expiring on
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
27th July 2000, the final rate for this will be exactly equal to the spot Index
rate on that day. As a corollary, it means that the differences between the
Futures price and the spot price will narrow down as the expiry date
approaches.
Details regarding the rules of trading and settlement can be had from the
NSE web site - www.nse-india.com
The most popular stock Index in India is the S&P Nifty Index and the Junior
Nifty Index, managed by the National Stock Exchange, and is taken as the
basis. The S & P Nifty Index is based on the following principles:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The stocks in the Index are among the top market capitalized companies in the
country. The stocks in the Index are liquid by the impact cost criterion. The
liquidity of stocks at the given price level is tested by relative price
determination. The market impact cost tends to accurately reflect costs faced
when actually trading an Index.
In order to qualify for S&P CNX Nifty, the criteria is that it has to reliably have
a market impact cost of below 1.5%, when doing S &P CNX Nifty trades of 5
million rupees. Among the shares that get so qualified, the 50 companies with
the maximum market capitalization go into the Index. The next 50 companies
with the same criteria go into the JUNIOR NIFTY category.
NIFTYs structure is based on a paper by Shah and Thomas (1998)2. The paper
looks at the question of illiquidity of market indices and how this can influence
Index construction. The authors say that the evidence against hedging
effectiveness and the evidence on the impact cost of alternative Index sets led
to the choice of NSE Index in 1996. Two rules govern the ongoing modifications
to the Index set:
2
Shah Ajay and Thomas Susan, Market Microstructure considerations in Index constructions, 1998
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
There are three Futures going in the market at a given point of time.
Theoretically, these three Futures must be all following the cost of carry
principle and hence the longest Futures (3-month Futures) must have a
price proportionately higher than the 2-month Futures and the 1-month
Futures.
As maturity draws near, the cost of carry keeps coming down until, on
the date of expiration of the Futures the price converges with the Spot
price. Here there will be no cost of carry and hence the Spot price and
the Futures prices will be equal.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
that needs to be bought as one lot. This figure changes from time to time
and from exchange to exchange. The current rules followed in the
National Stock Exchange can be seen from their website3
Further, if the holding period matches with the horizon of the Futures,
a perfect hedge is possible
Additionally, Index Futures offer Cross hedges and rolling the hedge
forward in a more structured manner. Besides, there are several
advanced uses for Index Futures discussed below.
Suppose this relationship does not hold, the Futures are incorrectly
priced and this gives rise to a theoretically risk-free arbitrage. For
instance, if the Futures price is lower than the theoretical price
described above, it will be worthwhile for a share dealer to buy the
3
www. nse.co.in, giving full details of settlement and margin positions for Futures
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Futures and simultaneously sell the spot, The proceeds from the sale of
the spot could then be invested in risk-free securities and at the end of
the tenure when the Futures contract expires, he would buy the stock
back on the strength of the Futures contract at a cost less than what his
investment has yielded. He thus makes a clean risk-less profit. As more
and more investors like him do this Futures prices will find its correct
level vis-a vis the spot. This is illustrated in the box alongside
Suppose the spot Index price is Rs.1250 and the one-month Futures are trading
at 1280. Assuming that the risk-free rate of interest will yield an interest of
Rs.10 on Rs.1250, the theoretical Futures price ignoring dividends is Rs.1260.
Because the actual price is Rs.1280, dealers in the market can sell the Futures
at Rs.1280 and buy the spot at Rs.1250. After one month, on the convergence
date, the spot and the Futures will be priced identically by rule. At that time
our dealer would square up the Futures position by buying back and
simultaneously sell in the spot market. The outcome of his deals will be as
follows. It has been assumed that the converged price after 1 month is Rs.1290.
It does not make any difference what that price is, because, both the spot and
the Futures will be priced identically then.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Now let us take the converse case. If the actual Futures price were higher than
the theoretical Futures price, the trader would borrow money and buy the spot
and sell the Futures. At the expiry of the Futures contract, he would offer the
stocks in delivery and collect the proceeds, which will be higher than the price
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
of the stock plus the interest. Again, he makes a risk-free profit. As more and
more people do it, the Futures price will find its correct level, vis-a vis the spot.
Suppose the spot is Rs.1250 and the Futures are Rs.1220. Assuming a
theoretical cost of carry of Rs.10 on the Rs.1250, the Futures price ought to be
Rs.1260. Since it is trading at a discount to this, dealers will buy the Futures
and sell in the spot segment. For doing this, they would require ready delivery
of the stocks constituting the Index, in the proportion as near as can be to the
Index. Alternatively, they must have access to stock borrowing facility.
Otherwise, they could be a portfolio holder seeking to take advantage of the
disparity. After one month, convergence of prices takes place. Then the Index
Futures position is squared off by selling and at the same rate the stock is
bought back.
This results in a risk-free gain of Rs.40. (The gains of Futures is Rs.70, the cost
of carry gain is Rs.10, but the loss on stock is Rs.40). As more and more dealers
indulge in this, the Futures price adjusts itself to the theoretically correct level.
Two aspects need elaboration here. When we say, buy spot or sell spot, we
refer to the buying or selling of all the stocks that
constitute the Index in the same proportion as in the Index. This may, at first
sight, seem an impossible task given the fractional composition of the stocks in
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Sell Futures Rs. 1290 (+) Actually, the Futures contracts do not
result in a delivery situation at all, If
Now, why should the actual Futures price vary from the theoretical Futures
price at all? The explanation is that arbitrage though theoretically available,
will not always be practicable. Transaction costs, absence of sellable stock,
difficulty in borrowing, or the absence of a suitable counter-party to conclude
deals, could contribute to this phenomenon.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Another aspect to be noted in this context is the risk-free interest rate needed
for arriving at the theoretical Futures price. For the theory to be absolutely
correct, money must be freely borrowable and lendable at the risk-free rate.
On account of transaction difficulties, the cost of carry might be reckoning a
slightly higher level of interest than the conceptual risk-free rate.
Dividend yield has been ignored in the above calculations. To the extent of the
dividend yield, the cost of carry will be lower. This is so because the holder of
the spot is partly compensated for his invested capital by the dividend that he
receives.
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The Optimal Hedge ratio tells us the number of Futures contracts to be used
for hedging given a value of the portfolio now and the value of a typical Futures
contract.
If an asset manager has a portfolio worth Rs.15 lakh consisting of shares in the
same proportion as the Index itself, and if the size of a typical Futures contract
as specified by the exchange is Rs.3 lakh, then she will have to go in for 5
Futures (Rs.15 lakh portfolio value divided by Rs.3 lakh being the value of one
contract) for hedging purposes. In this case the calculation is straightforward
as the asset managers holding is a market portfolio and therefore has a Beta
of 1.
If the portfolio held is different from the market portfolio and has a Beta of say
0.8, then the value to be hedged using the Index Futures is 0.8 multiplied by
Rs.15 Lakh = Rs.12 lakh and since one contract is of Rs.3 lakh, 4 contracts will
suffice. The reason for the difference between the two situations is that in the
former the Beta being 1, any change in the market portfolio is fully represented
in the Index. In the latter case, the portfolio is different and experience tells
us that we require only lesser number of Futures contracts to hedge our
position, since the volatility of the portfolio is less than that of the Index.
Conversely if the portfolio Beta had been 1.2, the value to be hedged would
have been 1.2 multiplied by Rs.15 lakh, coming to Rs.18 lakh, divided by the
standard contract size of Rs.3 lakh, = 6 contracts.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Beta of 0.8. She feels that the market is showing a bullish trend and in order
to participate in the upward movement wants to temporarily increase the Beta
of her portfolio to say 1.2. The most obvious way of achieving this would be to
buy new stocks with a higher level of Beta and simultaneously selling some
stock from the existing portfolio in such a way that the Beta is on a weighted-
average basis 1.2. However, this will involve complications of rebalancing the
portfolio and consequent transaction expenses. Besides her intention is not to
permanently change the portfolio but only to change it temporarily. The
answer for her would be to go in for Index Futures to the extent of the difference
in the two Betas.
She will buy Index Futures to the extent of -> {Portfolio Value now * (Desired
Beta Existing Beta)/ Value of 1 contract}. In the above example her target
Beta is 1.2 as against the existing Beta of 0.8. The difference is 0.4 to which
extent she wants new contracts. Thus she has to take Futures to the extent of
Rs.6 Lakh ( 15*(1.2-0.8)). Since each contract is for Rs.3 lakh, she has to buy
2 contracts.
If the market does go up as she expects, she will have a gain from the
Futures position apart from whatever gains she has from the portfolio itself.
In the above example if she had feared a temporary fall in the market and
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
would have liked to reduce her Beta to say 0.6, she would have shorted Futures
as follows.
The portfolio value is Rs.15 lakh and her present Beta is 0.8. She wants to
reduce it to 0.6. To the extent of Rs.15 lakh *(0.8-0.6) = 3 lakh, she will short
Futures. This corresponds to 1 contract since the size of 1 contract is Rs.3
lakh. If as she expects the prices fall, she will gain from the Futures short
position.
At first glance this might look like pure speculation. But if done with a
proper estimation of Beta, this could bring in short-term profits.
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It should be noted that some of the higher uses of Futures look very much like
speculation, but is best indulged in based on specific strategies.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Portfolio managers having a horizon greater than 3 months, use the technique
of rolling the hedge forward to keep their hedges intact. Of course, tracking
errors and transaction costs make these difficult.
Dealers in the stock market also look for Calendar Spreads. If the cost of carry
principle is not uniformly held as between the Futures of various months a
strategy of selling the overpriced Futures and buying the under priced
Futures can be embarked upon, with the belief that the market will correct
itself and restore the cost of carry uniformly. The temporary anomaly can be
exploited for quick gains. For instance, if the 2-month Futures is
disproportionately high compared to the Spot and the 1-month Futures, the 2-
month Futures can be sold and simultaneously the 1-month Futures can be
bought. If the market corrects the discrepancy, the two Futures will have the
correct difference between them. If this correction takes place within 1 month,
the original positions can be reversed for profits.
5.9 Illustrations
Table I.5.1 Illustration showing convergence of
Futures prices to Spot prices in respect of Bajaj Auto
(Amount in Rs.)
Futures
Date Spot Price
Settle Price
18-Nov-05 1991.9 2,001.00
21-Nov-05 2038.05 2,049.80
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
5.10 Summary
Stock Futures constitute an important derivative and one that is most popular.
These Futures have a number of advanced and straight applications Stock
indices are based on the principle of market portfolio. A market portfolio is a
typical selection of stocks in the market which represent the market fairly
accurately.
Based on the estimation of the Beta of a portfolio and its relationship to the
market, it is possible to evolve several strategies using Index Futures. These
involve basis hedging, working on increasing the Beta and reducing the Beta
and some other sophisticated applications
While some of the strategies of an asset manager using Index Futures look like
speculation, they are based on principles of strategy and will be successful in
the long run only if based on a plan.
Index Futures are rampantly used for hedging. Hedging follows the same
principles as the regular asset-hedging, but the calculation of the Optimal
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Hedge Ratio assumes importance here. This is based on the respective Betas
of the portfolio as compared to the market and suitably adjusted to come to the
market lot.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Module 2
INTRODUCTION TO OPTIONS
1 Types of Options
1.1 Objectives
The objectives of this unit are:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
1.2 Introduction
The subject of Options has been familiar to traders and investors in many ways.
Whenever we get an opportunity to delay a decision without the foregoing of
any rights it is an option. Thus the offer coupon that comes along with the
daily newspaper inviting us to shop in a particular mall and get a discount of
10% on purchases by producing the coupon is an example of an option. The
buyer of the option in this case the newspaper reader- is under no obligation
to go to the mall and buy. Yet, he has a right to shop to get a discount. It is up
to him to exercise the right or not according to his convenience.
In the same way, sometimes vendors of goods give buyers a choice of sell-back
within a particular time and at a particular price. Thus if the buyer is not
happy with the performance of the product he can return it and obtain the
amount pre-determined. Here again, the customer is under no obligation to
sell, but can sell and obtain the price if he wants.
The above are just two examples of a variety of Options we enjoy and give in
our regular lives. What makes the study of Options exciting is the fact that
there are multiple possibilities and strategies that arise out of these
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Options have also attracted a lot of criticism for their abject misuse by certain
operators. The example of Barings disaster is often quoted for establishing the
dangers of this instrument. It should be noted that misuse of a good thing by
certain elements should not result in the instrument, which is otherwise useful
being dismissed as worthless. Necessary regulatory measures will result in
greater control over misuse, while retaining all the advantages.
Calls
Calls are rights without obligation to buy a certain underlying after a certain
period at a specified price. The buyer of the call gets a right to buy the
underlying asset, without any obligation to do so. He can enforce his right after
the specified time, if conditions favor such an action. Or, if conditions are not
favorable he can discard the right. All he will lose is what he has paid originally
as the price for the right.
Here, the enforcement of his right is called exercise. Any exercise has to be at
the pre-determined price, called the Exercise Price or Strike Price.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The price the buyer pays for getting the right is called premium. As will be
seen in subsequent Chapters, a number of considerations come into play in the
determination of this price.
The buyer of the call will enforce his right if the price of the underlying falls
above the Exercise Price. If the price is below the Exercise Price he will discard
the call.
Puts
Puts are rights without obligation to sell a certain underlying asset after a
particular period at a specified price. The buyer of the put gets a right to sell
the underlying asset, without any obligation to do so. He can enforce his right
after the specified time, if conditions favor such an action. Or, if conditions are
not favorable he can discard the right. All he will lose is what he has paid
originally as the price for the right. As in a call, the enforcement of his right is
called exercise. Any exercise has to be at the pre-determined price, called the
Exercise Price or Strike Price.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The price the buyer pays for getting the right is called premium. As will be
seen in subsequent Chapters, a number of considerations play a role in the
determination of this price.
It can be safely concluded that the buyer of the put will enforce his right if the
price of the underlying falls below the Exercise Price. If the price is above the
Exercise Price he will discard the put.
A call is said to be at the money when the actual asset price is around the level
of the strike price. If the asset value exceeds the strike price then the call is in
the money. On the other hand, if the asset price is less than the Strike price,
then the call is out of the money. The converse of the above applies to puts.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
An option that is very much in the money is also called deep in the money,
and an option that is very much out of the money is also called
deep out of the money
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American calls can be exercised at any time before the expiry. Hence the buyer
strictly need not wait till the expiry for all exercise if the price of the underline
asset exceeds the strike price at any time during the tenure, he is within his
rights to exercise. However, as we will see in a later unit it can be shown that
it is not optimal for a buyer to exercise the American power ahead of maturity.
A European put will be exercised by the buyer on expiry if the underlying asset
price is less than the Exercise Price. Here again the theory of Options assumes
investors to be rational and assumes that any put that expires in the money
will be exercised. An American put can be exercised at any time during the
tenure of the contract. Unlike the American call, it can be shown that it is
optimal to exercise the American put ahead of the expiry if the put is
sufficiently in the money.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
subsequent month and the third option two months hence. Trading is carried
out in various Exercise Prices. Whenever the underlying asset prices change
trading is allowed on new strike price to correspond to the new levels of the
underlying asset price. As with the parties to a Futures transaction, writers of
Options are required to pay margins. It can be observed that buyers of Options
need not pay any margin since they are not exposed to any risk.
A large segment of the Options market is speculative and the dealers have
naked positions in the Options and either buy or write only for speculative
purposes. Stringent margins are imposed by the exchange to avoid huge losses
and consequent pay out problems.
It has been observed that in the initial years of the introduction of Options the
premia charged for calls and puts are very high. This is particularly because
the writers are over cautious about their exposure and would like to be amply
compensated. As markets mature option combinations by various dealers
result in more rational prices.
Options are traded in the National Stock Exchange (NSE). Details regarding,
trading and settlement can be had from their website www.nseindia.com. The
key features are:
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The seller of a Futures contract is obliged to sell the asset at the price
stipulated. The writer of the call is similarly obliged to sell the asset at
the price stipulated. The only difference is that the writer of the call
gets a premium while the seller of the Futures does not.
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Even if the final price of the underlying asset ends up lower than
expected, a buyer of a Futures contract still has to buy the asset at the
agreed price. A buyer of a call is under no such obligation.
1.7 Summary
Options are a part of our everyday transaction. Broadly, Options refer to a
right without an obligation to buy or sell an asset during or after a particular
time at a specified price. A direct deal in the underlying asset involves buying
or selling the asset itself. In an Options contract the buying or selling is not of
the asset but of a right to buy or sell the asset.
A call Option signifies the right to buy while a put Option signifies a right to
sell. The seller of a call or a put is called a Writer of the Options. The
enforcement of a right to buy or sell is called exercise
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A buyer of a call will exercise his right if the underlying asset price exceeds the
strike price. A buyer of a put will have this right if the underlying asset price
is below the strike price.
Options are of two types- European and American. European Options can be
exercised only on the expiry of the tenure of the contract, while an American
Option can be exercised at any time during the tenure of the contract.
An Option is said to be in the money if the asset price is greater than the
Exercise Price for a call: or if the asset price is less than the Exercise Price for
a put. An Option is said to be out of the money if the asset price is less than
the Exercise Price for a call: or if the asset price is greater than the exercise for
a put.
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2.1 Objectives
The objectives of this unit are:
2.2 Introduction
In the last unit we have seen the basic definitions of various Options and their
general pattern of enforcement. The potential profits and maximum losses are
different for the various players in the Options market. We now look at the
general payoff of the buyers and sellers separately and draw conclusions as to
their motivations in entering into these positions.
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The examples in this unit are based on stock prices. This is because it is
intuitively easier to understand the instrument of Options through stocks more
than any other asset. Stocks are generally well traded and their price
movements are very transparent. The Options market in respect of stocks also
gets good coverage in newspapers and business dailies and therefore the
investors are well-versed with price movements. However, the broad principles
of payoff will apply for any other asset as well.
Buying a call
Table II.2.1 Payoff from buying a call
Asset price today 120
Call premium 4
BUYING A CALL
Gain from
If end asset price Premium Net
exercising
is paid gain
call
120 0 -4 -4
121 0 -4 -4
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122 0 -4 -4
123 0 -4 -4
124 0 -4 -4
125 0 -4 -4
126 1 -4 -3
127 2 -4 -2
128 3 -4 -1
129 4 -4 0
130 5 -4 1
131 6 -4 2
132 7 -4 3
133 8 -4 4
134 9 -4 5
135 10 -4 6
136 11 -4 7
137 12 -4 8
138 13 -4 9
139 14 -4 10
140 15 -4 11
The buyer of a call will gain whenever the price of the asset exceeds the strike
price. However, since he has to pay the premium the gains will arise only after
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the premium amount has been recovered beyond the Exercise Price. If the
asset price ends up below the Exercise Price, the buyer will discard the call,
resulting in a loss of the premium amount paid. The buyer of an American call
can exercise this right at any time during the tenure of the contract.
Thus the maximum loss that he can incur is only the premium amount, while
the maximum profit can be infinite.
Selling a call
The seller of a call will gain whenever the price of the asset ends up below the
strike price. The initial premium gained by him will be his total gain in such
circumstances. However, if the price of the asset exceeds the strike price, he
will suffer losses. The premium initially received will offset the losses for a
small extent, but as the price ends up higher, his losses are greater. The seller
of an American call is exposed to this risk at any time during the tenure of the
contract.
Thus the maximum loss that he can incur is infinite, while the maximum profit
will be the premium received.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Call premium 4
WRITING A CALL
Loss from
If end asset price Premium Net
call being
is received gain
exercised
121 0 4 4
122 0 4 4
123 0 4 4
124 0 4 4
125 0 4 4
126 -1 4 3
127 -2 4 2
128 -3 4 1
129 -4 4 0
130 -5 4 -1
131 -6 4 -2
132 -7 4 -3
133 -8 4 -4
134 -9 4 -5
135 -10 4 -6
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136 -11 4 -7
137 -12 4 -8
138 -13 4 -9
Buying a put
Table II.2.3 Payoff from buying a put
Put premium 4
BUYING A PUT
Gain from
If end asset price Premium Net
exercising
is paid gain
put
117 8 -4 4
118 7 -4 3
119 6 -4 2
120 5 -4 1
121 4 -4 0
122 3 -4 -1
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
123 2 -4 -2
124 1 -4 -3
125 0 -4 -4
126 0 -4 -4
127 0 -4 -4
128 0 -4 -4
129 0 -4 -4
130 0 -4 -4
131 0 -4 -4
132 0 -4 -4
133 0 -4 -4
134 0 -4 -4
135 0 -4 -4
136 0 -4 -4
The buyer of a put will gain whenever the price of the asset ends up below the
strike price. However, since he has to pay the premium the gains will arise
only after the premium amount has been recovered. If the asset price ends up
above the Exercise Price, the buyer will discard the put, resulting in a loss of
the premium amount paid. The buyer of an American put can exercise this
right at any time during the tenure of the contract.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Thus the maximum loss that he can incur is only the premium amount, while
the maximum profit can be the strike price. The asset value cannot be negative
and the lowest it can reach is only 0. In such an eventuality, he will get a gain
of (Strike price -0.). Hence, the maximum gain that he can get is the Strike
Price.
Selling a put
The seller of a put will gain whenever the price of the asset ends up above the
strike price. The initial premium gained by him will be his total gain in such
circumstances. However, if the price of the asset falls below the strike price,
he will suffer losses. The premium initially received will offset the losses for a
small extent, but as the price ends up lower, his losses are greater. The seller
of an American call is exposed to this risk at any time during the tenure of the
contract.
Thus the maximum loss that he can incur is the Strike Price (since the asset
value cannot go below 0), while the maximum profit will be the premium
received.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Put premium 4
SELLING A PUT
Loss from
If end asset price Premium Net
put being
is received gain
exercised
117 -8 4 -4
118 -7 4 -3
119 -6 4 -2
120 -5 4 -1
121 -4 4 0
122 -3 4 1
123 -2 4 2
124 -1 4 3
125 0 4 4
126 0 4 4
127 0 4 4
128 0 4 4
129 0 4 4
130 0 4 4
131 0 4 4
132 0 4 4
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
133 0 4 4
134 0 4 4
135 0 4 4
136 0 4 4
The possible motivations of the various players in the Options market are
examined below:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
2. The buyer of a put expects the market to take a downward slide, but is
not fully confident about it. The alternative would be to short sell the
asset, but that would be dangerous, if the prices go up contrary to
expectations. The buyer of a put also has the best of both worlds (he
participates in profits if the prices do come down, and he only loses the
premium if the prices go up). The bought put comes at a premium. Like
call premia, put premia is also decided by market forces and the intrinsic
value of the put. The pricing of puts involves certain noarbitrage
conditions, which get covered in a later unit.
3. The seller of a call expects the price to remain steady, or go down and in
any case does not expect the price to rise radically. Some sellers of calls
are speculators who do so for making quick profits. Buyers of calls feel
that the premia paid by them for getting this choice is trivial. But as
several buyers enter into such transactions, the premia gain becomes
substantial for the sellers. Occasionally, sellers have a covered position
in the assets. This is a strategy called covered call writing, which will
be discussed in a later unit.
4. The seller of a put expects the price to remain steady or go up, and does
not expect the prices to fall. Sellers of puts are sometimes speculators
who seek to make gains out of the premia collected. However, the risks
are high and sometimes they end up suffering huge losses. A put can
also be written with covered position in stocks for strategic reasons.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
2.6 Illustrations
Table II.2.5 Illustration on payoff of various Options
Payoff Calculation Stock prices in Rs..
Put Call
Stock Call, Call, Put, Put,
option option
Stock price on Exercise price on Strike Strike Strike Strike
premium premium
Jan 1, 2007 Price expiry of price price price price
as on as on
call = 55 = 60 = 55 = 60
Jan 1 Jan 1
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8
6
Pay4off
2
0
52 5354 55 56 57 5859 60 61 626364 65
-2
-4
Stock Price
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4
3
Pay2off
1
0
52 53 54 55 56 57 58 59 6061 62 63 64 65
-1
-2
Stock Price
0.5
0
Pay -0.5
off 52 53 54 55 56 57 58 59 60 61 62 63 64 65
-1
-1.5
-2
-2.5
-3
Stock Price
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
3
2
1
0
Pay off
-1 52 53 54 55 56 57 58 59 60 61 62 63 64 65
Series1
-2
-3
-4
-5
-6
Stock Price
2.7 Summary
The payoff of various players in the Options market depends upon the possible
range of final prices and the premium paid/received initially. A buyer of a call
gains if the asset price exceeds the strike price and does not lose when the asset
price ends up below the strike price. The buyer of the call has a maximum loss
of the premium and an infinite potential for gains.
A buyer of a put has a maximum gain of the Strike Price and a maximum loss
of the premium. The put buyer will gain whenever the asset ends up below the
strike price
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The seller of a call earns a premium upfront but is exposed to the risk of the
asset price ending up higher than the strike price. His potential losses are
infinite, while his maximum gain is the premium collected
The seller of a put earns a premium upfront but is exposed to the risk of the
asset price ending up lower than the strike price. His potential losses are up to
the Strike Price, while his maximum gain is the premium collected
3.1 Objectives
The objectives of this unit are:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
3.2 Introduction
As seen in the previous unit, the payoff situation is different for the buyer and
the seller. Option positions can be naked or covered. Naked positions are
speculative in nature and do not conform to any analytical theory. We are
therefore concerned basically with covered positions and combinations, which
can stem out of a strategy.
The two most common strategies followed by dealers in Options are the
Covered Call Strategy and the Protective Put Strategy. These are explained
in detail hereunder.
For instance, an investor holding 2000 shares of Punjab Tractor can write (sell)
calls for 2000 shares. In the process, a premium is earned on the calls sold
1. If on expiry, the stock price exceeds the Exercise Price, the call will be
exercised against the investor. Since theoretically, there is no upper
limit to the stock prices on expiry, the investor is actually open to
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
unlimited loss. The loss is, however, cushioned to the extent of the
premium earned on selling the calls.
2. If the stock price ends up equal to or less than the Exercise Price, it will
not be exercised against the investor. So the initial gain from selling the
call will be the net gain from the transaction.
3. The underlying value of the portfolio also goes up with any rise in the
prices. So the loss on the call writing is compensated by the rise in
portfolio value in equal measure. Effectively, it comes down to having
sold the portfolio at the Exercise Price.
In the above case, assume that Punjab Tractor is currently going at Rs.320. Let
us say our investor has written calls at an Exercise Price of Rs.320. If Punjab
Tractor ends up at Rs.360 on expiry, there will be a loss of Rs.40 (360320). This
is the similar to selling the shares at Rs.320, which is the Exercise Price.
Let us now look at situations that will be ideal for entering into covered call
writing.
a) When the market is listless and does not appear to be likely to have big
movements in the short-run, the portfolio owner could write covered
calls. By doing so, the portfolio manager is seeking to enhance the value
of the portfolio by earning extra income on the call writing. When the
call is written for a short tenure, the volatility is unlikely to be big, and
the opportunity loss is also not likely to be high.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
b) A portfolio manager, who has assessed that the overall variation in the
markets is not likely to be substantial, can keep on playing this strategy
over and over again. While there would be occasional losses, the strategy
is likely to return steady income over a long duration. This would work
particularly if the manager is a buy and hold investor and does not
intend to sell in the near future.
Two other strategic considerations come into play in respect of covered call
writing. The writer has the choice of the Exercise Price. Naturally, higher the
Exercise Price, the lower the premium he can charge, but correspondingly the
risk level changes too. In order to strike the right balance between the
premium that can be earned and the risk that is borne in the process, the
possible outcomes and returns can be drawn up for various scenarios and the
ideal level arrived at.
Secondly, the writer has the choice of reversing the position prior to expiry
should the situation begin to look dangerous. Alternatively, he can soften
losses by buying calls.
Some studies have shown covered call writing to be more profitable than buying
naked calls outright. However, if this is really so at all times, then there will
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
be a scramble for writing calls and that process itself will reduce the
attractiveness of the premium. In the initial stages of derivative market
acceptance, it is likely that a number of new players like the conceptual
winwin of buying a call and would therefore provide a good market for the
covered call writing strategy. Professional fund managers, can, in such a
situation reap rich rewards by having a portfolio of covered calls.
Net
Net
Portfolio Gain/loss
At expiry price value at
value from call
end
writing
95 95 4 99
96 96 4 100
97 97 4 101
98 98 4 102
99 99 4 103
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Another example is shown below. The Asset Value here is Rs.55 and the Call
premium is Rs.2.875 for an Exercise Price of Rs.55. The example is continued
with a covered call on the same stock with an Exercise price of Rs.60, written
for Rs.1.75
Asset value 55
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Net
Portfolio Gain/loss Net value
At expiry price
value from call at end
writing
52 52 2.875 54.875
53 53 2.875 55.875
54 54 2.875 56.875
55 55 2.875 57.875
56 56 1.875 57.875
57 57 0.875 57.875
58 58 -0.125 57.875
59 59 -1.125 57.875
60 60 -2.125 57.875
61 61 -3.125 57.875
62 62 -4.125 57.875
63 63 -5.125 57.875
64 64 -6.125 57.875
65 65 -7.125 57.875
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
58.5
58
57.5
57
56.5
56
55.5
55
54.5
54
53.5
53
5253 54 5556 57 5859 60 6162 63 6465
Stock price at expiry
Net
Portfolio Gain/loss Net value at
At expiry price
value from call end
writing
54 54 1.75 55.75
55 55 1.75 56.75
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
56 56 1.75 57.75
57 57 1.75 58.75
58 58 1.75 59.75
59 59 1.75 60.75
60 60 1.75 61.75
61 61 0.75 61.75
62 62 -0.25 61.75
63 63 -1.25 61.75
64 64 -2.25 61.75
65 65 -3.25 61.75
64
62
60
58
56
54
52
50
48
52 53 54 55 56 57 58 59 60 61 62 63 64 65
Stock price
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
would have been to sell the stock itself. If the portfolio manager feels that the
fall is temporary and if she is happy with her portfolio composition, she may
choose to just sell the Futures for protection. Buying an appropriate number
of puts will serve the same purpose. If the asset value falls below the strike
level ( which is what the portfolio manager fears), the puts will give a payoff of
the difference between the strike price and the final price. Thus, if the put is
bought at around the level of the current portfolio value, any depletion in value
as a result of the fall in the prices will be compensated by the put. This is called
the Protective Put strategy.
There are important points of difference between the Protective Put strategy
and a strategy of selling Futures. A Protective Put gives protection without
committing the buyer to the strike price.
An example of Protective Puts is shown below:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Net
Net
Portfolio Gain/loss
At expiry price value at
value from call
end
writing
95 95 1 96
96 96 0 96
97 97 -1 96
98 98 -2 96
99 99 -3 96
100 100 -4 96
101 101 -4 97
102 102 -4 98
103 103 -4 99
Contrary to expectations, if the price of the portfolio goes up, the buyer of the
put can just discard the put and continue to enjoy any appreciation in the
portfolio. However, the seller of the Futures will be committed to the price and
will not be able to participate in the higher profits.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The Protective Put comes with a price in the form of a premium, while Futures
do not involve any premium.
The mimicking portfolio ends up with a profit or loss which is different from
the main portfolio by only Rs.4. Here the mimicking portfolio consisted of
buying a call and selling a put. The put that was sold fetched a premium, while
the call had to be bought at a premium. Thus there was a total cost of Rs.4.
When the asset expires at various prices as shown in the table, there is a payoff
for the call and the put that has been written. The total position corresponds
to the main portfolio of the asset itself, subject to a difference of Rs.4.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Total cost 4
Compare to
Call Put Position Total from
Stock at end loss in
value value cost mimic. port
portfolio
91 0 -9 -4 -13 -9
92 0 -8 -4 -12 -8
93 0 -7 -4 -11 -7
94 0 -6 -4 -10 -6
95 0 -5 -4 -9 -5
96 0 -4 -4 -8 -4
97 0 -3 -4 -7 -3
98 0 -2 -4 -6 -2
99 0 -1 -4 -5 -1
100 0 0 -4 -4 0
101 1 0 -4 -3 1
102 2 0 -4 -2 2
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
103 3 0 -4 -1 3
104 4 0 -4 0 4
105 5 0 -4 1 5
106 6 0 -4 2 6
107 7 0 -4 3 7
108 8 0 -4 4 8
109 9 0 -4 5 9
110 10 0 -4 6 10
In a synthetic portfolio, the value of the portfolio and its payoff both correspond
with the asset portfolio. In the above example, if a risk-free bond costing Rs.96
and maturing at Rs.100 on expiry of the Options is also bought, the total initial
investment matches exactly with the portfolio and so does the payoff.
Total cost 4
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Value of
Stock at Call Put Bond
synthetic
end value value value
portfolio
95 0 -5 100 95
96 0 -4 100 96
97 0 -3 100 97
98 0 -2 100 98
99 0 -1 100 99
3.6 Summary
The basic pay off structure of Options gives rise to certain common strategies
that could be used for by portfolio managers. The most common of such
strategies are the Covered Call Strategy and the Protective Put Strategy.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
In the Covered Call Strategy, the asset manager combines his portfolio with a
sold position in calls. The calls are written at such a level of the strike price
that the writer does not expect it to be exercised. Moreover, market conditions
may be such that price movements are within a narrow range. However, if
prices do shoot up and the call gets exercised, the asset manger has the position
in the stock to cover for the eventuality. The net result would then be that the
sale has been made at the strike price and a potential for gains in the asset had
been lost by the call having been written. Portfolio managers use this strategy
on a continuous basis and not for isolated transactions.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
4.1 Objectives
The objectives of this unit are:
4.2 Introduction
As a first step to price determination, it is necessary to appreciate the
maximum and minimum limits to which Option prices can go. These limits are
based on principles which if violated, would create an opportunity for risk-free
arbitrage. Arbitrage can be performed by any player in the market and with
the force of more and more dealers doing it; prices will stabilize to the correct
levels.
Sometimes it is argued that the upper and lower limits are pure theoretical
values and do not have any practical relevance. It is said that prices will never
be near the limits as such and therefore the limits, by themselves do not serve
any purpose. However, this is a wrong notion. The limits to prices reinforce
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Options pricing consists of two elements intrinsic value and time value.
Intrinsic value refers to the extent to which the Option is in the money, and
factors in interim dividends. The time value refers to the time available with
the buyer for exercising the option. Obviously, the more the time available, the
more valuable the option. The phenomenon of time value explains why even
Options which apparently do not have an intrinsic value still have certain
overall value.
Here, any dealer can write the call and buy the stock, for getting a difference
of Re.1. If on expiry the call is exercised against him, the stock position will
cover the deal. If the call goes unexercised, the stock can be sold in the market
for whatever small value and the dealer ends up getting a total of the Rs.41
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
from writing the call and the sale proceeds of the stock. His potential for profit
is risk-free. Thus the call price can never exceed the value of the asset
In the above example if dividends are Rs.3 and are known with certainty, the
call value cannot exceed Rs.37 (40-3). If it exceeds Rs.37, the call can be sold
and the stock bought for Rs.37, pocketing the difference. A dividend will be
received of Rs.3 and with this the dealer has Rs.40 to cover for the call written.
If the stock price ends up higher than Rs.40, the call will be exercised against
the dealer, but he has the stock to cover this. If the stock price ends up lower
than Rs.40, the call will not be exercised against him, and he can sell the stock
for whatever price in the market for additional gains.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Suppose the Stock price is Rs.41 and the Strike Price is Rs.42. Discounting the
Strike Price at the risk-free interest, we get the Present Value of the Strike
Price to be Rs.40.50.
Strike price 42
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
if it is 0.25, say
Invest in risk-free
bonds
40.5
At maturity
Get 42 from the bonds
The gains are risk-free. Hence the bound of prices will be maintained.
131
FUNDAMENTALS OF FINANCIAL DERIVATIVES
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
133
FUNDAMENTALS OF FINANCIAL DERIVATIVES
(Amount in Rs.)
Stock price 41
Strike price 40
if it is 0.75, say
Dividend expected 5
Tenure 3 months
PV of dividend 4.966778
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
If it is say Rs.4
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Two American calls on the same stock having the same Exercise Price
has to be priced such that the one with the longer maturity is worth as
much or more than the one with the shorter maturity.
If the stock price is 0, the value of an American put must be its Exercise
Price.
4.8 Summary
Call prices have to be within certain boundaries determined by no-arbitrage
conditions. These limits hold regardless of the specific values of the stock.
When it comes to American Options, the question of exercise involves a number
of considerations. While the bounds are not directly indicative of the price of
the call, they show the economics behind the working of the Options market
and tell us the factors that govern pricing.
136
FUNDAMENTALS OF FINANCIAL DERIVATIVES
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
5.1 Objectives
The objectives of this unit are:
5.2 Introduction
In the previous unit we saw the upper and lower limits of European and
American calls with or without dividends. The no-arbitrage principles given
there will apply in equal measure to the determination of put bounds as well.
It should be remembered that that these bounds are not actually indicative of
the prices, but show only the maximum and minimum limits of these prices.
We seek to do separate analysis in respect of puts and determine the
noarbitrage maximum and minimum prices. We also then look at the
principles governing the determination of bounds of American put prices.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Strike price 45
PV of strike price 43
If price is 44
sell P get 44
invest
43
Invest PV of K
Loss 45
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Profit 1
The position does not change with availability of Dividends and so a European
put with dividends also cannot have a value greater than the present value of
the Strike price.
Another principle here is that the maximum loss to be suffered by a put writer
will be only the strike price and if he is able to invest the present value of that
straightaway he is safe. The fact that there may be dividends on the stock is
not relevant because, the dealer is not looking at the stock at all, but only at
the strike price and the price of the put.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Strike price
45
PV of strike price
43
If price is 42
if it is say 0.5
borrow 43
At maturity, if Stock
exceeds Strike
discard put
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Strike 45
PV of strike 43
PV of dividends 3
43-40+3 6
If put is 5
spend
40
Buy stock
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Strike 45
If price is 46
sell P get 46
your loss 45
profit 1
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The factor to be borne in mind here is that the maximum loss to be suffered by
a put writer will be only the strike price and if he is able to invest the present
value of that straightaway he is safe. The fact that there may be dividends on
the stock is not relevant because, the dealer is not looking at the stock at all,
but only at the strike price and the price of the put
Strike 45
144
FUNDAMENTALS OF FINANCIAL DERIVATIVES
if it is say 2.5
at
maturity
if Stock exceeds
Strike
discard put
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
This is broadly the same as the European put with dividends. The timing and
quantum of dividends might influence the exercise decision. Early exercise is
governed by the principle of time value of money and cannot be generalized.
5.7 Summary
The bounds of put prices also work on the no-arbitrage argument. Separate
bounds can be determined for the European and American puts, with or
without dividend.
The early exercise itself is based on the quantum of dividends and the timing
thereof and the intrinsic value at that time
It can be seen that the intrinsic value and the time value both play a role in
the determination of bounds.
Option bounds are useful in determining the worst outcome from certain
positions. Unless there are severe market imperfections, the bounds will have
to hold..
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Dividends
147
FUNDAMENTALS OF FINANCIAL DERIVATIVES
Module 3
148
FUNDAMENTALS OF FINANCIAL DERIVATIVES
1 Option combinations
1.1 Objectives
The objectives of this unit are:
1.2 Introduction
The advent of Options has resulted in a number of possibilities for mimicking
and creating synthetic portfolios. The pay off profile of Options in combination
creates situations very much useful for certain specific trading requirements.
Speculators use these combinations for short-term gains
Each of the combinations listed below have various profiles of profitability and
risk. They come at a cost in the form of premium, if these involve some long
positions. Written positions give a premium income in the beginning, but
involve risks.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
1.3 Straddle
A straddle involves buying a call and a put at the same Exercise Price and for
the same tenure. A buyer of a straddle buys both the call and the put.
This position is illustrated below:
Call
premium
5
Put premium 4
initial inv. 9
96 0 4 -5
97 0 3 -6
98 0 2 -7
99 0 1 -8
100 0 0 -9
101 1 0 -8
102 2 0 -7
103 3 0 -6
104 4 0 -5
105 5 0 -4
85 0 15 6
115 15 0 6
150
FUNDAMENTALS OF FINANCIAL DERIVATIVES
A short straddle involves selling both the call and the put. Of course the long
or short straddle can be established without buying or selling from the same
counterparty. In the above example, the call could have been bought from one
dealer and the put from another dealer.
A long straddle gains only when there is volatility and the price goes beyond
the Exercise Price in either direction beyond the total premia incurred. A short
straddle works whenever the prices remain within the band.
Another illustration is given below:
Table III.1.2. Straddle illustration (Amount in Rs.)
Amounts
in Rs.
Strike Price
60
Call premium
1.75
Put premium
5.5
Net Cost
(-7.25)
Buy Call, Buy Put
50 0 10 2.75
51 0 9 1.75
52 0 8 0.75
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
53 0 7 -0.25
54 0 6 -1.25
55 0 5 -2.25
56 0 4 -3.25
57 0 3 -4.25
58 0 2 -5.25
59 0 1 -6.25
60 0 0 -7.25
61 1 0 -6.25
62 2 0 -5.25
63 3 0 -4.25
64 4 0 -3.25
65 5 0 -2.25
66 6 0 -1.25
67 7 0 -0.25
68 8 0 0.75
69 9 0 1.75
68 8 0 0.75
69 9 0 1.75
70 10 0 2.75
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Long
Straddle
1
5
1
0
Gai
n 5
Cgai
n
0 Pgai
5 5 6 6 7 n
- 0 5 0 5 0 Ne
5 t
gai
n
-
10
Stock
Price
1.4 Strangle
This is identical to the straddle except that the call has an Exercise Price above
the stock price and the Put an exercise price below the stock price. It is
illustrated below. As in the straddle, an initial investment is required to go
long a strangle.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Call strike 85
Put strike 80
Call
premium
3
Put premium 4
initial inv. 7
76 0 4 -3
77 0 3 -4
78 0 2 -5
79 0 1 -6
80 0 0 -7
81 0 0 -7
82 0 0 -7
83 0 0 -7
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
84 0 0 -7
85 0 0 -7
65 0 15 8
100 15 0 8
Put Put
strike premium
55 -2.625
Net
Inflow
4.375
Call Put
Stock Net gain
payoff payoff
50 0 -5 -0.625
51 0 -4 0.375
52 0 -3 1.375
53 0 -2 2.375
54 0 -1 3.375
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
55 0 0 4.375
56 0 0 4.375
57 0 0 4.375
58 0 0 4.375
59 0 0 4.375
60 0 0 4.375
61 -1 0 3.375
62 -2 0 2.375
63 -3 0 1.375
64 -4 0 0.375
65 -5 0 -0.625
Short
Strangle
6
Gai 2
n Cgai
0 n
5 5 6 6 7 Pgai
- 0 5 0 5 0 n
2 Ne
- t
gai
4 n
-
6
Stock
Price
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Price below the Stock price and sells a call with Exercise Price above the stock.
The strategy has limited risk and limited profit potential. This is illustrated
below.
Table III.1.5 Bull Spreads with calls (Amount in Rs.):
Stock 100
Call strike 1 95
Call
premium 1
7
Call
premium 2
3
initial inv. 4
98 3 0 -1
99 4 0 0
100 5 0 1
101 6 0 2
102 7 0 3
103 8 0 4
104 9 0 5
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
105 10 0 6
106 11 -1 6
107 12 -2 6
80 0 0 -4
115 20 -10 6
A bull spread can also be initiated with puts. This involves writing a put at a
higher strike price and buying a put at a lower strike price. This then will
involve an initial cash inflow. This is demonstrated below:
Put strike 1 95
Put premium
1
3
Put premium
2
7
initial inflow 4
96 0 -9 -5
97 0 -8 -4
98 0 -7 -3
99 0 -6 -2
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
100 0 -5 -1
101 0 -4 0
102 0 -3 1
103 0 -2 2
104 0 -1 3
105 0 0 4
80 15 -25 -6
115 0 0 4
Stock
P1Gain P2Gain Net Gain
Price
50 0 -5 -2.625
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
51 0 -4 -1.625
52 0 -3 -0.625
53 0 -2 0.375
54 0 -1 1.375
55 0 0 2.375
56 0 0 2.375
57 0 0 2.375
58 0 0 2.375
59 0 0 2.375
60 0 0 2.375
Bull Spread
with Puts
4
2
Gai
n 0 P1gai
n
- 5 5 5 5 5 6
2 0 2 4 6 8 0 P2gai
- n
4 Ne
- t
Gai
6 n
Stock
Prices
1.6 Bear spread
A bear spread with calls will involve selling a call with a lower Exercise Price
and buying a call at a higher Exercise Price. There will be no initial investment
since the call that is sold will fetch higher than the bought call.
Both profits and losses are limited. An example is shown below:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Stock 100
Call strike 1 95
Call premium 1 7
Call premium 2 3
Initial inflow. 4
96 -1 0 3
97 -2 0 2
98 -3 0 1
99 -4 0 0
100 -5 0 -1
101 -6 0 -2
102 -7 0 -3
103 -8 0 -4
104 -9 0 -5
105 -10 0 -6
106 -11 1 -6
80 0 0 4
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
115 -20 10 -6
50 0 0 1.125
51 0 0 1.125
52 0 0 1.125
53 0 0 1.125
54 0 0 1.125
55 0 0 1.125
56 -1 0 0.125
57 -2 0 -0.875
58 -3 0 -1.875
59 -4 0 -2.875
60 -5 0 -3.875
61 -6 1 -3.875
62 -7 2 -3.875
63 -8 3 -3.875
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
64 -9 4 -3.875
65 -10 5 -3.875
A bear spread can also be carried out with puts. This will involve selling a put
with a lower Exercise Price and buying a put with a higher Exercise Price. An
initial cash outflow will be required. This is demonstrated below:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Put strike 1 95
Put premium 1 3
Put premium 2 7
initial inv. -4
96 0 9 5
97 0 8 4
98 0 7 3
99 0 6 2
100 0 5 1
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
101 0 4 0
102 0 3 -1
103 0 2 -2
104 0 1 -3
105 0 0 -4
80 -15 25 6
115 0 0 -4
Call strike 1 95
165
FUNDAMENTALS OF FINANCIAL DERIVATIVES
Call premium 1 7
Call premium 2 4
Call premium 3 3
initial inv. -2
96 1 0 0 -1
97 2 0 0 0
98 3 0 0 1
99 4 0 0 2
100 5 0 0 3
101 6 -2 0 2
102 7 -4 0 1
103 8 -6 0 0
104 9 -8 0 -1
105 10 -10 0 -2
106 11 -12 1 -2
80 0 0 0 -2
115 20 -30 10 -2
166
FUNDAMENTALS OF FINANCIAL DERIVATIVES
1
Tot. gain
0
-1
-2
-3
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
volatility and risk free rates, there will be no scope to enter into a box spread
at all. But when the market has differently interpreted assumptions for
volatility and risk free interest, the prices can offer scope for a box spread.
Call strike 1 95
Call premium 1 7
Call premium 2 3
Put strike 1 95
Put premium 1 3
Put premium 2 7
inv. -8
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
96 1 0 0 9 2
97 2 0 0 8 2
98 3 0 0 7 2
99 4 0 0 6 2
100 5 0 0 5 2
101 6 0 0 4 2
102 7 0 0 3 2
103 8 0 0 2 2
104 9 0 0 1 2
105 10 0 0 0 2
80 0 0 -15 25 2
115 20 -10 0 0 2
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Stock Call 1 gain Call 2 gain Put 1 gain Put 2 gain Net gain
45 0 0 -5 10 0.5
46 0 0 -4 9 0.5
47 0 0 -3 8 0.5
48 0 0 -2 7 0.5
49 0 0 -1 6 0.5
50 0 0 0 5 0.5
51 1 0 0 4 0.5
52 2 0 0 3 0.5
53 3 0 0 2 0.5
54 4 0 0 1 0.5
55 5 0 0 0 0.5
56 6 -1 0 0 0.5
57 7 -2 0 0 0.5
58 8 -3 0 0 0.5
59 9 -4 0 0 0.5
60 10 -5 0 0 0.5
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Box
Spread
1
2
1
08
Gain 6 C1gai
s n
4 C2gai
2 n
P1gai
0 n
P2gai
- 4 5 5 6 n
Net
2
- 5 0 5 0 gain
4
-
6
Stock
Price
1.9 Summary
Option combinations are important synthetic instruments which can be used
very effectively by the securities dealer. When these combinations involve
some short positions and are entered into without a covered position, they
may sometimes result in huge losses. It is therefore, necessary to frequently
monitor positions and cover and unwind them as necessary. Combinations
offer possibilities of steady profits if employed judiciously.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Butterfly spread
Box Spread
Bull Spread
Bear Spread
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
2.1 Objectives
The objectives of this unit are:
2.2 Introduction
From our understanding of the behavior of Options prices and their bounds
gained from the illustrations in the previous Chapters, we can note the
following:
1. The lower the Exercise Price, the more valuable the call
2. The difference in call prices of two calls identical except for Exercise
Price cannot exceed the difference in Exercise Price
3. Calls will be worth at least the difference between the Stock price and
the Present Value of the Exercise Price
4. The more the time till maturity, the more the call price is likely to be
5. Before expiration, a put must be equal to at least the Present Value of
the difference between the Exercise Price and the Stock Price
6. The higher the Exercise Price, the more valuable the put
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
7. The price difference of two puts cannot exceed the difference in the
Present Value of the Exercise Price.
8. If the stock price is 0, the value of an American call must be 0
9. The minimum value of an American call is given by either 0, or the
difference between the Stock price and Exercise Price, whichever is
greater.
10. An American call can never be worth less than the corresponding
European call.
11. Two American calls on the same stock having the same Exercise Price
have to be priced such that the one with the longer maturity is worth as
much or more than the one with the shorter maturity..
12. If the stock price is 0, the value of the American put must be its
Exercise Price
13. An American put is worth at least as much as its European equivalent
The Lower the Exercise Price the more valuable the call
Always, the call with the lower Exercise Price must have greater value. Let us
take two calls
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Here it will be possible for the dealer to sell Call P and buy Call Q for a riskfree
profit. The prices have to adjust in such a way that the difference in the two
call prices does not exceed Rs.5, being the difference between the two
Exercise Prices
The more the time to expiration the greater the call price
Time Exercise Price Call price
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Here any dealer can sell Call E and buy Call F, to make risk-free profits. The
prices will have to adjust to a situation where Call F, which has the greater
tenure has the greater price.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
difference between the Exercise Prices. The difference in the two put prices
must not exceed the 5 (205-200).
Let us take the example of two portfolios. The first portfolio has a long position
in stock and a long put. The second portfolio has a long call and an investment
in risk-free bonds to the extent of the present value of the strike price. This
investment in the present value of the strike price will grow to become the
177
FUNDAMENTALS OF FINANCIAL DERIVATIVES
strike price at the end of the tenure. At expiry the stock can end up greater
than the strike price or equal to or below it. The performance of the two
portfolios in these eventualities is mapped below:
At expiry
If Stock
is
If Stock is greater
less than than
Ex.Price Ex.Price
Port. A
Stock
Stock price price at
Stock at end end
Ex.Price-
Stock price
Put 0
Stock
Exercise Price at
TOTAL Price end
Port B
Stock
Price at
end
Calls 0 Ex.Price
Bonds Ex.Price Ex.Price
Stock
Exercise
TOTAL Price at
Price
end
So original values should be
equal
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Stock
+Put
= Call +PV of strike
179
FUNDAMENTALS OF FINANCIAL DERIVATIVES
IF STOCK AT STRIKE
END<STRIKE PRICEert
PRICE
IF STOCK AT (STRIKE
END<STRIKE PRICESTOCK
PRICE AT END) +
STOCK AT
END
Portfolio P is more valuable than Portfolio Q. In case of stock price being higher
than exercise price, Portfolio P is greater by the interest earned on the Strike
Price. If the stock price is lower than exercise price, the value is higher than
Portfolio Q again because of the interest earned on the Strike Price.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
So
European Call + Strike Price > American Put + Stock
We know from the Put-Call parity rule for European Options that
European Call + Present Value of Strike =European Put +Stock
Or
European Call European Put = Stock Present Value of Strike (Equation 2)
American call is at least as valuable as the European call
Combining Equations 1 and 2
(Stock Exercise Price) < (American Call American Put) < (Stock PV of Strike)
This gives us the range of prices for American Puts given the corresponding
Call prices and vice-versa
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
There are only two alternatives if one were to exercise the call option before
expiry:
1. One can keep the shares obtained out of the exercise as an investment.
2. One can sell the shares in the market straightway.
The first choice is inferior to retaining the option itself. If one exercises the
option and keeps the shares as an investment, one will have to incur capital
expenditure for buying the shares. If, instead, the option is retained, one can
exercise the option at any time one likes and there is no need for upfront
investment. Besides, by exercising and holding, one is taking a risk of the
investment value falling, whereas if the option is retained, it acts as an
insurance against such a fall, such that one need not exercise the call at all.
This shows that whatever the eventual price, exercising the option for
investment purposes is not optimal.
The second choice relates to selling the shares in the market immediately after
the exercise of the option. This implies that the option is sufficiently in the
money and for fear of a fall in the market the option could be exercised
straightway and the shares obtained out of the exercise immediately sold off.
But if this is the intention, the call itself could be sold off in the market for the
same pay-off. An American in-the-money call has to have the minimum value
of (stock price minus Exercise Price), so the advantage of exercising, taking the
shares and then selling them off can also be obtained by just selling the call.
By the second choice one gets (Stock Exercise Price), which will always be the
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The cost that you paid entering into for the option is irrelevant because it is a
sunk cost and is the same for both the alternatives.
Illustration
Let us take the case of an American call option purchased for Rs.5 with an
Exercise Price of Rs.50 and time to expiry of 3 months. Let us assume that the
option becomes in the money (i.e. the stock price exceeds the strike price) and
the stock price is Rs.60. The alternatives open to the buyer of the option are:
1. Exercise and sell the stock. He will pay Rs.50 per share for the exercise
and get Rs.60 for the sale thereby making a profit of Rs.10.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
2. Sell the call itself. The call will now be priced at a minimum of Rs.10
(stock price Exercise Price). This is because if the option were priced
lower say at Rs.8, all anyone has to do is to buy the option at 8 and
exercise straightway to get Rs.10 (60-50) and make a risk free profit of
Rs.2. So the in-the-money American option price has to be necessarily
Rs.10. It can of course be greater than Rs.10 taking into account the
volatility of the underlying asset.
So coming back to our example, the minimum price that we will get by selling
the call itself is Rs.10. Whereas the maximum price one will get by selling the
share is Rs10. So, early exercise does not make sense.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
For example suppose X holds a put option on a scrip with Exercise Price of
Rs.50. Suppose a month before the maturity, the scrip is trading at 40. X has
to decide
1. Whether the Rs.10 that he will make by exercising the put now will be
enough as per his portfolio profit strategy.
2. What is the extent of volatility now in the scrip? If the volatility is high
even now, it may be worthwhile holding on in the expectation of a further
fall.
The above two issues have to be balanced and a decision arrived at. The actual
exercise is a matter of judgment. The point to be noted, however, is that, early
exercise is not a non-optional solution, as in the case of calls.
2.7 Summary
The pricing of Options follows certain principles. These principles are based
upon no-arbitrage conditions. If disparities exist in prices alert dealers will
buy and sell in the market in such a way that they reap risk-free profits. As
more and more dealers exploit the disequilibrium, the prices adjust to their
correct levels.
Several principles have been laid down in this unit based upon these no
arbitrage conditions. The intricate relationships between the expiry time in
the asset price and option values result in a number of valid principles.
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For a given call price there must be a corresponding put price on the same
underlying asset with the same Exercise Price. This can again be established
using the no arbitrage condition. This principle is called put-call parity.
It can be shown by using principles of time value of money that it is not optimal
to exercise the American call earlier than maturity. Although, American calls
carry this right it will be not worthwhile for the holder to exercise this right
before maturity. However, in case of necessity the dealer can sell the American
Option in the market .
This principle does not hold for an American put because of the favorable time
value of money. Here it is optimal to exercise the American put before maturity
if it is sufficiently in the money.
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3.1 Objectives
The objectives of this unit are:
3.2 Introduction
We have seen how the option prices work in relation to the time to expiry and
Exercise Price. The impact of the stock price on the pricing has also been seen.
We have set upper and lower bounds of option prices. Now we have to attempt
to pinpoint a price which should be appropriate for an option given the time to
maturity, strike price and stock price.
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For the purpose the Binomial model has been found to be an intuitive
explanation of the pricing of Options. While the assumptions of the Binomial
Model might appear to be far-fetched., it can be established that these do not
mar the ability of the model to come to almost correct prices. Studies have also
shown that if the Binomial Model is carried to a large number of periods it will
correspond to the Black Scholes model of Option pricing.
Up Rs.120 Rs.20
Down Rs.90 0
From the above let us work out for a combination of shares and calls in such a
way that the total value remains the same both on the Up and Down
movements. This involves a ratio of shares long and calls short. A combination
of long two shares and short three calls will result in the following final payoff.
Stock Calls Total
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shares long and three calls short was arrived at using simple arithmetic.
Formally this proportion is called the Optimal Hedge Ratio and is found out by
the following formula:
CU CD
-----------
SU SD
Where CU stands for the payoff of the call for the up movement
CD stands for the payoff of the call for the down movement
SU stands for the payoff of the stock for the up movement
SD stands for the payoff of the stock for the down movement
In the above example the formula gives us an answer of 2/3 which means 3
calls for 2 shares.
So the final value is always Rs.180 after 1 year. It may be recalled that as a
principal assumption to the Binomial Model there can be only two scenarios
and either case the portfolio is Rs.180. A portfolio that always yields Rs.180 is
risk free in nature and its present value is its discounted figure based upon a
risk free rate of return. Rs.180 discounted for one year at 8% risk free rate of
interest (assumed) gives a figure of Rs.166.67.
The portfolios value today ought to be Rs.166.67. The portfolio consists of two
shares long and two calls short. The two shares long cost Rs.212 (the present
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
stock price of Rs.106 multiplied by 2). The difference between Rs.212 and the
portfolio value of Rs.166.67 gives us the value of the three calls shorted. This
value is Rs.45.33 and therefore the value of 1 call is Rs.15.11.
The same answer could have been obtained by following a different approach
called The Risk Neutral Valuation. The theory of Risk Neutrality says that
investors are indifferent to the actual probabilities of payoff and are only
concerned with getting a payoff equal to the risk free rate of return. The two
movements of the asset values are not assigned any probabilities but the
implied probability for their movements can be determined by using the risk
free rate of return.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The above formula seeks to equate the implied chances of up and down
movements to the risk free rate of return on the original value of the stock
calculated using continuous compounding. The equation yields a p value of
0.816. Therefore (1 p) is Rs.0.184. Since we are interested in the call prices
and since we have already determined that the call payoff will be either Rs.20
or 0 the following equation can be used to determine the value of the call.
( 20 * p + 0 *1 p)
= 20 * 0.816 + 0 = 16.32.
This figure of 16.32 is the value of the call after one year. When this is
discounted at the risk free return of 8% we get Rs.15.11.
It can thus be seen that both the optimal hedge approach and the risk neutral
approach yield the same answer.
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Let us assume that the stock price is Rs.100 and that it can either go up by 10%
or come down by 5% in a single period. For simplicity, we can take one period
to be 1 year. We are trying to value a call option on the stock with an Exercise
Price of Rs.105. The call is assumed to be valid for 2 years. The risk-free rate
of return is 8%.
The first step is to draw the payoff diagram for the stock
121
110
104.5
100
95
90.25
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16
0
?
The procedure is to first determine the Options payoff in the end and work
backwards node by node. The three branches at end of year 2 have payoff of
Rs.16, 0 and 0. The top most branch will be in-the-money and fetch Rs.16.
The other two branches end up out-of-the-money and hence have a value of 0.
(Please recall that Options cannot have a negative value, since they can be
discarded when not in profits).
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The call value at the top branch of Year 1 can be calculated using the payoff
estimations for year 2. But before that the implied probabilities under the risk-
neutral valuation should be computed. This is found by using the formula
Using this we can calculate the payoff in the top branch of Year 1 as (16 *0.87)
+ (0*.13) =13.92, discounted for 1 year at the risk-free rate of 8%. This gives a
figure of 12.89 as the figure for the top portion of Year 1.
We can calculate the value of the bottom node in the same way. In this
example, the two possible payoff figures at end of Year 2 are both 0, and hence
the value of the bottom node at end of Year 1 will also have to be 0. In case the
two payoff figures in Year 2 are positive, we can calculate their corresponding
value for the node in Year 1 by attributing p values and (1-p) values and then
discounting by the risk-free rate for 1 year.
The figure looks as follows now:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
13.92
The p value is 0.87 and (1-p) is 0.13. Applying these to the Year 1 payoff figures
and discounting for 1 year yields Rs.11.21as follows:
(13.92*0.87) + (0*0.13) = 12.11. This discounted for 1 year at 8% gives 11.21.
So the value of the call at inception is Rs.11.21.
If the period of possible price change is shorter than 1 year, we have to adjust
the discount rate accordingly. Thus, if the changes are recorded for every half-
year, the applicable discount rate for bringing back the possible payoff figures
is 4%, being half the annual rate.
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Lastly, while it may look far-fetched that we can have only two possible
movements of prices under the model, it should be noted the we can achieve
more accuracy by just reducing the duration of each period, thereby increasing
the number of nodes.
Beyond a point it is difficult to calculate the above by hand and we may require
the assistance of a software program. There are a number of spreadsheet
models designed for calculating the Binomial Options price. percentages.
The major difficulty confronting the analyst will be to assert that estimated
levels of up and down movements will remain the same for all periods to come.
3.6 Summary
An understanding of pricing of Options is best had with the Binomial model.
The Binomial model assumes that stock prices can have only two possible
movements in a period, by a specified percentage up or specified percentage
down.
Valuation under the Binomial model can be done using the no-arbitrage
argument or the risk-neutral approach. Under the former, a portfolio of long
stocks and short calls is created, in such a way that the final payoff is identical
for both the possibilities. The combination is arrived at by calculating an
Optimal Hedge Ratio. When the final payoff is identical and does not involve
any risk, its value initially will be its discounted value at the risk-free rate.
This initial value consists of the value of both stock and calls.
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The value of stock being known is deducted to get the value of the calls.
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No Arbitrage
Implied chance
Risk free return
4.1 Objectives
The objectives of this unit are :
4.2 Introduction
The Black Scholes model is a Nobel-prize winning attempt to define option
prices. As we have seen the Binomial approach gives us fair indication of
option prices subject to certain conditions. A different approach has been used
in formulating the Black Scholes model.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The model uses ideas from other sciences in determining the value of the
Option. First, share prices have been known to follow the principle of random
walk and stock returns have been found to be best represented by a log-normal
distribution. The model takes into account several important inputs the most
important of which is the stock volatility. Intuitively, a greater level of
volatility will result in a greater option price. Similarly, the longer the time
available the greater the option value.
The model works on certain assumptions which some critics say are unrealistic.
However, as we know most of the models in finance are based on some extreme
assumptions which need to be fine-tuned by the user depending upon his
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Empirical evidence of the Black Scholes model is divided. Ultimately the model
will work only on our inputs being right. If the correct price is not reflected by
the model it could be because the wrong input has been fed in.
The model has five specific inputs stock price, strike price, risk free rate of
return, tenure and volatility. Each of these inputs has different impacts on the
option price as demonstrated later.
The Black-Scholes model has been developed for European Options and can
easily be applied to American calls on non-dividend paying stocks.
The derivation of the model is complex and involves advanced mathematics.
No attempt has been made to show the derivation here. However, the logic
behind certain aspects of the model merits attention.
Lognormal distribution
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A stock is supposed to follow a Brownian model and the distribution of the stock
returns are hence lognormal. Under this, the least value of a stock return is -
100%. This is superior to the idea under a pure normal distribution that the
price can be less than -100%. Lognormal distributions can be seen to be skewed
to the right and do not follow the bell shape of a normal distribution.
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where
4.6 Illustration
Let us take the stock price to be Rs..20 and the strike price to be also Rs, 20.
The tenure of the option is 3 months. The risk-free rate is 12% and the variance
of returns is 0.16. The value of the Option under the Black-Scholes method can
be calculated as under:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Here the stock price is Rs.30 and the Exercise Price is Rs.25. The time to go is
3 months (0.25). The risk-free return is 5% and the standard deviation is 0.45.
( the variance is 0.2025)
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0.45*0.25
We get the answer to be 0.978.
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There are several versions of the calculator available. One version is available
for download from the internet and is applicable for direct use with Microsoft
Excel.
Numa Financial Systems Ltd
email: info@numa.com
web: http://www.numa.com/
Taking our two illustrations above, we can compute the option prices using the
calculator as follows:
Input data
Stock price Rs.20
Strike price Rs.20
Time to go 3 month (0.25)
Risk-free rate 12%
Volatility (standard deviation) 0.4
Inputting this data, we get Rs.1.88 as the value of the call, exactly the same
result as we got by the long calculation.
Stock price
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The value of the call increases as the Stock price increases. This is
demonstrated below, for the illustration already covered. We had found that
the Options price was Rs.1.88 for a stock price of Rs.20. The Options price for
various other stock prices are below. Please note that the other variables are
the same:
Stock Options
price Price
18.0000 0.8894
19.0000 1.3340
21.0000 2.5275
22.0000 3.2568
23.0000 4.0556
Exercise Price
The value of the call decreases with increase in Exercise Price. This is
demonstrated below using the same inputs.
Strike Call
Price Values
18.0000 3.0860
19.0000 2.4358
21.0000 1.4258
22.0000 1.0584
23.0000 0.7719
Tenure
When the tenure increases the value of the option goes up. This is intuitive in
that the more the time available the more the value of the option. This is shown
below. In the original case the time was 0.25 ( 3 months). Let us find the
values for other time periods.
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Option
Time
Value
0.1500 1.4105
0.2000 1.6582
0.3000 2.0902
0.3500 2.2849
0.4000 2.4695
Option
Interest
value
0.1000 1.8326
0.1100 1.8575
0.1300 1.9078
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0.1400 1.9333
0.1500 1.9589
Volatility
As the volatility goes up, the value of the Option goes up. An option derives its
value from uncertainty and the greater the level of uncertainty the greater the
value of the option. This goes back to the basic feature of Options as
instruments. An Option has an edge over the asset itself in that it takes only
the favorable swings and can discard the unfavorable swings. As such the
option holder will hope for greater chances of a swing. In the original
illustration we had taken the standard deviation to be 0.4. The impact of
changes to the standard deviation on the option prices are given below:
Std. Option
Deviation price
0.3000 1.4968
0.3500 1.6894
0.4500 2.0761
0.5000 2.2698
0.5500 2.4634
4.10 Summary
The Black Scholes model is considered as a very elegant piece of research into
option prices. The model uses ideas from the Brownian motion and other
theories based on random walk . The model involves certain inherent
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assumptions and yields the European call price. Among the assumptions the
most notable are the one relating to the log normal distribution of the stock
price. Studies have shown that this assumption is quite valid. Another
assumption regarding the constant volatility during the tenure of the option,
is open to question. The formula for calculating the Black Scholes model price
is relatively simple. The presence of special calculators and spreadsheet
solutions make the task very easy for traders and investors.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
5.2 Introduction
Among the several inputs into the Black Scholes model volatility is the most
crucial. This refers to the extent to which the stock price can change during
the tenure of the contract. An option carries greater inherent value with
greater volatility.
Estimation of volatility is a controversial subject. If volatility is based upon
historical data, the implicit assumption is that the future will behave in the
same way as the past. Even if that is taken as a valid assumption the question
remains as to how many months in the past do we have to go to for ascertaining
the past volatility. The figures of volatility could be vastly different if taken
for say a three-year period compared to say a six-month period. The
implication of this is that whatever we feed in as volatility will result in a
corresponding price right, or wrong.
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The fifth input Volatility is difficult to estimate. The model wants the likely
swing that the stock price can take over the period of time under consideration.
For this the standard approach is to take a historical volatility. Here, we take
the standard deviation of returns over a period of time and expect this to be
the volatility. However the period of reckoning can make a difference in the
estimate. The figure of volatility could be totally different say if a 1-year
historical volatility is taken as compared to a situation if a 3-month historical
volatility is taken. Consequently, there could be substantial differences in the
Option values as calculated.
Market observers seek to solve this problem by studying the extent of volatility
that the market seems to be imputing to the prices. This can be arrived at by
studying the four clear inputs with the Option prices prevalent in the market.
A trial and error estimation gives us an idea as to the volatility that is implied
in the market actions and is called Implied Volatility. Many calculators have
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
features which calculate this directly given the four standard inputs and the
Options price.
5.4 A discussion
The impact of volatility can be assessed from various angles. From the angle
of checking the validity of the model itself, the test would involve comparing
the historical volatility of a scrip or a basket, with the implied volatility arising
out of the going option price. The latter is used taking the BlackScholes
assumptions to be valid for the case in point. Alternatively, the option price
that should have been there given a historical volatility can be compared with
the actual option price for testing the significance of the differences, if any.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The other type of risk is the systematic risk or market risk. Here, depending
on the overall market movements, the scrip will move up or down depending
on its connection with the market. We are all aware that there are certain
incidents that affect the entire stock market such as changes in budget policy,
fall in agricultural production, changes in RBI policy and fluctuations in
foreign exchange position. Apart from these, there is something called market
sentiment which takes the overall stock prices up or down from time to time.
Depending upon each stocks relationship with the overall market, it will be
affected by some degree. Some stocks move exactly with the market with some
moving more than proportionately on the same side of the market, while some
others moving inversely.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The next question is the period to be considered for the purpose. Here
there cannot be unanimity. Just as in the case of estimation of Beta,
the period to be reckoned becomes a matter of subjectivity. Unless the
market is highly volatile in the short run, it may make more sense to
take the long-term (say 3 years) volatility as the basis. However,
because changes in Government policy have a great bearing on the
systematic risk, it may be sometimes safer to take a 1-year horizon
In the initial stages of Options being introduced, the general perception is that
options prices will not correspond to a model-determined price. This is because
the writers charge a special premium and there are few combinations going
around which act as an effective mechanism for checking radical price changes.
However, as the market becomes a little experienced (as in India now), it
becomes increasingly adept at using option combinations and other synthetic
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
instruments, which make sure that the prices are based on uniform
assumptions. Since the Black-Scholes model describes Optionsprice
determination in the most scientific way, we will have to take the postulates of
the model to be right unless evidence is overwhelmingly different. As such, the
estimates of volatility by the Options market has to be based on volatility
estimate for the spot asset market, with some modifications for the period of
the option.
The actual data of stock prices, call prices and put prices of Hindustan Lever
Ltd, for a short period in 2006 has been shown below, to show that the putcall
parity rule has not held for most dates. Further, the question as to whether
the prices indicated have the correct volatility depends on the volatility
estimates we have in mind. The implied volatility during this period has not
been consistent.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Stock price-
Stock Call price for put price for
Date CallPut Ex.price
price strike 215 strike 215
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
5.5 Summary
Empirical evidence shows that actual call values of stock-based Options in the
sample period are significantly different from the theoretical prices based on
volatility for various periods indicated. The degree of differences has varied
from study to study depending on the markets studied and the nature of price
movements. There appears to be good correlation between the theoretical
prices and the actual prices. But this only indicates the direction of the
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
movement of change and not the magnitude. Intuitively the direction can be
more easily predicted than the magnitude.
Many studies on the subject of implied volatility have shown that actual call
values of the Index are quite different from the indications of volatility.
Further it appears that the market relies more on the volatility estimate of a
1-year historical period in arriving at the call values.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Module 4
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
1.2 Introduction
We have seen that the Black Scholes model is an elegant exposition of the
determination of option prices. Five specific inputs are required for getting the
option price out of the model. These are the stock price, the strike price, the
tenure, risk free rate of return and volatile return. The impact of changes in
call prices on account of changes in these inputs are determined by Option
Greeks.
Market analysts and traders find Option Greeks very useful in formulating
specific strategies. The impact of specific inputs on the price is a very useful
piece of information in drawing up a plan for a portfolio of Options. While the
derivation of these Greeks is mathematical, it can be readily taken from an
Options calculator.
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P
c= = S
C
S p
The Delta of a call approaches 0 as it becomes more and more out-of-themoney.
A call that is at the money will hover around the 0.5 level. An in-themoney call
approaches 1.
The purchase of a call which has a Delta of 0.5 is equivalent to buying half
stock by borrowing at the risk-free rate of interest
The purchase of a put with Delta (-0.2) is equivalent to selling short 0.20 stock
and investing in risk-free assets
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Delta mimics the number of shares required to match the change in prices of
Options. Suppose a call has a Delta of 0.80 it works like having 0.80 stock and
a change in stock price of Re.1 results in change in call value of Rs.0.8
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
We take the case of a stock which is going at Rs.42. A dealer has written a call
on the stock with an Exercise Price of Rs.40. He has earned a premium of
Rs.3.53 on this written call. He wants to embark upon a Delta hedge to cover
this short position. The risk-free rate of interest is 10%.
Let us further assume that the trader wants to Delta Hedge by only
rebalancing once in a week. There are 13 weeks to go to the end of the contract.
It may be noted in this context that a Delta hedge will work better if rebalanced
very frequently. A weekly rebalancing may serve the purpose, by and large,
but cannot be expected to be fool proof.
The full chart of prices of the stock at the end of each of the 13 weeks to
expiration, along with corresponding call price and call delta is shown below.
Please note that the time has been specified in decimals with 13 weeks
corresponding to 0.25, 12 weeks corresponding to 0.23 and so on.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The dealer buys shares to the extent of Delta times the position, at the end of
each week. The Delta keeps changing week after week in the light of the
changing stock price, and the reducing period. He buys this Delta times stock
by borrowing at the interest rate of 10%.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The changes in prices result in change in the number of shares held for Delta
hedging. Occasionally, the dealer sells shares from his holding if the new Delta
at any point of time entails only a lesser holding. Interest is calculated for
every week and shown in the last column.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The call having ended in the money, his Delta has become quite close to 1 at
the end of the 12th week. Let us assume that the price remains at this level at
the end of week 13 as well. Now the dealer is able to use his holding of 100000
shares to cover his short position. He will get the call strike price of Rs.40 per
share. The future value of the premium he received up front Rs.353000
(100000*3.53), works out to Rs.357097.
Against this, the dealer has incurred a cumulative cost of Rs.4327807 for
buying the shares as indicated in various weeks shown above. His net position
then is as under:
gain loss
Call Strike received 4327807 Amount paid
4000000 for shares
Value of
premium 357097
4357097 4327807
This shows that the loss has been lower than the gains and that that he has
gained a little in the Delta Hedge. Had the time interval of rebalancing been
smaller the dealer would have been able to rebalance every day instead of every
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
week, and the position would have been more equal. Since the rebalancing
cannot be continuous there will always be a tracking error.
Gamma
Gamma is the second derivative of the option premium in relation to the stock
price. Thus, Gamma is the first derivative of Delta to the stock price.
c
2
C
G = =
S S
c 2
2
P p
G = =
S S
p 2
Gamma tells us the extent to which the Option portfolio needs to be adjusted
to conform to a Delta hedged position. A gamma of 0 indicates that the Delta
is not very sensitive to price changes. If Gamma is small, delta changes only
slowly. The Gamma of a call is equal to the Gamma of a corresponding put at
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
the same exercise price. Gamma is never negative. Adjustments to keep the
portfolio delta-neutral need to be done only infrequently in such a case.
Sine the time available can only get shorter, Theta is represented as a negative
number. Any passage of time is not beneficial to the buyer of an option, but is
beneficial to the seller.
The Theta for calls and puts can be calculated as follows:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Long call + - +
Long Put - - +
Short call - + -
Short put + + -
Vega
Vega is the derivative of the Option price with reference to volatility. An
Option derives value from volatility. A Vega of 0.2 indicates that a change of
volatility by 1% will result in 0.2% change in option prices. Vega is measured
as follows:
2
0 .5 ( d 1 )
S te
vega = 2
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Rho
Rho is the derivative of the Option price with reference to the risk-free rate of
interest, used as an input in the model. It is the least important of the Greeks.
Unless an option has a very long tenure, a small interest rate change is unlike
to have any great impact on the option price.
1.5 Summary
Option Greeks constitute an important source of strategic information for the
dealer. These measures Delta, Theta, Rho, Vega and Gamma show the
impact of specific inputs on the option price. The likely change in the option
price as a result of a small change in these inputs is measured .
The most actively used Greek is Delta. Many traders use Delta for hedging
their short call exposures. Sometimes asset managers who have a portfolio of
Options decide to Delta-hedge to avoid losses from a portion of their portfolio.
Further alert investors can sometimes use the Delta technique for exploiting
wrong implied volatility in the market.. However, the assumption here is that
wrong implied volatility will soon get corrected to the levels anticipated by the
trader.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Gamma
Vega
Delta Hedging
Delta Hedging Arbitrage
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
2.1 Objectives
The objectives of this unit are:
2.2 Introduction
We have seen the operation and broad use of general Derivatives. We now look
at the use of these instruments in managing a portfolio of fixed income
securities. These assets carry considerable risk which can be covered with the
use of special Derivatives. Interest rates are a matter of great uncertainty and
these Derivatives seek to cover this risk.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The bond price has an inverse relationship with YTM. When the market YTM
goes up the bond prices come down and vice versa. This stems out of the
operation of the internal rate of return.
Interest rate Derivatives seek to cover some of the exposure that bond
managers have. First it is necessary for the portfolio manager to determine
the specific direction of movement of interest rates that she fears and then
choose appropriate interest rate Derivatives.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Thus a 90- day Bill quoted at say 98.50 will have a yield of 6 %. The day count
convention for these bills generally has 360 days in the year.
From the discount yield the price to be paid for purchase can be determined as
follows:
Suppose T Bill Futures are bought at Rs.93 ( discount yield of 7%), the price to
be paid then will be
Rs.982500, using the above formula for a 90-day period.
If interest rates rise to 7.25%, the new price will be Rs.981875, using the same
formula but now inputting 7.25% as the discount yield.
The results are intuitive in that the price of the bond comes down when the
yield goes up.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Speculators buy T-Bond Futures when they expect the interest rates to fall and
vice-versa
The present interest is 7%. The price then will be Rs.982500 for every Rs.1
million contract, and therefore Rs.19,650,000 ,for the Rs.20 million contract.
If as expected by the Treasurer the interest rate falls to say 6.5%, the new price
of the T Bill/T- Note will be Rs.983750 for a Rs.1 million contract. The total
price available to the Treasurer on the Rs.20 million contract will be
Rs.19,675,000, gaining Rs.25,000 on the Futures contract.
Now the treasurer can invest his surplus Rs.20 mn. in the market and along
with the additional Rs.25000 got out of the Futures contract, he can makeup
for the loss in interest rates.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Just as we saw in our discussion on regular Futures, the treasurer would have
lost on the Futures contract if the interest rates had gone up instead of coming
down. In such an eventuality he would have been better off without a Futures
contract at all. He could then have participated in the higher interest by
investing the Rs.20 mn. as and when available at the higher interest rate.
While he can still do so, the loss in the Futures contract drags down his profits.
However, in trying to freeze an interest yield the Futures results in
unfavorable conditions on opposite movements.
The London Inter-bank Offer Rate ( LIBOR) is the arithmetic average of the
rates at which six major Institutions in London would be willing to deposit or
lend their dollar funds.
Eurodollar Futures are popular in the US. The yield on a Eurodollar Futures
contract is calculated on a 360-day basis, and is calculated as a discount from
the par value.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
interest on a Notional Principal over the specified period in exchange for giving
a floating rate of interest.. A buyer of an FRA will receive a floating rate of
interest against paying a fixed interest.
The concept of Notional Principal is very important for FRAs. The amount is
not exchanged between the counterparties but forms the basis for determining
the payoff.
Let us take the case of a Company which has been sanctioned a loan of Rs.10
million. The loan will become operative in 3 months and the Company is
obliged to pay a floating rate of interest on the loan at 1% over the SBI PLR as
on the last date of this quarter. Suppose the loan is to be taken with effect
from 01/04/07, the SBI PLR as at 31/03/07 will be reckoned and a 1% addition
made thereto to. This will be the applicable interest rate on the loan for the 3
months from 01/04/07 to 30/06/07. The interest for the next 3-month period
(01/07/07 to 30/09/07) will be reckoned by taking the SBI PLR rate as on
30/06/07 and adding 1% to it.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Coming back to our example our Company fears that interest rate in the
markets are likely to go up in the short run. Particularly, it fears that interest
for the quarter 01/04/07 to 30/06/07,will shoot up but expects interest rates to
stabilize in the subsequent quarters to lower levels. Therefore it wants to
safeguard against payment of high interest in the ensuing quarter.
For this purpose it can enter into an FRA promising to pay a fixed rate of
interest against receiving the benchmark floating rate (plus or minus a few
basis points).
In this example let us assume that the current SBIPLR (as on 01/01/07) is 8%.
So if interest rates were to remain at this level the Company will have to pay
9 %( SBIPLR plus 1%) on the loan for the period starting 01/04/07.
However, since it fears a rise in interest rates, the actual interest payable could
be much higher. An FRA with another counter party will ensure that the
Company pays 9% fixed on the notional principal, against receiving the
SBIPLR plus 1% from the counter party.
Before we map the payoff under the FRA in various scenarios, it is necessary
to appreciate that the FRA terms can be customized in any way. For instance
the notional principal need not be the Rs.10 million that the Company has in
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
mind but could be a smaller figure. Further the exchange payment in floating
rate need not exactly match the Companys potential liability under the loan.
Thus the FRA could provide for a floating rate receipt of say SBIPLR plus 0.5%.
The FRA payoff under different rates of ultimate interest is given below.
Table V.2.1. FRA payoff (Amount in Rs.)
Interest Rate Interest Net
FRA in FRA out
rate % +1% due payment
6 7 175000 175000 225000 225000
The first column shows the interest rates in the end. The corresponding rate
+1% is the next column. Before entering into the FRA, the Company had
contracted to pay the applicable floating rate +1% to its bank. This is the
amount shown in Column 3. In terms of the FRA the Company will receive the
SBIPLR +1% from the counterparty, in exchange of paying 9% fixed. These
amounts are indicated in the next two columns. The amounts have been
calculated using the 3 month period as the basis. The last column indicates the
net amount incurred by the Company from the deal, which is the total of the
interest it pays to its bank plus the amount it pays on the FRA minus the
amount it receives from the FRA.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
In the above example, the FRA has succeeded in freezing the amount it has to
pay out, in every eventuality.
There is one more aspect to FRAs. The net payment shown in the last column
is due only on the expiry of the 3-month period. For instance the interest rates
as shown in Column 1 is as on 31/03/07, it is applicable for the period from
01/04/07 to 30/06/07, and becomes actually due on 30/06/07. Thus, if the
exchange of payment has to be done immediately on determination of date
31/03/07 it has be the Present Value of the amount as shown in the last
column, discounted at the ruling floating rate.
2.7 Caps
A cap is an option by which the buyer gets the right to get the difference
between the actual interest rate and a strike interest rate on a notional
principal. For example let us assume A buys a European cap from B with strike
interest rate of 8% on a notional principal of Rs.1 million, for a 3 month period.
If the interest after the three month period becomes 10%, B will be obliged to
pay A Rs.20,000(2% on Rs.1 million). The principal is purely notional and is
not exchanged. The payoff position under various interest rates, is mapped
below.
Table V.2.2. Cap payoff (Amount in Rs.)
Cap struck at 8%
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interest CAP
rate inflow
6% 0
7% 0
8% 0
9% 10000
10% 20000
11% 30000
12% 40000
It may be noted that a cap is similar to a call option. It does not force the buyer
to a level of interest but gives him the cushion in case the interest rates go up.
Thus this is superior to buying an FRA . Here the buyer gets the best of both
the worlds. However, like any other option a cap will also entail payment of a
premium.
2.8 Floors
A floor is an option by which the buyer gets the right to get the difference
between the strike interest rate and the actual interest rate on a notional
principal. For example let us assume P buys a European floor from Q with
strike interest rate of 8% on a notional principal of Rs.1 million, for a 3 month
period. If the interest after the three month period becomes 7% Q will be
obliged to pay P Rs.10,000(1% on Rs.1 million). The principal is purely notional
and is not exchanged. The payoff position under various interest rates, is
mapped below.
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Interest CAP
rate inflow
6% 20000
7% 10000
8% 0
9% 0
10% 0
11% 0
12% 0
It may be noted that a floor is similar to a put option. It does not force the
buyer to a level of interest but gives him the cushion in case the interest rates
come down. Thus this is superior to selling an FRA . Here the buyer gets the
best of both the worlds. However, like any other option a floor will also entail
payment of a premium.
2.9 Collars
A collar is a combination of calls and puts. Generally a collar involves buying
one option and selling the other. Thus the premium received on selling one
option goes to reasonably offset the premium paid on buying the other. In an
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
ideal situation the two premia will offset each other resulting in what is called
a costless collar.
The payoff of a typical collar is mapped below. For the purpose of the table
below, we assume that the buyer of the collar pays a premium on the call put
and gets a premium on the floor sold. The notional principal in both the cases
is Rs.1 million and the collar is costless.
7% 0 -10000 -10000
8% 0 0 0
9% 10000 0 10000
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
2.10 Summary
Derivatives are very useful in interest rate risk management. These basically
cater to two broad category of users holders of bond portfolios and regular
dealers fearing interest rate changes. The Bond Portfolio manager is
concerned about possible depletion in net value consequent to changes in
interest rate. Every decline in market interest rate results in the bond portfolio
value going up and every increase in value results in the value coming down.
Interest rate Derivatives can be used to cover these risks. General borrowers
or lenders of money can also use interest rate Derivatives to cover themselves
against possible increases or decline in interest rates.
T-Bill Futures constitute the most basic of Interest rate Derivatives. These are
traded in many stock exchanges the world over. Similar to this in function is
the Eurodollar Futures which are based on the London Inter-bank Offer Rate
(LIBOR). Forward Rate Agreements (FRAs) constitute another category of
such Derivatives. FRAs are similar to Futures in terms of functions and enable
the participant to freeze levels of interest. Pure interest rate Options like caps
and floors are also useful in capturing any unforeseen value while at the same
time covering the risks.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Yield to maturity
T-Bill Futures
Forward Rate Agreements
Eurodollar Futures
Caps
Floors
Collars
3 Swaps
3.1 Objectives
The objectives of this unit are:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
3.2 Introduction
Companies are committed to certain specific liabilities in their everyday
management. Occasionally, they seek to come out of certain risky obligations
by exchanging these with others who have a mirror-image requirement. The
reasons for this cleaning up could vary from Company to Company. Many
reasons exist like seeking to reduce the overall risk exposure, wanting to shift
the exposure to a new type and to generally diversify ones portfolio.
Most of the other Derivatives and particularly the interest rate Derivatives we
saw work only on the basis of unilateral requirements. Their success assumes
a certain level of market participation and volumes in the market. Swaps, on
the other hand require a tailor-made agreement with a specific counterparty
with a similar requirement, but in the opposite direction.
There are many types of swaps. We look at interest rate swaps and currency
swaps and then seek to understand their valuation.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Let us take the case of a Company X which has an outstanding loan of Rs.10
million, which will get fully repaid in 4 years time. The loan had been taken
2 years back based on a floating rate of interest based on SBI PLR. The SBI
PLR at the time when the loan was taken was 9% and currently it is 10.5%.
The Company will be more comfortable if the interest rate were fixed at around
10%. Of course, the Company realizes that a fixed interest rate will not give it
the benefit of any fall in the floating rate, but taking into account its general
level of profits and other inflows, the Company would like to freeze the interest
payment at 10%.
Another Company let us call it Company Y- has a similar loan amount, but
its liability is fixed in nature. Its policy requires it to align its interest liability
to market conditions. In the process, it is prepared to take the risk of interest
rates going up as well.
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Company X
Company X
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X. Of course the two payments will be netted. Further, if the interest rates
rise to say 12%, Company Y will still have to pay 12% floating to Company X,
against receiving 10% from Company X. Thus, its liability will be floating
In the process of the swap Company A has succeeded in converting its floating
rate liability to fixed rate liability, and Company Y has converted its fixed rate
liability to a floating rate liability.
The actual terms can be varied based on the convenience of the two
counterparties. Thus, it could be that Company X may pay a fixed of 10.25%
against receiving SBI PLR -.25%, etc.
Company P wants a loan of Rs.10 million. Its bankers have told the Company
that a fixed interest loan can be sanctioned at 10% interest, while a floating
interest rate can be sanctioned at the half-yearly SBI PLR + 1 %.
Let us assume that another Company Company P- is also looking for a Rs.10
million loan. Its bankers have given it a quote of 11% for a fixed interest loan
and SBI PLR + 3 % for a floating interest loan.
The position can be mapped as follows:
Type of loan Company P Company Q
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Here it can be observed that Company Q pays more than Company P in respect
of both Fixed and Floating loans. Obviously, Company P is better credit-rated.
However, Company Q is not paying proportionately the same level higher both
the type of loans. Thus, for the floating loan, Company Q has to pay more
excess relatively that it has to pay for the fixed rate loan. It will have to pay
1% extra on a fixed rate loan, but will have to pay 2% extra if it chooses a
floating rate loan. This is called the Spread Differential and can be exploited
by the two counterparties if certain other conditions exist.
To carry the example forward, let us assume that both Companies P and Q are
indifferent as to the type of loan that they take. They are comfortable as of
now with both a Fixed or a Floating loan. Since Company Q gets the fixed rate
loan cheaper relatively, it can borrow on the Fixed segment and Company P
can borrow on the other segment in this case floating. This is called the
principle of Comparative Advantage. They then can swap their flows. One such
possible swap can be that Company P will pay Company Q 9.25% as its swap
flows, in return for getting SBIPLR + 1% from Company Q.
The position will then be as follows:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
In the above case, the Spread Differential of 1% has been shared by Companies
P and Q with P getting 0.75% and Q getting 0.25%. This is just a matter of
negotiation. On a different level of sharing, the swap inflows and outflows will
get rearranged to come to the new level. The two counterparties know what
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they have to pay to their lending banks. Having decided the sharing ratio, they
know what they have to end up having to pay. These two figures enable the
actual swap flows to be drawn up.
It should be noted that this scheme will work only if the two counterparties are
indifferent as to the type of interest rates that they are going to end up paying.
If either of the parties is particular about a type of interest, then the swap will
work only if the Comparative Advantage position allows this. Thus, if
Company P was particular about having only a floating rate liability, the swap
would not have worked, since it entails P to end up having a fixed liability.
The actual swap flows can be drawn up in any manner to suit the final position.
In practice, only the differences are netted. The principal is notional and not
transferred.
Interest rate swaps might also involve an intermediary for arranging the deal
and to sometimes take over the default risk. In such circumstances, the
intermediary also has to be paid and this will be reduced from the total
available Spread Differential in a suitable manner. So the amounts to be
shared by the two counterparties and the intermediary bank have to be
determined in advance to enable the mapping of the sharing and flow.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Let us assume that the exchange rate between the two currencies as of today
is Rupees 85 to one pound.
The UK Company will find it easier to borrow in UK rather than in India. Its
credit rating in UK will be higher and regulatory procedures will not create
any difficulties if the loan is to be in pounds. For the same reason, the Indian
Company will like to have its loan in Indian rupees. However, the actual
requirement of the two companies is in the opposite currency. Hence, one
feasible solution would be for them to borrow in the currency of their
convenience (comparative advantage) and then swap it with each other. In a
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Borrowed 240.00
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Borrowed 2.82
The net effect is that the Indian Company has been able to get funds from UK
(2.82 million pounds) at a rate of interest of 7%. The UK firm has been able to
get a loan of Rs.240 million Indian rupees at a rate of interest of 10%.
At the end of the tenure both these loans have to be repaid.
There are many variations to the basic currency swap model shown above. One
of the interest swap payments could be floating. Or the swap could be through
an intermediary and based on swap quotations. The easiest way of mapping a
swap flows is to treat it as a deposit by the Company of loan proceeds in its own
currency and borrowing in foreign currency. At the end both the deposit and
loan are closed.
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For instance let us take a situation of a loan for Rs.10000, where the floating
rates are 7.2% ( applicable to interest payment to be made one year from now).
Let us assume interest payments to be annual. The floating rates are expected
to be 7.2% after 1 year( applicable to interest payment to be made 2 years from
now) and then are expected to rise to 8% ( applicable to interest payment to be
made 3 years from now). Thus the interest payments on such a floating loan
are expected to be Rs.720, Rs.720 and Rs.800 for Years 1, 2 and 3. The principal
is to be repaid in Yr.3. The flows are as follows:
Interest
payment
720 720 830
principal
repay
10000
Here, yr.1 flows have to be discounted back at 7.2%, year 2 flows at 7.2% and
yr.3 flows at 8%.
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After a swap has been entered into, one of the parties will become a loser. If
the floating rates come down to a level lower than expected, the floating payer
will be better off and vice versa. Sometimes, the suffering counterparty might
want to unwind the swap and come out of its obligations for the rest of the
period. This can be done only with the consent of the other counterparty and
is likely to involve payment of the difference amount between the fixed and
floating present values of remaining streams, apart from whatever penalty
that is agreed upon. Alternatively, the suffering counterparty could enter into
another swap which when combined with the existing swap could nullify the
flows.
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has a cap struck at 8% and has written a floor with a strike price of 8%. The
payoff map is shown below:
6% 6% 8% -2% 0 2% -2%
7% 7% 8% -1% 0 1% -1%
8% 8% 8% 0% 0 0 0%
9% 9% 8% 1% 1% 0% 1%
10% 10% 8% 2% 2% 0% 2%
:
3.8 Summary
Swaps are important Derivatives used in the management of interest rate risks
and currency risks. Like other Derivatives, swaps are also used by speculators.
A plain vanilla interest rate swap involves the exchange of obligations by two
counterparties in such a way, that one which has to pay a fixed rate of interest
to its lending bank gets this reimbursed in part or full from the other
counterparty. Similarly, the second counterparty gets its floating rate due to
its bank reimbursed in part or full by the first counterparty. The exact
amounts to be exchanged and the periodicity are matters of contract and will
vary from case to case.
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more interest on both fixed and floating segments. However, the amounts it is
required to pay in excess may not be the same. This gives rise to an economic
phenomenon called Spread Differential, which enables the two counterparties
to reap mutual benefits.
Currency swaps stem from the same principle, but arise out of multinational
obligations. This involves exchange of flows in two different currencies. The
effective result is that the borrowing entity deposits the amount it borrows in
exchange of getting a loan in the foreign currency. At the end of the contract
both the deposit and the loan are closed. Currency swaps will be useful only if
the amount to be paid as interest as a result of it is lower than what the
Company itself would have been able to get.
After a swap has been entered into changes in circumstances will make it less
or more valuable. Sometimes companies wish to come out of their swap
obligations by entering into another swap. Unwinding a swap may involve
paying a penalty and the difference in present values to the counterparty.
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Spread Differential
Currency Swap
Unwinding of a swap
4 Credit Derivatives
4.1 Objectives
The objectives of this unit are:
4.2 Introduction
In recent years, banking literature in India has been concentrating on
Operational Risk of Banks and the impact of the Basel II norms. While there
can be no doubt that this is a crucial feature of Bank management, the
development of Credit Derivatives which is becoming increasingly popular
abroad does not seem to have captured the imagination of the Indian Banker
to a great extent. This paper seeks to give the broad features of some common
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The extant credit risk management practices involve monitoring and constant
follow-up on loan accounts. But cyclically, banks have the problem of having
to manage funds and risk concurrently. Credit Derivatives seek to transfer the
returns and risk of an asset portfolio without transferring the ownership per
se. They are thus off-Balance Sheet items. The basic idea is to un-bundle the
risk underlying an asset and trade it separately. The success of these
instruments will depend on a continuing market for various riskdenominated
securities and a market that follows at least the semi-strong Efficient Market
Hypothesis. The fear of misuse and the whole question of recourse and timing
thereof have all slowed down the process of their acceptance in India.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The present set of rules does not permit commercial banks absolute freedom in
using Credit Derivatives as buyers and sellers. Only plain instruments of the
plain vanilla type are permitted and that too and cannot be trading intent,
except to a limited extent. The deals should be on the basis of market rates
and free availability of information. A full gamut of systems and procedures
must be in place before any Bank can embark upon this activity.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
There are several issues involved in the setting up of a credit default swap
agreement. Specifically the following points need attention:
Notional Value The value of the assets under question and how their
final values will be determined
Premium the extent of premium to be paid for the agreement and the
mode and timing of payment are to be specified
Mode of settlement The agreement will have to spell out the mode of
settlement and the timing of payment to be effected
How the collaterals are treated after the payment the counterparty
steps into the shoes of the Bank and will have the right to enforce the
collaterals. The procedure for transfer of this right and the timing
thereof has to be spelt out.
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The motivation of the bank could be that some of its heavy debts should be
changed and converted into more certain inflows. The counterparty might
want to take a little more risk and wishes to exchange relatively low interest
rates for potentially higher bond returns.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
riskreturn balance. For this, the bundle of debt instruments (loans or bonds
with varying tenures, returns and perceived risks) are bundled together and
assigned to a Special Purpose Vehicle (SPV) formed for the purpose. The SPV
in turn informs to interested counterparties about the existence of this bundle.
The bundle itself is then split into suitable tranches of differing risks and
returns. For instance, the first 5% of default (highest risk) of the portfolio can
be labeled as Tranche 1 and can carry a very high return. The investor segment
subscribing to this tranche will be willing to assume the higher risk for the
higher expected return. This will be akin to subscribing to a junk bond. The
tranches after this will have reduced levels of expected risk and
correspondingly reduced levels of expected return. The last tranche can even
be less risky than the original portfolio (since the expected level of risk has
been taken over by earlier tranches) and need only be rewarded with low
return. This will be similar to investing in an AAA bond. For the originating
bank, the loan has effectively been collected, while for the counterparty this is
an avenue of investment based on risk aversion. The SPV is merely a
facilitator.
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Under this the subscribers to the first tranche get a higher return but are
exposed to great risk. The next tranche takes some risk, but lesser than the
first tranche and hence is rewarded only with a lower return and so on. The
last tranche has virtually no risk, since the first 40% of risk of default will be
borne by the other tranches. This tranche thus becomes as good as a AAA bond,
and enjoys the lowest return. It may be noted that the weighted average of the
returns to all the four tranches comes to 9%, which the yield of the portfolio in
the first place.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
The Total Return Swap is fraught with more regulatory problems. Here the
Bank seeks to transfer the entire return on the debt portfolio in return for a
floating rate yield. The Banks motivation is again to get rid of the risk involved
and pay the price for it by accepting a lower return. The counterpartys
motivation is to have an avenue for investment with moderate risk and
corresponding high return. The problems arise as to what securities the first
Bank can be allowed to assign. In particular the following points merit
consideration:
1. Definition of Total return. This involves the market yield and the
tradability or otherwise of the underlying. Also, broad norms for
categorizing various investments in terms of Duration and Tenure may
be needed to make the volatility recognizable
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Apart from the general uses for credit risk management, Credit Derivatives
can also develop into a useful tool for Asset Liability Management (ALM) of
Banks. Banks who follow strategies based on Gap analysis will be concerned
about certain Rate Sensitive Assets or Liabilities and one of the additional tools
in the hands of the Bank would be to enter into a credit derivative transaction.
4.10 Summary
The Credit Derivative Market in India is in a nascent stage. With the full
development of the fixed income securities market and the advent of interest
rate Derivatives, the logical next step is the popularity of Credit Derivatives.
The advantages of having a vibrant credit derivative market will be felt by all
sections of the market. The world over, innovations are being made to this
broad type of derivative and it is only a matter of time before we have this
working in full swing in India. Before that, the regulatory authorities will need
to have clear guidelines in place for the Banks and participating Institutions.
These guidelines will need to be flexible while taking care of possible misuse.
That is indeed a challenge.
The total returns swap and credit default swap are two common instruments
of Credit Derivatives. They seek to transfer the returns from the risky asset
to an interested buyer. Collateralized Debt Obligations create sub-bundles
from a pool of risky assets. The idea is to have a special purpose vehicle take
over the risky asset and then re -issue it as several instruments of varied risk
and return. Credit Derivatives are slowly gaining popularity and acceptance
in India..
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5.1 Objectives
The objectives of this unit are:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
5.2 Introduction
Derivatives have a great deal of use in Risk Management. A judicial use of
Derivatives in the right proportion enables a Corporate manger to optimize his
risk-return matrix.
Basic hedging has already been discussed at the appropriate places in earlier
Chapters. Here we look at some sophisticated use of Option Greeks to manage
risk better.
One inherent assumption under most of the models given below should be
borne in mind. As we have seen, Options Pricing is a complex subject and there
cannot be any unanimity as to what factors influence the prices more. Besides,
the Black-Scholes model need not always reflect the correct price, although the
model is in great use and arguably the best suited. However, in the examples
and strategies illustrated below, we have taken the calculations as per the
Black-Scholes model for computational purposes. If the markets consistently
ignore the Black-Scholes model and go by another framework (there is no
evidence of this), then we need to re-compute our projections on that basis.
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Position Delta
Position Delta refers to the Weighted average Delta of a portfolio of holdings
(of stock and Options) on the same underlying. Position Delta measures the
extent to which a portfolio changes for a small change in stock prices. This can
be understood easily with an example.
Stock 100 38 1
A portfolio manager has 100 shares long of a stock (present market price
Rs.38), and has written 50 calls on it with an Exercise Price of 40, and has
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
bought 50 puts on the same stock with an Exercise Price of Rs.41. Let us
assume the volatility to be 25%, the time to go to be 3 months (0.25) and the
risk free interest rate to be 7%. Inputting the above data into the BlackScholes
calculator we get the following:
The position delta is ((1*100 )+ (0.42* -50) +(-0.66 *50) = 46. This signifies that
an increase of the stock price by Re.1 will result in the portfolio value going up
by Rs.46. This can be verified as follows.
Let us assume the stock price goes up to Rs.39 the very next day. The relevant
figures then will be as follows:
Stock 100 39 1
The actual value goes up by 47. But for rounding errors, the Position Delta
reflects changes reasonably accurately for small changes in the underlying.
After the change the Delta of the portfolio will also remain stable if the Gamma
is not substantial.
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Apart from arbitrage operations, many market makers use this strategy to lock
up fluctuations arising out of stock movements, so that they can concentrate
on changes in bid-ask spreads
Position Gamma
Position Gamma is the weighted average of Gammas of the various components
in the portfolio. We know that the Gamma of a call is equal to the Gamma of
a put and that it cannot be negative. However, a portfolio gamma can be
negative if it contains some short positions.
Let us take the case of a stock currently priced at Rs.80. A call on the stock
with 3 month maturity, 25% volatility, a risk free rate of return of 7% and
strike price of Rs.85 will have a price of 2.55, a Delta of 0.3888 and Gamma of
0.0383, as per the Black-Scholes model.
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Stock 39 80 1 0
The Position Gamma of the portfolio is just the weighted average of the
Gammas of the components of the portfolio. We get (-100*0.0383) + (39*0)=
3.83
Let us see the impact of small changes in the stock price on the very next day.
When the price goes up to Rs.82, the portfolio value will be (-100*3.4061)
+ (82 * 39) = 2857.
When the price comes down to Rs.78, the portfolio value will be (-100*1.85)
+ (78 * 39) = 2857.
Either way the portfolio changes to a minimum extent but in the negative
direction. This happens whenever the Portfolio Gamma is negative. The
portfolio, of course, is delta hedged, so the value will not deteriorate by much.
Conversely, if the Portfolio Gamma had been positive ( as a result of a Delta
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hedged portfolio consisting of long puts and long stock), the changed value
would still have been around the Delta-hedged level, but would have moved
slightly to the positive direction.
Let us take a delta-hedged portfolio consisting of long puts and long delta times
the stock. As in the last case, the stock is currently priced at Rs.80 and we seek
to go long to the extent of 100 puts at an Exercise Price of Rs.85. There are 3
months to go in the contract the risk-free rate is 7%. And the volatility is 25%.
Table V.5.5. Delta hedging with puts Position Gamma- Price in Rs.
Instrument Quantity Price Delta Gamma
Stock 61 80 1 0
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Table V.5.6. Impact of price changes and Put Gamma- Price in Rs.
Stock Put Put Put
price price Delta Gamma
82 4.93 -.53 0.0388
When the price goes up to Rs.82, the portfolio value will be (100*4.93) + (82 *
61) = 5495.
When the price comes down to Rs.78, the portfolio value will be (100*7.37)
+ (78 * 61) = 5495.
Either way the portfolio changes by a small margin, but in the positive
direction.
If Gamma is small, Delta moves slowly and so rebalancing need not be very
frequent. Position Gamma gives an indication of how much the portfolios
Delta will fluctuate because of stock movements. This, in turn, gives an
indication of the re-balancing strategy to be followed.
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hedging). This ensures that the portfolio need not be rebalanced from time to
time.
An example will show the effect of this.
Let us take the following situation:
Volatility 15%
Risk-free rate 8%
Time 3 months
A trader wants has sold 100 calls on the above strike price at a premium of
Rs.2.50. (This can be verified from the Black-Scholes calculator). She wants to
be Delta-Gamma hedged. The Delta of the call is 0.4051 and the Gamma
0.0431.
To be delta-hedged the Delta times the number of stock has to be bought. This
entails buying of 41 shares at the current market price of Rs.120. The portfolio
value is:
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
Stock 41 120 1 0
In order to be Gamma hedged as well, another call on the same stock has to be
used in conjunction with this to make the total Gamma 0 along with the
Delta of 0. Suppose there is another call going with a strike price of Rs.130.
Its call price as per the Black-Scholes calculator will be Rs.1.11, and its Delta
and Gamma will be 0.22 and 0.03 respectively.
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Let us verify our finding for some changes in stock prices and take two
scenarios by which stock prices go to Rs.122 and Rs.118.
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The portfolio value remains at around the base-case level. All the figures are
taken using the Black-Scholes calculations.
This involves a two-way analysis of the return and fluctuations to the return
likely. The word risk denotes the levels to which the expected returns can
fluctuate based on various scenarios. The firm has to take a calculated view of
the risk and the levels to which risk should be reduced. The following points
may be noted in this connection:
1. In an ideal market, higher expected returns can be got only by taking
correspondingly higher levels of risk. A Company has to evolve a policy
of the level of risk it wants to expose itself to and correspondingly plan
for its returns.
2. The risk levels could be analyzed from two specific angles the business-
related risk and financial risk. Business-related risk is what all
companies will be exposed to because of factors of production,
governmental policy, environmental issues, tax exposure, competition to
the industry etc. Financial risk, on the other hand, is more micro in
nature and depends on the Companys policy regarding use of debt
finance, its treasury operations and its reinvestment policy.
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5.6 Summary
Option Greeks are widely used in risk management. Inherently, the corporate
hedger assumes that the prices and other parameters relating to the Options
will remain within predictable limits. The Black-Scholes model is used for
calculating the Greeks. For small changes in the underlying hedging policies
using Greeks are likely to succeed.
Position Delta refers to the average Delta of the portfolio. Position Delta will
tell us the extent to which the portfolio value is likely to go up or down given a
small change in the stock prices. Position Delta is likely to be very accurate
only for small changes in stock value.
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to change the portfolio is not very frequent. A position Gamma gives the
measure of overall Gamma for a portfolio
A Delta Gamma hedge makes sure that the portfolio managers hedging
strategy works correctly and that Deltas rebalancing frequency will not greatly
affect the portfolios hedge performance.
In framing a Corporate Hedging Policy, the extent of return desired, the risk
to be taken to meet the return expectation and the instruments to be used all
play a role. Though the use of Derivatives in a naked way is fraught with risk,
their use in Risk Management and Hedging make them powerful tools of the
future.
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
References
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FUNDAMENTALS OF FINANCIAL DERIVATIVES
290
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291
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Discount yield, 192 227, 228, 229, 230, 231, 232, 236,
Dividend, 42, 61, 110, 116 237 Hedging, 1, 2, 3, 6, 7, 28, 29, 39, 40,
Dividends, 111 Early 57,
61, 67, 181, 183, 185, 190, 193, 226,
Exercise, 111 228, 233, 235, 237
Eurodollar Futures, 191, 195, 201, In the money, 73
202 Index Futures, 1, 3, 54, 56, 57, 60, 62,
European Option, 73, 74, 77, 78, 111, 63, 67 Log normal
147, 164, 182
distribution, 172
Exercise Price, 71, 72, 74, 75, 77, 81,
84, 87, 91, 92, 93, 94, 96, 106, 107, Margins, 32
109, 110, 111, 122, 123, 125, 128, Mark to market, 32
131, 133, 134, 136, 141, 142, 143, Mimicking portfolio, 103
144, 145, 147, 148, 149, 150, 151,
No-arbitrage condition, 111
152, 153, 154, 157, 166, 167, 169,
Optimal Hedge Ratio, 3, 61, 67, 68, 154,
170, 183, 226, 229, 232, 233
161
Floor, 200 Options, 1, 3, 4, 5, 10, 11, 14, 15, 70, 71,
Forward, 6, 10, 13, 15, 17, 18, 19, 21, 73, 74, 75, 76, 77, 78, 79, 86, 87, 89,
23, 24, 25, 26, 27, 28, 29, 30, 31, 34, 91, 100, 102, 104, 105, 108, 109, 110,
37, 41, 52, 53, 68, 191, 195, 201, 202, 111, 113, 116, 117, 119, 122, 141,
203, 215 142, 147, 149, 151, 152, 153, 154,
FRA, 195, 197, 198, 199, 200, 202 158, 160, 161, 164, 168, 169, 171,
Futures, 1, 2, 3, 6, 8, 10, 14, 15, 17, 19, 174, 176, 178, 181, 182, 189, 202,
21, 22, 25, 26, 27, 28, 29, 30, 31, 32, 217, 225, 226, 234, 236, 239, 240
33, 34, 35, 36, 37, 38, 39, 40, 41, 42,
Position Delta, 226, 227, 236, 237
43, 44, 45, 46, 47, 48, 49, 50, 51, 52,
53, 54, 56, 57, 58, 59, 60, 61, 62, 63, Position Gamma, 228, 230, 236, 237
64, 65, 66, 67, 68, 70, 75, 76, 77, 78, Protective puts, 103
97, 98, 99, 102, 103, 191, 192, 193, Put, 1, 3, 4, 78, 83, 85, 87, 91, 97, 98,
194, 195, 201, 202, 234, 239, 240 99, 100, 101, 102, 103, 114, 117, 123,
Gamma, 5, 7, 187, 188, 189, 190, 225, 124, 125, 126, 127, 129, 130, 134,
137, 138, 141, 143, 144, 145, 146,
147, 151, 178, 183, 188, 201, 226,
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227, 230
Put-call parity, 146
Random walk, 172
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