Pricing Factor

Chapter 4
Pricing futures
Stock index futures began trading on NSE on the 12th June 2000. Stock futures were launched on
9th November 2001. The volumes and open interest on this market has been steadily growing.
Looking at the futures prices on NSE’s market, have you ever felt the need to know whether
the quoted prices are a true reflection of the price of the underlying index/stock? Have you
wondered whether you could make risk-less profits by arbitraging between the underlying and
futures markets? If so, you need to know the cost-of-carry to understand the dynamics of pricing
that constitute the estimation of fair value of futures.
4.1 The cost of carry model

We use fair value calculation of futures to decide the no-arbitrage limits on the price of a futures
contract. This is the basis for the cost-of-carry model where the price of the contract is defined as:
F S
where:
F Futures price
S Spot price
C Holding costs or carry costs
This can also be expressed as:
F S

where:
r Cost of fi nancing
50 Pricing futures
T Time till expiration
If

or
, arbitrage opportunities would exist i.e. whenever

the futures price moves away from the fair value, there would be chances for arbitrage. We
know what the spot and futures prices are, but what are the components of holding cost? The
components of holding cost vary with contracts on different assets. At times the holding cost
may even be negative. In the case of commodity futures, the holding cost is the cost of financing
plus cost of storage and insurance purchased etc. In the case of equity futures, the holding cost
is the cost of financing minus the dividends returns.
Note: In the futures pricing examples worked out in this book, we are using the concept of
discrete compounding, where interest rates are compounded at discrete intervals, for example,
annually or semiannually. Pricing of options and other complex derivative securities requires
the use of continuously compounded interest rates. Most books on derivatives use continuous
compounding for pricing futures too. However, we have used discrete compounding as it is more
intuitive and simpler to work with. Had we to use the concept of continuous compounding, the
above equation would have been expressed as:
F S

where:
r Cost of fi nancing(using continuously compounded interest rate)
T Time till expiration
e 2.71828
4.1.1 Pricing futures contracts on commodities

Let us take an example of a futures contract on a commodity and work out the price of the
contract. The spot price of silver is Rs.7000/kg. If the cost of financing is 15% annually, what
should be the futures price of 100 gms of silver one month down the line ? Let us assume that
we’re on 1st January 2002. How would we compute the price of a silver futures contract expiring
on 30th January? From the discussion above we know that the futures price is nothing but the
spot price plus the cost-of-carry. Let us first try to work out the components of the cost-of-carry
model.
1. What is the spot price of silver? The spot price of silver, S= Rs.7000/kg.

2. What is the cost of financing for a month?
3. What are the holding costs? Let us assume that the storage cost = 0.
In this case the fair value of the futures price, works out to be = Rs.708.

F

" " $

"
4.2 Pricing equity index futures 51

Under normal market conditions, F, the futures price is very close to . However, on October
19,1987, the US market saw a breakdown in this classic relationship between spot and futures prices.
It was the day the markets fell by over 20% and the volume of shares traded on the New York Stock
Exchange far exceeded all previous records. For most of the day, futures traded at signifi cant discount
to the underlying index. This was largely because delays in processing orders to sell equity made index
arbitrage too risky. On the next day, October 20,1987, the New York Stock Exchange placed temporary
restrictions on the way in which program trading could be done. The result was that the breakdown of
the traditional linkages between stock indexes and stock futures continued. At one point, the futures
price for the December contract was 18% less than the S&P 500 index which was the underlying index
for these futures contracts! However, the highlight of the whole episode was the fact that inspite of
huge losses, there were no defaults by futures traders. It was the ultimate test of the effi ciency of the
margining system in the futures market.
Box 4.8: The market crash of October 19, 1987
If the contract was for a three-month period i.e. expiring on 30th March, the cost of financing
would increase the futures price. Therefore, the futures price would be

"

. On the other hand, if the one-month contract was for 10,000 kg. of silver instead

" $ "
"
of 100 gms, then it would involve a non-zero storage cost, and the price of the futures contract
would be Rs.708 plus the cost of storage.
4.2 Pricing equity index futures

A futures contract on the stock market index gives its owner the right and obligation to buy or
sell the portfolio of stocks characterized by the index. Stock index futures are cash settled; there
is no delivery of the underlying stocks.
In their short history of trading, index futures have had a great impact on the world’s securities
markets. Indeed, index futures trading has been accused of making the world’s stock markets
more volatile than ever before. The critics claim that individual investors have been driven out
to the equity markets because the actions of institutional traders in both the spot and futures
markets cause stock values to gyrate with no links to their fundamental values. Whether stock
index futures trading is a blessing or a curse is debatable. It is certainly true, however, that its
existence has revolutionized the art and science of institutional equity portfolio management.
The main differences between commodity and equity index futures are that:
There are no costs of storage involved in holding equity.
Equity comes with a dividend stream, which is a negative cost if you are long the stock and a positive
cost if you are short the stock.
Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial aspect of dealing with
equity futures as opposed to commodity futures is an accurate forecasting of dividends. The
better the forecast of dividend offered by a security, the better is the estimate of the futures price.
52 Pricing futures
4.2.1 Pricing index futures given expected dividend amount

The pricing of index futures is also based on the cost-of-carry model, where the carrying cost is
the cost of financing the purchase of the portfolio underlying the index, minus the present value
of dividends obtained from the stocks in the index portfolio.
Example
Nifty futures trade on NSE as one,two and three-month contracts. Money can be borrowed at a
rate of 15% per annum. What will be the price of a new two-month futures contract on Nifty?
1. Let us assume that M & M will be declaring a dividend of Rs. 10 per share after 15 days of purchasing
the contract.
2. Current value of Nifty is 1200 and Nifty trades with a multiplier of 200.
3. Since Nifty is traded in multiples of 200, value of the contract is 200*1200 = Rs.240,000.
4. If M & M has a weight of 7% in Nifty, its value in Nifty is Rs.16,800 i.e.(240,000 * 0.07).
5. If the market price of M & M is Rs.140, then a traded unit of Nifty involves 120 shares of M & M
i.e.(16,800/140).
6. To calculate the futures price, we need to reduce the cost-of-carry to the extent of dividend received.
The amount of dividend received is Rs.1200 i.e.(120 * 10). The dividend is received 15 days later
and hence compounded only for the remainder of 45 days. To calculate the futures price we need
to compute the amount of dividend received per unit of Nifty. Hence we divide the compounded
dividend fi gure by 200.

7. Thus, futures price F Rs.

4.2.2 Pricing index futures given expected dividend yield

If the dividend flow throughout the year is generally uniform, i.e. if there are few historical cases
of clustering of dividends in any particular month, it is useful to calculate the annual dividend
yield.

where:
F futures price
S spot index value
r cost of fi nancing
q expected dividend yield
T holding period
4.2 Pricing equity index futures 53
Figure 4.1 Variation of basis over time

The fi gure shows how basis changes over time. As the time to expiration of a contract reduces, the basis reduces.
Towards the close of trading on the day of settlement, the futures price and the spot price converge. The closing
price for the June 28 futures contract is the closing value of Nifty on that day.
Price
Futures price
Spot price
Time
t1 t2 T
Example
A two-month futures contract trades on the NSE. The cost of financing is 15% and the dividend
yield on Nifty is 2% annualized. The spot value of Nifty 1200. What is the fair value of the
futures contract? Fair value Rs.

$ " " $ $ $ "

The cost-of-carry model explicitly defines the relationship between the futures price and the
related spot price. As we know, the difference between the spot price and the futures price is
called the basis.
Nuances
As the date of expiration comes near, the basis reduces - there is a convergence of the futures price
towards the spot price. On the date of expiration, the basis is zero. If it is not, then there is an
arbitrage opportunity. Arbitrage opportunities can also arise when the basis (difference between spot
and futures price) or the spreads (difference between prices of two futures contracts) during the life
of a contract are incorrect. At a later stage we shall look at how these arbitrage opportunities can be
exploited.
There is nothing but cost-of-carry related arbitrage that drives the behavior of the futures price.
Transactions costs are very important in the business of arbitrage.
Note: The pricing models discussed in this chapter give an approximate idea about the true
future price. However the price observed in the market is the outcome of the price–discovery
mechanism (demand–supply principle) and may differ from the so-called true price.
54 Pricing futures
4.3 Pricing stock futures

A futures contract on a stock gives its owner the right and obligation to buy or sell the stocks.
Like index futures, stock futures are also cash settled; there is no delivery of the underlying
stocks. Just as in the case of index futures, the main differences between commodity and stock
futures are that:
There are no costs of storage involved in holding stock.
Stocks come with a dividend stream, which is a negative cost if you are long the stock and a positive
cost if you are short the stock.
Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial aspect of dealing with
stock futures as opposed to commodity futures is an accurate forecasting of dividends. The better
the forecast of dividend offered by a security, the better is the estimate of the futures price.
4.3.1 Pricing stock futures when no dividend expected

The pricing of stock futures is also based on the cost-of-carry model, where the carrying cost is
the cost of financing the purchase of the stock, minus the present value of dividends obtained
from the stock. If no dividends are expected during the life of the contract, pricing futures on
that stock is very simple. It simply involves multiplying the spot price by the cost of carry.
Example
SBI futures trade on NSE as one,two and three-month contracts. Money can be borrowed at 15%
per annum. What will be the price of a unit of new two-month futures contract on SBI if no
dividends are expected during the two-month period?
1. Assume that the spot price of SBI is Rs.228.

2. Thus, futures price F
Rs.
4.3.2 Pricing stock futures when dividends are expected

When dividends are expected during the life of the futures contract, pricing involves reducing
the cost of carry to the extent of the dividends. The net carrying cost is the cost of financing the
purchase of the stock, minus the present value of dividends obtained from the stock.
Example
M & M futures trade on NSE as one,two and three–month contracts. What will be the price
of a unit of new two–month futures contract on M & M if dividends are expected during the
two–month period?
4.3 Pricing stock futures 55
1. Let us assume that M & M will be declaring a dividend of Rs. 10 per share after 15 days of purchasing
the contract.
2. Assume that the market price of M & M is Rs.140.
3. To calculate the futures price, we need to reduce the cost-of-carry to the extent of dividend received.
The amount of dividend received is Rs.10. The dividend is received 15 days later and hence
compounded only for the remainder of 45 days.

4. Thus, futures price F
Rs.
Solved problems
Q: The model is used for pricing futures contracts.
1. Black & Scholes 3. Miller
2. Cost–of–carry 4. Time–value
A: The correct answer is number 2.
Q: Suppose the Nifty spot is at 1000 and two-month futures trade at 1040. Suppose the transaction costs
involved in placing an index trade are 0.25% and the Nifty index dividends over two months are 0.10%.
What is the net rate of return?
1. 1.5% per month 3. 1.75% per month
A: The return on the futures is 1040/1000, i.e. 4%. After adding 0.1% dividends and deducting 0.25%
transactions cost, the total return over 2 months works out to be 3.85%. Therefore the net return per month
works out to be 1.92%. The correct answer is number 4.
Q: What is the riskless profi t that can be earned over two months if the Nifty spot is at 1000 and the two
month futures are at 1010. Suppose cash can be risklessly invested at 12% p.a. and there are no transaction
costs.
1. 1.09% 3. 0.9%
2. 0.01% 4. 0.4%
A: At a riskfree rate of 12%, futures are underpriced. One can make an arbitrage profi t by buying Nifty
futures at 1010, selling Nifty spot and investing the 1000 risklessly for two months. At the end of two
months this money would grow to be about 1019. i.e. a return of (1019-1010)/1000. The correct answer
is number 3.
56 Pricing futures
Q: What is the fair value of one month future if the spot value of Nifty is 1150? The money can be
invested at 11% p.a. and Nifty gives a dividend yield of 1% per annum.
1. 1162 3. 1180
2. 1159 4. 1170

A: The fair value is

. The correct answer is number 2.
Q: What is the fair value of one month future if the spot value of Nifty is 1150? The money can be
invested at 14% p.a. and Nifty gives a dividend yield of 4% per annum.
1. 1162 3. 1180
2. 1159 4. 1170

A: The fair value is

. The correct answer is number 2.
Q: The Nifty spot stands at 1260 and the cost of fi nancing is 12% per year. What is the fair value of
one-month Nifty futures contracts?
1. 1262 3. 1268
2. 1272 4. 1275

A: Using the cost-of-carry model, the price of the futures contract is computed as

which is approximately 1272. The correct answer is number 2.
Q: The Nifty spot stands at 1260 and the cost of fi nancing is 12% per year. The annual dividend yield on
the Nifty works out to be 2%. What is the fair value of one-month Nifty futures contracts?
1. 1268 3. 1268
2. 1272 4. 1270


which is approximately 1270. The correct answer is number 4.

4.3 Pricing stock futures 57
Q: Nifty futures trade on NSE as one, two and three-month contracts. Spot Nifty stands at 1200. BASF
which currently trades at Rs.120 has a weight of 5% in Nifty. It is expected to declare a dividend of Rs.20
per share after 15 days of purchasing the contract. The cost of borrowing is 15% per annum. What will
be the price of a new two-month futures contract on Nifty?
1. 1225.50 3. 1230.85
2. 1227.80 4. 1217.70
A: Since Nifty stands at 1200, value of the contract is 200*1200 = Rs.240000. If BASF has a weight of
5% in Nifty, its value in Nifty is Rs.12000. If the market price of BASF is Rs.120, then a traded unit of

Nifty involves 100 shares. Thus, the futures price F Rs.

The correct answer is number 4.
Q: The Tata Tea trades on the spot market at Rs.177. The cost of fi nancing is 12% per year. What is the
fair value of one-month futures on Tata Tea?
1. 178.65 3. 180.15
2. 179.05 4. 177.65


which is 178.65. This could also be computed as which gives approximately the same
answer.The correct answer is number 1.
Q: The Tata Tea trades on the spot market at Rs.177. The cost of fi nancing is 12% per year. It is expected
to pay a dividend of Rs.10, 45 days later. What is the fair value of three-month futures on Tata Tea?
1. 173.65 3. 182.05
2. 171.88 4. 177.65


which is 171.88. The correct answer is number 2.
Q: The ITC trades on the spot market at Rs.720. The cost of fi nancing is 15% per year. What is the fair
value of two-month futures on ITC?
1. 736.73 3. 731.45
2. 728.65 4. 732.55


which
is 736.73. The correct answer is number 1.
58 Pricing futures
Q: The Tata Tea trades on the spot market at Rs.177. The cost of fi nancing is 15% per year. It is expected
to pay a dividend of Rs.10, 45 days later. What is the fair value of three-month futures on Tata Tea?
1. 173.05 3. 181.05
2. 171.20 4. 177.65


which is 173.05. The correct answer is number 1.

Chapter 5
Using index futures
There are eight basic modes of trading on the index futures market:
Hedging
1. Long security, short Nifty futures

2. Short security, long Nifty futures
3. Have portfolio, short Nifty futures
4. Have funds, long Nifty futures
Speculation
1. Bullish index, long Nifty futures

2. Bearish index, short Nifty futures
Arbitrage
1. Have funds, lend them to the market

2. Have securities, lend them to the market
5.1 Hedging: Long security, short Nifty futures

Investors studying the market often come across a security which they believe is intrinsically
undervalued. It may be the case that the profits and the quality of the company make it seem
worth a lot more than what the market thinks. A stockpicker carefully purchases securities based
on a sense that they are worth more than the market price. When doing so, he faces two kinds of
risks:
1. His understanding can be wrong, and the company is really not worth more than the market price; or,
2. The entire market moves against him and generates losses even though the underlying idea was correct.
60 Using index futures
The second outcome happens all the time. A person may buy Reliance at Rs.190 thinking
that it would announce good results and the security price would rise. A few days later, Nifty
drops, so he makes losses, even if his understanding of Reliance was correct.
There is a peculiar problem here. Every buy position on a security is simultaneously a buy
position on Nifty. This is because a LONG RELIANCE position generally gains if Nifty rises
and generally loses if Nifty drops. In this sense, a LONG RELIANCE position is not a focused
play on the valuation of Reliance. It carries a LONG NIFTY position along with it, as incidental
baggage. The stockpicker may be thinking he wants to be LONG RELIANCE, but a long position
on Reliance effectively forces him to be LONG RELIANCE + LONG NIFTY.
Even if you think WIPRO is undervalued, the position LONG WIPRO is not purely about
WIPRO; it is also partly about Nifty. Every trader who has a LONG WIPRO position is forced to
be an index speculator, even though he may have no interest in the index. It is useful to ask: does
the person feel bullish about WIPRO or about the index?
Those who are bullish about the index should just buy Nifty futures; they need not trade individual securities.
Those who are bullish about WIPRO do wrong by carrying along a long position on Nifty as well.
There is a simple way out. Every time you adopt a long position on a security, you should
sell some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every
long–security position. Once this is done, you will have a position which is purely about the
performance of the security. The position LONG WIPRO + SHORT NIFTY is a pure play on the
value of WIPRO, without any extra risk from fluctuations of the market index. When this is done,
the stockpicker has “hedged away” his index exposure. The basic point of this hedging strategy
is that the stockpicker proceeds with his core skill, i.e. picking securities, at the cost of lower
risk.
Warning: Hedging does not remove losses. The best that can be achieved using hedging is
the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less
profits than the un-hedged position, half the time. One should not enter into a hedging strategy
hoping to make excess profits for sure; all that can come out of hedging is reduced risk.
How do we actually do this?

1. We need to know the “beta” of the security, i.e. the average impact of a 1% move in Nifty upon the security. If
betas are not known, it is generally safe to assume the beta is 1. Suppose we take LUPINLAB, whose beta is
1.2, and suppose we have a LONG LUPINLAB position of Rs.200,000.
2. The size of the position that we need on the index futures market, to completely remove the hidden Nifty
exposure, is 1.2 200,000, i.e. Rs.240,000.

3. Suppose Nifty is at 1200, and the market lot on the futures market is 200. Hence each market lot of Nifty is
Rs.240,000. To sell Rs.240,000 of Nifty we need to sell one market lot.
4. We sell one market lot of Nifty (200 nifties) to get the position:
LONG LUPINLAB Rs.200,000
SHORT NIFTY Rs.240,000
5.1 Hedging: Long security, short Nifty futures 61
This position will be essentially immune to fluctuations of Nifty. The profi ts/losses position will fully reflect
price changes intrinsic to LUPINLAB, hence only successful forecasts about LUPINLAB will benefi t from this
position. Returns on the position will be roughly neutral to movements of Nifty.
Example
1. Shyam adopts a position of Rs.1 million LONG MTNL on date 5th June 2001. He plans to hold the position till
the 25th.
2. Suppose the beta of MTNL happens to be 1.2.
3. Hence he needs a short position of Rs.1.2 million on the index futures market to totally remove his Nifty
exposure.
4. On date 5th June 2001, Nifty is 980 and the nearest futures contract (with expiration 28th June 2001) is trading
at about 1000. Hence, each market lot of the futures (200 nifties) is worth Rs.200,000. To sell Rs.1.2 million
of Nifty, we need to sell 6 lots (by rounding off to the nearest market lot).
5. He sells 6 market lots of Nifty (1200 nifties) to get the position:

LONG MTNL Rs.1,000,000
SHORT NIFTY Rs.1,200,000
6. 10 days later, Nifty crashed because of instability in the government.
7. On Thursday, Shyam unwound both positions. His position on MTNL lost Rs.120,000 since MTNL had
dropped to 880,000. His short position on Nifty June futures earned Rs.141,600. Overall, he earned Rs.21,600.
Nuances
1. How do I fi nd out the beta of a security? The betas of major securities are available in the NSE Newsletter
or over the Internet on http://www.nse-india.com. Note that the security prices and betas used in
this workbook are only illustrative in nature.
2. What if I am still stuck without a beta estimate? If a beta is not known, it is generally useful to guess that
the beta of an unknown security is near 1. In other words, a speculative long position of Rs.500,000 on any
security should be accompanied by selling Rs.500,000 of Nifty in order to obtain a complete hedge. This
(slightly wrong) hedged position is always much better than a totally un-hedged position (i.e. not selling any
Nifty). Of course, knowing the true beta gives the most accurate hedge.
3. Does this only work for index–securities? No, this works for any securities in the country. Some index
securities have a weak link to the index, and some non–index securities have a very tight link with the index.
4. How much risk reduction do I gain? It varies from security to security. The naked LONG SILVERLINE position
is around twice the risk of the hedged position LONG SILVERLINE + SHORT NIFTY. The risk reductions
obtained range of 25% to 60%.
Suppose the daily returns of a security has a variance of . Then the variance of the fully hedged position

is
where
is the standard deviation of daily returns on Nifty. Typically,

is around 1.6

percent/day. For example, if SILVERLINE has a variance of 9 and a beta of 1.2, then the fully hedged position
has a variance of 5.31. Through this formula, we can precisely quantify the magnitude of the risk reduction
that complete hedging delivers.
5. Will hedging always help if my forecast about the security is wrong? It depends. If the forecast about the
security itself is wrong, then hedging is no help. If the forecast goes wrong because Nifty crashes, then a
complete hedge will reimburse these losses.
6. Nifty futures with several different expirations are available at the same time. Which one should I use?
There are three criteria: liquidity, expiration date, and potential mispricings:
Liquidity Using the most liquid of them (i.e. the one with the tightest bid–ask spread) saves money on impact
cost.
Expiration date If the speculative position is a two–week view, then it’s convenient if the index futures that
is used also has at least two weeks to go.
Potential mispricings Finally, it never hurts to be clever and sell a futures contract which is somewhat
overpriced. This will not only do the job of hedging, but it could also yield some profi ts out of the
mispriced futures. Hence it helps to check the market price of all available futures contracts against
their fair values, and try to use the most overpriced contract as part of the hedging.
Solved problems
Q: The beta of ORIENTBANK is 0.8. A person has a long position of Rs.200,000 of ORIENTBANK.
Which of the following gives a complete hedge?
1. SELL 200,000 of Nifty 3. BUY 160,000 of Nifty
2. BUY 200,000 of Nifty 4. SELL 160,000 of Nifty
A: A long position in ORIENTBANK of Rs.200,000 is as vulnerable to the index as a long position of

Rs.160,000 of Nifty. To neutralize this, the hedger would need to sell Rs.160,000 of Nifty. The correct
answer is number 4.
Q: The beta of SBI is 0.8. A person has a LONG SBI position of Rs.200,000 coupled with a SHORT NIFTY
position of Rs.100,000. Which of the following is true?
1. He has a partial hedge against fluctuations of 4. He is bullish on Nifty and bearish on SBI
Nifty
2. He has a complete hedge against fluctuations 5. This is not a hedge; it is just speculation
of Nifty
3. He is bearish on Nifty as well as on SBI 6. He is overhedged
A: A long position in SBI of Rs.200,000 is as vulnerable to the index as a long position of Rs.160,000 of
Nifty. To completely neutralize this, the hedger would need to sell Rs.160,000 of Nifty. He has actually
sold Nifty to the extent of only Rs.100,000. Hence he is partially hedged. The correct answer is number
1.
5.1 Hedging: Long security, short Nifty futures 63
Q: The beta of STERLITE is 1.3 and the total risk of STERLITE is 9. The daily of Nifty is 1.6. Once
complete hedging is done, how much risk are we left with?
1. 4.1 4. 5.6
2. 4.6
3. 5.1 5. 6.1

A: A fully hedged position has total risk (variance) of

, which evaluates to 4.6. Hence the risk

suffered by the person with a view that STERLITE is undervalued drops from 9 to 4.6.
This illustrates the sharp reduction in risk that a stockpicker obtains using the futures. A naked LONG
STERLITE position has a variance of 9. The position LONG STERLITE + SHORT NIFTY fully captures
the extent to which STERLITE is undervalued, but suffers a total risk of only 4.6. The correct answer is
number 2.
Q: Hari buys 1000 shares of HPCL at Rs.190 and obtains a complete hedge by shorting 300 nifties at
Rs.972 each. He closes out his position at the closing price of the next day; at this point HPCL has dropped
5% and the Nifty futures have dropped 4%. What is the overall profi t/loss of this set of transactions?
1. Profi t of Rs.2,164 3. Profi t of Rs.9,500
A: The HPCL position loses Rs.9,500 and the short position on Nifty earns Rs.11,664. The net profi t on
the position is Rs.2,164. The correct answer is number 1.
Q: A speculator hopes that ROLTA is going to rise sharply. He has a long position on the cash market of
Rs.1 crore on ROLTA. The beta of ROLTA is 1.2. Which of the following positions on the index futures
gives him a complete hedge:
1. Long Nifty Rs.1 crore 4. Short Nifty Rs.1.2 crore

2. Short Nifty Rs.1 crore
3. Long Nifty Rs.1.2 crore 5. Do nothing.

Q: A speculator expects that the rupee will depreciate, and hence profi ts of INFOSYSTCH will rise.
Hence he does LONG INFOSYSTCH to the tune of Rs.2 lakh. The beta of INFOSYSTCH is 1.03. How can
this speculator completely remove his Nifty exposure?
1. Short Nifty Rs.2.06 lakh 4. Long Nifty Rs.2 lakh

2. Short Nifty Rs.2 lakh
3. Long Nifty Rs.2.06 lakh 5. Do nothing.
Q: A speculator expects that the rupee will depreciate, and hence profi ts of PENTSFWARE will rise.
Hence he does LONG PENTSFWARE to the tune of Rs.2 lakh. The beta of PENTSFWARE is 1.03. In order
to remove his Nifty exposure, he does SHORT NIFTY to the tune of Rs.2.5 lakh. Which is true:
1. He is overhedged 3. He is completely hedged
2. He is underhedged 4. None of the above
Q: The beta of VIKASWSP is 1.2 and the total risk of VIKASWSP is 9. The daily of Nifty is 1.3. One
1. 6.5 4. 5.4
2. 6.0
3. 6.2 5. 5.8
Q: Hari buys 1000 shares of HLL at Rs.210 and obtains a complete hedge by shorting 200 Nifties at
Rs.1,078 each. He closes out his position at the closing price of the next day; at this point HLL has
dropped 2% and the Nifty futures have risen 1%. What is the overall profi t/loss of this set of transactions?
2. Loss of Rs.6,356 4. Profi t of Rs.2,156

5.2 Hedging: Short security, long Nifty futures 65
5.2 Hedging: Short security, long Nifty futures

Investors studying the market often come across a security which they believe is intrinsically
over-valued. It may be the case that the profits and the quality of the company make it worth a
lot less than what the market thinks. A stockpicker carefully sells securities based on a sense that
they are worth less than the market price. In doing so he faces two kinds of risks:
1. His understanding can be wrong, and the company is really worth more than the market price; or,
2. The entire market moves against him and generates losses even though the underlying idea was correct.
The second outcome happens all the time. A person may sell Reliance at Rs.190 thinking
that Reliance would announce poor results and the security price would fall. A few days later,
Nifty rises, so he makes losses, even if his intrinsic understanding of Reliance was correct.
There is a peculiar problem here. Every sell position on a security is simultaneously a sell
position on Nifty. This is because a SHORT RELIANCE position generally gains if Nifty falls
and generally loses if Nifty rises. In this sense, a SHORT RELIANCE position is not a focused
play on the valuation of Reliance. It carries a SHORT NIFTY position along with it, as incidental
baggage. The stockpicker may be thinking he wants to be SHORT RELIANCE, but a short position
on Reliance on the market effectively forces him to be SHORT RELIANCE + SHORT NIFTY.
Even if you think WIPRO is over-valued, the position SHORT WIPRO is not purely about
WIPRO; it is also partly about Nifty. Every trader who has a SHORT WIPRO position is forced
to be an index speculator, even though he may have no interest in the index. It is useful to ask:
does the person feel bearish about WIPRO or about the index?
Those who are bearish about the index should just sell nifty futures; they need not trade individual securities.
Those who are bearish about WIPRO do wrong by carrying along a short position on Nifty as well.
There is a simple way out. Every time you adopt a short position on a security, you should
buy some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every
short–security position. Once this is done, you will have a position which is purely about the
performance of the security. The position SHORT WIPRO + LONG NIFTY is a pure play on the
value of WIPRO, without any extra risk from fluctuations of the market index. When this is done,
the stockpicker has “hedged away” his index exposure. The basic point of this hedging strategy
is that the stockpicker proceeds with his core skill, i.e. picking securities, at the cost of lower
risk.
Warning: Hedging does not remove losses. The best that can be achieved using hedging is
the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less
profits than the unhedged position, half the time. One should not enter into a hedging strategy
hoping to make excess profits for sure; all that can come out of hedging is reduced risk.

1. We need to know the “beta” of the security, i.e. the average impact of a 1% move in Nifty upon the security. If
betas are not known, it is generally safe to assume the beta is 1. Suppose we take LUPINLAB, where the beta
is 1.2, and suppose we have a SHORT LUPINLAB position of Rs.200,000.
2. The size of the position that we need on the index futures market, to completely remove the hidden Nifty
exposure, is 1.2 200,000, i.e. Rs.240,000.

3. Suppose Nifty is at 1200, and the market lot on the futures market is 200. Hence each market lot of Nifty is
Rs.240,000. To long Rs.240,000 of Nifty we need to buy one market lot.
4. We buy one market lot of Nifty (200 nifties) to get the position:
SHORT LUPINLAB Rs.200,000
LONG NIFTY Rs.240,000
This position will be essentially immune to fluctuations of Nifty. The profi ts/losses position will fully reflect
price changes intrinsic to LUPINLAB, hence only successful forecasts about LUPINLAB will benefi t from this
position. Returns on the position will be roughly neutral to movements of Nifty.
Example
1. Shyam adopts a position of Rs.1 million SHORT MTNL on date 1st April 1997. He plans to hold the position
till Thursday the 24th.
2. The beta of MTNL happens to be 1.2.
3. Hence he needs a long position of Rs.1.2 million on the index futures market to totally remove his Nifty
exposure.
4. On date 1st April 97, Nifty is 980 and the nearest futures contract (with expiration 24th April) is trading at
about 1000. Hence, each market lot of the futures (200 nifties) is worth Rs.200,000. To buy Rs.1.2 million of
Nifty, we need to buy 6 lots (by rounding off to the nearest market lot).
5. He buys 6 market lots of Nifty (1200 nifties) to get the position:

SHORT MTNL Rs.1,000,000
LONG NIFTY Rs.1,200,000
6. 20 days later, Nifty rose because of stable political outlook.
7. On Thursday, Shyam unwound both positions. His position on MTNL lost Rs.120,000 since MTNL had gone
up to 1,120,000. His short position on Nifty April futures earned Rs.93,600. Overall, he lost Rs.26,400.
Solved problems
Q: The beta of ORIENTBANK is 0.8. A person has a short position of Rs.200,000 of ORIENTBANK.
Which of the following gives a complete hedge?
1. SELL 200,000 of Nifty 4. SELL 160,000 of Nifty

2. BUY 200,000 of Nifty
3. BUY 160,000 of Nifty 5. Do nothing
A: A short position in ORIENTBANK of Rs.200,000 is as vulnerable to the index as a short position of

Rs.160,000 of Nifty. To neutralize this, the hedger would need to buy Rs.160,000 of Nifty. The correct
answer is number 3.
5.2 Hedging: Short security, long Nifty futures 67
Q: The beta of SBI is 0.8. A person has a SHORT SBI position of Rs.200,000 coupled with a LONG NIFTY
position of Rs.100,000. Which of the following is true?
1. He has a partial hedge against fluctuations of 4. He is bullish on Nifty and bearish on SBI
Nifty
2. He has a complete hedge against fluctuations 5. This is not a hedge; it is just speculation
of Nifty
3. He is bearish on Nifty as well as on SBI 6. He is overhedged
A: A short position in SBI of Rs.200,000 is as vulnerable to the index as a short position of Rs.160,000 of
Nifty. To completely neutralize this, the hedger would need to buy Rs.160,000 of Nifty. He has actually
bought Nifty to the extent of only Rs.100,000. Hence he is partially hedged. The correct answer is number
1.
Q: The beta of STERLITE is 1.3 and the total risk of STERLITE is 9. The daily of Nifty is 1.6. One
1. 4.1 4. 5.6
2. 4.6
3. 5.1 5. 6.1

A: A fully hedged position has total risk (variance) of

, which evaluates to 4.6. Hence the risk

suffered by the person with a view that STERLITE is undervalued drops from 9 to 4.6.
This illustrates the sharp reduction in risk that a stockpicker obtains using the futures. A naked SHORT
STERLITE position has a variance of 9. The position SHORT STERLITE + LONG NIFTY fully captures the
extent to which STERLITE is undervalued, but suffers a total risk of only 4.6. The correct answer is
number 2.
Q: Gopal sells 1000 shares of HPCL at Rs.190 and obtains a complete hedge by buying 300 nifties at
Rs.972 each. He closes out his position at the closing price of the next day; at this point HPCL has risen
5% and the Nifty futures have risen 4%. What is the overall profi t/loss of this set of transactions?
A: The HPCL position loses Rs.9,500 and the long position on Nifty earns Rs.11,664. The net profi t on
the position is Rs.2,164. The correct answer is number 1.
Q: A speculator thinks that ROLTA is going to crash sharply. He has a short position on the cash market
of Rs.1 crore on ROLTA. The beta of ROLTA is 1.2. Which of the following positions on the index futures
gives him a complete hedge?
1. Long Nifty Rs.1 crore 4. Short Nifty Rs.1.2 crore

2. Short Nifty Rs.1 crore
3. Long Nifty Rs.1.2 crore 5. Do nothing.
Q: A speculator expects that the rupee will appreciate, and hence profi ts of INFOSYSTCH will fall.
Hence he does SHORT INFOSYSTCH to the tune of Rs.2 lakh. The beta of INFOSYSTCH is 1.03. How
can this speculator completely remove his Nifty exposure?
1. Short Nifty Rs.2.06 lakh 4. Long Nifty Rs.2 lakh

2. Short Nifty Rs.2 lakh
3. Long Nifty Rs.2.06 lakh 5. Do nothing.
Q: A speculator expects that the rupee will appreciate, and hence profi ts of PENTSFWARE will fall.
Hence he does SHORT PENTSFWARE to the tune of Rs.2 lakh. The beta of PENTSFWARE is 1.03. In
order to remove his Nifty exposure, he does LONG NIFTY to the tune of Rs.2.5 lakh. Which is true:
1. He is overhedged 3. He is completely hedged
2. He is underhedged 4. None of the above
Q: The beta of ITC is 1.3 and the total risk of ITC is 9. The daily of Nifty is 1.3. One complete hedging
is done, how much risk are we left with?
1. 6.5 4. 5.4
2. 6.0
3. 6.1 5. 5.8

5.3 Hedging: Have portfolio, short Nifty futures 69
Q: Hari sells 1000 shares of HLL at Rs.210 and obtains a complete hedge by buying 200 Nifties at Rs.1078
each. He closes out his position at the closing price of the next day; at this point HLL has risen 2% and
the Nifty futures have fallen 1%. What is the overall profi t/loss of this set of transactions?
2. Loss of Rs.6,356 4. Profi t of Rs.2,156
5.3 Hedging: Have portfolio, short Nifty futures

The only certainty about the capital market is that it fluctuates! A lot of investors who own
portfolios experience the feeling of discomfort about overall market movements. Sometimes,
they may have a view that security prices will fall in the near future. At other times, they may see
that the market is in for a few days or weeks of massive volatility, and they do not have an appetite
for this kind of volatility. The union budget is a common and reliable source of such volatility:
market volatility is always enhanced for one week before and two weeks after a budget. Many
investors simply do not want the fluctuations of these three weeks.
This is particularly a problem if you need to sell shares in the near future, for example, in
order to finance a purchase of a house. This planning can go wrong if by the time you sell shares,
Nifty has dropped sharply.
When you have such anxieties, there are two alternatives:
1 Sell shares immediately. This sentiment generates “panic selling” which is rarely optimal for the investor.
2 Do nothing, i.e. suffer the pain of the volatility. This leads to political pressures for government to “do
something” when security prices fall.
In addition, with the index futures market, a third and remarkable alternative becomes available:
3 Remove your exposure to index fluctuations temporarily using index futures. This allows rapid response to
market conditions, without “panic selling” of shares. It allows an investor to be in control of his risk, instead
of doing nothing and suffering the risk.
The idea here is quite simple. Every portfolio contains a hidden index exposure. This statement
is true for all portfolios, whether a portfolio is composed of index securities or not. In the case
of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual
securities, where only 30–60% of the securities risk is accounted for by index fluctuations).
Hence a position LONG PORTFOLIO + SHORT NIFTY can often become one–tenth as risky as the
LONG PORTFOLIO position!
Suppose we have a portfolio of Rs.1 million which has a beta of 1.25. Then a complete hedge
is obtained by selling Rs.1.25 million of Nifty futures.
Warning: Hedging does not always make money. The best that can be achieved using
hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will
make less profits than the unhedged position, half the time. One should not enter into a hedging
strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk.

1. We need to know the “beta” of the portfolio, i.e. the average impact of a 1% move in Nifty upon the portfolio.
It is easy to calculate the portfolio beta: it is the weighted average of securities betas. Suppose we have a
portfolio composed of Rs.1 million of Hindalco, which has a beta of 1.4 and Rs.2 million of Hindustan Lever,
which has a beta of 0.8, then the portfolio beta is (1 1.4 + 2 0.8)/3 or 1. If the beta of any securities is not

known, it is safe to assume that it is 1.
2. The complete hedge is obtained by adopting a position on the index futures market which completely removes
the hidden Nifty exposure. In the above case, the portfolio is Rs.3 million with a beta of 1, hence we would
need a position of Rs.3 million on the Nifty futures.
3. Suppose Nifty is 1250, and the market lot on the futures market is 200. Each market lot of Nifty costs
Rs.250,000. Hence we need to sell 12 market lots, i.e. 2400 Nifties to get the position:
LONG PORTFOLIO Rs.3,000,000
SHORT NIFTY Rs.3,000,000.
This position will be essentially immune to fluctuations of Nifty. If Nifty goes up, the portfolio gains and the
futures lose. If Nifty goes down, the futures gain and the portfolio loses. In either case, the investor has no
risk from market fluctuations when he is completely hedged.
The investor should adopt this strategy for the short periods of time where (a) the market
volatility that he anticipates makes him uncomfortable, or (b) when his financial planning
involves selling shares at a future date and would be affected if Nifty drops. It does not make
sense to use this strategy for long periods of time – if a two–year hedging is desired, it is better
to sell the shares, invest the proceeds, and buy back shares after two years. This strategy makes
the most sense for rapid adjustments.
Another important choice for the investor is the degree of hedging. Complete hedging
eliminates all risk of gain or loss. Sometimes the investor may be willing to tolerate some risk
of loss so as to hang on to some risk of gain. In that case, partial hedging is appropriate. The
complete hedge may require selling Rs.3 million of the futures, but the investor may choose to
only sell Rs.2 million of the futures. In this case, two–thirds of his portfolio is hedged and one–
third of the portfolio is held unhedged. The exact degree of hedging chosen depends upon the
appetite for risk that the investor has.
Example
1. On 25 May 2001, Shyam has a portfolio composed of fi ve securities: ITCHOTEL (100 shares, value
Rs.112.00), ORIENTBANK (200 shares, value Rs.68.25), CIPLA (100 shares, value Rs.847.65), LUPINLAB
(200 shares, value Rs.149.85), and SIEMENS (200 shares, value Rs.237.50). The total portfolio value is
187,085 and the fi ve securities have weights (5.98%, 7.29%, 45.31%, 16.02%, 25.40%). Shyam does not want
to worry about budget-related fluctuations from 26 May 2001 till 10 June 2001.
2. The fi ve securities have the following betas: ITCHOTEL (beta 0.59), ORIENTBANK (beta 0.90), CIPLA (beta
0.75), LUPINLAB (beta 1.13), and SIEMENS (beta 1.10). Hence the portfolio beta works out to (0.0598*0.59
+ 0.0729*0.90 + 0.4531*0.75 + 0.1602*1.13 + 0.2540*1.10) or 0.90.
3. For complete hedging he will need to sell futures worth 0.90 * 187,085, i.e. Rs.168,376.50. On 25 May 2001,
Nifty is at 1,122.95. So he decides to sell 200 Nifties.
5.3 Hedging: Have portfolio, short Nifty futures 71
Table 5.1 Example of hedging a portfolio

This example deliberately uses a small portfolio of small securities (each of the securities in this example has a
market capitalization of below Rs.200 crore); in practice, the effectiveness of hedging would be greater with larger
portfolios of larger securities.
The hedging strategy is designed to dodge budget–related volatility for the budget announcement of 1 June 2001.
The hedging strategy is initiated on 25 May 2001 and ended on 10 June 2001. Over this period, the portfolio loses
Rs.32990 or 17.63%.
Security 25 May 2001 10 June 2001 Profi t/Loss

ITCHOTEL 112.00 95.30
OREINTBANK 68.25 46.10
CIPLA 847.65 720.85
LUPINLAB 149.85 113.65
SIEMENS 237.50 202.65
Portfolio 187,085.00 154095 32990 (17.63%)
Nifty 1122.95 962.90 160.05 (14.25%)
4. Hence Shyam supplements his portfolio with a short position on the Nifty futures with expiry on 25th JUNE
worth Rs.224,590.
5. On 10 June he buys back futures at a lower price and ends his hedge (see Table 5.1). His profi ts on the futures
hedging was Rs.32,010 and his losses on the portfolio were Rs.32,990. Thus the net loss is Rs. 980. If he had
not hedged, he would have lost 32,990.
In this example, the budget announcement led to a drop in Nifty, so the short position on
the futures market generated profits. If the budget announcement had led to a rise in Nifty, then
the investor would have gained money on his securities portfolio, and lost money on the futures
position. In either event, he would be hedged, i.e. he would neither gain nor lose from index
fluctuations.
Solved problems
Q: A portfolio is composed of Rs.1000 invested in a securities with beta 1.1 and Rs.1000 invested in a
securities with beta 0.8. What is the portfolio beta?
1. 0.85 3. 0.95
2. 0.90 4. 1.0

Q: On 1 Jan 2001, an investor has a portfolio worth Rs.1 million which has a beta of 1.3. He will need
money in middle March as there is a marriage in the family. So he wants to totally remove his equity
market risk. The investor wants to be over–cautious so he sells Rs.2 million of the Nifty futures. What
has he achieved?
1. He is partially hedged. 3. He is overhedged (he has effectively become

a speculator betting that Nifty will drop).
2. He is completely hedged. 4. None of the above
A: To obtain a market–neutral position requires selling 1.3 Rs.1 million or Rs.1.3 million of the Nifty
futures. Over and above this, the remaining Rs.0.7 million is a bet that Nifty will drop. Even the most
over–cautious hedger does not benefi t by a larger sell position on the index futures market than the formula
specifi es – he just becomes a speculator. (Conversely, if a short position smaller than Rs.1.3 million is
taken on the index futures market, the investor is speculating that Nifty will rise). The only way to not
speculate is to completely hedge. The correct answer is number 3.
Q: When the nuclear bombs go off, an investor with $1 billion invested in India becomes fundamentally
gloomy about India and wants to embark a hedging program for the next three years. He will sell $1
billion of Nifty futures now, and constantly initiate new futures positions as old ones expire. What is the
major problem with this strategy?
1. He suffers from “rollover risk”of getting into 3. He will suffer market impact cost selling $1
new positions on the futures positions. billion of the Nifty futures.
4. He would just be better off liquidating his

2. He will have to recalculate his beta from time portfolio, staying out for 3 years, and then
to time when adopting new futures positions. getting back into equity.
A: All the alternatives have a grain of truth in them. But the most powerful criticism is number 4. It is
cheaper to implement long–duration changes of position by trading in the equity cash market. The index
futures is best–suited for rapid, short–term changes in position. The correct answer is number 4.
Q: On 1 Jan 2001, an investor has a portfolio worth Rs.2 million which has a beta of 0.5. He needs money
in middle February as there is a marriage in the family. So he wants to totally remove his equity market
risk. What is the correct hedging strategy?
1. Short Nifty futures Rs.1 million, February ex- 3. Buy Nifty futures Rs.1 million, February ex-
piration piration
2. Short Nifty futures Rs.1.3 million, March ex- 4. Buy Nifty futures Rs.1.3 million, March ex-
piration piration

5.4 Hedging: Have funds, buy Nifty futures 73
Q: On 1 Jan 2001, an investor has a portfolio worth Rs.1 million which has a beta of 1.3. He will need
money in middle March as there is a marriage in the family. So he wants to totally remove his equity
market risk. What is the correct hedging strategy?
1. Short Nifty futures Rs.1 million, February ex- 3. Buy Nifty futures Rs.1 million, February ex-
piration piration
2. Short Nifty futures Rs.1.3 million, March ex- 4. Buy Nifty futures Rs.1.3 million, March ex-
piration piration
A: To obtain a market–neutral position requires selling 1.3 Rs.1 million or Rs.1.3 million of the Nifty
futures. Since the planned expenditures will take place in late February and early March, it would make
sense to use the late March contract for hedging. The correct answer is number 2.
Q: A portfolio is composed of Rs.1000 invested in a securities with beta 0.8 and Rs.2000 invested in a
securities with beta 1.1. What is the portfolio beta?
1. 0.8 4. 1.1
2. 0.9
3. 1.0 5. 1.2
A: Portfolio beta is (1000*0.8 + 2000*1.1)/3000 or 1. The correct answer is number 3.
5.4 Hedging: Have funds, buy Nifty futures

Have you ever been in a situation where you had funds which needed to get invested in equity?
Or of expecting to obtain funds in the future which will get invested in equity. Some common
occurrences of this include:
A closed-end fund which just fi nished its initial public offering has cash which is not yet invested.
Suppose a person plans to sell land and buy shares. The land deal is slow and takes weeks to complete. It takes
several weeks from the date that it becomes sure that the funds will come to the date that the funds actually
are in hand.
An open-ended fund has just sold fresh units and has received funds.
Getting invested in equity ought to be easy but there are three problems:
1. A person may need time to research securities, and carefully pick securities that are expected to do well. This
process takes time. For that time, the investor is partly invested in cash and partly invested in securities. During
this time, he is exposed to the risk of missing out if the overall market index goes up.
2. A person may have made up his mind on what portfolio he seeks to buy, but going to the market and placing
market orders would generate large ‘impact costs’. The execution would be improved substantially if he could
instead place limit orders and gradually accumulate the portfolio at favorable prices. This takes time, and
during this time, he is exposed to the risk of missing out if the Nifty goes up.
3. In some cases, such as the land sale above, the person may simply not have cash to immediately buy shares,
hence he is forced to wait even if he feels that Nifty is unusually cheap. He is exposed to the risk of missing
out if Nifty rises.
So far, in India, we have had exactly two alternative strategies which an investor can adopt: to
buy liquid securities in a hurry, or to suffer the risk of staying in cash. With Nifty futures, a third
alternative becomes available:
The investor would obtain the desired equity exposure by buying index futures, immediately. A person who
expects to obtain Rs.5 million by selling land would immediately enter into a position LONG NIFTY worth
Rs.5 million. Similarly, a closed-end fund which has just fi nished its initial public offering and has cash which
is not yet invested, can immediately enter into a LONG NIFTY to the extent it wants to be invested in equity.
The index futures market is likely to be more liquid than individual securities so it is possible to take extremely
large positions at a low impact cost.
Later, the investor/closed-end fund can gradually acquire securities (either based on detailed research and/or
based on aggressive limit orders). As and when shares are obtained, one would scale down the LONG NIFTY
position correspondingly. No matter how slowly securities are purchased, this strategy would fully capture
a rise in Nifty, so there is no risk of missing out on a broad rise in the securities market while this process
is taking place. Hence, this strategy allows the investor to take more care and spend more time in choosing
securities and placing aggressive limit orders.
Hedging is often thought of as a technique that is used in the context of equity exposure. It is
common for people to think that the owner of shares needs index futures to hedge against a drop
in Nifty. Holding money in hand, when you want to be invested in shares, is a risk because Nifty
may rise. Hence it is equally important for the owner of money to use index futures to hedge
against a rise in Nifty!
Warning: Hedging does not always make money. The best that can be achieved using
hedging is the removal of unwanted risk. The hedged position will make less profits than the
unhedged position, half the time. One should not enter into a hedging strategy hoping to make
excess profits for sure; all that can come out of hedging is reduced risk.

1. Iqbal obtained Rs.5 million on 17 Feb 1998. He made a list of 14 securities to buy, at 17 Feb prices, totaling
Rs.5 million.
2. At that time Nifty was at 991.70. He entered into a LONG NIFTY MARCH FUTURES position for 5000 nifties,
i.e. his long position was worth 5,053,600.
3. From 18 Feb 1998 to 09 March 1998 he gradually acquired the securities (see Table 5.2). On each day, he
purchased one securities and sold off a corresponding amount of futures.
On each day, the securities purchased were at a changed price (as compared to the price prevalent on 17
Feb). On each day, he obtained or paid the ‘mark–to–market margin’ on his outstanding futures position, thus
capturing the gains on the index.
4. By 09 Mar 1998 he had fully invested in all the shares that he wanted (as of 17 Feb) and had no futures position
left.
5. The same sequencing of purchases, without the umbrella of protection of the LONG NIFTY MARCH FUTURES
position, would have cost Rs.249,724 more.
5.4 Hedging: Have funds, buy Nifty futures 75
Table 5.2 Gradual acquisition of securities, hedged

On 17 Feb, Iqbal purchased 5000 nifties to obtain a position of Rs.5 million. From 18 Feb onwards, on each
day, Iqbal purchased one security worth Rs.357,000 (at 17 Feb prices) and sold off a similar value of futures thus
shrinking his futures position. For this example, we deliberately use non–index small securities; hedging using index
futures works for all portfolios regardless of what securities go into them. Nifty rose sharply on 27 February and 28
February, so his outstanding futures position generated an infusion of cash for him on these days. This inflow paid
for the higher securities prices that he suffered.
Date Futures position Security purchase Futures sold MTM profi t/loss
(in Rs.)
17 Feb +5,000,000
18 Feb 4,597,074 2700 shares of ASIANHOTL 400 -17,042
19 Feb 4,190,807 2800 shares of BATAINDIA 400 38,430
20 Feb 3,786,330 5400 shares of BOMDYEING 400 18,801
23 Feb 3,375,976 55500 shares of SAIL 400 55,828
24 Feb 2,964,000 6050 shares of ESCORTS 400 13,795
25 Feb 2,648,488 1600 shares of DABUR 300 65,300
26 Feb 2,330,165 500 shares of CIPLA 300 25,290
27 Feb 2,007,454 1150 shares of CADBURY 300 35,112
02 Mar 1,673,850 4700 shares of APOLLOTYRE 300 76,248
03 Mar 1,350,948 5100 shares of FEDERALBK 300 -64,214
04 Mar 1,019,453 2150 shares of ITCHOTEL 300 42,968
05 Mar 690,853 2100 shares of LAKME 300 -11,582
06 Mar 362,993 700 shares of PFIZER 300 -2,220
09 Mar 29,828 6300 shares of TITAN 300 10,611
Total 4,982,538 249,724
Nuances
1. Why is this called “hedging”? A person who needs to invest in securities is exactly as vulnerable to a rise in
Nifty as a person who has securities is vulnerable to a drop in Nifty. Hence the natural hedging strategy is to
buy Nifty on the futures market, and reach the desired equity exposure. Later, the composition of securities
can always be adjusted over time.
2. Don’t betas enter this picture? If the investor has not decided what securities to buy, it is safe to think that the
beta will be about 1. This is the stance we have taken in this discussion.
If the investor accurately knows what portfolio will be purchased, it is obviously better to use this information
in choosing a futures position. If shares worth Rs.5 Lakh will be purchased and the desired portfolio has a
beta of 1.5 then a long position of Rs.7.5 Lakh on Nifty futures will be required.
3. Do you imply that every “IPO” of a closed-end equity growth fund should immediately invest the entire
proceeds into the Nifty futures market? Yes. The typical closed-end fund IPO has money trickling in over
a week. The funds obtained everyday should be “invested” into a long position on the Nifty futures before the
end of trading hours on that day.
After this, time is available for (a) security selection and (b) aggressive limit orders. Gradually, as the limit
orders get executed, the futures position can be unwound.
Solved problems
Q: Mythili will get Rs.5 Lakh in the next two/three weeks which she plans to buy shares with. She
adopts a long position on the Nifty futures market. Now broad market prices rise. Which of the following
happens?
1. The shares she wants to buy get costlier and but her Nifty futures position pays her daily
Nifty gets cheaper. MTM margins to compensate for that.
2. The shares she wants to buy get cheaper even
4. The shares she wants to buy get cheaper but
though Nifty rises.
her Nifty futures position requires payment of
3. The shares she wants to buy get costlier daily MTM margins to compensate for that.
A: When broad market prices rise, the shares she wants to buy and Nifty both rise. In this case, her long
position on the futures market earns profi ts, which are paid to her as MTM margin. This fi nances her
(larger) outgo in buying shares. She is hedged. The correct answer is number 3.
Q: Mythili will get Rs.5 Lakh in the next two/three weeks which she plans to buy shares with. She adopts
a long position on the Nifty futures market. Now broad market prices crash. Which of the following
happens:
1. The shares she wants to buy get costlier and but her Nifty futures position pays her daily
Nifty gets cheaper. MTM margins to compensate for that.
2. The shares she wants to buy get cheaper even
4. The shares she wants to buy get cheaper but
though Nifty rises.
her Nifty futures position requires payment of
3. The shares she wants to buy get costlier daily MTM margins to compensate for that.
Q: Mythili has fi xed up to sell some land and expect to raise Rs.5 Lakh from this. The money will appear
in her hands within two/three weeks. She plans to invest it into shares and is worried that the security
market might rise in the next few days. She should:
1. Study the security market closely and accu- 3. Hedge herself by building a LONG NIFTY po-
rately forecast prices. sition of Rs.5 Lakh.
4. Immediately go to the market and buy securi-

2. Hedge herself by shorting Rs.5 Lakh of Nifty. ties.
A: The fi rst alternative does not help if prices do rise. The second alternative is a hedging strategy for
someone with a portfolio who is afraid that Nifty might drop. The fourth is not feasible since she won’t
have Rs.5 Lakh when the time comes to take delivery of the shares. The correct answer is number 3.
5.5 Speculation: Bullish index, long Nifty futures 77
5.5 Speculation: Bullish index, long Nifty futures

Do you sometimes think that the market index is going to rise? That you could make a profit by
adopting a position on the index? After a good budget, or good corporate results, or the onset of
a stable government, many people feel that the index would go up. How does one implement a
trading strategy to benefit from an upward movement in the index? Today, you have two choices:
1. Buy selected liquid securities which move with the index, and sell them at a later date: or,
2. Buy the entire index portfolio and then sell it at a later date.
The first alternative is widely used – a lot of the trading volume on liquid securities is based on
using these liquid securities as an index proxy. However, these positions run the risk of making
losses owing to company–specific news; they are not purely focused upon the index. The second
alternative is cumbersome and expensive in terms of transactions costs.
Taking a position on the index is effortless using the index futures market. Using index
futures, an investor can “buy” or “sell” the entire index by trading on one single security. Once a
person is LONG NIFTY using the futures market, he gains if the index rises and loses if the index
falls.

When you think the index will go up, buy the Nifty futures. The minimum market lot is 200
Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000. When the
trade takes place, the investor is only required to pay up the initial margin, which is something
like Rs.20,000. Hence, by paying an initial margin of Rs.20,000, the investor gets a claim on the
index worth Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a claim on Nifty
worth Rs.2.4 million.
Futures are available at several different expirations. The investor can choose any of them to
implement this position. The choice is basically about the horizon of the investor. Longer dated
futures go well with long–term forecasts about the movement of the index. Shorter dated futures
tend to be more liquid.
Example
1. On 1 July 2001, Milan feels the index will rise.
2. He buys 200 Nifties with expiration date on 31st July 2001.
3. At this time, the Nifty July contract costs Rs.960 so his position is worth Rs.192,000.
4. On 14 July 2001, Nifty has risen to 967.35.
5. The Nifty July contract has risen to Rs.980.
6. Milan sells off his position at Rs.980.
7. his profi ts from the position are Rs.4000.

Solved problems
Q: You are a speculator. You predict the market will go up in the near future and want to take advantage
of it. You would:
1. Buy Nifty futures 3. Sell securities in the cash market
2. Sell Nifty futures 4. None of the above
A: If you think the market will go up, then the futures will seem underpriced compared to what it will be
in the future. So you should buy Nifty futures now and sell them later to make a profi t. The correct answer
is number 1.
Q: A long position of 10 market lots of Nifty Sep futures is purchased at 1100 and held till expiry when
the Nifty closes at expiry in September at 1124. What would be the profi t on this position?
1. 1,148,000 3. 24,000
2. 1,124,000 4. 48,000
A: Ten market lots of Nifty futures translates to Rs. 2,200,000 (10 market lots x 200 Nifties per market lot
x Rs. 1100, the price of the September futures). At the price of unwind of Rs. 1124 per Nifty, the profi t is
Rs.48,000 (Rs.2,248,000 - Rs.1,100,000). The correct answer is number 4.
Q: Babbanseth expects a bumper agricultural harvest. He is highly optimistic about the performance of
the economy. He hopes the market will go up and buys 10 market lots of the Nifty December futures.
Nifty December futures trade at 1150. His forecasts come true and he closes his position at maturity at
1174. How much profi t does he make?
1. 2,300,000 3. 48,000
2. 2,348,000 4. 480,000
A: The answer is number 3.
5.6 Speculation: Bearish index, short Nifty futures

Do you sometimes think that the market index is going to fall? That you could make a profit by
adopting a position on the index? After a bad budget, or bad corporate results, or the onset of a
coalition government, many people feel that the index would go down. How does one implement
a trading strategy to benefit from a downward movement in the index? Today, you have two
choices:
1. Sell selected liquid securities which move with the index, and buy them at a later date: or,
5.6 Speculation: Bearish index, short Nifty futures 79
2. Sell the entire index portfolio and then buy it at a later date.
The first alternative is widely used – a lot of the trading volume on liquid securities is based on
using these securities as an index proxy. However, these positions run the risk of making losses
owing to company–specific news; they are not purely focused upon the index.
The second alternative is hard to implement. This strategy is also cumbersome and expensive
in terms of transactions costs. Taking a position on the index is effortless using the index futures
market. Using index futures, an investor can “buy” or “sell” the entire index by trading on one
single security. Once a person is SHORT NIFTY using the futures market, he gains if the index
falls and loses if the index rises.
When you think the index will go down, sell the Nifty futures. The minimum market lot is 200
Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000. When the
trade takes place, the investor is only required to pay up the initial margin, which is something
like Rs.20,000. Hence, by paying an initial margin of Rs.20,000 the investor gets a claim on the
index worth Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a claim on Nifty
worth Rs.2.4 million.
Futures are available at several different expirations. The investor can choose any of them to
implement this position. The choice is basically about the horizon of the investor. Longer dated
futures go well with long–term forecasts about the movement of the index. Shorter dated futures
tend to be more liquid.
Example
1. On 1 June 2001, Milan feels the index will fall.
2. He sells 200 Nifties with a expiration date of 26th June 2001.
3. At this time, the Nifty June contract costs Rs.1,060 so his position is worth Rs.212,000.
4. On 10 June 2001, Nifty has fallen to 962.90.
5. The Nifty June contract has fallen to Rs.990. Milan squares off his position.
6. His profi ts from the position work out to be Rs.14,000.

Solved problems
Q: You are a speculator. You predict the market will go down in the near future and want to take advantage
of it. You would:
1. Buy Nifty futures 3. Sell securities in the cash market
2. Sell Nifty futures 4. None of the above
A: If you think the market will go down, then the futures will seem overpriced compared to what it will
be in the future. So you should sell Nifty futures now and buy them later to make a profi t. The correct
answer is number 2.
Q: A short position of 10 market lots of Nifty Sep futures is purchased at 1100 and held till expiry when
the Nifty closes at expiry in September at 1076. What would be the profi t on this position?
1. 2,200,000 3. 480
2. 2,248,000 4. 48,000
A: Ten market lots of Nifty futures translates to Rs. 2,200,000 (10 market lots x 200 Nifties per market lot
x Rs. 1100, the price of the September futures). At the price of unwind of Rs. 1076 per Nifty, the profi t is
Rs.48,000 (Rs.2,200,000 - 2,152,000). The correct answer is number 4.
Q: Ravi expects a sluggish Industrial growth . He is pessimistic about the performance of the economy.
He hopes the market will go down and sells 10 market lots of the Nifty Dec futures. Nifty December
futures trade at 1150. His forecasts comes true and he closes his position at maturity at 1126. How much
profi t does he make?
1. 1,150,000 3. 48,000
2. 1,174,000 4. 480,000
A: The answer is number 3.
5.7 Arbitrage: Have funds, lend them to the market

Most people would like to lend funds into the security market, without suffering the risk.
Traditional methods of loaning money into the security market suffer from (a) price risk of shares
and (b) credit risk of default of the counter-party. What is new about the index futures market
is that it supplies a technology to lend money into the market without suffering any exposure to
Nifty, and without bearing any credit risk.
5.7 Arbitrage: Have funds, lend them to the market 81
The basic idea is simple. The lender buys all 50 securities of Nifty on the cash market, and
simultaneously sells them at a future date on the futures market. It is like a repo. There is no
price risk since the position is perfectly hedged. There is no credit risk since the counterparty on
both legs is the NSCCL which supplies clearing services on NSE. It is an ideal lending vehicle
for entities which are shy of price risk and credit risk, such as traditional banks and the most
conservative corporate treasuries.

1. Calculate a portfolio which buys all the 50 securities in Nifty in correct proportion, i.e. where the money
invested in each security is proportional to its market capitalization.
2. Round off the number of shares in each security.
3. Using the NEAT software, a single keystroke can fi re off these 50 orders in rapid succession into the NSE
trading system. This gives you the buy position.
4. A moment later, sell Nifty futures of equal value. Now you are completely hedged, so fluctuations in Nifty do
not affect you.
5. A few days later, you will have to take delivery of the 50 securities and pay for them. This is the point at which
you are “loaning money to the market”.
6. Some days later (anytime you want), you will unwind the entire transaction.
7. At this point, use NEAT to send 50 sell orders in rapid succession to sell off all the 50 securities.
8. A moment later, reverse the futures position. Now your position is down to 0.
9. A few days later, you will have to make delivery of the 50 securities and receive money for them. This is the
point at which “your money is repaid to you”.
What is the interest rate that you will receive? We will use one specific case, where you will
unwind the transaction on the expiration date of the futures. In this case, the difference between
the futures price and the cash Nifty is the return to the moneylender, with two complications:
the moneylender additionally earns any dividends that the 50 shares pay while he has held them,
and the moneylender suffers transactions costs (impact cost, brokerage) in doing these trades.
On 1 July 1998, if the Nifty spot is 942.25, and the Nifty July 1998 futures are at 956.5 then the
difference (1.5% for 30 days) is the return that the moneylender obtains.
Example
On 1 August, Nifty is at 1200. A futures contract is trading with 27 August expiration for 1230.
Ashish wants to earn this return (30/1200 for 27 days).
1. He buys Rs.3 million of Nifty on the spot market. In doing this, he places 50 market orders and ends up paying
slightly more. His average cost of purchase is 0.3% higher, i.e. he has obtained the Nifty spot for 1204.
2. He sells Rs.3 million of the futures at 1230. The futures market is extremely liquid so the market order for
Rs.3 million goes through at near–zero impact cost.
3. He takes delivery of the shares and waits.

4. While waiting, a few dividends come into his hands. The dividends work out to Rs.7,000.
5. On 27 August, at 3:15, Ashish puts in market orders to sell off his Nifty portfolio, putting 50 market orders to
sell off all the shares. Nifty happens to have closed at 1210 and his sell orders (which suffer impact cost) goes
through at 1207.
6. The futures position spontaneously expires on 27 August at 1210 (the value of the futures on the last day is
always equal to the Nifty spot).
7. Ashish has gained Rs.3 (0.25%) on the spot Nifty and Rs.20 (1.63%) on the futures for a return of near 1.88%.
In addition, he has gained Rs.7000 or 0.23% owing to the dividends for a total return of 2.11% for 27 days,
risk free.
It is easier to make a rough calculation of the return. To do this, we ignore the gain from
dividends and we assume that transactions costs account for 0.4%. In the above case, the return
is roughly 1230/1200 or 2.5% for 27 days, and we subtract 0.4% for transactions costs giving
2.1% for 27 days. This is very close to the actual number.
Nuances
1. What if the return is something low, like 1% for a month, and hence uncompetitive? A return of 1% per month,
i.e. 12.7% per year without bearing any risk is an excellent return in India. It is competitive.
2. Okay, what if the return works out to something uncompetitive, like 0.5% for a month? Then it is not worth
lending into the index futures market.
3. Is it possible to somehow do this in quantities smaller than Rs.3 million? Portfolios of shares smaller than
Rs.3 million do not exactly replicate Nifty hence it is simplest and completely riskless to do this in portfolios
of Rs.3 million or more.
4. This sounds great – what are the catches? Some of the 50 securities might be stuck at price limits when you
are getting in or getting out.
Of course, it could always be the case that the spot–futures basis is too low, so the interest rate in lending is
unattractive. In that case it is not worth doing anyway.
5. Does one have to hold till the futures expiration date or can one “square off ” earlier? Many times the market
presents suitable opportunities to square off early and make a tidy profi t. Suppose we entered with the Nifty
spot at 1200 and the futures at 1230. Suppose, two hours later, the Nifty spot is running at 1205 and the futures
are at 1225. Then one can square off and make a profi t of (roughly) 10/1200 or 0.8% on the same day itself.
This is called “early unwind”. Internationally, early unwind is extremely common.
5.8 Arbitrage: Have securities, lend them to the market 83
Solved problems
Q: Suppose the Nifty spot is at 1000 and the two–month futures are at 1040. Suppose the transactions
costs involved are 0.4% and dividends over the two months are 0. Then what is the rate of return in loaning
money to the market?
1. 1.8% per month. 4. 1% per month.

2. 1.25% per month.
3. 1.75% per month. 5. 2% per month.
A: 1040/1000 means a return of 4% over two months. Subtract out 0.4% to get 3.6% over two months,
i.e. 1.8% per month. The correct answer is number 1.
Q: Suppose the Nifty spot is at 1000 and the two–month futures are at 1040. Suppose the transactions
costs involved are 0.4% and dividends over the two months are 0.20%. Then what is the rate of return in
loaning money to the market?
1. 1.5% per month. 3. 1.75% per month.
2. 1.25% per month. 4. 1.9% per month.
A: 1040/1000 means a return of 4% over two months. Subtract out 0.4% and add back the 0.20% received
by way of dividend. The correct answer is 4.
5.8 Arbitrage: Have securities, lend them to the market
Owners of a portfolio of shares often think in terms of juicing up their returns by earning revenues
from stocklending. However, stocklending schemes that are widely accessible do not exist in
India.
The index futures market offers a riskless mechanism for (effectively) loaning out shares
and earning a positive return for them. It is like a repo; you would sell off your certificates
and contract to buy them back in the future at a fixed price. There is no price risk (since you
are perfectly hedged) and there is no credit risk (since your counterparty on both legs of the
transaction is the NSCCL).
The basic idea is quite simple. You would sell off all 50 securities in Nifty and buy them
back at a future date using the index futures. You would soon receive money for the shares you
have sold. You can deploy this money as you like until the futures expiration. On this date, you
would buy back your shares, and pay for them.

Suppose you have Rs.5 million of the NSE-50 portfolio (in their correct proportion, with each
share being present in the portfolio with a weight that is proportional to its market capitalization).
1. Sell off all 50 shares on the cash market. This can be done using a single keystroke using the NEAT software.
2. Buy index futures of an equal value at a future date.
3. A few days later, you will receive money and have to make delivery of the 50 shares.
4. Invest this money at the riskless interest rate.
5. On the date that the futures expire, at 3:15 PM, put in 50 orders (using NEAT again) to buy the entire NSE-50
portfolio.
6. A few days later, you will need to pay in the money and get back your shares.
When is this worthwhile? When the spot-futures basis (the difference between spot Nifty and
the futures Nifty) is smaller than the riskless interest rate that you can find in the economy. If the
spot–futures basis is 2.5% per month and you are loaning out the money at 1.5% per month, it
is not profitable. Conversely, if the spot-futures basis is 1% per month and you are loaning out
money at 1.2% per month, this stocklending could be profitable.
It is easy to approximate the return obtained in stocklending. To do this, we assume that
transactions costs account for 0.4%. Suppose the spot–futures basis is

and suppose the rate
at which funds can be invested is . Then the total return is
%, over the time that

"
the position is held.

This can also be interpreted as a mechanism to obtain a cash loan using your portfolio of
Nifty shares as collateral. In this case, it may be worth doing even if the spot–futures basis is
somewhat wider.
Example
Suppose the Nifty spot is 1100 and the two–month futures are trading at 1110. Hence the spot–
futures basis (10/1100) is 0.9%. Assume that the transactions costs are 0.4%. Suppose cash can
be risklessly invested at 1% per month. Over two months, funds invested at 1% per month yield
2.01%. Hence the total return that can be obtained in stocklending is 2.01-0.9-0.4 or 0.71% over
the two–month period. Let us make this concrete using a specific sequence of trades. Suppose
Akash has Rs.4 million of the Nifty portfolio which he would like to lend to the market.
1. Akash puts in sell orders for Rs.4 million of Nifty using the feature in NEAT to rapidly place 50 market orders
in quick succession. The seller always suffers impact cost; suppose he obtains an actual execution at 1098.
2. A moment later, Akash puts in a market order to buy Rs.4 million of the Nifty futures. The order executes at
1110. At this point, he is completely hedged.
3. A few days later, Akash makes delivery of shares and receives Rs.3.99 million (assuming an impact cost of
2/1100).
4. Suppose Akash lends this out at 1% per month for two months.

5. At the end of two months, he get back Rs.40,70,199. Translated in terms of Nifty, this is 1098*
or 1120.
5.8 Arbitrage: Have securities, lend them to the market 85
6. On the expiration date of the futures, he puts in 50 orders, using NEAT, placing market orders to buy back his
Nifty portfolio. Suppose Nifty has moved up to 1150 by this time. This makes shares are costlier in buying
back, but the difference is exactly offset by profi ts on the futures contract.
When the market order is placed, suppose he ends up paying 1153 and not 1150, owing to impact cost. He has
funds in hand of 1120, and the futures contract pays 40 (1150-1110) so he ends up with a clean profi t, on the
entire transaction, of 1120 + 40 - 1153 or 7. On a base of Rs.4 million, this is Rs.25,400.
Nuances
1. What if the shares that I own are not exactly the NSE-50 portfolio? This only works exactly for more than Rs.3
million of the NSE-50 portfolio. You can always reshuffle your portfolio to have at least Rs.3 million of Nifty.
Any large investor can plan in advance and have a sub–component of his portfolio which looks exactly like
Nifty; the only constraint is that this sub–component has to be larger than Rs.3 million. Once this preparation
is done, it can be used for stocklending anytime the terms look attractive.
2. How does a stocklending scheme fi t into this? Suppose you do not have the exact Nifty portfolio worth Rs.3
million or more. In that case, some or all the components which are missing can be borrowed if a stocklending
scheme is working. Of course, the rate of return in stocklending through the index futures market would have
to high enough to compensate for the cost of borrowing stock through the stocklending scheme.
3. This sounds great – what is the catch? Some of the 50 securities might be stuck at price limits when you are
getting in or getting out.
Of course, it could always be the case that the spot–futures basis is too high, so the stocklending is unattractive.
In that case it is not worth doing anyway.
4. What is the relationship between moneylending and stocklending into the index futures market? When the
spot–futures basis is “too wide”,i.e. the futures price is higher than its fair value as per the cost of carry model,
moneylending is attractive. When the spot–futures basis is “too low”,i.e. the futures price is lower than its fair
value as per the cost of carry model, stocklending is attractive.
For example, assume that the Nifty spot is at 1200 and the fair value of a one month futures contract works
out to be 1220. This means that the fair basis is 20. If futures trade at 1230, the basis has widened to 30. Now
it becomes profi table to lend money to the market. Assume instead that the futures trade at 1210. The basis
has narrowed down to 10, and it now becomes profi table to lend securities to the market.
If one is highly attractive, the other will be highly unattractive. Both cannot be attractive at the same time.
The market will bounce around; sometimes the basis will be too thin and sometimes the basis will be too wide.
Alert traders will spot these opportunities and connect them up with either stocklending or moneylending,
depending upon the situation.
Solved problems
Q: Suppose the Nifty spot is 1000 and the two month futures are at 1010. Suppose cash can be risklessly
invested at 1% per month and the transactions costs involved are 0.4%. Then the total return that can be
obtained in stocklending is
1. 0.61% over two months 3. 1.61% over two months
A: 1% invested over two months earns 2.01%. Subtract from the interest earned spot-futures basis
1010/1000, that is 1% and 0.4% transactions cost to get 0.61% over two months. The correct answer is 1.
Q: Suppose the Nifty spot is at 1100 and the two-month futures are at 1120. Suppose cash can be risklessly
invested at 1.5% per month and there are no transactions costs. Then the total return that can be obtained
in stocklending is
1. 1% over two months 3. 1.55% over two months
A: 1.5% invested over two months earns 3.02%. Subtract from the interest earned spot-futures basis
1120/1100, that is 1.82% to get 1.2%. The correct answer is 2.
5.9 F&O market watch: Spot the mispricing

In all the applications so far, we assumed that there was a single futures price. In reality when
one trades on the futures market, one encounters two prices - a bid and an ask. In the following
section, we shall discuss two trading strategies that can be implemented by an investor following
the market watch screen.
Do you sometimes think that a futures contract is mispriced? As per the cost-of-carry logic
which we learned in Chapter 4, the futures price must be equal to the spot price plus the cost of
carry. If the futures price is less than the spot price plus cost of carry or if the futures price is
greater than the spot plus cost of carry, arbitrage opportunities exist.
If for instance , arbitrageurs will borrow funds, buy the spot with these

borrowed funds, sell the futures contract and carry the asset forward to deliver against the futures
contract. This is called cash-and-carry arbitrage.
If

, arbitrageurs will sell the asset, invest the proceeds from this sale and buy

futures cheap. This is called reverse cash-and-carry. As arbitrageurs enter the market, buying the
cheaper of the two (future and spot) and selling the expensive, prices will return to an equilibrium
where they obey the cost-of-carry rule.
5.9 F&O market watch: Spot the mispricing 87
Table 5.3 Market watch showing bid and ask for various futures contracts
Month Quantity Bid Ask Quantity
November 1000 1009 1010.5 1000
December 200 1022 1025 400
January 400 1028 1032 200
Table 5.4 Fair values vis-a-vis market prices for various futures contracts
Month Quantity Bid Ask Quantity Fair value
November 1000 1009 1010.5 1000 1009.50
December 200 1022 1025 400 1019.00
January 400 1028 1032 200 1028.70
What we spoke of above were arbitrage opportunities arising out of mispricings. However,
when futures price is not equal to its fair value, speculators too enter the market, buy the cheaply
available contract and sell the expensive one, wait till prices return to their fair values and close
out their positions. Hence identifying mispricings is an essential skill that must be developed.
Let us look at a few examples that will make this clear.
Case 1
On the first day of November, Nifty stands at 1000. The market watch screen shows the three
futures contracts trading at prices given in Table 5.3. .

$
How would an investor spot mispricings? At we can calculate the fair value of the

$
futures contracts using the relationship given below:

The fair values of the three contracts are given in Table 5.4. If the fair value of the contract
is higher than the ask, the contract is underpriced and should be bought at the ask price. If the
fair value of the contract is below the bid, the contract is overpriced and should be sold at the bid
price. In the above example we can see that the December contract is overpriced. The fair value
of the contract is 1019 whereas there is a buyer at 1022. Hence an investor can sell 200 Nifties
i.e. one contract at 1022 and close the position when the contract returns to its fair value.
Case 2
On the first day of November, Nifty stands at 1000. The market watch screen shows the three
futures contracts trading at prices given in Table 5.5. . Identify the mispricing.

$
Table 5.5 Fair values vis-a-vis market prices for various futures contracts
Month Quantity Bid Ask Quantity Fair value
November 1000 1006.5 1007 1000 1009.50
December 200 1018 1025 400 1019.00
January 400 1028 1032 200 1028.70
Table 5.6 Basis and Spreads on various futures contracts

Spot Futures contract Fair values Basis Spread
1000
1010 10

1020 20 10
1030 30 10
In this case we can see that the November contract is underpriced. The fair value of the
contract is 1009.35 whereas there is a seller at 1007. The trader has the opportunity to buy 1000
Nifties i.e. 5 contracts at 1007 and close the position when the contract returns to fair value.
5.10 F&O market watch: Spread trading

As we’ve already defined earlier, basis is the difference between the spot and the futures prices.
Basis should reflect the fair value of the futures contract. When the basis between spot and futures
or the spread between two futures contracts is incorrect, arbitrage opportunities arise. Table 5.7
gives the fair values and basis of the three futures contracts. The last column shows the spreads
between the futures contracts. As we can see, the spread between and
is 10. Similarly the

spread between
and is 10 as well. We shall first try to get an intuitive understanding of the

topic assuming for the time being that there is just one single futures price.
If the basis happens to be incorrect, there can be arbitrage opportunities. Exploiting this
mispricing involves the following trades. When the spread between the two futures contracts
narrows, buy the far month contract and sell the near month one. Why do we buy the far month
and sell the near month? Because we know that if the fair spread between two contracts is 10,
but the one observed on the market watch is 6, the far month contract is underpriced and the
near month is overpriced. There is a mispricing which will be wiped out as soon as traders start
exploiting it. The basis and the spread will correct itself and return close to its fair value. Now is
the time to close the position, i.e. sell the far month contract and buy the near month.
Refer to Table 5.7 and similarly observe the spread between and . When the spread

between two futures contracts widens, sell the far month contract and buy the near-month one.
Why do we sell the far month and buy the near month? Because we know that if the fair spread
between two contracts is 10, but the one observed on the market watch is 14, the far month
contract is overpriced and the near month is underpriced. There is a mispricing which will be
5.10 F&O market watch: Spread trading 89
Table 5.7 Mispricing of Basis and Spreads on various futures contracts

The table shows the basis and spreads on one-month,two-month and three-month futures contracts. Basis is the
difference between the spot and the futures prices. It is usually negative. The difference between two futures
contracts is referred to as spreads. The fair spread between and is 10. However the spread that we observe on

the market at the moment is 6. Since the spread has narrowed, we can profi t by selling the near-month contract,i.e.
and buying the far-month contract,i.e. . Once we do this, we would have a position of:

Sell @ 1012

Buy @ 1018
After some time, the spread corrects itself and we close our position by entering into the following trades:

Buy

@ 1010

Sell

@ 1020
We end up making a profi t of Rs.4 on the round trip.

Similarly observe the spread between and . The spread has widened from an expected value of 10 to an

observed value of 14. Hence we sell the far month contract and buy the near month one. Once we do this we would
have a position of:

Sell

@ 1032

Buy @ 1018
After some time, the spread corrects itself and we close our position by entering into the following trades:

Buy

@ 1030

Sell

@ 1020
We end up making a profi t of Rs.4 on the round trip.However a word of caution. Although transaction costs on the
futures market are less than the transactions costs on the cash market, they exist anyway and should be factored into
these trades. As far as possible, closing out of positions should be done using limit orders. The Market by Price
(MBP) screen gives a fair idea of the depth of the market, and should be used while placing the limit orders. It will
help to remember that a person who trades using limit orders earns impact costs whereas a person who trades using
market orders pays impact costs.
Spot Contract Fair price Fair basis Fair Spread Mkt price Obs. basis Obs. spread
1000
1010 10 1012 12

1020 20 10 1018 18 6
1030 30 10 1032 32 14
wiped out as soon as traders start exploiting it. The basis and the spread will correct itself and
return close to its fair value. Now is the time to close the position, i.e. buy the far month contract
and sell the near month.
Table 5.8 Bid-ask on various futures contracts at time T1 and time T2

Trading to profi t from misaligned spreads seems simple when we look at a single futures price, but in the real world
we are faced with two prices, a bid and an ask. The trick is to get used to detecting misalignment of spreads across
futures contracts, given three bids and three asks.
The table shows the bid and ask for various futures contracts as one would see them on the market watch at time T1
and T2. If we typically believe that the spread between the one-month and two-month futures contracts should be
10 points, we will buy a spread at time T1 when it is less than 10 and sell a spread at time T2 when it is greater than
10. Buying a spread basically means selling the near month and buying the far month contract. So if we think that
the spread between and is narrow, what we really need to look at is the bid on

and the ask on . If the

difference between this is narrower than we expect it to be, we sell and buy . Once we do this we would have

a position of:

Sell

@ 1012

Buy

@ 1016
We now watch the market to see if the spread corrects itself. To close our position at time T2 what we should be
watching is the difference between ask on and the bid on . Once this returns close to our expected spread,

10 in this case, we close our position by buying and selling at time T2. When we do this we would have a

position of:

Buy @ 1011

Sell @ 1019
As we can see, we sold at 1012 and bought it back at 1011 making a profi t of 1. We bought at 1016 and sold

it at 1019 making a profi t of 3. Our net profi t from this set of transactions is 4.
The point to note is that when faced with a bid and an ask price, one must watch the correct prices to calculate the
spread. Familiarizing oneself with this set of transactions will enable one to quickly detect misaligned spreads on
the futures contract and instantly enter into trades to profi t from them.
Market watch at time T1

Spot Contract Bid Ask
1000
1012 1013

1014 1016
1027 1037
1000
1010 1011

1019 1022
1028 1035
Solved problems
Q: When the spread between the one–month and two–month futures contracts narrows, you can profi t by:
1. Buying the near–month contract and selling 3. Both the above

the far–month one
2. Selling the near–month contract and buying
the far–month one 4. None of the above
A: When the spread between the one–month and two–month futures contract narrows, it implies that the
one–month contract is selling at a price higher than its fair value and the two–month contract is selling at
a price lower than its fair value. Hence one can profi t by selling the one–month contract and buying the
two–month one. The correct answer is number 2.
5.10 F&O market watch: Spread trading 91
Q: In the fi rst week of March, you observe that the spread between the March and April futures contracts
has widened. How can you profi t from this observation?
1. By buying the March contract and selling the 3. Both the above
April one
2. By selling the March contract and buying the
April one 4. None of the above
A: In this case, March contract is underpriced and the April contract is overpriced. You can profi t by
buying the March contract and selling the April one. The correct answer is number 1.
Q: When the spread between the one–month and two–month futures contracts widens, you can profi t by:
1. Buying the near–month contract and selling 3. Both the above

the far–month one
2. Selling the near–month contract and buying
the far–month one 4. None of the above
Q: The bid and ask for various futures contracts at time T1 are given below. If the typical spread between
the one–month and two–month futures contracts is 10 points, what strategy will you adopt?

1000
1012 1013

1014 1016
1. At time T1, buy
@ 1013 and sell
@ 3. At time T1, buy
@ 1012 and sell
@
1014 1014
2. At time T1, sell
@ 1012 and buy
@
1016 4. None of the above
A: The correct strategy is to buy a spread at time T1 when it is less than 10 and sell a spread at time
T2 when it is greater than 10. In this case, observe that the spread between one–month and two–month
futures contracts has narrowed. When the spread narrows, you should sell the near–month contract and
buy the far–month one. Hence you should sell @ 1012 and buy

@ 1016. The correct answer is

number 2.
Q: The typical spread between the one–month and two–month futures contract is 10 points. At time T1
the spread had narrowed, so you sold @ 1012 and bought

@ 1016. You would like to unwind your

position and book your profi ts. The bid and ask for various futures contracts at time T2 are given below.
What trades will you enter into?

1000
1010 1011

1019 1022
1. At time T2, buy
@ 1011 and sell
@ 3. At time T2, buy
@ 1010 and sell
@
1019 1022
2. At time T2, sell
@ 1012 and buy
@
1016 4. None of the above
A: You are watching the market and notice that the spread has corrected itself at time T2. It has now
returned to your expected value of 10. You would now close our position by buying
at 1011 and selling

at 1019. The correct answer is number 1.
Q: In the fi rst week of March, you observe that the spread between the March and April futures contracts
has narrowed. How can you profi t from this observation?
1. By buying the March contract and selling the 3. Both the above
April one
2. By selling the March contract and buying the
April one 4. None of the above

Chapter 6
Using futures on individual securities
Index futures began trading in India in June 2000. An year later, options on index were available
for trading. July 2001 saw the launch of options on individual securities(herein referred to as
stock options) and the onset of rolling settlement. With the launch of futures on individual
securities(herein referred to as stock futures) on the 9th of November,2001, the basic range of
equity derivative products in India seems complete. Of the above mentioned products, stock
futures are particularly appealing due to familiarity and ease in understanding. A purchase or
sale of futures on a security gives the trader essentially the same price exposure as a purchase
or sale of the security itself. In this regard, trading stock futures is no different from trading
the security itself. Besides speculation, stock futures can be effectively used for hedging and
arbitrage reasons.
6.1 Difference between trading securities and trading futures on

individual securities
To trade securities, a customer must open a security trading account with a securities broker
and a demat account with a securities depository. Buying security involves putting up all the
money upfront. With the purchase of shares of a company, the holder becomes a part owner
of the company. The shareholder typically receives the rights and privileges associated with
the security, which may include the receipt of dividends, invitation to the annual shareholders
meeting and the power to vote.
Selling securities involves buying the security before selling it. Even in cases where short
selling is permitted, it is assumed that the securities broker owns the security and then “lends” it
to the trader so that he can sell it. Besides, even if permitted, short sales on security can only be
executed on an up-tick.
To trade futures, a customer must open a futures trading account with a derivatives broker.
Buying futures simply involves putting in the margin money. They enable the futures traders to
take a position in the underlying security without having to open an account with a securities
broker. With the purchase of futures on a security, the holder essentially makes a legally binding
promise or obligation to buy the underlying security at some point in the future(the expiration
94 Using futures on individual securities
date of the contract). Security futures do not represent ownership in a corporation and the holder
is therefore not regarded as a shareholder.
A futures contract represents a promise to transact at some point in the future. In this light,
a promise to sell security is just as easy to make as a promise to buy security. Selling security
futures without previously owning them simply obligates the trader to selling a certain amount
of the underlying security at some point in the future. It can be done just as easily as buying
futures, which obligates the trader to buying a certain amount of the underlying security at some
point in the future. In the following sections we shall look at some uses of security future.
6.2 Hedging: Long security, sell futures

Stock futures can be used as an effective risk–management tool. Take the case of an investor
who holds the shares of a company and gets uncomfortable with market movements in the short
run. He sees the value of his security falling from Rs.450 to Rs.390. In the absence of stock
futures, he would either suffer the discomfort of a price fall or sell the security in anticipation of
a market upheaval. With security futures he can minimize his price risk. All he need do is enter
into an offsetting stock futures position, in this case, take on a short futures position. Assume
that the spot price of the security he holds is Rs.390. Two–month futures cost him Rs.402. For
this he pays an initial margin. Now if the price of the security falls any further, he will suffer
losses on the security he holds. However, the losses he suffers on the security, will be offset by
the profits he makes on his short futures position. Take for instance that the price of his security
falls to Rs.350. The fall in the price of the security will result in a fall in the price of futures.
Futures will now trade at a price lower than the price at which he entered into a short futures
position. Hence his short futures position will start making profits. The loss of Rs.40 incurred
on the security he holds, will be made up by the profits made on his short futures position.
6.3 Speculation: Bullish security, buy futures

Take the case of a speculator who has a view on the direction of the market. He would like to trade
based on this view. He believes that a particular security that trades at Rs.1000 is undervalued
and expect its price to go up in the next two–three months. How can he trade based on this
belief? In the absence of a deferral product, he would have to buy the security and hold on to it.
Assume he buys a 100 shares which cost him one lakh rupees. His hunch proves correct and two
months later the security closes at Rs.1010. He makes a profit of Rs.1000 on an investment of
Rs.1,00,000 for a period of two months. This works out to an annual return of 6 percent.
Today a speculator can take exactly the same position on the security by using futures
contracts. Let us see how this works. The security trades at Rs.1000 and the two-month futures
trades at 1006. Just for the sake of comparison, assume that the minimum contract value is
1,00,000. He buys 100 security futures for which he pays a margin of Rs.20,000. Two months
later the security closes at 1010. On the day of expiration, the futures price converges to the spot
price and he makes a profit of Rs.400 on an investment of Rs.20,000. This works out to an annual
6.4 Speculation: Bearish security, sell futures 95
return of 12 percent. Because of the leverage they provide, security futures form an attractive
option for speculators.
6.4 Speculation: Bearish security, sell futures

Stock futures can be used by a speculator who believes that a particular security is over–valued
and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a
deferral product, there wasn’t much he could do to profit from his opinion. Today all he needs to
do is sell stock futures.
Let us understand how this works. Simple arbitrage ensures that futures on an individual
securities move correspondingly with the underlying security, as long as there is sufficient
liquidity in the market for the security. If the security price rises, so will the futures price. If
the security price falls, so will the futures price. Now take the case of the trader who expects to
see a fall in the price of SBI. He sells one two–month contract of futures on SBI at Rs.240(each
contact for 100 underlying shares). He pays a small margin on the same. Two months later,
when the futures contract expires, SBI closes at 220. On the day of expiration, the spot and the
futures price converges. He has made a clean profit of Rs.20 per share. For the one contract that
he bought, this works out to be Rs.2000.
6.5 Arbitrage: Overpriced futures: buy spot, sell futures

As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the
spot price. Whenever the futures price deviates substantially from its fair value, arbitrage
opportunities arise.
If you notice that futures on a security that you have been observing seem overpriced, how
can you cash in on this opportunity to earn riskless profits? Say for instance, ABB trades at
Rs.1000. One–month ABB futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you
can make riskless profit by entering into the following set of transactions.
1. On day one, borrow funds, buy the security on the cash/spot market at 1000.
2. Simultaneously, sell the futures on the security at 1025.
3. Take delivery of the security purchased and hold the security for a month.
4. On the futures expiration date, the spot and the futures price converge. Now unwind the position.
5. Say the security closes at Rs.1015. Sell the security.
6. Futures position expires with profi t of Rs.10.
7. The result is a riskless profi t of Rs.15 on the spot position and Rs.10 on the futures position.
8. Return the borrowed funds.

When does it make sense to enter into this arbitrage? If your cost of borrowing funds to
buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage.
This is termed as cash–and–carry arbitrage. Remember however, that exploiting an arbitrage
opportunity involves trading on the spot and futures market. In the real world, one has to build
in the transactions costs into the arbitrage strategy.
6.6 Arbitrage: Underpriced futures: buy futures, sell spot

Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise.
It could be the case that you notice the futures on a security you hold seem underpriced. How can
you cash in on this opportunity to earn riskless profits? Say for instance, ABB trades at Rs.1000.
One–month ABB futures trade at Rs. 965 and seem underpriced. As an arbitrageur, you can
make riskless profit by entering into the following set of transactions.
1. On day one, sell the security in the cash/spot market at 1000.
2. Make delivery of the security.
3. Simultaneously, buy the futures on the security at 965.
4. On the futures expiration date, the spot and the futures price converge. Now unwind the position.
5. Say the security closes at Rs.975. Buy back the security.
6. The futures position expires with a profi t of Rs.10.
7. The result is a riskless profi t of Rs.25 on the spot position and Rs.10 on the futures position.
If the returns you get by investing in riskless instruments is less than the return from the
arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse–cash–and–carry
arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with
the cost–of–carry. As we can see, exploiting arbitrage involves trading on the spot market. As
more and more players in the market develop the knowledge and skills to do cash–and–carry and
reverse cash–and–carry, we will see increased volumes and lower spreads in both the cash as
well as the derivatives market.
Solved problems
Q: Exchange traded stock futures began trading on the NSE from
1. November 2001 3. November 1999
2. November 2000 4. November 1995

6.6 Arbitrage: Underpriced futures: buy futures, sell spot 97
Q: A speculator with a bullish view on a security can
1. buy stock futures 3. sell stock futures
2. buy index futures 4. sell index futures
Q: Mohan owns a thousand shares of Reliance. Around budget time, he get uncomfortable with the price
movements. Which of the following will give him the hedge he desires?
1. Buy 10 Reliance futures contracts 3. Buy 5 Reliance futures contracts
2. Sell 10 Reliance futures contracts 4. Sell 5 Reliance futures contracts
A: Since he owns a thousand shares of Reliance, he will have to sell 10 Reliance futures contracts(one
contract has 100 underlying shares) to give him a complete hedge. Correct answer is number 2.
Q: Rajeev owns a 200 shares of Reliance. Around budget time, he get uncomfortable with the price
movements. Which of the following will give him the hedge he desires?
1. Buy 1 Reliance futures contract 3. Buy 2 Reliance futures contracts
2. Sell 1 Reliance futures contract 4. Sell 2 Reliance futures contracts
A: Since he owns 200 shares of Reliance, he will have to sell 2 Reliance futures contracts(one contract
has 100 underlying shares) to give him a complete hedge. Correct answer is number 4.
Q: Santosh is bullish about Reliance and buys ten one-month Reliance futures contracts at Rs.2,96,000.
On the last Thursday of the month, Reliance closes at Rs.271. He makes a
1. profi t of Rs.15000 3. loss of Rs.15000
A: At Rs.2,96,000 per futures contract, it costs him Rs.296 per unit of futures,i.e. 2,96,000/(10 * 100). On
expiration day the spot and futures converge. Therefore he makes a loss of (296 - 271) * 1000 = 25000.
Q: Rajiv is bearish about ACC and sells twenty one-month ACC futures contracts at Rs.3.04,000. On the
last Thursday of the month, ACC closes at Rs.134. He makes a
A: At Rs.3,04,000 per futures contract, it costs him Rs.152 per unit of futures,i.e. 3,04,000/(20 * 100).
On expiration day the spot and futures converge. Therefore his profi t is (152 - 134) * 2000 = 36000. The
correct answer is number 2.
Q: Suppose the ABB trades at 1000 in the cash market and two month ABB futures trade at 1030. If
transactions costs involved are 0.4%. What is the arbitrage return possible?
1. 1.8% per month 3. 2% per month
A: Return over two months is 1030/1000 = 3%. Minus transactions costs of 0.4% and the net return works
out to be 2.6%. The return per month is 1.3%. The correct answer is number 2.
Chapter 7
Pricing options
An option buyer has the right but not the obligation to exercise on the seller. The worst that
can happen to a buyer is the loss of the premium paid by him. His downside is limited to this
premium, but his upside is potentially unlimited. This optionality is precious and has a value,
which is expressed in terms of the option price. Just like in other free markets, it is the supply and
demand in the secondary market that drives the price of an option. On dates prior to 31 Dec 2000,
the “call option on Nifty expiring on 31 Dec 2000 with a strike of 1500” will trade at a price
that purely reflects supply and demand. There is a separate order book for each option which
generates its own price. The values shown in Table 7.1 are derived from a theoretical model,
namely the Black-Scholes option pricing model. If the secondary market prices deviate from
these values, it would imply the presence of arbitrage opportunities, which (we might expect)
would be swiftly exploited. But there is nothing innate in the market which forces the prices in
the table to come about.
There are various models which help us get close to the true price of an option. Most of these
are variants of the celebrated Black-Scholes model for pricing European options. Today most
Table 7.1 Option prices: some illustrative values

Option strike price
1400 1450 1500 1550 1600
Calls
1 mth 117 79 48 27 13
3 mth 154 119 90 67 48
Puts
1 mth 8 19 38 66 102
3 mth 25 39 59 84 114
Assumptions: Nifty spot is 1500, Nifty
volatility is 25% annualized, interest rate
is 10%, Nifty dividend yield is 1.5%.
100 Pricing options
calculators and spread-sheets come with a built-in Black-Scholes options pricing formula so to
price options we don’t really need to memorize the formula. What we shall do here is discuss
this model in a fairly non-technical way by focusing on the basic principles and the underlying
intuition.
7.1 Introduction to the Black–Scholes formulae

Intuition would tell us that the spot price of the underlying, exercise price, risk-free interest rate,
volatility of the underlying, time to expiration and dividends on the underlying(stock or index)
should affect the option price. Interestingly before Black and Scholes came up with their option
pricing model, there was a widespread belief that the expected growth of the underlying ought
to affect the option price. Black and Scholes demonstrate that this is not true. The beauty of
the Black and Scholes model is that like any good model, it tells us what is important and what
is not. It doesn’t promise to produce the exact prices that show up in the market, but certainly
does a remarkable job of pricing options within the framework of assumptions of the model.
Virtually all option pricing models, even the most complex ones, have much in common with the
Black–Scholes model.
Black and Scholes start by specifying a simple and well–known equation that models the
way in which stock prices fluctuate. This equation called Geometric Brownian Motion, implies
that stock returns will have a lognormal distribution, meaning that the logarithm of the stock’s
return will follow the normal (bell shaped) distribution. Black and Scholes then propose that
the option’s price is determined by only two variables that are allowed to change: time and the
underlying stock price. The other factors - the volatility, the exercise price, and the risk–free rate
do affect the option’s price but they are not allowed to change. By forming a portfolio consisting
of a long position in stock and a short position in calls, the risk of the stock is eliminated. This
hedged portfolio is obtained by setting the number of shares of stock equal to the approximate
change in the call price for a change in the stock price. This mix of stock and calls must be
revised continuously, a process known as delta hedging.
Black and Scholes then turn to a little–known result in a specialized field of probability known
as stochastic calculus. This result defines how the option price changes in terms of the change in
the stock price and time to expiration. They then reason that this hedged combination of options
and stock should grow in value at the risk–free rate. The result then is a partial differential
equation. The solution is found by forcing a condition called a boundary condition on the model
that requires the option price to converge to the exercise value at expiration. The end result is the
Black and Scholes model.
7.2 The Black–Scholes option pricing formulae

The Black–Scholes formulas for the prices of European calls and puts on a non-dividend paying
stock are:

7.2 The Black–Scholes option pricing formulae 101

where

and

The Black/Scholes equation is done in continuous time. This requires continuous compounding. The

“r” that fi gures in this is . Example: if the interest rate per annum is 12%, you need to use

or 0.1133, which is the continuously compounded equivalent of 12% per annum.

is the cumulative normal distribution. is called the delta of the option which is a measure
of change in option price with respect to change in the price of the underlying asset.
a measure of volatility, is the annualized standard deviation of continuously compounded returns

on the underlying. When daily are given, they need to be converted into annualized .
" " % ' * + ' -
/ Number of trading days per year. On an average there are 250

trading days in a year.
X is the exercise price, S the spot price and T the time to expiration measured in years.
7.2.1 Pricing index options

Under the assumptions of the Black–Scholes options pricing model, index options should be
valued in the same way as ordinary options on common stock. The assumption is that investors
can costlessly purchase the underlying stocks in the exact amount necessary to replicate the
index; that is, stocks are infinitely divisible and that the index follows a diffusion process such
that the continuously compounded returns distribution of the index is normally distributed. To
use the Black–Scholes formula for index options, we must however make adjustments for the
dividend payments received on the index stocks. If the dividend payment is sufficiently smooth,
this merely involves replacing the current index value S in the model with where q is the
1

annual dividend yield and T is the time to expiration in years.

The Black-Scholes formula is so commonly used that it comes programmed into most
calculators and spreadsheets. Hence it is not necessary to memorize the formula. One only
needs to know how to use it.
Note: The pricing models discussed in this chapter give an approximate idea about the true
options price. However the price observed in the market is the outcome of the price–discovery
mechanism (demand–supply principle) and may differ from the so-called true price.
Example: A three-month call option on the Nifty with a strike of 1180 is available for
trading. Nifty stands at 1150, and it has a volatility of 30% per annum. The annual risk-free rate
is 12%. We can calculate the price of the 1180 option using the Black-Scholes option pricing
formula. We take T = 0.25, S=1150, X=1180, r=ln(1.12), and = 0.3. Substituting these values
in the formula, we get the call price as Rs.70.15. The put price on an option with the same strike
works out to be 67.19.
102 Pricing options
When working on the option pricing problem, Black and Scholes actually had some diffi culty in solving
the partial diffential equation. Though Black had a Ph.D in applied mathematics from Harvard, he
was not a specialist in differential equations and Scholes was only an economist. Solving differential
equations is often a matter of making educated guesses and using prior knowledge of what the fi nal
solution might possibly look like. Black and Scholes benefi tted from the fact that previous researchers
had almost found the elusive formula. Their predecessors solutions looked remarkably similar to what
we today know as the correct formula. The fi nal trick was found when their differential equation was
recognized as of a form known in Physics as the heat transfer equation. The equation had a known
solution, though it involved quite a few complicated steps before getting to it.
Their diffi culties didn’t end there. Black and Scholes had trouble getting publishers of academic
journals to care about their result. One after the other, distinguished economic journals rejected them.
Finally after a lot of pursuation, the article was accepted. The rest is history.
Box 7.9: The Black and Scholes option pricing formula story
7.2.2 Pricing stock options

Much of what was discussed about index options also applies to stock options. But before
learning how to price stock options, we shall have a quick look at the factors which affect option
prices.
Factors affecting option price

Various factors affect the price of options on stocks. We shall look at the impact of changes in
each of these factors on option prices one at a time, assuming that all other factors remain the
same. There are six factors affecting the price of a stock option:
The stock price: The payoff from a call option is the amount by which the stock price exceeds
the strike price. Call options therefore become more valuable as the stock price increases and less
valuable as the stock price decreases. The payoff from a put option is the amount by which the
strike price exceeds the stock price. Put options therefore become more valuable as the stock price
decreases and less valuable as the stock price increases.
The strike price: In the case of a call, as the strike price increases, the stock price has to make a
larger upward move for the option to go in–the–money. Therefore, for a call option, as the strike
price increases, options become less valuable and as the strike price decreases they become more
valuable. Put options behave exactly in the opposite way to call options.
Time to expiration: Both put and call American options become more valuable as the time to
expiration increases. Consider the case of two options that differ only as far as their expiration
date is concerned. The owner of the long–life option has all the exercise opportunities open to the
owner of the short–life option – and more. The long–life option must therefore always be worth at
least as much as the short life option.
Volatility: The volatility of a stock price is a measure of how uncertain we are about future stock
price movements. As volatility increases, the chance that the stock will do very well or very poorly
increases. The value of both calls and puts therefore increase as volatility increases.
Risk– free interest rate: The affect of the risk–free interest rate is less clear–cut. It is found that put
option prices decline as the risk–free rate increases whereas the prices of calls always increase as the
risk–free interest rate increases.
Dividends: Dividends have the effect of reducing the stock price on the ex–dividend date. This has
a negative affect on the value of call options and a positive affect on the value of put options.
Applying Black & Scholes option pricing formula to stock options

The Black & Scholes option pricing formula which we used to price European calls and puts,
with some adjustment can be used to price American calls and puts on stocks. Pricing American
options becomes a little difficult because unlike European options, American options can be
exercised any time prior to expiration. However, it is never optimal to exercise a call option on
a non–dividend paying stock before expiration. When no dividends are expected during the life
of the option, the option can be valued simply by substituting the values of the stock price, strike
price, stock volatility, risk–free rate and time–to–expiration in the Black & Scholes formula.
However, when dividends are expected during the life of the option, it is sometimes optimal
to exercise the option just before the underlying stock goes ex-dividend. Hence when valuing
options on dividend paying stock, we should consider exercise possibilities at two times, one -
just before the underlying stock goes ex-dividend, two - at expiration of the options contract.
Therefore, owning an option on a dividend paying stock today is like owning two options,
one is a long–maturity option with a time–to–maturity from today till the expiration day, and
the other is a short–maturity option with a time–to–maturity from today till just before the stock
goes ex–dividend.
Some adjustments need to be made before the Black & Scholes formula can be used. The
first step is to value the option on the assumption that it will be exercised at expiry. Thus the
present value of the dividends is deducted from the stock price and the adjusted value is used
*
in the Black & Scholes. The second step is to assume that the option will be exercised just before
the ex–dividend date. The un–adjusted stock price is used. In addition, the time to expiry is
shortened to be the period up to the ex–dividend date. Following these adjustments, the Black
& Scholes model can be applied. The actual value of the option will be the highest of the two
valuations.
Example: Assume that the price of a stock is Rs.50, the exercise price is Rs.45, the risk–free
rate of interest is 6% per annum and that an ex–dividend adjustment of 2.5 will occur 0.1644
years hence. The volatility of the stock is 20%. The discount rate on dividends is also taken to
be 6%. We now have two call options, a long–maturity call option with a maturity of 0.25 years
which can be exercised on the expiration date, and a short–maturity call option with a maturity
of 0.166 years which can be exercised just before the ex–dividend date. We will now value both
these options.

*

The details of the long option are: T=0.25, r=0.06, D=2.5, S=50, X=45 and =S-
.

*
The stock price to be used in the Black & Scholes option pricing formula is , the adjusted price of

the stock after deducting the present value of the dividends. Using these values, we get the price of
the long option as Rs.3.84.
104 Pricing options
The details of the short option are: T=0.166, r=0.06, D=2.5, S=50 and X=45. Note that in this case
since the option is exercised just before the stock goes ex–dividend, the unadjusted stock price of
Rs.50 is used. Using these values, we get the price of the short option as Rs.5.56.
Thus, using the above approximation, the American option on the dividend–paying stock
would be valued at the higher of the two options, i.e. at Rs.5.58.
Solved Problems
Q: If the daily volatility of Nifty is 1.92, the

fi gure used in the Black–Scholes formula should be
1. 30% 3. 1.38%
2. 1.92% 4. 35%
A: The Black–Scholes formula uses the annualized sigma. The daily sigma must be expressed in terms of
" " % ' * + ' -
annualized sigma. Number of trading days per year. On an average there

/

are 250 trading days in a year. Therefore the fi gure to be used is , i.e. about 30%. The correct /
answer is number 1.
Q: Assume that the daily volatility of Nifty is 1.75, and trading happens on 256 a year. The

fi gure
used in the Black & Scholes formula should be
1. 30% 3. 1.38%
2. 1.92% 4. 28%
A: The Black & Scholes formula uses the annualized sigma.

" " % ' * + ' -

Number of trading days per year. If there are 256 trading days in a year, the fi gure to be used is

, i.e.28%. The correct answer is number 4.
Q: If the annual risk–free rate is 12%, then the ‘r’ used in the Black–Scholes formula should be
1. 0.1133 3. 1.12
2. 0.12 4. None of the above
A: The Black–Scholes equation is done in continuous time. This requires continuous compounding. The

“r” that fi gures in this is . Therefore if the interest rate is 12%, you need to use
or 0.1133.
Q: If the continuously compounded annual risk-free rate is 0.095%, then the ‘r’ used in the Black &
Scholes formula should be
1. 0.095 3. 1.13
“r” that fi gures in this must be the continuously compounded rate. In this case it is 0.095. The correct
answer is number 1.
Q: On 1st February, a call option on the Nifty with a strike of 1280 is available for trading. Expiration
date is 22nd February. The ‘T’ that is used in the Black–Scholes formula should be
1. 0.06 3. 22
A: The time to expiration is 22 days. The ‘T’ used in the Black–Scholes is time-to-expiration measured

in years. Hence the ‘T’ used should be
, i.e.0.06. The correct answer is number 1.
Q: On 1st January, a three–month call option on the Nifty with a strike of 1280 is available for trading.
The ‘T’ that is used in the Black–Scholes formula should be
1. 0.25 3. 90
2. 3 4. None of the above
A: The time to expiration is 3 months. The ‘T’ used in the Black–Scholes is the time-to-expiration
measured in years. Hence the ‘T’ used should be
Q: On 1st May, a two–month call option on the Nifty with a strike of 1280 is available for trading. The
‘T’ that is used in the Black–Scholes formula should be
1. 0.166 3. 90
A: The time to expiration is 2 months. The ‘T’ used in the Black–Scholes is the time-to-expiration

measured in years. Hence the ‘T’ used should be

106 Pricing options
Q: A three-month call option on the Nifty with a strike of 1280 is available for trading. Nifty stands at
1260 and has a volatility of 30% per annum. If the annual risk-free rate is 12%, the price of the call is
1. Rs.63.50 3. Rs.40.85
2. Rs.83.10 4. None of the above
A: Use the Black-Scholes option pricing formula with T = 0.25, S=1260, X=1280, r=ln(1.12), and =
0.3. Substituting these values in the formula, the answer is Rs.83.10. The correct answer is number 2.
Q: A three–month put option on the Nifty with a strike of 1280 is available for trading. Nifty stands at
1260 and has a volatility of 30% per annum. If the annual risk-free rate is 12%, the price of the put is:
1. Rs.47.80 3. Rs.67.35
A: Use the Black–Scholes option pricing formula with T = 0.25, S=1260, X=1280, r=ln(1.12), = 0.3.
Substituting these values in the formula, the answer is Rs.67.35. The correct answer is number 3.
Q: A three–month call option on the Nifty with a strike of 1280 is available for trading. Nifty stands at
1260 and has a volatility of 30% per annum. The continuous dividend yield on the Nifty is 5%. If the
annual risk-free rate is 12%, the price of the call is
1. Rs.74.35 3. Rs.80.20
A: Use the Black–Scholes option pricing formula with T = 0.25, X=1280, r=ln(1.12), and = 0.3. In this

case where the annual dividend yield is known, replace the index value 1260 with 1244 ( ).
Substituting these values in the formula, the answer works out to be Rs.74.35. The correct answer is
number 1.
Q: A three–month put option on the Nifty with a strike of 1280 is available for trading. Nifty stands at
1260 and has a volatility of 30% per annum. The continuous dividend yield on the Nifty is 5%. If the
annual risk-free rate is 12%, the price of the put is
1. Rs.67.30 3. Rs.55.20
A: Use the Black–Scholes option pricing formula with T = 0.25, S=1260, X=1280, r=ln(1.12), =
0.3. In this case where the annual dividend yield is known, replace the index value 1260 with 1244

( ). Substituting these values in the formula, the answer works out to be Rs.74.60. The


Q: If the annual risk–free rate is 15%, then the ‘r’ used in the Black–Scholes formula should be
1. 0.15 3. 1.15

“r” that fi gures in this is

. Therefore if the interest rate is 15%, you need to use or 0.1398.
Q: A three–month call option on a stock with a strike of Rs.45 is available for trading. The spot price is
Rs.50. The risk–free rate of interest is 6% per annum and an ex–dividend adjustment of 2.5 will occur two
months hence. The volatility of the stock is 20%. The discount rate on dividends is also taken to be 6%.
The short–maturity option has a maturity of
1. 0.166 years 3. 0.5 years
2. 0.25 years 4. 0.0833 years
A: The short–maturity option has a maturity of 0.166 years since the ex–dividend date is two months later.
The long–maturity option has a maturity of
1. 0.166 years 3. 0.5 years
2. 0.25 years 4. 0.0833 years
A: The long–maturity option has a maturity of 0.25 years since it a three–month call option. The correct
answer is number 2.
The stock price to be used for valuing the long–maturity option is
1. 50 3. 47.52
2. 47.50 4. 52.50

A: The stock price to be used for valuing the long–maturity option is

*

=

. The
108 Pricing options
Rs.50. The risk–free rate of interest is 8% per annum and an ex–dividend adjustment of 5 will occur one
month hence. The volatility of the stock is 20%. The discount rate on dividends is also taken to be 8%.
The stock price to be used for valuing the long–maturity option is
1. 50 3. 47.52
2. 45.03 4. 55

A: The stock price to be used for valuing the long–maturity option is

*

=

. The
Chapter 8
Using index options
There are potentially innumerable ways of trading on the index options market. However we
shall look at eight basic modes of trading on the index options market:
Hedging
1. Have portfolio, buy puts
Speculation
1. Bullish index, buy Nifty calls or sell Nifty puts

2. Bearish index, sell Nifty calls or buy Nifty puts
3. Anticipate volatility, buy a call and a put at same strike
4. Bull spreads, Buy a call and sell another
5. Bear spreads, Sell a call and buy another
Arbitrage
1. Put-call parity with spot-options arbitrage

2. Arbitrage beyond option price bounds
8.1 Hedging: Have portfolio, buy puts

Owners of equity portfolios often experience discomfort about the overall stock market
movement. As an owner of a portfolio, sometimes you may have a view that stock prices will
fall in the near future. At other times you may see that the market is in for a few days or weeks
of massive volatility, and you do not have an appetite for this kind of volatility. The union budget
is a common and reliable source of such volatility: market volatility is always enhanced for one
week before and two weeks after a budget. Many investors simply do not want the fluctuations
of these three weeks. One way to protect your portfolio from potential downside due to a market
drop is to buy portfolio insurance.
110 Using index options
Index options is a cheap and easily implementable way of seeking this insurance. The idea
is simple. To protect the value of your portfolio from falling below a particular level, buy the
right number of put options with the right strike price. When the index falls your portfolio will
lose value and the put options bought by you will gain, effectively ensuring that the value of
your portfolio does not fall below a particular level. This level depends on the strike price of the
options chosen by you.
Portfolio insurance using put options is of particular interest to Mutual funds who already
own well-diversified portfolios. By buying puts, the fund can limit its downside in case of a
market fall.

We need to know the “beta” of the portfolio, i.e. the average impact of a 1% move in Nifty upon
the portfolio. It is easy to calculate the portfolio beta: it is the weighted average of stock betas.
Suppose we have a portfolio composed of Rs.1 million of Zee Telefilms, which has a beta of 1.4
and Rs.2 million of Hero Honda, which has a beta of 0.8, then the portfolio beta is (1 1.4 +
2 0.8)/3 or 1. If the beta of any stock is not known, it is safe to assume that it is 1. In general,
the beta of a well diversified portfolio is close to 1. We look at two cases, case one where the
portfolio has a beta of 1 and case two where the portfolio beta is not equal to 1.
Portfolio insurance when portfolio beta is 1.0

1. Assume we have a well diversifi ed portfolio with a beta of 1.0 which we would like to insure against a fall in
the market.
2. Now we need to choose the strike at which we should buy puts. This is largely a function of how safe we want
to play. Assume that the spot Nifty is 1250 and you decide to buy puts with a strike of 1125. This will insure
your portfolio against an index fall lower than 1125.
3. When the portfolio beta is one, the number of puts to buy is simply equal to the portfolio value divided by
the spot index . Assume your portfolio is worth Rs.1 million . Hence the number of puts you need to buy to
protect your portfolio from a fall in index is (10,00,000/1250) which works out to be 800. At a market lot of
200, it means that you will have to buy 4 market lots of two month puts with a strike of 1125.
Now let us look at the outcome. We have just bought two–month Nifty puts at a strike of
1125. This is designed to ensure that the value of our portfolio does not decline below Rs.0.90
million.( For a portfolio with a beta of 1, a 10% fall in the index directly translates into a 10%
fall in the portfolio value). During the two–month period, suppose the Nifty drops to 1080.
This is a 13.6% fall in the index. The portfolio value too falls at the same rate and declines to
Rs.0.864 million. However the options provide a payoff of (1125-1080)*4*200 which is equal to
Rs.36,000. This is the amount needed to bring the value of the portfolio back to Rs.0.90 million.
The above combination of portfolio plus long puts ensures that any fall in the portfolio value
will be accompanied by an equal gain on the options position, effectively ensuring that the
portfolio is insured against loses below some level. It is only the downside which is limited.
The upside is potentially unlimited. For instance if the Nifty rose to 1280, the investor would
8.1 Hedging: Have portfolio, buy puts 111
Protective puts with the required expiration and strikes are often not available in the market. Investment
managers sometimes turn to a dynamically–adjusted version of the protective put, which came to be
known as “portfolio insurance” in the mid-80s. This involved combining stocks with futures or treasury
bills. During the famous crash of 1987, the portfolio insurers were selling quickly because market
moves were faster than their models had assumed. This is called the gamma effect. Portfolio insurance
got a bad name and practically disappeared. The fact however was that portfolio insurers didn’t cause
the crash. The large amount of selling by insurers may have exacerbated the fall but not caused it. The
biggest problem with portfolio insurance was that it was based on the idea that market moves would
be very small, so that deltas could be reset reasonably fast. The insurers had missed the gamma effect.
The situation got worse when the market stopped trading and the futures price came detached from the
cash price. When this happened, portfolio insurance did not replicate a protective put as it had been
planned. However history testifi es that those who had portfolio insurance were certainly better off than
those that didn’t.
Box 8.10: Portfolio insurance and the crash of ’87
simply let the puts expire. He would of course, lose the put premium paid up–front, but that’s his
cost of buying insurance.
Portfolio insurance when portfolio beta is not 1.0

1. Assume we have a portfolio with beta equal to 1.2 which we would like to insure against a fall in the market.
2. Now we need to choose the strike at which we should buy puts. This is largely a function of how safe we want
to play. Assume that the spot Nifty is 1200 and we decide to buy puts with a strike of 1140. This will insure
our portfolio against an index fall lower than 1140.
3. For a portfolio with a non-unit beta, the number of puts to buy equals (portfolio value portfolio beta)/Index

. Assume our portfolio is worth Rs.1 million with a beta of 1.2. Hence the number of puts we need to buy to
protect our portfolio from a downside is (10,00,000 1.2)/1200 which works out to 1000. At a market lot of

200, it means that we will have to buy 5 market lots of two month puts with a strike of 1140.
Now let us look at the outcome. We have just bought two month Nifty puts at a strike of 1140.
This is designed to ensure the value of our portfolio does not decline below Rs.0.94 million. (For
a portfolio with a beta of 1.2, an index fall of 5% translates into a 6% fall in the portfolio value).
During the two-month period, suppose the Nifty drops to 1080. The portfolio value has declined
to Rs.0.88 million. (Again, for a portfolio with a beta of 1.2, a 10% fall in the index translates into
a 12% fall in the portfolio value). However the options provide a payoff of (1140-1080)*5*200
which is equal to Rs.60,0000. This is the amount needed to bring the value of the portfolio back
to Rs.0.94 million.
The above combination of portfolio plus long puts ensures that any fall in the portfolio
value will be accompanied by an equal gain on the options position effectively ensuring that
the portfolio is insured against losses below some level. Note that it is only the downside which
is limited. The upside is potentially unlimited. For instance if the Nifty rose to 1280, the investor
would simply let the puts expire. He would of course lose the put premium paid up-front, but
that’s his cost of buying insurance.
Solved problems
Q: You are the fund manager with a 1 million portfolio of beta 1.0. You would like to insure your portfolio
against a fall in the index of magnitude higher than 10%. Spot Nifty stands at 1250. Put options on the
Nifty are available at three strike prices. Which strike will give him the insurance he seeks?
1. 1240 3. 1125
A: For a portfolio with beta of 1.0, a 10% fall in the index translates into a 10% fall in the portfolio value.
Hence to protect his portfolio from a fall worse than 10%, he should buy Nifty puts with a strike of 1125.
Q: You own a 1 million portfolio with a beta of 1.0. Current Nifty level is 1250. Three-month puts at a
strike of 1080 are available. How many put contracts should you buy for insuring your portfolio against
an index fall below 1080?
1. Four 3. Eight
2. Five 4. Ten
A: At a spot Nifty level of 1250, for a portfolio value of 1 million with a beta of 1.0 , the right number of
puts to buy is (10,00,000/1250), i.e. 800 puts. At a market lot of 200 per contracts, you have to buy four
contracts to insure your portfolio against an index fall below 1080. The correct answer is number 1.
1. Four 3. Eight
2. Five 4. Ten
A: At a spot Nifty level of 1250, for a portfolio value of 1 million with a beta of 1.0, the right number of
puts to buy is (10,00,000/1250), i.e. 800 puts. At a market lot of 200 per contracts, you have to buy four
contracts to insure your portfolio against an index fall below 1000. The correct answer is number 1.
8.1 Hedging: Have portfolio, buy puts 113
1. Four 3. Eight
2. Five 4. Ten
A: At a spot Nifty level of 1250, for a portfolio value of 1 million with a beta of 1.25 , the right number
of puts to buy is (10,00,000*1.25)/1250, i.e. 1000 puts. At a market lot of 200 per contracts, you have to
buy fi ve contracts to insure your portfolio against an index fall below 1100. The correct answer is number
2.
Q: You are a fund manager managing a 5 million portfolio having a beta of 1. The spot Nifty stands
at 1250. You would like to insure your portfolio against a 10% fall in the index and hence you buy 25
contracts of January 1125 Nifty puts. Now your portfolio is
1. Partially insured against a 10% drop in the in- 3. Under-insured against a 10% drop in the in-
dex dex
4. Adequately insured against a 10% drop in the

2. Over-insured against a 10% drop in the index index.
A: To get an insurance for a portfolio worth Rs.5 million, you will have to buy (50,00,000/1250) = 4000
puts. For a contract size of 200, it means you will have to buy 20 Nifty put contracts. The strike price will
influence the level of hedge that you acquire, not the number of puts to buy. The correct answer is number
2.
Q: You are a fund manager managing a 5 million portfolio having a beta of 1.4. The spot Nifty stands
at 1250. You would like to insure your portfolio against a 10% fall in the index and hence you buy 20
contracts of January 1125 Nifty puts. Now your portfolio is
1. Partially insured against a 10% drop in the in- 3. Adequately insured against a 10% drop in the
dex index
2. Over-insured against a 10% drop in the index
A: To get an insurance for a portfolio worth Rs.5 million, you will have to buy (50,00,000*1.4)/1250 =
5600 puts. For a contract size of 200, it means you will have to buy 28 Nifty put contracts. The strike
price will influence the level of hedge that you acquire, not the number of puts to buy. The correct answer
is number 1.
Q: You are the fund manager with a 1 million portfolio of beta 1.2. You would like to insure your portfolio
against a fall in the index of magnitude higher than 10%. Spot Nifty stands at 1250. Put options on the
Nifty are available at three strike prices. Which strike will give you the insurance you seek?
1. 1240 3. 1125
A: To insure against a 10% fall in the index he should buy a put option with a strike that is 10% below
the present index level. In this case the correct answer is 3. He will have to buy (10,00,000 * 1.2)/1250
number of puts. i.e. 960 puts. Now let us assume he can buy exactly 960 puts. Suppose the index fell by
15%. For a portfolio with beta of 1.2, a 15% fall in the index translates into a 18% fall in the portfolio
value. His portfolio value will fall to Rs.8,20,000. However with the index now at 1062.5, his put options
will provide a payoff of (1125 - 1062.5)* 960 = Rs.60,000. This is the amount needed to bring his portfolio
value back to Rs.8,80,000 which is 12% of his initial portfolio value (which results out of a 10% fall in
the index). No matter how low the index falls, his portfolio value will never fall below Rs.8,80,000. Note
that since Nifty puts will be available for trading in contract sizes of 200, he will have to buy 5 contracts
and will be slightly overinsured.
Q: You are the fund manager with a 1 million portfolio of beta 1.2. You get uncomfortable when the value
of your portfolio falls more than 12% and hence would like to insure your portfolio against a fall in value
worse than 12%. Spot Nifty stands at 1250. Put options on the Nifty are available at three strike prices.
Which strike will give you the insurance you seek?
1. 1240 3. 1125
A: For a portfolio with a beta of 1.2, a 12% fall in the portfolio value would come from a 10% fall in the
index.This means he has to insure against a 10% fall in the index. To do this he should buy a put option
with a strike that is 10% below the present index level. In this case the correct answer is 3. He will have to
buy (10,00,000 * 1.2)/1250 number of puts. i.e. 960 puts. For now let us assume he can buy exactly 960
puts. Suppose the index fell by 15%. For a portfolio with beta of 1.2, a 15% fall in the index translates
into a 18% fall in the portfolio value. His portfolio value will fall to Rs.8,20,000. However with the index
now at 1062.5, his put options will provide a payoff of (1125 - 1062.5)* 960 = Rs.60,000. This is the
amount needed to bring his portfolio value back to Rs.8,80,000 which is 12% of his initial portfolio value.
No matter how low the index falls, his portfolio value will never fall below Rs.8,80,000. Note that since
Nifty puts will be available for trading in contract sizes of 200, he will have to buy 5 contracts and will be
slightly overinsured.
8.2 Speculation: Bullish index, buy Nifty calls or sell Nifty puts 115
8.2 Speculation: Bullish index, buy Nifty calls or sell Nifty puts
There are times when investors believe that the market is going to rise. For instance, after a good
budget, or good corporate results, or the onset of a stable government. How does one implement
a trading strategy to benefit from an upward movement in the index? Today, using options you
have two choices:
1. Buy call options on the index; or,
2. Sell put options on the index
We have already seen the payoff of a call option. The downside to the buyer of the call option is
limited to the option premium he pays for buying the option. His upside however is potentially
unlimited. Suppose you have a hunch that the market index is going to rise in a months time.
Your hunch proves correct and the index does indeed rise, it is this upside that you cash in on.
However, if your hunch proves to be wrong and the market index plunges down, what you lose
is only the option premium.
Having decided to buy a call, which one should you buy? Table 8.1 gives the premia for
one month calls and puts with different strikes. Given that there are a number of one–month
calls trading, each with a different strike price, the obvious question is: which strike should you
choose? Let us take a look at call options with different strike prices. Assume that the current
index level is 1250, risk-free rate is 12% per year and index volatility is 30%. The following
options are available:
1. A one month call on the Nifty with a strike of 1200.
Which of these options you choose largely depends on how strongly you feel about the
likelihood of the upward movement in the market index, and how much you are willing to lose
should this upward movement not come about. There are five one–month calls and five one–
month puts trading in the market. The call with a strike of 1200 is deep in–the–money and hence
trades at a higher premium. The call with a strike of 1275 is out–of–the–money and trades at a
low premium. The call with a strike of 1300 is deep–out–of–money. Its execution depends on
the unlikely event that the Nifty will rise by more than 50 points on the expiration date. Hence
buying this call is basically like buying a lottery. There is a small probability that it may be
in–the–money by expiration, in which case the buyer will make profits. In the more likely event
of the call expiring out–of–the–money, the buyer simply loses the small premium amount of
Rs.27.50.
As a person who wants to speculate on the hunch that the market index may rise, you can
also do so by selling or writing puts. As the writer of puts, you face a limited upside and an
unlimited downside. If the index does rise, the buyer of the put will let the option expire and you
Table 8.1 One month calls and puts trading at different strikes
The spot Nifty level is 1250. There are fi ve one-month calls and fi ve one-month puts trading in the market. The call
with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is
out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution
depends on the unlikely event that the Nifty will rise by more than 50 points on the expiration date. Hence buying
this call is basically like buying a lottery. There is a small probability that it may be in-the-money by expiration in
which case the buyer will profi t. In the more likely event of the call expiring out-of-the-money, the buyer simply
loses the small premium amount of Rs. 27.50. Figure 8.1 shows the payoffs from buying calls at different strikes.
Similarly, the put with a strike of 1300 is deep in-the-money and trades at a higher premium than the at-the-money
put at a strike of 1250. The put with a strike of 1200 is deep out-of-the-money and will only be exercised in the
unlikely event that Nifty falls by 50 points on the expiration date.Figure 8.2 shows the payoffs from writing puts at
different strikes.
Nifty Strike price of option Call Premium(Rs.) Put Premium(Rs.)

1250 1200 80.10 18.15
1250 1225 63.65 26.50
1250 1250 49.45 37.00
1250 1275 37.50 49.80
1250 1300 27.50 64.80
will earn the premium. If however your hunch about an upward movement in the market proves
to be wrong and the index actually falls, then your losses directly increase with the falling index
level. If for instance the index falls to 1230 and you’ve sold a put with an exercise of 1300, the
buyer of the put will exercise the option and you’ll end up losing Rs.70. Taking into account the
premium earned by you when you sold the put, the net loss on the trade is Rs.5.20.
Having decided to write a put, which one should you write? Given that there are a number of
one-month puts trading, each with a different strike price, the obvious question is: which strike
should you choose ? This largely depends on how strongly you feel about the likelihood of the
upward movement in the market index. If you write an at–the–money put, the option premium
earned by you will be higher than if you write an out–of–the–money put. However the chances of
an at–the–money put being exercised on you are higher as well. In the example in Figure 8.2, at a
Nifty level of 1250, one option is in–the–money and one is out–of–the–money. As expected, the
in–the–money option fetches the highest premium of Rs.64.80 whereas the out–of–the–money
option has the lowest premium of Rs.18.15.
8.2 Speculation: Bullish index, buy Nifty calls or sell Nifty puts 117
Figure 8.1 Payoff for buyer of call options at various strikes

The fi gure shows the profi ts/losses for a buyer of Nifty calls at various strikes. The in–the–money option with a
strike of 1200 has the highest premium of Rs.80.10 whereas the out–of–the–money option with a strike of 1300 has
the lowest premium of Rs.27.50.
Profit
1200 1250 1300

| | |
Nifty
27.50
49.45
80.10
Loss
Figure 8.2 Payoff for writer of put options at various strikes

The fi gure shows the profi ts/losses for a writer of Nifty puts at various strikes. The in–the–money option with a
strike of 1300 fetches the highest premium of Rs.64.80 whereas the out–of–the–money option with a strike of 1200
has the lowest premium of Rs.18.15.
Profit
64.80
37.00
18.15 1250
1200 1300
| | |
Nifty
Loss
Solved problems
Q: Anand is bullish about the index. Spot Nifty stands at 1200. He decides to buy one three-month Nifty
call option contract with a strike of 1260 at a premium of Rs 15 per call. Three months later, the index
closes at 1295. His payoff on the position is
1. Rs.4,000 3. Rs.12,000
2. Rs.19,000 4. None of the above
A: Each call option earns him (1295 - 1260 - 15)*200 = 20*200= Rs.4,000.The correct answer is number
1.
Q: Chetan is bullish about the index. Spot Nifty stands at 1200. He decides to buy one three month Nifty
call option contract with a strike of 1260 at Rs.60 a call. Three months later the index closes at 1240. His
payoff on the position is
1. - 7,000 3. - 4,000
2. - 8,000 4. -12,000
A: The call expires out of the money, so he simply loses the call premium he paid, i.e 60 * 200 =
Rs.12,000.The correct answer is number 4.
Q: Deepak is bullish about the index. Spot Nifty stands at 1250. He decides to buy one three-month Nifty
call option contract with a strike of 1290 at Rs.20 per call. Three months later the index closes at 1330.
His payoff on the position is
1. Rs.7,000 3. Rs.4,000
A: Each call option earns him (1330 - 1290 - 20)*200 = 20*200= Rs.4,000. The correct answer is number
3.
Q: Satish is bullish about the index. Spot Nifty stands at 1225. He decides to buy one three-month Nifty
call option contract with a strike of 1260 at Rs.20 a call. Three months later the index closes at 1235. His
payoff on the position is
1. - 7,000 3. - 4,000
2. - 8,000 4. -12,000
A: The call expires out of the money, so he simply loses the call premium he paid, i.e 20 * 200 = Rs.4,000.
8.3 Speculation: Bearish index: sell Nifty calls or buy Nifty puts 119
8.3 Speculation: Bearish index: sell Nifty calls or buy Nifty puts
Do you sometimes think that the market index is going to drop? That you could make a profit
by adopting a position on the index? Due to poor corporate results, or the instability of the
government, many people feel that the index would go down. How does one implement a trading
strategy to benefit from a downward movement in the index? Today, using options, you have two
choices:
1. Sell call options on the index; or,
2. Buy put options on the index
We have already seen the payoff of a call option. The upside to the writer of the call option is
limited to the option premium he receives upright for writing the option. His downside however
is potentially unlimited. Suppose you have a hunch that the market index is going to fall in a
months time. Your hunch proves correct and the index does indeed fall, it is this downside that
you cash in on. When the index falls, the buyer of the call lets the call expire and you get to keep
the premium. However, if your hunch proves to be wrong and the market index soars up instead,
what you lose is directly proportional to the rise in the index.
Having decided to write a call, which one should you write? Table 8.2 gives the premiums
for one month calls and puts with different strikes. Given that there are a number of one-month
calls trading, each with a different strike price, the obvious question is: which strike should you
choose ? Let us take a look at call options with different strike prices. Assume that the current
index level is 1250, risk-free rate is 12% per year and index volatility is 30%. You could write
the following options :
Which of this options you write largely depends on how strongly you feel about the likelihood of
the downward movement in the market index and how much you are willing to lose should this
downward movement not come about. There are five one-month calls and five one-month puts
trading in the market. The call with a strike of 1200 is deep in-the-money and hence trades at a
higher premium. The call with a strike of 1275 is out-of-the-money and trades at a low premium.
The call with a strike of 1300 is deep-out-of-money. Its execution depends on the unlikely event
that the Nifty will rise by more than 50 points on the expiration date. Hence writing this call is
a fairly safe bet. There is a small probability that it may be in-the-money by expiration in which
case the buyer exercises and the writer suffers losses to the extent that the Nifty is above 1300. In
the more likely event of the call expiring out-of-the-money, the writer earns the premium amount
of Rs.27.50.
As a person who wants to speculate on the hunch that the market index may fall, you can
also buy puts. As the buyer of puts you face an unlimited upside but a limited downside. If the
Table 8.2 One month calls and puts trading at different strikes
The spot Nifty level is 1250. There are fi ve one-month calls and fi ve one-month puts trading in the market. The call
with a strike of 1200 is deep in-the-money and hence trades at a higher premium. The call with a strike of 1275 is
out-of-the-money and trades at a low premium. The call with a strike of 1300 is deep-out-of-money. Its execution
depends on the unlikely event that the Nifty will rise by more than 50 points on the expiration date. Hence writing
this call is a fairly safe bet. There is a small probability that it may be in-the-money by expiration in which case the
buyer exercises and the writer suffers losses to the extent that the Nifty is above 1300. In the more likely event of
the call expiring out-of-the-money, the writer earns the premium amount of Rs.27.50. Figure 8.3 shows the payoffs
from writing calls at different strikes. Similarly, the put with a strike of 1300 is deep in-the-money and trades at a
higher premium than the at-the-money put at a strike of 1250. The put with a strike of 1200 is deep out-of-the-money
and will only be exercised in the unlikely event that Nifty falls by 50 points on the expiration date. The choice of
which put to buy depends upon how much the speculator expects the market to fall. Figure 8.4 shows the payoffs
from buying puts at different strikes.

1250 1200 80.10 18.15
1250 1225 63.65 26.50
1250 1250 49.45 37.00
1250 1275 37.50 49.80
1250 1300 27.50 64.80
index does fall, you profit to the extent the index falls below the strike of the put purchased by
you. If however your hunch about a downward movement in the market proves to be wrong and
the index actually rises, all you lose is the option premium. If for instance the index rises to 1300
and you’ve bought a put with an exercise of 1250, you simply let the put expire. If however the
market index does fall to say 1225 on expiration date, you make a neat profit of Rs.25.
Having decided to buy a put, which one should you buy? Given that there are a number of
one-month puts trading, each with a different strike price, the obvious question is: which strike
should you choose? This largely depends on how strongly you feel about the likelihood of the
downward movement in the market index. If you buy an at-the-money put, the option premium
paid by you will by higher than if you buy an out-of-the-money put. However the chances of an
at-the-money put expiring in-the-money are higher as well.
8.3 Speculation: Bearish index: sell Nifty calls or buy Nifty puts 121
Figure 8.3 Payoff for seller of call option at various strikes

The fi gure shows the profi ts/losses for a seller of Nifty calls at various strike prices. The in–the–money option has
the highest premium of Rs.80.10 whereas the out–of–the–money option has the lowest premium of Rs.27.50.
Profit
80.10
49.45
27.50
1200 1250 1300
| | |
Nifty
Loss
Figure 8.4 Payoff for buyer of put options at various strikes

The fi gure shows the profi ts/losses for a buyer of Nifty puts at various strike prices. The in–the–money option has
the highest premium of Rs.64.80 whereas the out–of–the–money option has the lowest premium of Rs.18.50.
Profit
1200 1250 1300

| | |
Nifty
18.15
37.00
64.80
Loss
Solved problems
Q: Anish is bearish about the index. Spot Nifty stands at 1250. He decides to buy one three month Nifty
put option contract with a strike of 1275 at a premium of Rs.40. Three months later the index closes at
1225. His payoff on the position is :
1. Rs.2,000 3. Rs.7,500
A: The put option contract earns him (1275 - 1225 - 40)*200 = 10*200= Rs.2,000.The correct answer is
number 1.
Q: Anand is bearish about the index. Spot Nifty stands at 1250. He decides to buy one three month Nifty
put option contract with a strike of 1225 at Rs.26.50 a put. Three months later the index closes at 1260.
His payoff on the position is :
1. - 7,000 3. - 4,000
2. - 5,300 4. -12,000
A: The put expires out of the money, so he simply loses the put premium he paid, i.e 26.50 * 200 =
Rs.5,300.The correct answer is number 2.
Q: Ashish is bearish about the index. Spot Nifty stands at 1240. He decides to buy one three month Nifty
put option contract with a strike of 1225 at Rs.34.50 a put. Three months later the index closes at 1280.
His payoff on the position is :
1. - 6,900 3. - 4,000
2. - 5,300 4. -12,000
A: The put expires out of the money, so he simply loses the put premium he paid, i.e 34.50 * 200 =
Rs.6,900. The correct answer is number 1.
Q: Anand is bearish about the index. Spot Nifty stands at 1250. He decides to sell one three month Nifty
call option contract with a strike of 1275 for a premium of Rs.28.60. Three months later the index closes
at 1225. His payoff on the position is :
1. Rs.2,860 3. Rs.7,500
A: The index closes below the strike of 1275, so the option buyer does not exercise the option. Anand
earns the option premium of Rs.5,720. The correct answer is number 2.
Q: Ashish is bearish about the index. Spot Nifty stands at 1250. He decides to sell one three month Nifty
call option contract with a strike of 1275 for a premium of Rs.28.60. Three months later the index closes
at 1295. His net payoff on the position is :
1. - 1,720 3. - 7,500
2. - 4,000 4. + 1,720
A: The index closes above the strike of 1275, so the option buyer exercises the option. Ashish earns a
upfront premium of Rs.28.60 but loses Rs.20 because of the rise in the index. His net profi t is 8.6 * 200.
8.4 Speculation: Anticipate volatility, buy a call and a put 123
8.4 Speculation: Anticipate volatility, buy a call and a put
Do you sometimes think that the market index is going to go through large swings in a given
period, but have no opinion on the direction of the swing? This could typically happen around
budget time, or during times of political uncertainty when a change in the government is
anticipated. How does one implement a trading strategy to benefit from market volatility ?
Combinations of call and put options provide an excellent way to trade on volatility. Here is
what you would have to do:
1. Buy call options on the index at a strike K and maturity T, and
2. Buy put options on the index at the same strike K and of maturity T.
This combination of options is often referred to as a Straddle and is an appropriate strategy for
an investor who expects a large move in the index but does not know in which direction the move
will be.
Consider an investor who feels that the index which currently stands at 1252 could move
significantly in three months. The investor could create a straddle by buying both a put and a call
with a strike close to 1252 and an expiration date in three months. Suppose a three month call at
a strike of 1250 costs Rs.95.00 and a three month put at the same strike cost Rs.57.00. To enter
into this positions, the investor faces a cost of Rs.152.00. If at the end of three months, the index
remains at 1252, the strategy costs the investor Rs.150 .(An up-front payment of Rs.152, the put
expires worthless and the call expires worth Rs.2). If at expiration the index settles around 1252,
the investor incurs losses. However, if as expected by the investors, the index jumps or falls
significantly, he profits. For a straddle to be an effective strategy, the investor’s beliefs about the
market movement must be different from those of most other market participants. If the general
view is that there will be a large jump in the index, this will reflect in the prices of the options.
Solved problems
Q: You are a speculator. You predict that the market will be volatile in the next three months. However
you have no idea if it will move upwards or downwards. To take advantage of this volatility you would
buy
1. Three-month calls with the same strike

2. Three-month puts
4. A three-month call and sell a three-month put
3. A three-month call and a three-month put with the same strike
A: If you think the market will be volatile, but do not know whether it will move up or down, you
should create a payoff which gives you profi ts when the market makes a large move either upward or
downward.The correct answer is number 3.
Figure 8.5 Payoff for buyer of three-month call and put options at strikes of 1250
The fi gure shows the profi ts/losses for a combination of a long call and a long put at the same strike and expiration.
The investor has bought both a call and a put on the Nifty index. If on the expiration date, the index closes between
1098 and 1402, he losses a maximum of Rs.152. If however, his expectation of high volatility does come true,
his profi ts are potentially unlimited. If for instance the index jumps to 1420, he makes a neat profi t of Rs.18 i.e.
(1420-1250)-152. The effectiveness of this combination depends how different is the investors belief about market
movement from that of most other participants. The higher the cost of setting up this combination, the more the
index would have to move for it to be profi table.
Profit
1098 1193 1250 1345 1402

| | | | |
Nifty
57.00
95.00
152.00
Loss
Q: To profi t from market volatility you buy one market lot of three-month Nifty calls at Rs.95/call and one
market lot of three-month Nifty puts at 57/put. If at the end of three months the markets haven’t shown
the magnitude of movement that you expected, the maximum you will lose on this combination position
is Rs.
1. 19,000 3. 7,600
2. 11,400 4. 30,400
A: The maximum loss would be the total premium paid for buying the calls and the puts. At a market lot
of 200, the total cost of taking on the combination position works out to be ( 95 + 57) * 200. The correct
answer is number 4.
8.5 Speculation: Bull spreads - Buy a call and sell another 125
Table 8.3 Three-month calls and puts trading at different strikes

Given below are the three-month call and put option premia on the S&P CNX Nifty. An investor who decides to
play on the volatility of the market must decide at what strike to generate the straddle. In this case he has three
three-month option contracts to choose from.

1248 1250 48.00 38.30
1248 1245 50.65 35.95
1248 1230 59.05 29.50
Q: With elections around the corner Babbanseth expects the markets to go through a period of high
volatility in the coming three months and would like to take a bet on this volatility . He is however unsure
of the direction that the market will take and decides to enter into a straddle. Three months call and put
premiums are given in Table 8.3 . He decides to buy one market lot of calls and one market lot of puts at a
strike of 1250. If three months later, the Nifty closes at 1380, his profi t net of costs from the combination
will be Rs.
1. 8,740 3. 13,000
2. 26,000 4. 16,400
A: If Nifty closes at 1380, he makes a profi t on the position of Rs.26,000, that is (1380-1250)* 200.
However he has paid an up-front price of Rs.17,260 (i.e.48.00*200 + 38.30*200). So his net profi t on the
combination works out to be Rs.8,740. The answer is number 1.
8.5 Speculation: Bull spreads - Buy a call and sell another

There are times when you think the market is going to rise over the next two months, however
in the event that the market does not rise, you would like to limit your downside. One way you
could do this is by entering into a spread. A spread trading strategy involves taking a position in
two or more options of the same type, that is, two or more calls or two or more puts. A spread
that is designed to profit if the price goes up is called a bull spread.
How does one go about doing this? This is basically done utilizing two call options having
the same expiration date, but different exercise prices. The buyer of a bull spread buys a call with
an exercise price below the current index level and sells a call option with an exercise price above
the current index level. The spread is a bull spread because the trader hopes to profit from a rise
in the index. The trade is a spread because it involves buying one option and selling a related
option. What is the advantage of entering into a bull spread? Compared to buying the underlying
asset itself, the bull spread with call options limits the trader’s risk, but the bull spread also limits
Figure 8.6 Payoff for a bull spread created using call options
The fi gure shows the profi ts/losses for a bull spread. As can be seen, the payoff obtained is the sum of the payoffs
of the two calls, one sold at Rs.37.85 and the other bought at Rs.76.50. The cost of setting up the spread is Rs.38.65
which is the difference between the call premium paid and the call premium received. The downside on the position
is limited to this amount. As the index moves above 1260, the position starts making profi ts (cutting losses) until
the spot reaches 1350. Beyond 1350, the profi ts made on the long call position get offset by the losses made on the
short call position and hence the maximum profi t on this spread is made if the index on the expiration day closes at
1350. Hence the payoff on this spread lies between -38.85 to 51.35.
Profit
51.35
37.85
1260 1298.65 1336.50 1350 1387.85

| | | | |
0
Nifty
38.65
76.50
Loss
the profit potential. In short, it limits both the upside potential as well as the downside risk. The
cost of the bull spread is the cost of the option that is purchased, less the cost of the option that
is sold. Table 8.4 gives the profit/loss incurred on a spread position as the index changes. Figure
8.6 shows the payoff from the bull spread.
Broadly, we can have three types of bull spreads:
1. Both calls initially out-of-the-money,
2. One call initially in-the-money and one call initially out-of-the-money, and
3. Both calls initially in-the-money.
The decision about which of the three spreads to undertake depends upon how much risk the
investor is willing to take. The most aggressive bull spreads are of type 1. They cost very little
to set up, but have a very small probability of giving a high payoff.
8.5 Speculation: Bull spreads - Buy a call and sell another 127
Table 8.4 Expiration day cash flows for a Bull spread using two-month calls
The table shows possible expiration day profi t for a bull spread created by buying one market lot of calls at a strike
of 1260 and selling a market lot of calls at a strike of 1350. The cost of setting up the spread is the call premium
paid (Rs.76.50) minus the call premium received (Rs.37.85), which is Rs.38.65. This is the maximum loss that the
position will make. On the other hand, the maximum profi t on the spread is limited to Rs.51.35. Beyond an index
level of 1350, any profi ts made on the long call position will be cancelled by losses made on the short call position,
effectively limiting the profi t on the combination.
Nifty Buy Jan 1260 Call Sell Jan 1350 Call Cash Flow Profi t&Loss (Rs.)
1245 0 0 0 -38.65
1255 0 0 0 -38.65
1265 +5 0 5 -33.65
1275 +15 0 15 -23.65
1285 +25 0 25 -13.65
1295 +35 0 35 -3.65
1305 +45 0 45 +6.35
1315 +55 0 55 +16.35
1325 +65 0 65 +26.35
1335 +75 0 75 +36.35
1345 +85 0 85 +46.35
1355 +95 -5 90 +51.35
1365 +105 -15 90 +51.35
Solved problems
Q: An investor buys one market lot of Feb 1300 Nifty calls at Rs.76 a call and sells one market lot of Feb
1400 Nifty calls for Rs.40 a call. If Nifty closes at 1360 on the expiration date, the payoff in Rs., net of
costs from this spread position is
1. 4,800 3. -4,800
2. -7,200 4. 12,000
A: A bull spread has a limited upside and a limited downside. If Nifty closes between 1300 and 1400,the
payoff is the amount by which the index exceeds 1300, which in this case is 60. The cost of setting up the
spread is Rs.36 i.e. (76 - 40). The net profi t from the position is Rs.24 i.e. ( 60 - 36). Hence the payoff on
one market lot is 24*200. The correct answer is number 1.
Q: An investor buys one market lot of Jan 1260 Nifty calls at Rs.96 a call and sells one market lot of Jan
1350 Nifty calls for Rs.55 a call. If on the expiration date Nifty closes at 1375, the payoff in Rs., net of
costs from this spread position is
1. +18,000 3. +9,800
2. -23,000 4. -8,200
A: A bull spread has a limited upside and a limited downside. If Nifty closes above 1350, the payoff from
the spread position is Rs.90 i.e. ( 1350 - 1260). However the investor has spent Rs.41 (Rs.96 paid for call
purchased minus Rs.55 received for call sold) on setting the spread. Hence his net profi t from the spread
position is Rs.49 i.e. ( 90 - 41). The profi t on one market lot is 49*200. The correct answer is number 3.
Q: An investor buys one market lot of Dec 1230 Nifty calls at Rs.70 a call and sells one market lot of Dec
1300 Nifty calls for Rs.34 a call. If Nifty closes at 1210 on the expiration date, the net Rs. payoff from
this spread position is
1. 14,000 3. 20,800
2. -7,200 4. -4000
A: A bull spread has a limited upside and a limited downside. If Nifty closes below 1230, both the options
are out-of-the-money and hence the payoff from the spread is the amount spent in setting it up, namely -
36 ( Rs.70 paid for call purchased minus Rs.34 received for call sold). Hence the net loss on one market
lot is 36*200. The correct answer is number 2.
Q: A bull spread is created by
1. Buying a call and a put 3. Buying two calls
2. Buying a call and selling a call 4. Selling two calls
8.6 Speculation: Bear spreads - sell a call and buy another

There are times when you think the market is going to fall over the next two months, however
in the event that the market does not fall, you would like to limit your downside. One way you
could do this is by entering into a spread. A spread trading strategy involves taking a position in
two or more options of the same type, that is, two or more calls or two or more puts. A spread
that is designed to profit if the price goes down is called a bear spread.
8.6 Speculation: Bear spreads - sell a call and buy another 129
How does one go about doing this? This is basically done utilizing two call options having
the same expiration date, but different exercise prices. How is a bull spread different from a bear
spread? In a bear spread, the strike price of the option purchased is greater than the strike price
of the option sold. The buyer of a bear spread buys a call with an exercise price above the current
index level and sells a call option with an exercise price below the current index level. The
spread is a bear spread because the trader hopes to profit from a fall in the index. The trade is a
spread because it involves buying one option and selling a related option. What is the advantage
of entering into a bear spread? Compared to buying the index itself, the bear spread with call
options limits the trader’s risk, but it also limits the profit potential. In short, it limits both the
upside potential as well as the downside risk.
A bear spread created using calls involves initial cash inflow since the price of the call sold
is greater than the price of the call purchased. Table 8.5 gives the profit/loss incurred on a spread
position as the index changes. Figure 8.7 shows the payoff from the bull spread.
Broadly we can have three types of bear spreads:
1. Both calls initially out-of-the-money,
2. One call initially in-the-money and one call initially out-of-the-money, and
3. Both calls initially in-the-money.
The decision about which of the three spreads to undertake depends upon how much risk the
investor is willing to take. The most aggressive bear spreads are of type 1. They cost very little
to set up, but have a very small probability of giving a high payoff. As we move from type 1 to
type 2 and from type 2 to type 3, the spreads become more conservative and cost higher to set
up. Bear spreads can also be created by buying a put with a high strike price and selling a put
with a low strike price.
Solved problems
Q: An investor buys one market lot of Feb 1400 Nifty calls at Rs.40 a call and sells one market lot of Feb
1300 Nifty calls for Rs.76 a call. If Nifty closes at 1320 on the expiration date, the net payoff from this
spread position is:
1. +3,200 3. +4,800
2. -7,200 4. 12,000
A: An investor enters into a bear spread position in the hope that the market will fall. If the market does
fall below both strikes, he profi ts to the extent of the difference between the two call premiums. If however
the market closes midway between the two strikes, his profi ts get reduced to the extent it falls short of the
lower strike. In this case the index falls short of the lower strike by 20. Hence his payoff is (36 - 20)= 16.
The payoff on one market lot is 16*200. The correct answer is number 1.
Figure 8.7 Payoff for a bear spread created using call options
The fi gure shows the profi ts/losses for a bear spread. As can be seen, the payoff obtained is the sum of the payoffs of
the two calls, one sold at Rs.76.50 and the other bought at Rs.37.85. The maximum gain from setting up the spread
is Rs.38.65 which is the difference between the call premium received and the call premium paid. The upside on the
position is limited to this amount. As the index moves above 1260, the position starts making losses(cutting profi ts)
until the spot reaches 1350. Beyond 1350, the profi ts made on the long call position get offset by the losses made on
the short call position. The maximum loss on this spread is made if the index on the expiration day closes at 1350.
At this point the loss made on the two call position together is Rs.90 i.e. ( 1260-1350). However the initial inflow on
the spread being Rs.38.65, the net loss on the spread turns out to be -51.35 . The downside on this spread position
is limited to this amount. Hence the payoff on this spread lies between +38.85 to -51.35.
Profit
76.50
38.65
1260 1298.65 1336.50 1350 1387.85

| | | | |
0
Nifty
37.85
51.35
Loss
Q: An investor buys one market lot of Jan 1350 Nifty calls at Rs.55 a call and sells one market lot of Jan
1260 Nifty calls for Rs.96 a call. If on the expiration date Nifty closes at 1375, the net payoff in Rs. from
this spread position is
1. +18,000 3. -9,800
2. -23,000 4. +8,200
A: If Nifty closes above 1350, the payoff from the spread position is minus 90 i.e. ( 1260 - 1350) since the
investor has sold a call at a strike of 1350 and bought it at 1260. However the investor has earned Rs.41
(Rs.96 received for call sold minus Rs.55 paid for call bought)on setting the spread. Hence his net loss
from the spread position is Rs.49 i.e. ( 41- 90). The loss on one market lot is 49*200. The correct answer
is number 3.
8.7 Arbitrage: Put-call parity violations 131
Table 8.5 Expiration day cash flows for a Bear spread using two-month calls
The table shows possible expiration day profi t for a bear spread created by selling one market lot of calls at a strike
of 1260 and buying a market lot of calls at a strike of 1350. The maximum profi t obtained from setting up the
spread is the difference between the premium received for the call sold (Rs.76.50) and the premium paid for the call
bought(Rs.37.85) which is Rs.38.65.
In this case the maximum loss obtained is limited to Rs.51.35. Beyond an index level of 1350, any profi ts made on
the long call position will be canceled by losses made on the short call position, effectively limiting the profi t on the
combination.
Nifty Buy Jan 1350 Call Sell Jan 1260 Call Cash Flow Profi t&Loss (Rs.)
1245 0 0 0 +38.65
1255 0 0 0 +38.65
1265 0 -5 -5 +33.65
1275 0 -15 -15 +23.65
1285 0 -25 -25 +13.65
1295 0 -35 -35 +3.65
1305 0 -45 -45 -6.35
1315 0 -55 -55 -16.35
1325 0 -65 -65 -26.35
1335 0 -75 -75 -36.35
1345 0 -85 -85 -46.35
1355 +5 -95 -90 -51.35
1365 +15 -105 -90 -51.35
8.7 Arbitrage: Put-call parity violations
Have you ever wondered how the put prices relate to the call prices? If you happen to know the
call price on an asset, would that help you to get some idea of the price of a put on the same
asset? Do put prices have anything at all to do with call prices? Of course, they do. The put and
the call prices are related by a condition called the put-call parity. We shall see how.
Put-call parity
To get an intuitive understanding about the put-call parity, we could think of it in the following
way. I buy the asset on spot, paying S. I buy a put at X, paying P, so my downside below X is
taken care of (if S X, I will exercise the put). I sell a call at X, earning C, so if S X, the call

holder will exercise on me, so my upside beyond X is gone. This gives me X on T with certainty.
This means that the portfolio of S+P-C is nothing but a zero-coupon bond which pays X on date
T.
What happens if the above equation does not hold good ? It gives rise to arbitrage
opportunities. The put-call parity basically explains the relationship between put, call, stock
and bond prices. It is expressed as:

Where:
S Current index level
X Exercise price of option
T Time to expiration
C Price of call option
P Price of put option
risk-free rate of interest
The above expression shows that the value of a European call with a certain exercise price
and exercise date can be deduced from the value of a European put with the same exercise price
and date and vice versa. It basically means that the payoff from holding a call plus an amount of

cash equal to
is the same as that of holding a put option plus the index.

Case 1:
Suppose Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of a three
month Nifty 1260 call is Rs.96.50 and the price of a three month Nifty 1260 put is Rs.60. In this
case we can see that

1325 1321.30
What does this mean? If we think of index plus put as portfolio A and the call plus cash as
portfolio B, clearly portfolio A is overpriced relative to portfolio B. What would be the arbitrage
strategy in this case? Sell the securities in portfolio A and buy those in portfolio B. This involves
shorting the index and a put on the index and buying a call. How would one short the index?
One way to do it would be to actually sell off all 50 Nifty stocks in the proportions in which they
exist in the index. Another easier way to do this would be to sell units of Index funds instead
of the actual index stocks. This would achieve a similar outcome. This entire set of transactions
generates an up-front cash-flow of (1265 + 60 - 96.50) = Rs.1228.50. When invested at the
riskfree rate of 12%, this amount grows to Rs.1265.35.
At expiration, if the index is higher than 1260, you will exercise the call. If the index is lower
than 1260, the buyer of the put will exercise on you. In either case, the investor ends up buying
the index at Rs.1260. Hence the net profit on the entire transaction is Rs.5.35 (i.e. 1265.35-
1260).
8.7 Arbitrage: Put-call parity violations 133

1. Sell off all 50 index shares on the cash market in the proportion in which they exist in the index. This can be
done using a single keystroke using the NEAT software.
2. Sell a three month Nifty 1260 put.
3. Buy a three month Nifty 1260 call.
4. You will receive the money for the stocks and the put sold and have to make delivery of the 50 shares.
5. Invest this money at the riskless interest rate. In three months Rs.1228.50 will grow to Rs.1265.35.
6. On the exercise date at the end of trading hours, if the Nifty is above 1260, exercise the call. If the Nifty is
below 1260, the put will be exercised on you.
7. Either way, you end up buying the index at Rs.1260.
8. The riskless profi t on the transaction works out to be Rs.5.35.
Case 2:
Suppose Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of a three
month Nifty 1260 call is Rs.96 and the price of a three month Nifty 1260 put is 51.50. In this
case, we can see that

1316.50 1320.80
What does this mean? If we think of index plus put as portfolio A and the call plus cash as
portfolio B, clearly portfolio B is overpriced relative to portfolio A. What would be the arbitrage
strategy in this case? Buy the securities in portfolio A and sell those in portfolio B. This involves
buying the index and a put on the index and selling a call. How would one buy the index? One
way to do it would be to actually buy all 50 Nifty stocks in the proportions in which they exist
in the index. An easier way to do this would be to buy units of Index funds instead of the actual
index stocks. This would achieve a similar outcome. This entire set of transactions involves an
initial investment of Rs.1220.50(i.e. -1265 - 51.50 + 96) When financed at the riskfree rate of
12%, the repayment required at the end of three months is Rs.1257.
At expiration if the index is lower than 1260, you will exercise the put. If the index is higher
than 1260, the buyer of the call will exercise on you. In either case, the investor ends up buying
the index at Rs.1260. Hence the net profit on the entire transaction is Rs.3 (1260 - 1257).

1. Buy all 50 index shares on the cash market in the proportion in which they exist in the index. This can be done
using a single keystroke using the NEAT software.
2. Buy a three month Nifty 1260 put.

3. Sell a three month Nifty 1260 call.
4. You will have to pay for the shares and the put, and will receive the call premium. The entire set of transactions
will require an initial outflow of Rs.1221.20.
5. Finance this money at the riskless interest rate. The repayment at the end of three months works out to Rs.1257.
6. On the exercise date at the end of trading hours, if the Nifty is below 1260, exercise the put. If the Nifty is
above 1260, the call will be exercised on you.
7. Either way, you end up selling the index at Rs.1260.
8. The riskless profi t on the transaction works out to be Rs.3.
Nuances
1. What if the shares that I own are not exactly the NSE-50 portfolio? Any large investor can plan in advance and
have a sub–component of his portfolio which looks exactly like Nifty. Once this preparation is done, it can be
used for generating riskless profi ts due to breach in the put-call parity.
2. This sounds great – what is the catch? Some of the 50 stocks might be stuck at price limits when you are
getting in or getting out.
Solved problems
Q: Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of a three month Nifty
call is Rs.96.50 and the price of a three month Nifty 1260 put is 60. To exploit the arbitrage, you should
1. Sell the index plus a put and buy a call 3. Buy the index plus a put and sell a call
2. Sell the index plus a call and buy a put 4. None of the above

A: In the above case,

. i.e. 1325

1321.30. Hence you should sell the index and a

put and buy a call. The correct answer is number 1.
Q: Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of a three month Nifty
call is Rs.96 and the price of a three month Nifty 1260 put is 52.50. To exploit the arbitrage, you should
1. Buy the index plus a call and sell a put 3. Buy the index plus a put and sell a call
2. Sell the index plus a call and buy a put 4. None of the above

A: In the above case,

. i.e. 1317.50

1320.80. Hence you should buy the index and

a put and sell a call. The correct answer is number 3.
8.8 Arbitrage: Beyond option price bounds 135
8.8 Arbitrage: Beyond option price bounds

The value of an option before expiration depends on six factors:
The level of the underlying index
The exercise price of the option
The time to expiration
The volatility of the index
The risk-free rate of interest
Dividends expected during the life of the option
These factors set general boundaries for possible option prices. If the option price is above
the upper bound or below the lower bound, there are profitable arbitrage opportunities. We shall
try to get an intuitive understanding about these bounds.
Upper bounds for calls and puts

A call option gives the holder the right to buy the index for a certain price. No matter what
happens, the option can never be worth more than the index. Hence the index level is an upper
bound to the option price.

If this relationship is not true, an arbitrageur can easily make a riskless profit by buying the
index and selling the call option.
As we know a put option gives the holder the right to sell the index for X. No matter how low
the index becomes, the option can never be worth more than X. Hence,
If this is not true, an arbitrageur would make profit by writing puts.
Lower bounds for calls and puts

The lower bound for the price of a call option is given by . The price of a call

must be worth at least this much else, it will be possible to make riskless profits.

Consider an example. Suppose the exercise price for a three-month Nifty call option is 1260.
The spot index stands at 1386 and the risk-free rate of interest is 12% per annum. In this case,
the lower bound for the option price is $ !
i.e 161.20. Suppose the call is

$ !

" $

available at a premium of Rs.150 which is less than the theoretical minimum of Rs.161.20. An
arbitrageur can buy the call and short the index. This provides a cashflow of 1386-150 = 1236
. If invested for three months at 12% per annum, the Rs.1236 grows to Rs.1273. At the end of
three months, the option expires. At this point, the following could happen:
1. The index is above 1260, in which case the arbitrageur exercises his option and buys back the index
at 1260 making a profi t of Rs.1273 - 1260 = Rs.13.
2. The index is below 1260 at say 1235, in which case the arbitrageur buys back the index at the market
price. He makes an even greater profi t of 1273 - 1235 = Rs.38.
The lower bound for the price of a put option is given by . The price of a put

must be worth at least this much else, it will be possible to make riskless profits.

Consider an example. Suppose the exercise price for a three-month Nifty put option is 1260.
The spot index stands at 1165 and the risk-free rate of interest is 12% per annum. In this case the
lower bound for the option price is Rs.59.80. Suppose the put is available at a premium of Rs.45
which is less than the theoretical minimum of Rs.59.80. An arbitrageur can borrow Rs.1210 for
three months to buy both the put and the index. At the end of the three months, the arbitrageur
will be required to pay Rs.1246.3. Three months later the option expires. At this point, the
following could happen:
1. The index is below 1260, in which case the arbitrageur exercises his option, sells the index at
Rs.1260, repays the loan amount of Rs.1246.3 and makes a profi t of Rs.13.7.
2. The index is above 1260 at say 1275, in which case the arbitrageur discards the option, sells the index
at 1275, repays the loan amount of Rs.1246.3 and makes an even greater profi t of 1275 - 1246.3 =
Rs.28.7.
Solved problems
Q: Consider a two month Nifty call option with a strike of 1260. Nifty stands at 1350. The risk-free rate
of interest is 12% per annum. Arbitrage opportunities will arise when the call premium falls below
1. Rs.113.50 3. Rs.127
2. Rs.151 4. Rs.163
A: The lower bound for a call option is given by

. This works out to be

= Rs.113.50. The correct answer is number 1.
Chapter 9
Using stock options
From July 2001, stock options began trading on NSE’s F&O segment. Today, options on many
stocks are available for trading. The market on stock options is gradually building momentum
with a steady increase in the trading volume. In this chapter we shall study more about stock
options and how they differ from index options.
One of the main issues with respect to trading stock options is its exercise. Should the option
be exercised or not? If yes, when should it be exercised? Would the exercise decision change in
light of an upcoming dividend? These are a few of the issues we will look into.
9.1 Uses of stock options
As far as using stock options for hedging, speculation and arbitrage is concerned, it is almost
like using index options. Stock options can be used to hedge an open position in the stock. They
can be used to speculate on the underlying stock price as well as underlying stock volatility. And
finally, the arbitrage arguments that we use for index options also apply to stock options.
9.1.1 Hedging: Have stock, buy puts

This is probably one of the simplest ways to take on a hedge. Take the case of an investor Mr.
Mehta, who holds 1000 shares of HLL. He plans to sell the shares three months later as he would
need the money to get his daughter married. Today HLL trades at Rs.232 in the spot market.
Mr.Mehta worries about a fall in the price of HLL three months later, when he would actually
need the money. He could of course sell the shares today and get Rs.232 for them, however he
does not want to lose on the possibility of an increase in share price three months later. How
can he ensure that he gets to profit from a price increase but does not suffer losses from a price
decrease? The answer is simple - buy put options on HLL.
Let us see how this would work. Take for instance he buys a put option with a strike of
Rs.240. This option will cost him Rs.10. How does this option provide the hedge? Let us look
at two possible scenarios three months later:
138 Using stock options
The price of HLL falls to Rs.215. This means that he has suffered a loss of Rs.17 per share. However
the put options with a strike of Rs.240 at a premium of Rs.10 are in–the–money and now trade at
Rs.25. The loss he suffers on the shares held by him is made up for by the profi ts he earns on the put
options bought. Obviously, the hedge does not come for free and he will end up paying a premium
of Rs.10 per put. By paying this premium, he ensures that he will get at least Rs.240 for the shares
held by him.
The price of HLL rises to 250. He lets his option expire, losing the Rs.10 in the process. He sells the
shares held by him in the spot market for Rs.250 per share.
What the investor actually obtains in a limited downside(determined by the strike price he
chooses) and an unlimited upside.
9.1.2 Speculation: Bullish stock, buy calls or sell puts

This strategy is exactly like the one we described in the previous chapter using index options.
Take the case of a speculator who believes that the price of ACC will go up in the next two
months. He could do any of the following:
He could buy the stock, hold it for two months and sell it off for a profi t. Say for instance, he buys
200 shares of ACC. At the rate of Rs.150 a share, it would cost him Rs.30,000. Assume that his
hunch proved correct and at the end of two months ACC sells for Rs.160. He would have earned
Rs.2,000 on an investment of Rs.30,000, a return of 6.6 percent over two months.
He could buy call options on ACC. ATM calls on ACC with a strike of 150 trade at Rs.8. He buys
200 calls which costs him Rs.1,600. Assume that his hunch proves correct and two months later ACC
trades at Rs.160. After accounting for the call premium paid by him, he earns a net profi t of Rs.400
i.e.([(160-150)-8]*200) on an investment of Rs.1,600, a return of 25 percent over two months.
Options enable speculators to take leveraged positions on stocks. By paying a small premium
amount, speculators can take fairly large exposure on the stock.
A speculator with a bullish view can also express his view by selling puts. Take the case of
a speculator who thinks that the price of ACC is going to rise. He could sell/write puts on ACC.
Assume as in the above case that the price of ACC is Rs.150. He writes puts with a strike of 160
at a premium of Rs.12. As anticipated by him, if the price of ACC does rise, the buyer of the put
will let the puts expire, and the speculator will get to keep the premium. If however, his hunch
proves wrong and the prices of ACC fall, he will suffer losses to the extent of the difference
between the strike price and the (spot price + premium). As we know, the writer of a put has a
limited upside(the premium money) and an unlimited downside.
9.1.3 Speculation: Bearish stock, buy puts or sell calls

Once again, this strategy is exactly like the one we described in the previous chapter using index
options. Take the case of a speculator who believes that the price of ACC will go down in the
next two months. In the absence of short–selling he cannot trade in the spot market based on his
hunch. He can however trade in the options market. Assume that ACC trades at Rs.150 in the
spot market. He can do one of the following:
9.2 Combination positions using stock futures and stock options 139
Buy puts: Assume that he buys 200 ATM puts at a strike of 150 and at a premium of Rs.2. They cost
him Rs.400. Assume further that his hunch proves correct and ACC price does fall to Rs.140. The
ATM puts he bought now become ITM and trade at Rs.10. He ends up making a profi t of Rs.1,600
over a two month period.
Sell calls: He sells 200 call options on ACC with a strike of Rs.150 at a premium of Rs.14. If
his hunch proves correct and the price of ACC falls to Rs.140, the buyer of the calls will let the
option expire and the speculator gets to keep the premium of Rs.2,800. However if his hunch proves
incorrect and the price of ACC rises to 170, the buyer of the put options will exercise on him and
the speculator would suffer a loss equal to the difference between the spot price and the strike price,
reduced to the extent of premium received by him earlier on.
While options enable speculators to take leveraged positions on stocks, the losses incurred
by the buyer of the option are limited to the extent of premium paid, but the losses suffered by
the seller/writer of the option are potentially unlimited.
9.2 Combination positions using stock futures and stock options

With the availability of a range of basic derivative products for trading, it is possible to create
speculative/hedged positions using a combination of these. Given a clear understanding and
imagination, a wide range of interesting payoffs/trading strategies can be generated using futures
and options. Let us look at the payoffs of the following combinations.
Long stock futures + long ATM stock put: This position has a limited downside and an unlimited
upside. If the security price goes up, the long futures position starts making money. If the security
price falls, the long put position starts going in–the–money. However the profi ts on this put position
are offset by the losses on the long futures position. The combination is nothing but a synthetic
call. When ATM puts are underpriced, it makes sense to generate a synthetic call on the security by
combining a long put and a long futures position.
Long stock futures + long ATM Nifty put + long OTM stock put: Let us fi rst look at each component
of this position. The long stock futures position gives exposure to the security. If the security price
goes up, it generates profi ts. The at–the–money Nifty put hedges away the index exposure, hence
the combination is now a pure bet on the security. Finally, the out–of–the–money put option on
the security limits my overall loss on the combination. If the price of the security rises, the long
futures position will start making profi ts. If however the security price falls below the strike of the
OTM security put, any losses on the long futures position will be offset by the profi ts on the long
put position. The combination provides a ceiling on the losses from a position which is purely a
speculative bet on the security.
The plethora of equity derivatives products that are now available for trading form the
building blocks which can be used for generating various payoffs that match the needs and
requirements of investors. The leveraged nature of the futures markets makes stock futures very
attractive for speculators.
9.3 Early exercise of American options
Stock options being American in nature, can be exercised at any point of time before their
expiration/maturity. However, early exercise may not always be optimal. In this section we
shall look at when it may be optimal to exercise options on non–dividend paying stocks and
options on dividend paying stocks from the point of view of early exercise.
9.3.1 Early exercise of calls on non–dividend paying stock

A stock option on a non–dividend paying stock could be bought for any of the following reasons:
To acquire the underlying stock and hold it beyond the life of the option. For instance, a mutual fund
that wants to buy shares using subscription money it expects to receive in a months time, may want
to buy call options on the stocks it wants to acquire.
To acquire the stock and sell it off if/when it is overpriced. A speculator who bought a call option
when it was out–of–the–money may want to exercise the option, acquire the underlying stock at the
strike price and sell it in the market at the higher spot price.
However, in either of the above situations, it is never optimal to exercise a call option on a
non–dividend paying stock before expiration date. Let us take the example of a American call
option on a non–dividend paying stock with one month to expiration. Stock price is Rs.50. Strike
price is Rs.40. The option is deep in the money.
Case 1: You plan to hold the stock for more than one month. Should you exercise the option and buy
the stock at Rs.40? If you do exercise the option, you will get to buy the stock at Rs.40 when it trades
in the market at Rs.50. However, you are buying the stock as a part of a portfolio building activity,
and not for profi ting by selling the stock in the market at Rs.50. Whether you exercise today or a
month later, you will still get the stock at Rs.40. However, the earlier you exercise, the earlier will be
your cash outflow of Rs.40 per share. If instead, you exercise at maturity, you can earn the interest
on the cash for that period. Being an option on a non–dividend paying stock, you do not forgo any
dividend inflow. Besides, there is a chance that on the day of exercise, the stock price could be less
than Rs.40. By exercising early you will have lost the opportunity of buying the stock at a lower
price.
Case 2: You want to exercise, acquire the stock at Rs.40 and sell it in the market at Rs.50. Should
you exercise? If you do exercise, you will end up earning a profi t of Rs.10 per option which is the
intrinsic value of the option. However, recollect that the option premium consists of two components,
the intrinsic value and the time value. If you exercise the option, you will only earn the intrinsic value.
Instead if you sell the option in the market, you will earn the intrinsic value of Rs.10 plus the time
value of the one–month option.
As can be seen from the above two cases, it is never optimal to exercise an call option on a
non–dividend paying stock before expiration date.
9.3 Early exercise of American options 141
9.3.2 Early exercise of puts on non–dividend paying stock
The arguments for exercise of American put options differ significantly from that of for American
call options. The reason for this is that the put option’s payoff is bounded from above by the strike
price. That is, the maximum profit obtained from a long put position is the strike, which happens
when the spot price falls to zero. In contrast, the American call’s payoff has an unlimited upside.
It can be optimal to exercise American put options on a non–dividend paying stock early.
A put option should always be exercised early if it is sufficiently deep in–the–money. Consider
the case of the owner of an in–the–money put who is also very bearish. He believes that the
expiration day stock price will be below the strike price. Assume that the stock price is Rs.5
and the strike price is Rs.50. Assume further that the put is selling for its intrinsic value, Rs.45,
(deep–in–the money puts have very little time value). The investor has three possible courses of
action: he can hold on to the option, he can exercise the option and sell the stock at Rs.50, or he
can sell the put for Rs.45. By holding on to the put, at maximum his profit can increase by Rs.5.
Clearly, holding on to the option for another day is an inferior strategy to exercising the put. By
exercising, the investor receives Rs.50 today, and he can immediately invest it to earn interest.
By waiting one day, or waiting until the expiration day, he is foregoing interest that could be
earned on the Rs.50.
Should he sell the put? One would find it hard to find a buyer to whom one could sell a deep–
in–the money put. From the point of view of the buyer, typically, no one would ever want to buy
the put for Rs.45 and hold it, because the most that he could earn on the put, would be Rs.5 in
the event that the stock price falls to near–zero. Even in cases where the put sells for more than
its intrinsic value, if the interest earned on the Rs.50 from today to expiration exceeds the time
value of the put, the holder would be better off exercising the put. In most cases is optimal to
exercise in–the–money put options early.
9.3.3 Early exercise of calls on dividend paying stock
When the stock goes ex–dividend, the stock price falls by the amount of dividend. We know
that the value of a call option increases with increase in the underlying stock price and decreases
with a decrease in the underlying stock price. The fall in the stock price when the stock goes
ex–dividend makes the option on that stock less attractive. In the case of options on dividend
paying stocks, it may at times be optimal to exercise an American call option to capture the
dividend payment. Therefore early exercise should be considered only just before the stock goes
ex–dividend. In order to find out whether it is optimal to exercise the call option, we need to find
out the value of the option when the underlying stock trades cum–dividend versus when it goes
ex–dividend. If the value of the option when the underlying stock trades cum–dividend it higher
than the value of the option when it trades ex–dividend, then it is optimal to exercise just before
the stock goes ex–dividend. We shall discuss this in detail in the following section.
Bounds on call option prices: a recap

Recollect what we learned about the bounds on option prices in the previous chapter. The worst
that can happen to a call option is that it expires worthless. This will happen when the call is
out–of–the money. The optionality in an option is precious. It offers a limited downside and an
unlimited upside. Hence its value must always be positive, i.e. c 0.
For a non–dividend paying stock,

where:
S Spot price
c Call premium
r Continuously compounded risk–free rate of interest
X Exercise price
T Time to maturity in years
D Dividend in rupees
For a dividend paying stock,

. That is, the stock price falls to the extent of dividend declared and hence the dividend amount is
subtracted from the spot.
Let us assume that t is a moment in time prior to stock going ex–dividend and d is the
corresponding dividend. We are faced with a choice - should we exercise the option or not? We
would like to check if it would be optimal to exercise the option at time t which is before T, the
maturity of the option.

Case 1: If the option is exercised at time t, the buyer of the option will receive -X .

Case 2: If the option is not exercised, the stock price drops to

. As shown above, the value of
this option is greater than .

If

it cannot be optimal to exercise at time t. What this means is that, if the value of the option after
the ex–dividend date is more than the value of the option before the ex–dividend date, it makes
sense not to exercise the option. If however,

9.3 Early exercise of American options 143
, it is always optimal to exercise the option at time t. This means that if the value of the option
before the ex–dividend date is more than the value of the option after the ex–dividend date, it is
optimal to exercise the option just before the stock goes ex–dividend.
Rearranging the above two equations, we find that

If , it cannot be optimal to exercise at time t.

If
, it is always optimal to exercise at time t.

Let us try to apply the above conditions to the following numerical example. Consider an
American call option on a dividend paying stock with a maturity of six months(At the moment
only options having a maturity of one–month, two–month and three–month maturity are available
for trading in India). Ex–dividend date is three months later. Dividend on the ex–dividend date
is expected to be Rs.0.50. Current share price is Rs.40. Exercise price is Rs.40. Stock price
volatility is 30% per annum. Risk–free rate is 9% per annum. Should this option be exercised on
the ex–dividend date?
As we know, the dividend amount is Rs.0.50 which will be received three months later. We
shall test out the above conditions to see if early exercise is optimal.
In this case we find that

" $

"

. Since the dividend of Rs.0.50 is less than the Rs.0.85, the option should not be exercised on the
ex–dividend date.
Let us take the same example and assume that the ex–dividend date was five months later. If
so, we find that

" $

"

. Since the dividend amount of Rs.0.50 is more than the Rs.0.29, the option should be exercised
on the ex–dividend date if it is sufficiently deep in the money.
9.3.4 Early exercise of puts on dividend paying stock

When the stock goes ex–dividend, the stock price falls by the amount of dividend. We know that
the value of a put option increases with decrease in the underlying stock price and decreases with
an increase in the underlying stock price. The fall in the stock price when the stock goes ex–
dividend makes the put option on that stock more attractive. Hence dividends will tend to delay
the exercise of an American put option. Early exercise should be considered only just after the
stock goes ex–dividend. In order to find out whether it is optimal to exercise the put option, we
need to find out the value of the option when the underlying stock trades cum–dividend versus
when it goes ex–dividend. If the value of the option when the underlying stock trades cum–
dividend it higher than the value of the option when it trades ex–dividend, then it is optimal to
exercise just after the stock goes ex–dividend. We shall discuss this in detail in the following
section.
Bounds on put option prices: a recap

Recollect what we learned about the bounds on option prices in the previous chapter. The worst
that can happen to a put option is that it expires worthless. This will happen when the put is
out–of–the money. The optionality in an option is precious. It offers a limited downside and an
unlimited upside. Hence its value must always be positive, i.e. p 0.

For a non–dividend paying stock,

.

For a dividend paying stock,

. That is, the stock price falls to the

extent of dividend declared.
As the stock price falls, a put becomes more valuable. Since the stock price falls to the extent
of dividend declared, it always makes sense to check if it would be optimal to exercise the put
option just after the ex–dividend date. Let us assume that t is a moment in time immediately
after the stock goes ex–dividend and d is the corresponding dividend. We would like to check if
it would be optimal to exercise the option at time t which is before T, the maturity of the option.

Case 1: If the option is exercised at t, the buyer of the option will receive X - .

Case 2: If the option is not exercised, the stock price drops to

. As shown above, the value of

this option is greater than .

If

, it cannot be optimal to exercise at t. What this means is that, if the value of the option after
the ex–dividend date is more than the value of the option before the ex–dividend date, it makes
sense not to exercise the option. If however,

, it is always optimal to exercise the option at time t. This means that if the value of the option
before the ex–dividend date is more than the value of the option after the ex–dividend date, it is
optimal to exercise the option just after the stock goes ex–dividend.
Rearranging the above two equations, we find that

If
, it cannot be optimal to exercise at time t.

If

, it is always optimal to exercise at time t, i.e. just after the ex–dividend

date.

Let us try to apply the above conditions to the following numerical example. Consider an
American put option on a dividend paying stock with a maturity of six months(At the moment
only options having a maturity of one–month, two–month and three–month maturity are available
for trading in India). Ex–dividend date is three months later. Dividend on the ex–dividend date
9.4 Implied volatility 145
is expected to be Rs.0.50. Current share price is Rs.40. Exercise price is Rs.40. Stock price
volatility is 30% per annum. Risk–free rate is 9% per annum. Should this option be exercised on
the ex–dividend date?
As we know, the dividend amount is Rs.0.50 which will be received three months later. We
shall test out the above conditions to see if early exercise is optimal.
In this case we find that

" $

"

. Since the dividend of Rs.0.50 is less than the Rs.0.85, the option should be exercised just after
the ex–dividend date.
Let us take the same example and assume that the ex–dividend date was five months later. If
so, we find that

" $

"

. Since the dividend amount of Rs.0.50 is more than the Rs.0.29, it is not optimal to exercise the
option.
9.4 Implied volatility
Volatility is one of the important factors, which is taken into account while pricing options. It is
a measure of the amount and speed of price changes, in either direction. Everybody would like
to know what future volatility is going to be. Since it is not possible to know future volatility,
one tries to estimate it. One way to do this is to look at historical volatility over a certain period
of time and try to predict the future movement of the underlying. Alternatively, one could work
out implied volatility by entering all parameters into an option pricing model and then solving
for volatility. For example, the Black Scholes model solves for the fair price of the option by
using the following parameters – days to expiry, strike price, spot price, volatility of underlying
,interest rate, and dividend. This model could be used in reverse to arrive at implied volatility by
putting the current price of the option prevailing in the market.
Putting it simply, implied volatility is the market’s estimate of how volatile the underlying
will be from the present until the option’s expiration, and is an important input for pricing options
– when volatility is high, options are relatively expensive; when volatility is low, options are
relatively cheap. However, implied volatility estimate can be biased, especially if they are based
upon options that are thinly traded.
Solved problems
Q: Exchange traded stock options began trading on the NSE from
1. July 2000 3. July 1999
2. July 2001 4. July 1995
Q: Stock options that trade on NSE’s F&O segment are
1. American options 3. Asian options
2. European options 4. Look–back options
Q: The basis for any adjustment for corporate action shall be such that
1. The value of the position of the market partic- as possible.

ipants on ex–date is higher than the value of
the position on cum–date. 3. The value of the position on ex–date will be
independent of the value of position on cum–
2. The value of the position of the market partic- date as far as possible.
ipants on cum and ex–date for corporate ac-
tion shall continue to remain the same as far 4. None of the above
Q: In the F&O segment, any adjustment for corporate actions shall be carried out on
1. The fi rst day on which a security is traded on 3. The last day on which a security is traded on
a cum basis in the underlying cash market. a cum basis in the underlying cash market.
2. The fi rst day on which a security is traded on
an ex–dividend basis in the underlying mar-
ket. 4. None of the above.
Q: Which of the below listed factors does not affect the price of an option on a stock?
1. Stock price 3. Volatility
4. Liquidity of stock in the underlying cash mar-

2. Dividend ket

9.4 Implied volatility 147
Q: It is optimal to exercise a call option on a non–dividend paying stock.
1. Sometimes 3. always
2. Never 4. rarely
Q: Mr.Bal buys 100 calls on a stock with a strike of Rs.1200. He pays a premium of Rs.50/call. A month
later the stock trades in the market at Rs.1300. He decides to exercise. He will receive
1. Rs.100 3. Rs.50
2. Rs.10,000 4. Rs.5,000
A: He receives the cash–settlement amount of Rs.100 per call. He has bought 100 calls. The correct
answer is number 2.
Q: Ramesh is bullish about Cipla which trades in the spot market at Rs.1025. He buys two one-month
call option contracts on Cipla with a strike of 1050 at a premium of Rs.10 per call. One month later, Cipla
closes at Rs. 1080. His profi t on the position is
1. Rs.6000 3. Rs.4500
2. Rs.1500 4. Rs.4000
A: His profi t is (1080 - 1050 - 10), i.e. 20 per call. He buys two contracts. Therefore the profi t on the
position is 20 * 200. The correct answer is number 4.
Q: An American call option on a non–dividend paying stock with one month to expiration trades in the
market. Stock price is Rs.50. Strike price is Rs.40. You plan to hold the stock for more than one month.
What would be the most optimal thing to do?
1. Exercise the option immediately and buy the 3. Let the option expire and buy the stock from
stock at Rs.40. the market.
2. Exercise the option on the day of expiration
and buy the stock at Rs.40. 4. None of the above

market. Stock price is Rs.50. Strike price is Rs.40. At what price will this option trade in the market?
1. At a price higher than Rs.10. 3. At Rs.10.
2. At a price lower than Rs.10. 4. None of the above.
A: The correct answer is number 1. The option will trade in the market at a price which is the sum of the
intrinsic value plus the time value.
market. Stock price is Rs.50. Strike price is Rs.40. You think the stock is overpriced. What should you
do?
1. Exercise the option, acquire the stock at Rs.40 3. Buy the stock and sell the option.
and sell it off at Rs.50.
2. Sell the option in the market. 4. None of the above.
Q: An American call option on a dividend paying stock with a maturity of six months is available for
trading. Ex–dividend date is three months later. Dividend on the ex–dividend date is expected to be
Rs.0.50. Current share price is Rs.40. Exercise price is Rs.40. Stock price volatility is 30% per annum.
Risk–free rate is 9% per annum. You should
1. Exercise the option just before the stock goes 3. Not exercise the option before the stock goes
ex–dividend. ex–dividend date.
2. Exercise the option just after the stock goes
ex–dividend. 4. None of the above.
A: In this case we fi nd that

. Since the dividend of Rs.0.50 is less than the Rs.0.85, the option should not be exercised before the stock
goes ex–dividend. The correct answer is number 3.

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Chapter 4

4.1 The cost of carry model

C Holding costs or carry costs

This can also be expressed as:

T Time till expiration

, arbitrage opportunities would exist i.e. whenever

T Time till expiration

4.1.1 Pricing futures contracts on commodities

2. What is the cost of financing for a month?   

Box 4.8: The market crash of October 19, 1987

4.2 Pricing equity index futures

There are no costs of storage involved in holding equity.

4.2.1 Pricing index futures given expected dividend amount

7. Thus, futures price F Rs.

4.2.2 Pricing index futures given expected dividend yield

S spot index value

q expected dividend yield

Figure 4.1 Variation of basis over time

futures contract? Fair value Rs.

 $     "   "  $  $ $ " 

Transactions costs are very important in the business of arbitrage.

4.3 Pricing stock futures

There are no costs of storage involved in holding stock.

4.3.1 Pricing stock futures when no dividend expected

1. Assume that the spot price of SBI is Rs.228.

2. Thus, futures price F   

4.3.2 Pricing stock futures when dividends are expected

2. Assume that the market price of M & M is Rs.140.

4. Thus, futures price F      

1. Black & Scholes 3. Miller

A: The correct answer is number 2.

1. 1.5% per month 3. 1.75% per month

2. 2.25% per month 4. 1.92% per month

A: The fair value is

. The correct answer is number 2.

A: The fair value is

. The correct answer is number 2.

which is approximately 1272. The correct answer is number 2.

which is approximately 1270. The correct answer is number 4.

Nifty involves 100 shares. Thus, the futures price F Rs.

The correct answer is number 4.

which is 171.88. The correct answer is number 2.

which is 173.05. The correct answer is number 1.

Using index futures

1. Long security, short Nifty futures

1. Bullish index, long Nifty futures

1. Have funds, lend them to the market

5.1 Hedging: Long security, short Nifty futures

How do we actually do this?

2. Suppose the beta of MTNL happens to be 1.2.

5. He sells 6 market lots of Nifty (1200 nifties) to get the position:

6. 10 days later, Nifty crashed because of instability in the government.

is the standard deviation of daily returns on Nifty. Typically,

1. SELL 200,000 of Nifty 3. BUY 160,000 of Nifty

2. BUY 200,000 of Nifty 4. SELL 160,000 of Nifty

A: A long position in ORIENTBANK of Rs.200,000 is as vulnerable to the index as a long position of

A: A fully hedged position has total risk (variance) of

, which evaluates to 4.6. Hence the risk

1. Profi t of Rs.2,164 3. Profi t of Rs.9,500

2. Profi t of Rs.9,500 4. Profi t of Rs.11,664

1. Long Nifty Rs.1 crore 4. Short Nifty Rs.1.2 crore

A: The correct answer is number 4.

1. Short Nifty Rs.2.06 lakh 4. Long Nifty Rs.2 lakh

2. What is the cost of financing for a month?

$ " " $ $ $ "

2. Thus, futures price F

4. Thus, futures price F

A: Portfolio beta is (10000.8 + 20001.1)/3000 or 1. The correct answer is number 3.