A Study Material On Financial Derivatives

A Study Material
On
Financial Derivatives
Sathyanarayana K
Contents
Key Terms.............................................................................................................................................. 2
Introduction to Derivative .................................................................................................................. 11
MTM & Margin call ........................................................................................................................... 15
Valuation of Futures ........................................................................................................................... 20
Application of Future contracts ......................................................................................................... 26
Options ................................................................................................................................................. 32
Application of Options - Option Strategies....................................................................................... 39
Valuation of Options ........................................................................................................................... 58
Valuation of Futures Options............................................................................................................. 71
Concept of Exotic Option ................................................................................................................... 72
SWAPS ................................................................................................................................................. 73
Interest Rate Markets ......................................................................................................................... 81
Commodity Derivatives ...................................................................................................................... 90
Forward Contract ............................................................................................................................... 97
Credit Default Swaps .......................................................................................................................... 99
Currency Futures .............................................................................................................................. 101
Value at Risk ..................................................................................................................................... 103
Sathyanarayana K, Faculty- Finance, (M):984411378 1

Key Terms
Derivative
Derivatives is a contract that derives its value from the value of an underlying. The underlying
may be a financial asset such as currency, stock and market index, an interest bearing security
or a physical commodity
Arbitrageurs
Arbitrageurs assumes riskless position with no net investment in different markets and
instruments, so as to make a profit due to mispricing in different markets.
Exchange rate of risk

Risk emanating from changes in the foreign exchange markets.
Forwards
Forwards are contracts where both buyer and seller agree to exchange the asset and its price at
a future date, but at a price fixed in advance.
Future
Forward contracts traded on exchanges.
Hedgers
Those who enter into a derivatives contract with the objective of covering risk.
Interest rate risk

Risk emanating from changes in the interest rate.
Options
It is a right without an obligation to buy or sell an asset at a predetermined price within a
specified time interval.
Over-the-counter product
When a contract is directly entered into between two mutually consenting parties known to
each other with matching needs, it is called an OTC product.
Price risk
Business loss resulting from change in the prices of inputs and outputs.
Risk
It is a variance of the actual result from the expected.
Risk diversification
It is a risk reduction strategy by taking positions in several alternative markets and instruments.
Risk transfer
Risk transfer refers to the passing of risk from those unwilling to take it to those willing to
assume it.
Speculators: Those who enter into a derivatives contract to make profit by assuming risk.
Swaps
These are agreements between two parties to exchange a set of cash flows according a
predetermined method.
Backwardation
A situation where the futures price is less than the expected future spot price. In common use,
it refers to situation where the future price is less than a current spot price.
Cash-and-carry arbitrage
A risk-free profit-making situation where one could buy an asset by borrowing and then selling
a future contract.
Commodity futures
Future that have commodities as underlying assets.
Contango
A situation where the future price is more than the expected future spot price. In common use,
it refers to a situation where the futures price is more than the current spot price.
Convergence
Convergence refers to the fact than on the day of maturity of the future contract, its price must
converge with the spot price.
Cost of Carry
The cost that one would incur if a physical asset is possessed and carried for a period of time.
i.e till the tine of maturity of the future/forward contract.
Counterparty risk
The risk for one party to a contract that the other party would not perform its commitments on
the due date of the forward contract.
Financial futures
Futures that have financial assets as underlying assets.
Forward Contract
An agreement to buy or sell an asset at a price determined today, though the contract is settled
later at a predetermined date.
Future Contract
A forward contract that is traded on an exchange.
Margin
The amount of money required to be deposited with the exchange for taking a long, short or
combination of futures contract for covering potential loss.
Margin call
The replenishment of margins in case of mark-to-market losses exceeding the prescribed
minimum level of margin.
Mark to Market
The daily settlement of profit or loss incurred on the position of derivatives, as if the position
in derivatives is closed out.
Open Interest
The number of future contract still outstanding, awaiting settlement either by delivery or by an
offsetting contract. Over-the-counter: a direct contract between two parities addressing their
specific needs and getting settled between them at maturity.

Reverse cash-and-carry arbitrage

A risk-free profit-making situation where one could sell an asset and lend the proceedings and
then buy the future contract.
Settlement
It is the fulfilment of obligations under a forward contract (derivative) of delivery of the asset
and cash consideration (or Cash differential), or extinguishing of the claims of the
counterparties on the agreed date.
Tick size
The minimum change in the price that would be recognized in the price quotation of the future
contract.
Underlying asset
The asset on which the price of the derivative (forward or future) is based.
Basis
The difference between the future price and the spot price
Basis risk
The possibility that the basis would not be equal at the inception and termination of the hedge,
resulting in an imperfect hedge.
Consumption assets
Assets primarily held for consumption and not for investment purpose.
Cross hedge
When an exposure in an asset is covered by a position in future not in the same asset but in
another strongly correlated assets for hedging, It is referred as cross hedge.
Hedge Ratio
The ratio of positions taken in the futures and spot markets in the hedge.
Imperfect Hedge
In an imperfect hedge, gain/losses in the cash market are partially offset by losses/gains in the
derivative market.
Investment assets
Assets primarily held for investment purposes.
Long hedge
A long position in futures in order to hedge the short position in the cash market.
Optimum hedge ratio

The ratio of positions in the futures and spot markets that minimizes risk is optimum hedge
ratio.
Perfect hedge
In a perfect hedge, gain/losses in the cash market are fully offset by losses/gains in the
derivative market.
Rollover hedge
Under rollover hedge, position in near month contracts is squared up at maturity and new
position opened to cover the entire hedging period.

Short hedge
A short position in futures in order to hedge the long position in the cash market.
Spread
The difference in the prices of futures for different assets, different markets, or different
maturities.
Beta
A measure of systematic risk, and specifies the change in the value of the stock or portfolio
with a 1% change in the market.
Clearing price/Settlement price

The weighted average price for the last trading slab at which all outstanding contracts at the
end of the day are marked to market.
Impact cost
The difference in price caused by a change in size of the buy/sell order.
Index
A representative sample of the stock/assets that fairly represents the whole and is used for
gauging the state of the market and the economy.
Index future
Future whose underlying assets are indices.
Stock future
Future whose underlying assets are stocks.
Systematic risk
The change in price of a stock or portfolio attributable to market factors.
Tracking error
The difference between the actual returns of an index-based portfolio or fund attempting to
replicate the returns of the index and the actual returns of the index.
Unsystematic risk
The change in price of a stock or portfolio attributable to factors specific to the stock or
portfolio.
Ask rate
The rate at which a bank sells foreign currency.
Bid rate
The rate at which a bank buys foreign currency.
Currency futures
A forward contract in foreign exchange that is traded on an exchange
Forward premium or discount

The annualized percentage variation of the forward rate with respect to the spot rate. A forward
rate higher than the spot rate means the foreign currency is at a premium.
Forward transaction
A transaction that needs to be settled at a future date, at a rate specified now.

Interest rate parity

The condition that implies that the forward rate is determined by the equality of returns
indifferent currencies.
Non-deliverable forward
An off-shore forward contract in foreign currency where no delivery is required, and the
contract is necessarily cash-settled on maturity.
Option forward
A contract that allows flexibility of settlement date by specifying a period rather than a specific
date.
Spot transaction
The transactions in foreign exchange that are settled in two business days.
Swap transaction
A transaction consisting of two equal and opposite legs, to be completed at two different points
of time.
Conversion factor
Adjustment of prices of all deliverable bonds against the price of the specified bond in the
future contract is done suing the conversion factor.
CTD bond
The bond that is the cheapest to deliver, among the many bonds that satisfy the delivery
requirement under the future contract.
Discount yield
The annualized yield on T-bills, in terms of percentage of the face value of the T-bills.
Eurodollars
The US dollars held outside the USA,
Eurodollar futures
A futures contract with a Eurodollar deposit as the underlying asset.
Implied repo rate

The rate implied by the spot price and the future price on T-bills.
T-bills
These are discount instruments issued by government for a variety of reasons; they have fixed
maturity and are virtually free from default risk.
T-bill futures
These are exchange-traded contracts with T-bills as underlying asset, calling for delivery of the
T-bills on maturity.
Treasury bond futures

A future contract with T-bonds as underlying asset.
Basis swap
A swap in which both the legs are floating, but with different benchmarks.

Commodity swap
The exchange of cash flows based on the prices of commodities, with one payment fixed and
the other variable.
Counterparty risk
The risk that a counterparty to a contract would default on the promised commitment.
Equity Swap
A swap under which one fixed cash flow is exchanged for another cash flow dependent upon
an index.
Financial/currency swap
A series of cash inflows and out-flows between two parties based on currency exchange rates
on a notional principal.
Interest rate swap

A series of cash inflows and outflows between two parties based on interest rates on a notional
principles.
MIBOR
Mumbai interbank offer rate, akin to LIBOR
Parallel loans
The loans made by two parities to each other to meet requirements that otherwise could not be
met by either party by itself.
Reset date
The prior date at which the next payment for the floating leg is decided under a swap.
Swap dealer
An intermediary-usually a bank - that facilities a swap deal by becoming a counterparty to each
of the parties to the swap, and fill sin any gaps in the transaction.
American option
An option that can be exercised before or on maturity.
Assignment
The process of assigning the obligation of delivery to a specific seller upon exercise by the
holder in an exchange-traded option.
Call option
A call option confers a right, but no obligation, to buy an underlying asset at a given price
before or on maturity of the contract period.
European Option
An option that can be exercised only on maturity.
Option contract
An option contract confers a right, but no obligation, to buy or sell an asset at a given price
before or on maturity of the contract period.
Option premium
The amount of money paid upfront by the option buyer to the option seller.

Put option
A put option confers a right but no obligation to sell an underlying asset at a given price before
or on maturity of the contract period.
Intrinsic value
The money the holder gets upon immediate exercise.
Put-Call parity
The relationship between the call price and the put price of the same underlying asset, with the
same exercise price and the same time to maturity.
Time value of option

The excess of the actual price of the option over its intrinsic value.
Binomial option pricing model

An option pricing model that assumes that there can be only two possible states of value of the
underlying asset.
Equivalent portfolio approach

An approach that assumes that two portfolios that have the same value would be equivalent-
including the pricing of such portfolios - would fetch the same value, and command the same
price.
Monte Carlo simulation

The method of simulating the uncertainties for a given probability distribution by generating
thousands of random numbers and analysing the outcomes for understanding behaviour and
pricing.
Netting
A clause that has become standard in the Master Agreements that govern transactions in the
over-the-counter market is known as netting. This states that, if a company defaults on one
transaction it has with a counter party, it must default on all outstanding transactions with the
counterparty.
Option delta
The delta is the rate of change of an option value with respect to a change in the value of the
underlying asset.
Risk-neutral probability
The probability that equates the return of a portfolio/asset with the risk-free rate of interest.
Risk-neutral valuation
Risk-neutral valuation assumes that a portfolio that provides a definite value cannot grow by
more than the risk-free rate.
Historical volatility
The standard deviation of returns in the past.
Implied volatility
The volatility at which the fair price of an option as determined by the BSM matches and actual
market price.
Normal distribution
A bell-shaped probability distribution that is completely defined by its mean and variance.

Delta
The rate of change of the value of the option with respect to the spot price of the underlying
asset.
Delta neutrality
A portfolio whose delta is zero is called a delta-neutral portfolio. Its value remains the same
for any small change in the price of the underlying asset.
Gamma
The rate of the change of the value of the delta of the option with respect to the spot price of
the underlying asset.
Gamma neutrality
A portfolio whose gamma is zero is called a gamma-neutral portfolio. The value of a delta
remains constant for any small change in the price of the underlying asset for a gamma-neutral
portfolio.
Rho
The rate of change of the value of the option with respect to changes in the risk-free interest
rate.
Theta
The rate of change of the value of the option with respect to the time to maturity.
Vega
The rate of change of the value of the option with respect to the volatility of the underlying
asset.
Decay factor
The rate at which the importance of past data decreases.
Exponential smoothing
A situation where the weight of past date decreases exponentially at each new observation.
Historical simulation
A method of arriving at the VaR using past data as source, assuming history can foretell future
events.
Monte Carlo simulation

A method of arriving at a VaR by generating scenarios according to the expected pattern of
market variables.
Standard deviation
A measure of volatility as a percentage of deviation from average returns.
Stress testing
An exercise conducted to establish how a portfolio/an organisation would withstand a crises
situation on the basis of analysis of crises that occurred over the last 10-20 years.
Value at risk
A measure of risk that quantifies losses for a time horizon with a certain confidence level.
Volatility index
An index that reflects on expected volatility in the short term.

Protective put
A long position in an asset is protected against decline in the market.
Range forward
A combination of options – one long and the other short-created with the objective of reducing
cost and limiting the holder’s market risk to small range.
Ratio range forward

Where the numbers of options bought and options written are not equal but in a certain ratio.
Bear spread
A bear spread is a combination of a long call/put with a higher strike and a short call/put with
a lower strike.
Bull spread
A combination of a long call/put with a lower strike and a short call/put with a higher strike.
Butterfly spread
A butterfly spread is created by two long calls/puts at two different strikes and two short
calls/puts at the same strike price, in between the strikes of two long positions.
Calendar spread
A combination of options on the same asset but with different maturities.
Condor spread
A condor spread is created by two long calls/put at two different strikes and two short calls/puts
at different strike prices, both the between the strikes of the two long positions.
Covered call writing

Selling a call while possessing the underlying asset, with a view of earning a premium, but
with delivery of the asset in hand.
Credit spread
A spread combination that results in initial cash inflow.
Debit spread
A spread combination that results in initial cash outflow.
Diagonal spread
A diagonal spread is constructed by using different strike prices and different maturities of
options on the same asset.
Naked call writing

Selling a call without possessing the underlying asset, with a view to earning a premium.
Ratio Spread
A combination consisting of calls and puts on the same asset with the same expiry but in
different proportions.

Introduction to Derivative
A derivative is an instrument whose value is derived from its underlying asset.
Derivatives are Instruments in Respect of which Trading is carried out as a Right on an

Underlying Asset. When we deal with Derivatives, the Asset itself is not traded, but the Right
to Buy or Sell the Asset is traded, which may Ultimately Result in Trade. Right over the Asset
which after or during a particular period of time might result in a Buyer Buying or Selling the
Asset. The Price at which the Transaction is to be carried out is also spelt out in the Beginning
Itself.
Assets Traded in Derivatives

 Stocks
 Index
 Commodity
 Interest rate
 Currency
Spot Market
A Spot or Cash Market is the most commonly used for trading.
A Majority of our day-to-day transactions are in the cash
market. Where we pay cash and get the delivery of the goods.
Depending on how the pay offs are structured, it could be a:

 Forward
 Future
 Option
 Swap.
Forward Contract
Forward contract is an agreement to buy or sell an asset at a certain future time for a certain
price.
Features of Forward Contracts

 Two Parties
 Over-the-counter product
 Price is determined today
 Mutual obligation to perform
 Counter party risk
 Mutual consent for cancellation
 No upfront payment

Payoffs
Payoff Payoff
0 0 S
K S K
Long Position Short Position
Issues with Forward Contracts

 No Standardization - Each contract is unique
 Uncertainty in Performance
Future Contract
Need
 Future contracts were evolved to take care of problems with Forward Contracts.
“A Future Contract is a promise to buy/sell a certain quantity of Standardized goods/asset on

a certain Future Date at an Agreed Price”.
A Future Contract is very much like a Forward Contract and represents an agreement between
two parties to buy/sell an Asset at a Certain Time in the Future for a Certain Price.
Payment Sells Future Contract
Future Buyer Clearing Future Seller

Corporation
Buys Future Contract Payment

Specification of a Future Contract

 Underlying Asset
 Contract Expiry
 Contract size
 Price quotation
 Tick size
Settlement of Delivery
 Offsetting
 Delivery based
 Close-out
Distinction between Forwards and Futures
Trading Underlying vs. Trading Single Stock Futures
The single stock futures market in India has been a great success story. One of the reasons for
the success has been the ease of trading and settling these contracts.
To trade securities, one 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.
To trade in futures, one 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
date of the contract). Security futures do not represent ownership in a corporation and the holder
is therefore not regarded as a shareholder.
When buy a share in a spot market you are eligible for any corporate action of that particular
company where as in futures the buyer is not eligible for any corporate action

Option Contracts
A Right Being Created without a Corresponding Obligation. The Buyer of an option gets the
Right without the Obligation to either Buy or Sell the Underlying Asset. There is a timeframe
and a price fixed for the contract. For the privilege of going ahead with the contract as per the
Buyer’s Desire, the option buyer has to pay the Premium upfront to the Option Seller. If
ultimately prices do not allow the options to be exercised, then the premium is the only loss
incurred by the buyer of the option contract
Options
Call Option Put Option
European American
. Option
Set Expiration
Value Lower’s
Value Rises
Price Date
Stock Price
Call
Stock Price
Option Put
Option Types Option
Value Lower’s
Value Rises

MTM & Margin call
1. On Monday the 16th of February Mr. Ram bought Nifty February Futures at Rs.8,626 and
Mr. Shyam sold Nifty Futures at Rs. 8,646, both wants to hold the positions till expiry.
Calculate the Mark to Market for both of them with the following Settlement Prices of Nifty.
On 26th February Spot Nifty closes at 8,895
Date Price Date Price
16.02.2015 8,640 22.02.2015 8,790
18.02.2015 8,680 23.02.2015 8,845
19.02.2015 8,670 24.02.2015 8,925
20.02.2015 8,725 25.02.2015 8,910
Solution:
MTM of Mr. Ram (Long Nifty)
Date Trading Price Settlement Price MTM
16.02.2015 8,626 8,640 14
18.02.2015 8,680 40
19.02.2015 8,670 -10
20.02.2015 8,725 55
22.02.2015 8,790 65
23.02.2015 8,845 55
24.02.2015 8,925 80
25.02.2015 8,910 -15
26.02.2015 8,895 -15
MTM of Mr. Shyam (Short Nifty)

16.02.2015 8,646 8,640 6
18.02.2015 8,680 -40
19.02.2015 8,670 10
20.02.2015 8,725 -55
22.02.2015 8,790 -65
23.02.2015 8,845 -55
24.02.2015 8,925 -80
25.02.2015 8,910 15
26.02.2015 8,895 15
2. On Monday the 16th of May Mr. Raj bought one lot of SBIN February futures at Rs.313 and
Mr. John sold two lots of SBIN Futures at Rs. 307, both wants to hold the positions till
expiry. Calculate the Mark to Market for both of them with the following Settlement Prices
of SBIN. Lot size of SBIN is 2,000, On last 26th May SBIN closes at Rs.299
Date Price Date Price

16.05.2015 307.80 21.05.2015 296.85
18.05.2015 307.10 24.05.2015 297.50
19.05.2015 303.60 25.05.2015 295.80
20.05.2015 302.90

Solution:
MTM of Mr. Raj (Long SBIN)
16.02.2015 313 307.80 -5,200
18.02.2015 307.10 -700
19.02.2015 303.60 -3,500
20.02.2015 302.90 -700
23.02.2015 296.85 -6,050
24.02.2015 297.50 650
25.02.2015 295.80 -1,700
26.02.2015 299 3,200
MTM of Mr. John (Short SBIN)

16.02.2015 307 307.80 -1,600
18.02.2015 307.10 1,400
19.02.2015 303.60 7,000
20.02.2015 302.90 1,400
23.02.2015 296.85 12,100
24.02.2015 297.50 -1,300
25.02.2015 295.80 3,400
26.02.2015 299 -6,400
3. An Investor bought Infosys April future at Rs. 1,355 on 18th April 2021. The contract
expires on 29th April 2021. Lot size is 600 shares. Margin required is 18% of the contract
value. Using the following prices, prepare statement showing marking to market.
19- Apr- 20- Apr- 23- Apr- 24- Apr- 25- Apr- 26- Apr-
Date 18-Apr-21
21 21 21 21 21 21
Settlement
1,340 1,355 1,335 1,390 1,420 1,450 1,425
Price
Solution:
Required Margin = Rs.103275
Traded Settle Margin
Date MTM
Price Price Balance
18-Feb-15 2295 1,03,275
18-Feb-15 2,316 5,250 1,08,525
19-Feb-15 2,342 6,500 1,15,025
20-Feb-15 2,303 -9,750 1,05,275
23-Feb-15 2,279 -6,000 99,275
24-Feb-15 2,292 3,250 1,02,525
25-Feb-15 2,326 8,500 1,11,025
26-Feb-15 2,266 -15,000 96,025
4. An investor takes a long position on Reliance futures at Rs.920, from the following
information prepare margin a/c.
No. of Shares per lot - 250, Initial Margin 15% of the contract value, Maintenance margin
75% of Initial margin. On 2nd March investor will square off his position at Rs.875

18- 19- 20- 23- 24- 25- 26- 27- 28- 02-
Date Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Feb- Mar-
15 15 15 15 15 15 15 15 15 15
Settle Price 913 911 884 860 851 851 849 862 873 871
Solution:
Contract Value 2,30,000

Initial Margin 34,500
Maintenance Margin 25,875
Traded Settle Daily Cumulative Margin A/c Margin

Date
Price Price Gain Gain Balance Call
18-Feb-15 920 34,500.00
18-Feb-15 913 -1,750 -1,750 32,750.00
19-Feb-15 911 -500 -2,250 32,250.00
20-Feb-15 884 -6,750 -9,000 25,500.00 9,000.00
23-Feb-15 860 -6,000 -15,000 28,500.00
24-Feb-15 851 -2,250 -17,250 26,250.00
25-Feb-15 851 - -17,250 26,250.00
26-Feb-15 849 -500 -17,750 25,750.00 8,750.00
27-Feb-15 862 3,250 -14,500 37,750.00
28-Feb-15 873 2,750 -11,750 40,500.00
02-Mar-15 875 871 500 -11,250 41,000.00
5. The settlement price of Sensex future contract on a particular day was Rs.29,754. The initial
margin is set at Rs.75,000, while the maintenance margin is fixed at Rs.65,000. The Sensex
futures trades in multiples of 25 units. The settlement prices of following 12 days are as
follows:
Day Price Day Price

1 29,786 7 29,214
2 29,612 8 29,141
3 29,522 9 29,470
4 29,350 10 29,686
5 28,910 11 29,576
6 29,170 12 29,395
Calculate the mark-to-market cash flows and the daily closing balances in the accounts of:
i) An investor who has gone long at Rs.29,500
ii) An investor who has gone short at Rs.29,600
Calculate net profit/loss on each of the contracts.
Solution:
Initial Margin – Rs.75,000
Maintenance Margin - %s.65,000

For Long Position

Trading Settlement Cumulative Margin A/c Margin
Day
Price Price Daily Gain Gain Balance Call
0 29,500 29,754 6,350 6,350 81,350

1 29,786 800 7,150 82,150
2 29,612 -4,350 2,800 77,800
3 29,522 -2,250 550 75,550
4 29,350 -4,300 -3,750 71,250
5 28,910 -11,000 -14,750 60,250 14,750
6 29,170 6,500 -8,250 81,500
7 29,214 1,100 -7,150 82,600
8 29,141 -1,825 -8,975 80,775
9 29,470 8,225 -750 89,000
10 29,686 5,400 4,650 94,400
11 29,576 -2,750 1,900 91,650
12 29,395 -4,525 -2,625 87,125
Net Profit/Loss -2,625
For Short Position

Trading Settlement Cumulative Margin A/c Margin
Day
Price Price Daily Gain Gain Balance Call
0 29,600 29,754 -3,850 -3,850 71,150
1 29,786 -800 -4,650 70,350
2 29,612 4,350 -300 74,700
3 29,522 2,250 1,950 76,950
4 29,350 4,300 6,250 81,250
5 28,910 11,000 17,250 92,250
6 29,170 -6,500 10,750 85,750
7 29,214 -1,100 9,650 84,650
8 29,141 1,825 11,475 86,475
9 29,470 -8,225 3,250 78,250
10 29,686 -5,400 -2,150 72,850
11 29,576 2,750 600 75,600
12 29,395 4,525 5,125 80,125
Net Profit/Loss 5,125
6. From the following information prepare margin account of a trader:

a) Who has taken 2 lots long position in Nifty March Future and
b) Who has taken 3 lots of Nifty March Futures Short Position.
No. of units per contract – 100,
Traded price per unit Rs. 8,875 Initial Margin – 12%
Maintenance margin – 85% of Initial margin

Settlement Settlement
Day Day
Price Price
1 8,869 7 8,684
2 8,895 8 8,845
3 8,834 9 8,902
4 8,755 10 8,957
5 8,762 11 8,996
6 8,767 12 8920
Solution:
Initial Margin – Rs. 53,250
Maintenance Margin – Rs.45,263
Margin
Traded Settlement Daily Cumulative Margin
Day A/c
Price Price Gain Gain Call
Balance
1 8875 8,869 -300 -300 52,950
2 8,895 1,300 1,000 54,250
3 8,834 -3,050 -2,050 51,200
4 8,755 -3,950 -6,000 47,250
5 8,762 350 -5,650 47,600
6 8,767 250 -5,400 47,850
7 8,684 -4,150 -9,550 43,700 9,550
8 8,845 8,050 -1,500 61,300
9 8,902 2,850 1,350 64,150
10 8,957 2,750 4,100 66,900
11 8,996 1,950 6,050 68,850
12 8,920 -3,800 2,250 65,050

Valuation of Futures
Valuation of Stock Futures
When no dividend expected
1. ICICI Bank futures trade on NSE as one, two and three-month contracts. If money can be
borrowed at 10% p.a., and no dividends are expected during the two-month period, what
will be the price of a unit of new two-month futures contract on ICICI Bank? The spot
price of ICICI Bank is Rs. 658.
Solution:
Given: S0 = 228, r=0.10, t = 2months
Price of two-month ICICI Bank Future Contract is:
F = S0ert
F = 228e 0.1(2/12)
= Rs. 231.83
Note: It is assumed that interest rate of 10% p.a is computed continuously.
When dividends are expected
2. PTC ltd., futures trade on NSE as one, two and three-month contracts. The market price of
PTC ltd., is Rs.140 and it is giving dividend of Rs. 10 per share after 15 days of purchasing
the contract. If Money can be borrowed at 10% per annum compounded continuously,
what will be the price of a unit of new three-month futures contract on PTC ltd?
Solution:
Given: S0 = 140, r=0.10, t=3months, D=Rs.10 per share after 15 days.
Price of three-month PTC ltd., future contract is:
F = (S0 –I) ert
Find out the present value of dividend received after 15 days

I = De-rt
I = 10e-0.10(15/365)
I = 9.96
F = (140 – 9.96) e 0.1(3/12)

= Rs.133.33
3. A Stock is trading at Rs.600 today. What would be the fair value of future contract on the
stock maturing after 90 days, if risk free rate of interest is 12%p.a, and after 45 days stock
is expected pay a dividend of Rs.30 per shares? What would be the fair value of the future
contract if there were no dividend?
Solution:
Given: S0 = 600, r=0.12, t=90 days, D=Rs.30 per share after 45 days.
Price of stock future contract is:
F = (S0 –I) ert
Find out the present value of dividend received after 45 days

I = De-rt
I = 30e-0.12(45/365)
I = 29.56
F = (600-29.56) e 0.12(90/365)
= Rs.587.53

When there is no dividend

F = S0ert
F = 600e 0.12(90/365)
= Rs. 618.02
Exercise:
1. Consider a stock which is trading in NSE at Rs. 520 and which is going to expire on 26 th
March , 30th April 2015 and 28th May . Find out the value of future contract which are
going to expire on the above mentioned dates if money can be borrowed at 9% p.a. and
the stock is expected to give a dividend yield of 1% p.a. The stock will trade in multiples
of 250 shares in the derivatives market.

Valuation of Index Futures
When no dividend expected

1. An Index Quoting in the spot market at 15,750. If money can be invested at 11% p.a.
Compounded continuously, what is the fair value of a one-month futures contract on this
Index?
Solution:
F = S0ert
= 8,750e 0.11*(1/12)
= 8,830.58
2. Calculate the value of a futures contract using the following data:

Spot value of index = 52,090
Time to expiration = 76 days
Contract Multiplier = 10
Risk-free rate of return = 8% p.a compounded half yearly
Solution:
Convert Interest rate to Continuous Compounding i.e
r =2ln (1+(r/2))
=2ln (1+ (0.08/2)
= 0.078
F = S0ert
= 3,090e 0.078(76/365)
= 3,140.59
Thus, the value of a contract = 3140.59 X 100 = 3, 14,059
When dividends are expected

3. Nifty futures trade on NSE as one, two and three-month contracts. With the following
details calculate what will be the price of a new two-month futures contract on Nifty?
a. BHEL will give a dividend of Rs.20 per share after 15 days from today, it has 9%
weight in Nifty and currently trading at Rs.245.
b. Current value of Nifty is 8,500 and Nifty trades with a multiplier of 50.
c. Money can be borrowed at a rate of 10% p.a Compounded continuously.
Solution:
 If BHEL has a weight of 9% in Nifty, its value in Nifty is:
8,500 * 0.09 = 765.
 Since dividend will be paid per shares, we need to find out how many shares of BHEL
are there in one unit of Nifty:
= Value of BHEL in Nifty / Current market price of BHEL
= 765/245
= 3.12 Shares
 Since BHEL is giving dividend of Rs.20 per shares One Unit of Nifty will get:
= 3.12 * 20
= Rs.62.40 as dividend
 The dividend of Rs.62.4 will be received after 15 days from today, so the present value
of dividend is:
I = De-rt

I = 62.40e-0.10(15/365)
I = Rs.62.14
 Future value of Nifty after deducting present value of dividend (I)
F = (S0 –I) ert
F = (8,500 – 62.14) e 0.10 (2/12)
F = 8,579.67
 Value of two-month Future contract on Nifty is:
= 8,579.67 * 50
= 4, 28,983.50
4. The Market capitalisation weighted index contains only five stocks as shown below, the
current value of index is 8,800.
Company Shares Price (Rs.) Market Capitalisation (Rs. Crores)
ITC 320 260
BEL 450 380
SBIN 1800 340
M&M 620 450
TCS 900 410
BEL is giving a dividend of Rs.16 per share after 22 days and M&M is giving a dividend
of Rs.18 per shares after 28 days. The risk free rate of interest to be 15% p.a (Compounded
Continuously) and the lot size of Index is 50 units. Calculate the price of a future contract
with expiration in 60 days on this Index.
Solution:
 Find out the weightage of BEL and M&M in Index.
Shares Market Capitalisation
Company Weightage
Price (Rs.) (Rs. Cr)
ITC 320 260 0.14
BEL 450 380 0.21
SBIN 1800 340 0.18
M&M 620 450 0.24
TCS 900 410 0.22
Total 1,840 1.00
Calculation Present value of Dividend (I) for BEL

 Weightage of Dividend paying companies i.e BEL – 21%
 If BEL has a weight of 21% in Nifty, its value in Index is:
8,800 * 0.21 = 1,848.
 Since dividend will be paid per shares, we need to find out how many shares of BEL
are there in one unit of Index:
= Value of BEL in Index / Current market price of BEL
= 1,848/450
= 4.11 Shares
 Since BEL is giving dividend of Rs.16 per shares One Unit of Nifty will get:
= 4.11 * 16
 The dividend of Rs.65.76 will be received after 22 days from today, so the present value
of dividend is:
I = De-rt
I = 65.76e-0.15(22/365)
I = Rs.65.17

Calculation Present value of Dividend (I) for M&M

 Weightage of Dividend paying companies i.e M&M – 24%
 If M&M has a weight of 24% in Nifty, its value in Index is:
8,800 * 0.24 = 2,112.
 Since dividend will be paid per shares, we need to find out how many shares of M&M
are there in one unit of Index:
= Value of M&M in Index / Current market price of BEL
= 2,112/620
= 3.41 Shares
 Since M&M is giving dividend of Rs.18 per shares One Unit of Nifty will get:
= 3.41 * 18
 The dividend of Rs.61.38 will be received after 28 days from today, so the present
value of dividend is:
I = De-rt
I = 61.38e-0.15(28/365)
I = Rs.60.68
 Calculate future value of Nifty expiring in 60 days:
F = (S0 –I) ert
F = (8,800 – (65.17+60.68)) e 0.15 (60 / 365)
F = 8,890.69
 Value of Nifty two month contract:
= 8,890.69 * 50
= 4,44,534.50
5. An Index is currently stands at 8,500. Obtain the price of a future contract with expiration
in 115 days on this index having reference to the following additional information:
a) After 20 days from now a dividend of Rs.16 per share is expected on share B, which
is having a weightage of 0.08 and currently it is traded at Rs.85 per share.
b) After 28 days from now a dividend of Rs.10 per share is expected on share E, which is
having a weightage of 0.09 and currently it is traded at Rs.25 per share.
c) Risk free rate is 8% p.a (Compounded continuously)
d) Index trades in multiples of 50 units.
Solution:
Number of Share B in one unit of Index:
= 8500 * 0.08
= 680
= 680/85
= 8 Shares
Total dividend for one unit of Index
= 8 * 16
= Rs.128
Present value of dividend
= Rs.127.44
Number of Share E in one unit of Index:
= 8500 * 0.09
= 765
= 765/25
= 30.6 Shares
Total dividend for one unit of Index
= 30.6 * 10
= Rs.306
Present value of dividend = Rs.304.13
Value of Index Futures

F = (S0 –I) ert
F = (8,500 – (127.44+304.13)) e 0.08 (115 / 365)
F = 8,274.38
 Value of Nifty two month contract:
= 8,274.38 * 50
= 4,13,719.17
When dividend yields are expected

6. A two-month Nifty futures contract trades on the NSE. The cost of financing is 10% p.a
and the dividend yield on Nifty is 2% annualized. The spot value of Nifty 8,000. What is
the fair value of the Nifty futures contract?
Solution:
Fair value = S0e (r - y) t
Fair value = 8,000e (0.1 - 0.02) (2/12)
= 8,107.38
Exercises:
1. Nifty spot is trading at 4000. Wipro which is currently trading at Rs.500 per share has a
weight of 10% in Nifty. It is expected to declare a dividend of Rs.20 per share after 15
days of purchasing the futures contract. Cost of borrowing is 15%p.a. Find out the value
of a new 2 month futures contract on Nifty (market lot of Nifty is 50 Index)
2. Consider a 3 month future contract on an index. Suppose the stocks under underlying index
provide a dividend yield of 1% per annum and currently the index is at 1300. If risk free
rate of return is 7% p.a. What will be the future value of the index which is going to expire
after 3 months?

Application of Future contracts
Hedging by using stock Futures
1. On March 12, an Investor buys 2,000 shares of Infosys at the price of Rs. 2,900 per share.
The portfolio value being Rs. 58,00,000 (Rs. 2,900 * 2000). The investor feels that the
market will fall and thus wants to hedge by using Infosys Futures (stock futures). The
Infosys futures (near month) trades at Rs.2,912. What happens on futures expiry day
Infosys spot price is (a) Rs. 3,000 (b) Rs. 2,700
Solution:
 To hedge his portfolio, the investor has to sell 2,000 shares of Infosys futures.
 On futures expiry day:

a) When Infosys spot price is Rs. 3,000.
 The spot market price of Infosys has gone up from Rs.2,900 to Rs.3,000 i.e Rs. 100
per shares, so his portfolio value will be (R.3,000 * 2000) Rs.60,00,000.
 Since he has sold 2,000 shares of Infosys Futures at Rs.2,912 and the market has
done up to Rs.3,000 on expiry, the spot future price will be equal to spot price so
he losses (Rs.88 * 2,000) Rs.1,76,000
 His net portfolio value will be (Rs.60,00,000 – Rs.1,76,000) = 58,24,000
b) When Infosys spot price is Rs.2,700

 The spot market price of Infosys has gone down from Rs.2,900 to Rs.2,700 i.e Rs.
200 per shares, so his portfolio value will be (R.2,700 * 2000) Rs.54,00,000.
 Since he has sold 2,000 shares of Infosys Futures at Rs.2,912 and the market has
gone down to Rs.2,700 on expiry, the spot future price will be equal to spot price
so he makes a profit of (Rs.212 * 2,000) Rs.4,24,000
 His net portfolio value will be (Rs.54,00,000 + Rs.4,24,000) = 58,24,000
2. On March 13th 2015, an investor is holding 3000 shares of HUL which is trading at Rs.
290 per share. The investor fears that the market will fall and he needs to hedge. The HUL
April futures ate trading at Rs. 292 per share and it trades in multiples of 1000 shares.
What happens on the future expiry day if HUL spot price is (a) Rs. 300 (b) Rs. 280?
3. Reliance Industries currently trading at Rs. 950 in cash market and Reliance futures which
is going to expire in 1 month is trading at Rs. 953. Find out the fair value of Reliance
futures if the money can be borrowed at 8% p.a. compounded continuously and also find
out is there any arbitrage opportunity available in Reliance industries if there is an arbitrage
opportunity. What happens when Reliance industries closes at (a) Rs. 970 (b) Rs. 930 on
the expiry date?
4. NTPC is trading at Rs. 62 and NTPC 1 month futures is trading at Rs. 60.50. What will
be the fair value of 1 month NTPC futures when money can be borrowed at 9% p.a.
compounded half yearly. Find out is there any arbitrage opportunity available in this stock,
if yes what happens on the expiry day NTPC closes at (a) Rs. 55 (b) Rs. 65.
5. Currently Maruti is trading at Rs. 7,282 and Maruti 1 month futures are trading at Rs.
7,302. Considering a risk free borrowing rate of 10% p.a. compounded continuously, find
out is there any arbitrage opportunity available for this stock?

6. The current market price of Crompton greaves is Rs. 174 and 2 month Crompton greaves
futures are trading at Rs. 179.5. Find out is there any arbitrage opportunity available if
money can be borrowed at risk free rate of 10% p.a.
7. An investor is holding 10,000 shares of Tata Motors which is trading at Rs. 340 per share
and the beta of Tata Motors is 1.2. An investor is fearing that Tata Motors might come
down in the near future, But he don’t want to sell his holdings instead he wants to hedge
his holdings using Nifty futures which is trading at 15,700. What he needs to do to hedge
his portfolio.
Solution:
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 ℎ𝑜𝑙𝑑𝑖𝑛𝑔
Hedge ratio = × 𝛽 of stock
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑁𝑖𝑓𝑡𝑦 𝑓𝑢𝑡𝑢𝑟𝑒𝑠
15,00,0000
= × 1.2
8785
= 205
To hedge his portfolio, investor needs to sell 205 units of Nifty futures at Rs. 8785.
8. A company is having a portfolio of Rs. 20 Million with a beta of 1.1. He would like to use
future contracts on Nifty to hedge its risk. The index future current price is 15,840 and
each contract is traded in multiples of 75 units. What is the hedge that minimises risk?
What should the company do if it wants to reduce the beta of the portfolio to 0.7?
Solution:
= 89 lots.
To hedge his portfolio, the company needs to sell 89 lots of Nifty.
To reduce the beta of the portfolio to 0.6
By selling 44.44 or45 lots of Index futures, the beta of the portfolio can be reduced to 0.6.

9. On June 1st 2021, an investor has a portfolio of 8 shares as given here:
Security Price No. of shares ᵦ

A 29.4 400 0.59
B 318.7 800 1.32
C 660.2 150 0.87
D 5.2 300 0.35
E 281.9 400 1.16
F 275.4 750 1.24
G 514.6 300 1.05
H 170.5 900 0.76
The cost of capital for the investor is given to be 20% p.a. The investor fears a fall in the
prices of the shares in the near future. Accordingly he approaches you for advice. You
are required to:
a) State the options available to the investor to protect his portfolio
b) Calculate ᵦ of the portfolio
c) Calculate theoretical value of the futures contract expiring in Feb and March.
d) Calculate the number of units of CNX Nifty that you would have to sell if he desires
to hedge until March 120% of the portfolio.
e) Determine the number of future contracts the investor should trade if he desires to
reduce beta of his portfolio to 0.7.
Additional information:
The current CNX Nifty value is 986. CNX Nifty futures are traded in units of 200 only.
The Feb futures are currently quoted at 1010 and March futures are quoted at 1019.
Solution:
a) Investor has 2 options to protect his portfolio

 Sell entire portfolio now and buy back when market comes down.
 Investor can hedge his portfolio by using Index futures (Nifty futures)
b) Calculation of beta
Value
Security
No. of
shares
Price (Shares *
Price)
Weightage
(Wi) ᵦ Wi * ᵦ
A 400 29.40 11,760 0.01 0.59 0.0070
B 800 318.70 2,54,960 0.26 1.32 0.3384
C 150 660.20 99,030 0.10 0.87 0.0866
D 300 5.20 1,560 0.00 0.35 0.0005
E 400 281.90 1,12,760 0.11 1.16 0.1315
F 750 275.40 2,06,550 0.21 1.24 0.2576
G 300 514.60 1,54,380 0.16 1.05 0.1630
H 900 170.50 1,53,450 0.15 0.76 0.1173
9,94,450 1 1.1019
The portfolio beta is 1.10
c) FFeb = S0ert
= 986e (0.20*2/12)
= 1019.42
FMar = S0ert
= 986e (0.20*3/12)
= 1036.55
The theoretical value of Feb is 1019.42 and March is 1036.55
d) Hedge Ratio
9,94,450 ×1.2
= × 1.11
2,03,800
= 6.50 lots of CNX Nifty
Investor needs to sell 6.50 or 7 lots of March CNX Nifty futures.
e) Reducing portfolio beta to 0.7
(0.7−1.11)×9,94,450
=
2,03,800
= -2.00 lots
Investor needs to sell 2 lots of CNX Nifty March future to reduce the portfolio
beta to 0.7
10. On March 1st, 2015 investor’s portfolio is as follows:

Security Price No. of shares ᵦ
ITC Ltd 380 1500 0.9
HUL 670 1000 0.8
Infosys 2200 500 1.2
Reliance 900 750 1.1
The money can be borrowed at 10% p.a. compounded continuously. The investor fears a
fall in the prices of the shares in the near future. Accordingly he approaches you for an
advice, you are required to:
a) Find out portfolio beta
b) Find out fair value of Nifty futures expiring at the end of March, April and May.
c) If the investor wants to hedge 110% of his portfolio till end of April what he needs to
do?
d) The investor wants to increase the beta to 1.4. How can he do it?
Presently Nifty is at 8580 and March Nifty futures are trading at 8595, April Nifty futures
are trading at 8620 and May Nifty futures are trading at 8635

Solution:
a) Calculation of beta
Security Price
No. of
shares
Value (Shares
X Price)
Wi ᵦ Wi * ᵦ
ITC Ltd 380 1,500 5,70,000 0.19 0.9 0.1701
HUL 670 1,000 6,70,000 0.22 0.8 0.1778
Infosys 2,200 500 11,00,000 0.36 1.2 0.4378
Reliance 900 750 6,75,000 0.22 1.1 0.2463
30,15,000 1 1.0320
The beta of the portfolio is 1.03
b) FMar = S0ert
= 8580e (0.10*1/12)
= 8651.80
FApr = S0ert
= 8580e (0.10*2/12)
= 8724.20
FMay = S0ert
= 8580e (0.10*3/12)
= 8797.20
c) Hedge Ratio
3015000×1.1
= × 1.03
8620
= 396.29
Investor needs to sell 396.29 or 397 units of Index futures.
d) To Increase the portfolio Beta
(1.4−1.03)×30,15,000
=
8,620
= 129.41
Investor needs to buy 129.41 units of Nifty April future to increase the portfolio beta to
1.4

Exercises:
1. An investor is holding 2000 shares of Infosys which is trading at Rs. 2200 per share.
Investor is having an information that in the near term the market will be very volatile. So,
he wants to hedge 80% of his portfolio using index futures which is trading at 5200. The
beta of Infosys is 0.9. What he needs to do to hedge his portfolio?
2. From the following figures calculate the hedge ratio using individual stock beta. Value of
the Nifty 50 index is 5,00,000.
Share Shares Proportion of
Stock Beta
Price outstanding Portfolio
BOB 115 1,000 0.95 40%
ACC 160 2,000 1.2 40%
Bata 40 4,000 1.4 10%
BILT 50 6,000 1.3 10%

Options
Option Terminology
Index options: Have the index as the underlying. They can be European or American. They
are also cash settled.
Stock options: They are options on individual stocks and give the holder the right to buy or
sell shares at the specified price. They can be European or American.
Buyer of an option: The buyer of an option is the one who by paying the option premium buys
the right but not the obligation to exercise his option on the seller/writer.
Writer of an option: The writer of a call/put option is the one who receives the option premium
and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic
types of options, call options and put options.
Call option: It gives the holder the right but not the obligation to buy an asset by a certain date
for a certain price.
Put option: A It gives the holder the right but not the obligation to sell an asset by a certain
date for a certain price.
Option price/premium: It is the price which the option buyer pays to the option seller. It is also
referred to as the option premium.
Expiration date: The date specified in the options contract is known as the expiration date, the
exercise date, the strike date or the maturity.
Strike price: The price specified in the options contract is known as the strike price or the
exercise price.
American options: These can be exercised at any time up to the expiration date.
European options: These can be exercised only on the expiration date itself. European options
are easier to analyze than American options and properties of an American option are
frequently deduced from those of its European counterpart.
In-the-money option: An in-the-money (ITM) option would lead to a positive cash flow to the
holder if it were exercised immediately. A call option on the index is said to be in-the-money
when the current index stands at a level higher than the strike price (i.e. spot price > strike
price). If the index is much higher than the strike price, the call is said to be deep ITM. In the
case of a put, the put is ITM if the index is below the strike price.
At-the-money option: An at-the-money (ATM) option would lead to zero cash flow if it were
exercised immediately. An option on the index is at-the-money when the current index equals
the strike price (i.e. spot price = strike price).
Out-of-the-money option: An out-of-the-money (OTM) option would lead to a negative cash

flow if it were exercised immediately. A call option on the index is out-of-the money when the
current index stands at a level which is less than the strike price (i.e. spot price < strike price).
If the index is much lower than the strike price, the call is said to be deep OTM. In the case of
a put, the put is OTM if the index is above the strike price.

Intrinsic value of an option: The option premium has two components – intrinsic value and
time value. Intrinsic value of an option at a given time is the amount the holder of the option
will get if he exercises the option at that time. The intrinsic value of a call is Max[0, (S0 — K)]
which means that the intrinsic value of a call is the greater of 0 or (S0 — K). Similarly, the
intrinsic value of a put is Max[0, K — S0],i.e. the greater of 0 or (K — S0). K is the strike price
and S0 is the spot price.
Time value of an option: The time value of an option is the difference between its premium
and its intrinsic value. Both calls and puts have time value. The longer the time to expiration,
the greater is an option’s time value, all else equal. At expiration, an option should have no
time value.
Comparison between Futures and Options

Options are different from futures in several interesting senses. At a practical level, the option
buyer faces an interesting situation. He pays for the option in full at the time it is purchased.
After this, he only has an upside. There is no possibility of the options position generating any
further losses to him (other than the funds already paid for the option). This is different from
futures, which is free to enter into, but can generate very large losses. This characteristic makes
options attractive to many occasional market participants, who cannot put in the time to closely
monitor their futures positions.
Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance which
reimburses the full extent to which Nifty drops below the strike price of the put option. This is
attractive to many people, and to mutual funds creating “guaranteed return products”.
Comparison between Futures and Options

Futures Options
Exchange traded, with novation Same as futures.
Exchange defines the product Same as futures.
Price is zero, strike price moves Strike price is fixed, price moves.
Price is zero Price is always positive.
Linear payoff Nonlinear payoff.
Both long and short at risk Only short at risk.
More generally, options offer “nonlinear payoffs” whereas futures only have “linear payoffs”.
By combining futures and options, a wide variety of innovative and useful payoff structures
can be created.
1. You are given below information on options. State whether each one of these are in-the-
money, out-of-the money or at-the-money.
Sl. No. Option Strike Price Stock Price
1 Call 55 58
2 Call 40 40
3 Put 100 112
4 Put 110 104
5 Put 150 120
6 Call 35 37
7 Put 8,550 8,560
8 Call 8,550 8,540

Solution:
For a Call Option the strike prices which are below CMP of underlying asset will ITM,
above CMP will be OTM
For a Put option the strike prices which are below CMP of underlying asset will be OTM,
above CMP will be ITM.
Sl. No. Option Strike Price Stock Price Status

1 Call 55 58 ITM
2 Call 40 40 ATM
3 Put 100 112 OTM
4 Put 110 104 ITM
5 Put 150 120 ITM
6 call 35 37 ITM
7 Put 8,550 8,560 OTM
8 Call 8,550 8,540 OTM
2. From the following data determine the intrinsic value and the Time value for each of the
option.
Sl. No. Option Stock Price Strike Price Option Price
1 Put 36 32 5.3
2 Call 48 50 4.1
3 Call 107.5 105 8.4
4 Put 41 45 9.7
5 Call 50 40 12.5
6 Call 8,350 8,400 55
7 Put 565 540 15
8 Put 610 650 55
9 Call 265 240 40
10 Put 150 170 30
Solution:
Intrinsic value of a Call
Max (0, (S0 – K))
Intrinsic value of a Put
Max (0, (K-So))
Time value = Option premium – Intrinsic Value
Sl. Stock Option Intrinsic Time

Option Strike Price
No. Price Price Value Value
1 Put 36 30 5.3 0 5.3
2 Call 48 50 4.1 0 4.1
3 Call 107.5 105 8.4 2.5 5.9
4 Put 41 45 9.7 4 5.7
5 Call 50 40 12.5 10 2,5
6 Call 8,350 8,400 55 0 55
7 Put 565 540 15 0 15
8 Put 610 650 55 40 15
9 Call 265 240 40 25 15
10 Put 150 170 30 20 10

3. Presently Nifty is at 8,550 and Nifty 8,500 Call option is quoting Rs.86. Find out the
Intrinsic Value and Time Value of the Call Option. On Expiry If Nifty Spot Closes at
8,926 what will be the Profit for Buyer and Writer of the Call Option?
Solution:
Intrinsic Value = 8,550 – 8,500 = 50
Time Value = 86-50 = 36
For Buyer of option on Expiry = 8,926 – 8500 – 86 = Rs.340 (Profit)
For Writer of option on Expiry = Rs. 340 (Loss)
4. An investor buys 1,200 Shares of a call option with a Strike price of 80 for Rs.7.50. What
is the maximum loss that he could possibly incur on this? What is the maximum profit
which could accrue to him? Also, determine the break-even stock price
Solution:
Maximum loss for the buyer of call option is Rs.7.50 * 1200 = Rs.9,000
Maximum profit will be stock price – strike price – option price
The break-even will be when stock is trading at Rs.87.50
5. An investor purchases a put option involving 300 shares with a Strike Price of 180 for
Rs.9.50. What is the maximum loss that the investor could possibly incur? What is the
maximum profit which could accrue to him? Calculate the break-even stock price
Solution:
Maximum loss the investor who is long in put option will be Rs.2,850
Maximum profit will be Rs.180 – 9.5 * 300 = 51,150
Break-even will be when stock is trading at Rs.170.50
6. Nifty 8,500 Call Options is trading at a premium of Rs.85. What will be the payoff for a
buyer and a writer of this option, when Nifty is trading at following prices:
8,350, 8,400, 8,500, 8,585, 8,650, 8,690, 8,725, 8,885, 8,950, 9,000.
Solution:
Strike Trading For Buyer For Writer
Premium
Price Price Pay-off Profit Pay-off Profit
8,500 85 8,350 0 -85 0 85
8,500 85 8,400 0 -85 0 85
8,500 85 8,500 0 -85 0 85
8,500 85 8,585 85 0 -85 0
8,500 85 8,650 150 65 -65 -65
8,500 85 8,690 190 105 -190 -105
8,500 85 8,725 225 140 -225 -140
8,500 85 8,885 385 300 -385 -300
8,500 85 8,950 450 365 -450 -365
8,500 85 9,000 500 415 -500 -415

7. Nifty 8,600 Put Options is trading at a premium of Rs.95. What will be the payoff for
buyer and writer of this option when Nifty is trading at following prices.
8,875, 8,690 8,600, 8,550, 8,505, 8,450, 8400, 8,350
Solution:
Strike Trading For Buyer For Seller
Price Premium price Pay-off Profit Pay-off Profit
8,600 95 8,875 0 -95 0 95
8,600 95 8,690 0 -95 0 95
8,600 95 8,600 0 -95 0 95
8,600 95 8,550 50 -45 -50 45
8,600 95 8,505 95 0 -95 0
8,600 95 8,450 150 55 -150 -55
8,600 95 8,400 200 105 -200 -105
8,600 95 8,350 250 155 -250 -155
8. Write Payoff diagram for Exercise No. 6 and No. 7

Solution:
For Exercise No. 6
Pay off for a buyer of a call option
500
400
300
200
100
0
8,300 8,400 8,500 8,600 8,700 8,800 8,900 9,000 9,100
-100
-200
Pay Off for a writer of a call option

200
100
0
8,300 8,400 8,500 8,600 8,700 8,800 8,900 9,000 9,100
-100
-200
-300
-400
-500

For Exercise No. 7

Pay Off for a byer of a put option
200
150
100
50
0
8,300 8,400 8,500 8,600 8,700 8,800 8,900 9,000
-50
-100
-150
Pay off for a writer of a put option

150
100
50
0
8,300 8,400 8,500 8,600 8,700 8,800 8,900 9,000
-50
-100
-150
-200
9. An Investor bought call and put option with an exercise price of Rs. 500 at Rs. 25 and Rs.20
respectively. Show the pay offs and draw a graph indicating the results if the possible price
of stock on expiration date is: Rs.440, 460, 470, 480, 495, 505, 525, 535, 550, 580.
Solution:
Statement showing payoff profile of an investor who bought
call option
Stock Strike Premium Pay off from Net Profit /
Price price paid call option Loss
440 500 -25 0 -25
460 500 -25 0 -25
470 500 -25 0 -25
480 500 -25 0 -25
495 500 -25 0 -25
505 500 -25 5 -20
525 500 -25 25 0
535 500 -25 35 10
550 500 -25 50 25
580 500 -25 80 55

Pay off for Buyer of Call Option

60
50
40
30
20
10
0
-10 0 100 200 300 400 500 600 700
-20
-30
Statement showing payoff profile of an investor who bought put

option
Stock Strike Premium Pay off from Net Profit /
Price price paid put option Loss
440 500 -20 60 40
460 500 -20 40 20
470 500 -20 30 10
480 500 -20 20 0
495 500 -20 5 -15
505 500 -20 0 -20
525 500 -20 0 -20
535 500 -20 0 -20
550 500 -20 0 -20
580 500 -20 0 -20
Pay off for Put option buyer

50
40
30
20
10
0
0 100 200 300 400 500 600 700
-10
-20
-30

Application of Options - Option Strategies
Covered and Naked Calls

If a call writer owns the asset underlying the call, he/she is said to have written a covered call.
If a call is written where the writer does not have the asset underlying the call option, the call
is said to be a naked call.
Margin requirement
In options a buyer will have a maximum risk of the premium what he pays whereas the writer
of an option will have an unlimited loss. The cover the losses of option writer exchange will
collect the margin.
1. A Call option involving 2,000 shares, due to mature, is selling for Rs.3.25 on a share which
is selling in the market at Rs.166. The option has an exercise price equal to Rs.160. Is
there any arbitrageur opportunity available?
Solution:
Here, the call is priced lower than its intrinsic value. An arbitrageur may buy a call for
2,000 shares by paying Rs.6,500, exercise it and get the shares by paying Rs.3,20,000. The
2,000 shares may be sold immediately in the market to get Rs.3,32,000. It would yield a
net profit of Rs.3,32,000 - Rs.3,20,000 - Rs.6,500 = Rs.5,500.
Hedging: Have underlying buy puts

Owners of stocks or equity portfolios often experience discomfort about the overall stock
market movement. As an owner of stocks or an equity portfolio, sometimes one may have a
view that stock prices will fall in the near future. At other times one may witness massive
volatility. One way to protect your portfolio from potential downside due to a market drop is
to buy insurance using put options
2. You have gone a long on the stock at a price of Rs.340. A call and put options are available
in the market at a premium of Rs.30 and strike price of Rs.360 per share. If you are
planning in hedging strategy would it be better if you go short on call option or long on a
put option. Compute gain or loss if stock price on the maturity is Rs.270, 360, 500.
Solution:
Since we are long on stock the hedging can be done by buying a put option at Rs.30 with
an exercise price of Rs.360.
We can also hedge by going short on call option, but when market goes down by more
than Rs.30 then the loss increase.
The gain or loss if stock price on the maturity is:

Statement showing pay off profile for Long Put
Stock Strike Premium P/L from P/L from Spot Net Profit /
Price price paid Put option long position Loss
270 360 -30 60 -70 -10
360 360 -30 -30 20 -10
500 360 -30 -30 160 130

Statement showing pay off profile for Short Call

Stock Strike Premium P/L from P/L from Spot Net Profit
Price price received call option long position / Loss
270 360 30 30 -70 -40
360 360 30 30 20 50
500 360 30 -110 160 50
3. An investor holds a long position in 1000 shares of a stock. He bought these shares at
Rs.210 each. Fearing a fall in the market, he bought a put option contract involving 1000
shares with the exercise price of Rs.212 at a premium of Rs.7.8 per share. Explain how
this position will perform in the different price scenarios on expiration at Rs.190, 195, 200,
205, 210, 215, 220 and 225.
Solution:
Cost of buying a put options is Rs.7.8 * 1000 = Rs.7,800
If shares are traded lesser than the exercise price (S0 < K) the investor will exercise his put
options and book profit that will be equal to exercise price minus current share price.
If shares are traded higher than the exercise price the investor will not exercise his put
options and he will lose the premium whatever he paid
Statement showing payoff profile of an investor who went long in spot

market 1000 shares at Rs.210 and bought put option
Stock Strike Premium Pay off from P/L from Spot Net Profit /
Price price paid put option long position Loss
190 212 -7,800 22,000 -20,000 -5,800
195 212 -7,800 17,000 -15,000 -5,800
200 212 -7,800 12,000 -10,000 -5,800
205 212 -7,800 7,000 -5,000 -5,800
210 212 -7,800 2,000 0 -5,800
215 212 -7,800 0 5,000 -2,800
220 212 -7,800 0 10,000 2,200
225 212 -7,800 0 15,000 7,200
4. An investor has purchased shares of ABC Ltd., at Rs.440 per share. Anticipating decline
in the share price, he bought a put option on ABC stock at Rs.45 per share with a strike
price of Rs.425. Show the pay offs and draw a graph indicating the results if the possible
price range of stock on expiration date is: Rs. Zero, 150, 210, 350, 440, 500 and 560.
Solution:
Cost of buying a put options is Rs.45 per share
If shares are traded lesser than the exercise price (S0 < K) the investor will exercise his put
options and book profit that will be equal to exercise price minus current share price.
If shares are traded higher than the exercise price the investor will not exercise his put
options and he will lose the premium whatever he paid

Statement showing payoff profile of an investor who went long in spot

market Rs.440 and bought put option
Stock Strike Premium Pay off from P/L from Spot Net Profit /
Price price paid put option long position Loss
0 425 -45 425 -440 -60
150 425 -45 275 -290 -60
210 425 -45 215 -230 -60
350 425 -45 75 -90 -60
425 425 -45 0 -15 -60
500 425 -45 0 60 15
560 425 -45 0 120 75
100
80
60
40
20
0
0 100 200 300 400 500 600
-20
-40
-60
-80
Speculation: Bullish security, buy calls or sell puts

There are times when investors believe that security prices are going to rise. How does one
implement a trading strategy to benefit from an upward movement in the underlying security?
Using options there are two ways one can do this:

1. Buy call options; or
2. Sell put options
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 price of a particular security is going
to rise in a months’ time. Your hunch proves correct and the price does indeed rise, it is this
upside that you cash in on. However, if your hunch proves to be wrong and the security price
plunges down, what you lose is only the option premium
Long option strategy

A long option strategy is a strategy of buying an option according to the view on future price
movement of the underlying. A person with a bullish opinion on the underlying will buy a call
option on that asset/security, while a person with a bearish opinion on the underlying will buy
a put option on that asset/security. An important characteristic of long option strategies is
limited risk and unlimited profit potential. An option buyer can only lose the amount paid for
the option premium. At the same time, theoretically, the profit potential is unlimited.

Speculation: Bearish security, buy puts or sell calls
Short options strategy

A short options strategy is a strategy where options are sold to make money upfront with a
view that the options will expire out of money at the expiry date (i.e., the buyer of the option
will not exercise the same and the seller can keep the premium). As opposed to a long options
strategy, here a person with a bullish opinion on the underlying will sell a put option in the
hope that prices will rise and the buyer will not exercise the option leading to profit for the
seller. On the other hand, a person with a bearish view on the underlying will sell a call option
in the hope that prices will fall and the buyer will not exercise the option leading to profit for
the seller. As opposed to a long options strategy where the downside was limited to the price
paid for the option, here the downside is unlimited and the profit is limited to the price of selling
the option (the premium).
5. An investor is bullish on a stock, so he bought a call option with a strike price of Rs.520
at Rs. 10, and sold a put option with a strike price of Rs.510 at Rs.15. Compute gain or
loss if stock price on the maturity is Rs.525, 540, 550 and 600.
6. An investor is expecting a stock to go down in the near future, to take advantage he bought
a put option with a strike price of Rs.450 at Rs. 15 and sold a call option with a strike price
of Rs.440 at Rs. 20. Compute gain or loss if stock price on the maturity is Rs.460, 440,
420, 400 and 350.
Long Call
Buying a call is the most basic of all options strategies. It constitutes the first options trade for
someone already familiar with buying / selling stocks and would now want to trade options.
Buying a call is an easy strategy to understand. When you buy it means you are bullish. Buying
a Call means you are very bullish and expect the underlying stock / index to rise in future.
When to Use: Investor is very bullish on the stock / index.

Risk: Limited to the Premium. (Maximum loss if market expires at or below the option Strike
price).
Reward: Unlimited
Breakeven: Strike Price + Premium
Short Call
A Call option means an Option to buy. Buying a Call option means an investor expects the
underlying price of a stock / index to rise in future. Selling a Call option is just the opposite of
buying a Call option. Here the seller of the option feels the underlying price of a stock / index
is set to fall in the future.
When to use: Investor is very aggressive and he is very bearish about the stock / index.
Risk: Unlimited
Reward: Limited to the amount of premium
Break-even Point: Strike Price + Premium
Synthetic Long Call: Buy Stock, Buy Put

In this strategy, we purchase a stock since we feel bullish about it. But what if the price of the
stock went down. You wish you had some insurance against the price fall. So buy a Put on the
stock. This gives you the right to sell the stock at a certain price which is the strike price. The
strike price can be the price at which you bought the stock (ATM strike price) or slightly below
(OTM strike price).
When to use: When ownership is desired of stock yet investor is concerned about near-term
downside risk. The outlook is conservatively bullish.
Risk: Losses limited to Stock price + Put Premium – Put Strike price
Reward: Profit potential is unlimited.
Break-even Point: Put Strike Price + Put Premium + Stock Price – Put Strike Price
7. An investor bought a share for Rs.100. To guard against the risk of loss from a fall in its
price, he buys a put for Rs.16 for an exercise price of Rs.110. Construct a table to show
how profit would vary with stock price for the position and determine the profit or loss
when price is 70, 80, 90, 100, 110, 120, 130 and 140.
Solution:
Profit/Loss for selected share values: Long Stock and Long Put
Stock Strike Profit on P/L from Spot Net Profit /
Price price Exercise long position Loss
70 110 24 -30 -6
80 110 14 -20 -6
90 110 4 -10 -6
100 110 -6 0 -6
110 110 -16 10 -6
120 110 -16 20 4
130 110 -16 30 14
140 110 -16 40 24
30
25
20
15
10
0
0 20 40 60 80 100 120 140 160
-5
-10
Net Profit / Loss
Long Put
A long Put is a Bearish strategy. To take advantage of a falling market an investor can buy Put
options.
When to use: Investor is bearish about the stock / index.

Risk: Limited to the amount of Premium paid. (Maximum loss if stock / index expires at or
above the option strike price).
Reward: Unlimited
Break-even Point: Stock Price – Premium

Short Put
Selling a Put is opposite of buying a Put. An investor buys Put when he is bearish on a stock.
An investor Sells Put when he is Bullish about the stock – expects the stock price to rise or
stay sideways at the minimum. When you sell a Put, you earn a Premium (from the buyer of
the Put). You have sold someone the right to sell you the stock at the strike price.
When to Use: Investor is very Bullish on the stock / index. The main idea is to make a short
term income.
Risk: Put Strike Price – Put Premium.
Reward: Limited to the amount of Premium received.
Breakeven: Put Strike Price – Premium
Covered Call
The covered call is a strategy in which an investor Sells a Call option on a stock he owns
(netting him a premium). The Call Option which is sold in usually an OTM Call. The Call
would not get exercised unless the stock price increases above the strike price. Till then the
investor in the stock (Call seller) can retain the Premium with him.
When to Use: This is often employed when an investor has a short-term neutral to
moderately bullish view on the stock he holds. He takes a short position on the Call option to
generate income from the option premium. Since the stock is purchased simultaneously with
writing (selling) the Call, the strategy is commonly referred to as “buy-write”.
Risk: If the Stock Price falls to zero, the investor loses the entire value of the Stock but retains
the premium, since the Call will not be exercised against him. So maximum risk = Stock Price
Paid – Call Premium Upside capped at the Strike price plus the Premium received. So if the
Stock rises beyond the Strike price the investor (Call seller) gives up all the gains on the stock.
Reward: Limited to (Call Strike Price – Stock Price paid) + Premium received
Breakeven: Stock Price paid - Premium Received
8. An investor bought a share for Rs.100 and who writes a call with an exercise price of
Rs.105 and receives a premium of Rs.3. Construct a table to show how profit would vary
with stock price for the position and determine the profit or loss when price is 90, 95,100,
105,110,115 and120.
Solution:
Profit/Loss for selected share values: Long Stock and Short Call
Price price Exercise long position Loss
90 105 3 -10 -7
95 105 3 -5 -2
100 105 3 0 3
105 105 3 5 8
110 105 -2 10 8
115 105 -7 15 8
120 105 -12 20 8

Long Stock and Short Call

10
0
0 20 40 60 80 100 120 140
-5
-10
Net Profit / Loss
Long Combo: Sell a Put, Buy a Call

A Long Combo is a Bullish strategy. If an investor is expecting the price of a stock to move
up he can do a Long Combo strategy. It involves selling an OTM (lower strike) Put and buying
an OTM (higher strike) Call. This strategy simulates the action of buying a stock (or futures)
but at a fraction of the stock price. It is an inexpensive trade, similar in pay-off to Long Stock,
except there is a gap between the strikes (please see the payoff diagram). As the stock price
rises the strategy starts making profits
When to Use: Investor is Bullish on the stock.

Risk: Unlimited (Lower Strike + net debit)
Reward: Unlimited
Breakeven: Higher strike + net debit
Protective Call / Synthetic Long Put

This is a strategy wherein an investor has gone short on a stock and buys a call to hedge. An
investor shorts a stock and buys an ATM or slightly OTM Call. The net effect of this is that the
investor creates a pay-off like a Long Put, but instead of having a net debit (paying premium)
for a Long Put, he creates a net credit (receives money on shorting the stock). In case the stock
price falls the investor gains in the downward fall in the price. However, in case there is an
unexpected rise in the price of the stock the loss is limited. The pay-off from the Long Call will
increase thereby compensating for the loss in value of the short stock position. This strategy
hedges the upside in the stock position while retaining downside profit potential.
When to Use: If the investor is of the view that the markets will go down (bearish) but wants
to protect against any unexpected rise in the price of the stock.
Risk: Limited. Maximum Risk is Call Strike Price – Stock Price + Premium
Reward: Maximum is Stock Price – Call Premium
Breakeven: Stock Price – Call Premium
Covered Put
Covered Put is a neutral to Bearish strategy. Covered Put writing involves a short in a stock /
index along with a short put on the options on the stock / index.
When to Use: If the investor is of the view that the markets are moderately bearish.
Risk: Unlimited if the price of the stock rises substantially
Reward: Maximum is (Sale Price of the Stock – Strike Price) + Put Premium
Breakeven: Sale Price of Stock + Put Premium

9. An investor is short share for Rs.100 and who writes a put with an exercise price of Rs.100
and receives a premium of Rs.3. Construct a table to show how profit would vary with
stock price for the position and determine the profit or loss when price is 90, 95,100,
105,110,115 and120.
Solution:
Profit/Loss for selected share values: Short Stock and Short Put
Price price Exercise Short position Loss
90 100 -7 10 3
95 100 -2 5 3
100 100 3 0 3
105 100 3 -5 -2
110 100 3 -10 -7
115 100 3 -15 -12
120 100 3 -20 -17
Short Stock and Short Put

5
0
0 20 40 60 80 100 120 140
-5
-10
-15
-20
Net Profit / Loss
Bull Call Spread Strategy: Buy ITM Call Option, Sell OTM Call option
A bull call spread is constructed by buying an in-the-money (ITM) call option, and selling
another out-of-the-money (OTM) call option. Often the call with the lower strike price will be
in-the-money while the Call with the higher strike price is out-of-the-money. Both calls must
have the same underlying security and expiration month.
When to Use: Investor is moderately bullish.

Risk: Limited to any initial premium paid in establishing the position. Maximum loss occurs
here the underlying falls to the level of the lower strike or below.
Reward: Limited to the difference between the two strikes minus net premium cost. Maximum
profit occurs where the underlying rises to the level of the higher strike or above
Break-Even-Point (BEP): Strike Price of Purchased call + Net Debit Paid
10. You buy a call option with an exercise price of Rs.50 for Rs.8 and sell one with an exercise
price of Rs.60 for a premium of Rs.2, both on the same stock and with same expiration
date. Construct a table to show how profit would vary with stock price for the position and
determine the profit or loss when price is 50, 58, 60 and 65.

Solution:
Pay off from a Bull Call Spread
Stock Payoff from Payoff from Total
Price Long call Short call Payoff
50 -8 2 -6
58 0 2 2
60 2 2 4
65 7 -3 4
Payoff for Bull Call Spread

6
0
0 10 20 30 40 50 60 70
-2
-4
-6
-8
Total Payoff
Bull Put Spread Strategy: Sell ITM Put Option, Buy OTM Put Option
A bull put spread can be profitable when the stock / index is either range bound or rising. The
concept is to protect the downside of a Put sold by buying a lower strike Put, which acts as an
insurance for the Put sold. The lower strike Put purchased is further OTM than the higher strike
Put sold ensuring that the investor receives a net credit, because the Put purchased (further
OTM) is cheaper than the Put sold. This strategy is equivalent to the Bull Call Spread but is
done to earn a net credit (premium) and collect an income.
When to Use: When the investor is moderately bullish.

Risk: Limited. Maximum loss occurs where the underlying falls to the level of the lower strike
or below
Reward: Limited to the net premium credit. Maximum profit occurs where underlying rises to
the level of the higher strike or above.
Breakeven: Strike Price of Short Put - Net Premium Received
11. You buy put option with an exercise price of Rs.40 for Rs.6 and writes one with an
exercise price of Rs.50 for a premium of Rs.9, both on the same stock and with same
expiration date. Construct a table to show how profit would vary with stock price for the
position and determine the profit or loss when price is 35, 40, 44, 50, 55 and 60.

Solution:
Pay off from a Bull put Spread
Stock Price Payoff from Payoff from Total Payoff
Long put Short put
35 -1 -6 -7
40 -6 -1 -7
44 -6 3 -3
50 -6 9 3
55 -6 9 3
60 -6 9 3
Total Payoff
4
0
0 10 20 30 40 50 60 70
-2
-4
-6
-8
Total Payoff
12. A trader buys for Rs. 42 a call with a strike price of Rs. 610 and sells for Rs. 26 a call with
a strike price of Rs. 690. The possible price range of the underlying stock is 450, 560, 620,
680, 750 and 850.
(i) What is the cost of the strategy?
(ii) What is the network payoff for each of the possible price range?
Bear Call Spread Strategy: Sell ITM Call, Buy OTM Call
The Bear Call Spread strategy can be adopted when the investor feels that the stock / index is
either range bound or falling. The concept is to protect the downside of a Call Sold by buying
a Call of a higher strike price to insure the Call sold. In this strategy the investor receives a net
credit because the Call he buys is of a higher strike price than the Call sold. The strategy
requires the investor to buy out-of-the-money (OTM) call options while simultaneously selling
in-the-money (ITM) call options on the same underlying stock index. This strategy can also be
done with both OTM calls with the Call purchased being higher OTM strike than the Call sold.
If the stock / index falls both Calls will expire worthless and the investor can retain the net
credit. If the stock / index rises then the breakeven is the lower strike plus the net credit.
Provided the stock remains below that level, the investor makes a profit. Otherwise he could
make a loss. The maximum loss is the difference in strikes less the net credit received
When to use: When the investor is mildly bearish on market.

Risk: Limited to the difference between the two strikes minus the net premium.
Reward: Limited to the net premium received for the position i.e., premium received for the
short call minus the premium paid for the long call.
Break Even Point: Lower Strike + Net credit

13. You buy call option with an exercise price of Rs.50 for Rs.5 and writes a call option with
an exercise price of Rs.40 for a premium of Rs.12, both on the same stock and with same
Solution:
Pay off from a Bear Call Spread
Stock Payoff from Payoff from Total Payoff
Price Long call Short call
35 -5 12 7
40 -5 12 7
45 -5 7 2
50 -5 2 -3
55 0 -3 -3
60 5 -8 -3
Pay off from a Bear Call Spread

8
6
4
2
0
0 10 20 30 40 50 60 70
-2
-4
Total Payoff
14. The Call option on a stock are quoted on the stock exchange as
Option Price Strike Price
28 350
50 310
55 290
Construct a suitable spread strategy from the view point of a trader who is anticipating
decline in the stock price and work out the payoff from the strategy if the possible price
of stock on the expiration date is in the range of 170, 250, 300, 340, and 400.
Bear Put Spread Strategy: Buy ITM Put, Sell OTM Put
This strategy requires the investor to buy an in-the-money (higher) put option and sell an out-
of-the-money (lower) put option on the same stock with the same expiration date. This strategy
creates a net debit for the investor. The net effect of the strategy is to bring down the cost and
raise the breakeven on buying a Put (Long Put). The strategy needs a Bearish outlook since the
investor will make money only when the stock price / index falls. The bought Puts will have
the effect of capping the investor’s downside. While the Puts sold will reduce the investors
costs, risk and raise breakeven point (from Put exercise point of view). If the stock price closes
below the out-of-the-money (lower) put option strike price on the expiration date, then the
investor reaches maximum profits. If the stock price increases above the in-the-money (higher)
put option strike price at the expiration date, then the investor has a maximum loss potential of
the net debit.

When to use: When you are moderately bearish on market direction
Risk: Limited to the net amount paid for the spread. i.e. the premium paid for long position
less premium received for short position.
Reward: Limited to the difference between the two strike prices minus the net premium paid
for the position.
Break Even Point: Strike Price of Long Put – Net Premium Paid
15. You buy put option with an exercise price of Rs.50 for Rs.10 and writes a put option with
an exercise price of Rs.40 for a premium of Rs.5, both on the same stock and with same
Solution:
Pay off from a Bear Put Spread
Stock Payoff from Payoff from Total Payoff
Price Long put Short put
35 5 0 5
40 0 5 5
45 -5 5 0
50 -10 5 -5
55 -10 5 -5
60 -10 5 -5
Pay off from a Bear Put Spread

6
4
2
0
-2 0 10 20 30 40 50 60 70
-4
-6
Total Payoff
16. A put option on a stock are quoted on the stock exchange as

Strike Price Option Price
90 5
95 7
100 10
The investor wants to construct a bear strategy and would like to know what the payoffs
from the strategy if the stock price on the expiration date is 80, 85, 90, 95, 100, 105, and
110.

17. For each of the following cases, name the strategy adopted and calculate the profit/loss for
different price ranges of the stock taking S1> E2, E1 < S1<E2 and S1 < E1. Also, determine
the break-even stock price in each case.
Exercise Price of Option Premium on Option

Type of
Option Purchased Sold Purchased Sold
(Rs.) (Rs.) (Rs.) (Rs.)
1. Call 60 75 10 4
2. Call 80 70 5 11
3. Put 70 60 9 5
4. Put 50 65 4 11
Solution:
1. Buying a call with lower exercise price and selling a call with a greater exercise price
results in bull call spread. With price of long call, E1 = 60 and price of a short call,
E2 = 75, the profit/loss would be as follows:
Payoff from Payoff from Total Net Profit/Loss =
Stock Price
Long Call Short call Payoff Payoff – cost
S1> E2 S1 - 60 75 - S1 15 15 - 6 = 9
S1 - 60 - 6 = S1 –
E1 < S1< E2 S1 - 60 0 S1 - 60
66
S1 < E1 0 0 0 0-6=-6
The break-even price will be when S1 is at 66
2. Buying a call with higher exercise and selling a call with a lower exercise price is a
bear call spread strategy. Here E1 is the price of call sold and E2 is the price of call
purchased. Thus E1 = 70 and E2 = 80. Net premium obtained = 11-5 = 6. The
profit/loss would be as show below:
Payoff Payoff
Total Net Profit/Loss =
Stock Price from Long from Short
Payoff Payoff - cost
Call call
S 1 > E2 S1 - 80 70 - S1 -10 -10 + 6 = - 4
E1 < S1< E2 0 70 - S1 70 - S1 70 - S1 + 6 = 76 - S1
S 1 < E1 0 0 0 0+6= 6
The break-even price will be when S1 is at Rs 76.
3. The sale of lower exercise price put option and purchase of higher exercise price put
option is a bear put strategy. With E1 = 60, E2 = 70 and the net cost of Rs. 4 (Rs. 9 –
Rs.5), the profit/loss profile is as given below.
Stock Price
Long Put Short Put Payoff Payoff - cost
S1> E2 0 0 0 0-4=-4
E1 < S1< E2 70 - S1 0 70 - S1 70 - S1 - 4 = 66 - S1
S1 < E1 70 - S1 S1 - 60 10 10 - 4 = 6
The break-even price will be when S1 is at Rs.66
4. Buying a put option with lower exercise price and selling a put option with higher
exercise price is a bull Put spread. Buy E1 = 50 and selling E2 = 65. This would result
in a positive cash flow of Rs. 7 (11-4) to the investor upfront. The profit/loss position
is as given below.


Stock Price
Long Put Short Put Payoff Payoff - cost
S1> E2 0 0 0 0-7=7
E1 < S1< E2 0 S1 - 65 S1 - 65 S1 - 65 + 7 = S1 - 58
S1 < E1 50 - S1 S1 – 65 -15 -15 + 7 = - 8
The break-even price will be when S1 is at Rs.58
Long Straddle Strategy (bottom Straddle): Buy a call and put of same strike price
A Straddle is a volatility strategy and is used when the stock price / index is expected to show
large movements. This strategy involves buying a call as well as put on the same stock / index
for the same maturity and strike price, to take advantage of a movement in either direction, a
soaring or plummeting value of the stock / index. If the price of the stock / index increases, the
call is exercised while the put expires worthless and if the price of the stock / index decreases,
the put is exercised, the call expires worthless. Either way if the stock / index shows volatility
to cover the cost of the trade, profits are to be made. With Straddles, the investor is direction
neutral. All that he is looking out for is the stock / index to break out exponentially in either
direction.
When to Use: The investor thinks that the underlying stock / index will experience significant
volatility in the near term.
Risk: Limited to the initial premium paid.
Reward: Unlimited
Breakeven:
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
18. An investor feels that the price of a certain stock currently valued at Rs.85 in the market
is likely to move significantly upward or downward in next 2 months. Create a long
straddle strategy by using following information and write a payoffs in respect of straddle
with stock prices on expiration is: 50, 60, 70, 80, 90, 100, 110, 120, 130.
For an exercise price of Rs.85 on this stock a call option is quoting Rs.4 and a put option
is quoting Rs.2.
Solution:
Payoffs for long straddle
Long 85 Call Long 85
Spot Price at Rs.4 Put at Rs.2 Total Payoff
50 -4 33 29
60 -4 23 19
70 -4 13 9
80 -4 3 -1
90 1 -2 -1
100 11 -2 9
110 21 -2 19
120 31 -2 29
130 41 -2 39

Payoffs for long straddle

45
40
35
30
25
20
15
10
5
0
-5 0 20 40 60 80 100 120 140
Total Payoff
Short Straddle Strategy (top straddle): Sell a Call and Put of same strike price
A Short Straddle is the opposite of Long Straddle. It is a strategy to be adopted when the
investor feels the market will not show much movement. He sells a Call and a Put on the same
stock / index for the same maturity and strike price. It creates a net income for the investor. If
the stock / index does not move much in either direction, the investor retains the Premium as
neither the Call nor the Put will be exercised. However, in case the stock / index moves in
either direction, up or down significantly, the investor’s losses can be significant. So this is a
risky strategy and should be carefully adopted and only when the expected volatility in the
market is limited. If the stock / index value stays close to the strike price on expiry of the
contracts, maximum gain, which is the Premium received is made.
When to Use: The investor thinks that the underlying stock / index will experience very little
volatility in the near term.
Risk: Unlimited
Reward: Limited to the premium received
Breakeven:
· Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
· Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
17. From the following details construct a short straddle strategy and write a payoff when stock
is at 70, 80, 90, 100, 110, 120, 130 and 140.
Strike Expiration Option
Option Price Date Price
Call 110 24-06-2014 10
Put 110 24-06-2014 12
Call 110 29-07-2014 15
Put 100 29-07-2014 12
18. Create a straddle top and bottom with the payoff with price and as follows:
Price: 250, 260, 270, 280, 290, 300, 310, 320, 330, 340, 350. Exercise Price 300, Call
Premium 15 and Put premium 18.

Long Strangle Strategy: Buy OTM Call and Buy OTM Put
This strategy involves the simultaneous buying of a slightly out-of-the-money (OTM) put and
a slightly out-of-the-money (OTM) call of the same underlying stock / index and expiration
date. Here again the investor is directional neutral but is looking for an increased volatility in
the stock / index and the prices moving significantly in either direction. Since OTM options
are purchased for both Calls and Puts it makes the cost of executing a Strangle cheaper as
compared to a Straddle, where generally ATM strikes are purchased. Since the initial cost of a
Strangle is cheaper than a Straddle, the returns could potentially be higher. However, for a
Strangle to make money, it would require greater movement on the upside or downside for the
stock / index than it would for a Straddle. As with a Straddle, the strategy has a limited
downside (i.e. the Call and the Put premium) and unlimited upside potential.
When to Use: The investor thinks that the underlying stock / index will experience very high
levels of volatility in the near term.
Risk: Limited to the initial premium paid
Reward: Unlimited
Breakeven:
· Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
· Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
19. Using the following data, help an investor to create a bottom strangle. Compute payoff
assuming various ranges of spot prices of Rs.1, 110, 1,130 and 1,150 on maturity and
obtain break-even price also.
Option Expires Strike Premium
Nifty Call 29/07/2002 16,000 85
Nifty Put 29/07/2002 15,600 78
Solution:
A Bottom strangle can be created by buying a higher strike call option and lower level put
option. Accordingly the payoff will be:
Payoff for bottom strangle strategy
Payoff from Payoff from Total
Spot Price Long 1140 Call Long 1120 put Payoff
1110 -10 6 -4
1130 -10 -4 -14
1150 0 -4 -4
Breakeven price will be Rs.1106 on the down side and 1154 on the upper side.
18. From the following details construct a long strangle strategy and write a payoff for the
strategy on expiration if it is trading at: 150, 200, 240, 280, 320, 360, 450, and 500.
Option Option Exercise

Type Expiration Price Price
Call April 22 250
Call April 6 270
Put April 18 250
Put April 9 240
19. A call option with an exercise price of Rs. 50 costs Rs. 2. A put option with an exercise
price of Rs. 45 costs Rs. 3. Discuss how strangle can be created from these two options
and show profit profile of strangle suppose that stock price on expiration date is Rs. 60.

Short Strangle Strategy: Sell OTM Call and Sell OTM Put
A Short Strangle is a slight modification to the Short Straddle. It tries to improve the
profitability of the trade for the Seller of the options by widening the breakeven points so that
there is a much greater movement required in the underlying stock / index, for the Call and Put
option to be worth exercising. This strategy involves the simultaneous selling of a slightly out-
of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying
stock and expiration date. This typically means that since OTM call and put are sold, the net
credit received by the seller is less as compared to a Short Straddle, but the break even points
are also widened. The underlying stock has to move significantly for the Call and the Put to be
worth exercising. If the underlying stock does not show much of a movement, the seller of the
Strangle gets to keep the Premium.
When to Use: This options trading strategy is taken when the options investor thinks that the
underlying stock will experience little volatility in the near term.
Risk: Unlimited
Reward: Limited to the premium received
Breakeven: Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Long Call Butterfly: Sell 2 ATM Call Options, Buy 1 ITM Call Option and Buy 1 OTM Call
Option.
A Long Call Butterfly is to be adopted when the investor is expecting very little movement in
the stock price / index. The investor is looking to gain from low volatility at a low cost. The
strategy offers a good risk / reward ratio, together with low cost. A long butterfly is similar to
a Short Straddle except your losses are limited. The strategy can be done by selling 2 ATM
Calls, buying 1 ITM Call, and buying 1 OTM Call options (there should be equidistance
between the strike prices). The result is positive incase the stock / index remains range bound.
The maximum reward in this strategy is however restricted and takes place when the stock /
index is at the middle strike at expiration. The maximum losses are also limited.
When to use: When the investor is neutral on market direction and bearish on volatility.
Risk Net debit paid.
Reward Difference between adjacent strikes minus net debit
Break Even Point:
Upper Breakeven Point = Strike Price of Higher Strike Long Call – Net Premium Paid
Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid
20. Determine the profit from the butterfly spread based on the following data and interpret
the result:
a) First purchase a call option at Rs. 320 at a premium of Rs. 40.
b) Second purchase a call option of Rs. 400 at a premium of Rs. 20.
c) Sell 2 lots of call option of Rs. 360 at a premium of Rs. 30.
d) The price on the due date is 270, 300, 360, 400, 450, and 500.
21. What is butterfly spread? When do the investors use this strategy? The following data is
given to above the call options on a share which is currently traded at Rs. 54 with the
multiples of 800.
Exercise price 50 55 60
Call price 8 4.5 2
Determine profit or loss from these strategy when the share price is 42, 55, 58 and 59.

22. A certain stock is selling currently at Rs. 72. An investor who feels that a significant change
in this price is unlikely in next 3 months and he has collected market prices of 3 months
call option as given below.
Exercise price 65 70 75
Call price 11 8 6
The investor decides to go ling in 2 calls, one with exercise price of Rs. 65 and Rs. 75 and
writes 2 calls with an exercise price of Rs. 70. Determine his payoff function for different
level of stock price and also find his profit and loss at maturity when stock is (i) Rs. 63 (ii)
68 (iii) 73 (iv) 80. Construct a short butterfly strategy by using the above information.
Short Call Butterfly: Buy 2 ATM Call Options, Sell 1 ITM Call Option and Sell 1 OTM Call
Option.
A Short Call Butterfly is a strategy for volatile markets. It is the opposite of Long Call Butterfly,
which is a range bound strategy. The Short Call Butterfly can be constructed by Selling one
lower striking in-the-money Call, buying two at-the-money Calls and selling another higher
strike out-of-the-money Call, giving the investor a net credit (therefore it is an income strategy).
There should be equal distance between each strike. The resulting position will be profitable in
case there is a big move in the stock / index. The maximum risk occurs if the stock / index is
at the middle strike at expiration. The maximum profit occurs if the stock finishes on either
side of the upper and lower strike prices at expiration. However, this strategy offers very small
returns when compared to straddles, strangles with only slightly less risk
When to use: You are neutral on market direction and bullish on volatility. Neutral means
that you expect the market to move in either direction - i.e. bullish and bearish.
Risk Limited to the net difference between the adjacent strikes (Rs. 100 in this example) less
the premium received for the position.
Reward Limited to the net premium received for the option spread.
Break Even Point:
Upper Breakeven Point = Strike Price of Highest Strike Short Call - Net Premium Received
Lower Breakeven Point = Strike Price of Lowest Strike Short Call + Net Premium Received
Strips: Buy 1 Call Options and Buy 2 Put option.

A Strip results when a long position in one call is coupled with a long position in two puts, all
with the same exercise price and same date of expiration. Here the investor is expecting that a
big price movement in the stock price will take place but a decrease in the stock price more
likely than an increase. Since a put option is profitable when a price decrease occurs, two puts
are bought in this strategy.
The maximum risk occurs if the stock / index is at the middle strike at expiration. The maximum
profit occurs if the stock finishes on down side of the strike price at expiration
When to use: When a big price movement in the stock price will take place but a decrease in
the stock price more likely than an increase.
Risk Limited to the total premium paid for the position.
Straps: Buy 2 Call Options and Buy 1 Put option.

A Strap results when a long position in two calls is coupled with a long position in one put,
all with the same exercise price and same date of expiration. Here the investor is expecting
that a big price movement in the stock price will take place but a increase in the stock price
more likely than an decreases. Since a call option is profitable when a price increases, two
calls are bought in this strategy.
When to use: When a big price movement in the stock price will take place but an Increase in
the stock price more likely than a decrease.
Risk Limited to the total premium paid for the position.
Long Call Condor: Buy 1 ITM Call Option (Lower Strike), Sell 1 ITM Call Option (Lower
Middle), Sell 1 OTM Call Option (Higher Middle), Buy 1 OTM Call Option (Higher Strike).
(Long Condors: Buy S1, S4 and Sell S2, S3)
A Long Call Condor is very similar to a long butterfly strategy. The difference is that the two
middle sold options have different strikes. The profitable area of the payoff profile is wider
than that of the Long Butterfly (see pay-off diagram). The strategy is suitable in a range bound
market. The Long Call Condor involves buying 1 ITM Call (lower strike), selling 1 ITM Call
(lower middle), selling 1 OTM call (higher middle) and buying 1 OTM Call (higher strike).
The long options at the outside strikes ensure that the risk is capped on both the sides. The
resulting position is profitable if the stock / index remains range bound and shows very little
volatility. The maximum profits occur if the stock finishes between the middle strike prices at
expiration.
When to Use: When an investor believes that the underlying market will trade in a range with
low volatility until the options expire. Risk Limited to the minimum of the difference between
the lower strike call spread less the higher call spread less the total premium paid for the condor.
Reward Limited. The maximum profit of a long condor will be realized when the stock is
trading between the two middle strike prices.
Break Even Point: Upper Breakeven Point = Highest Strike – Net Debit Lower Breakeven
Point = Lowest Strike + Net Debit
24. Considering the given information construct a long Condor. Call with exercise price of
550 is trading at Rs.40, Call with exercise price of 600 is trading at Rs.25, Call with
exercise price of 650 is trading at Rs.20, call with exercise price of 700 is trading at Rs.10.
Short Call Condor: Short 1 ITM Call Option (Lower Strike), Long 1 ITM Call Option
(Lower Middle), Long 1 OTM Call Option (Higher Middle), Short 1 OTM Call Option
(Higher Strike). (Short Condors: Buy S2, S3 and Sell S1, S4)
A Short Call Condor is very similar to a short butterfly strategy. The difference is that the two
middle bought options have different strikes. The strategy is suitable in a volatile market. The
Short Call Condor involves selling 1 ITM Call (lower strike), buying 1 ITM Call (lower
middle), buying 1 OTM call (higher middle) and selling 1 OTM Call (higher strike). The
resulting position is profitable if the stock / index shows very high volatility and there is a big
move in the stock / index. The maximum profits occur if the stock / index finishes on either
side of the upper or lower strike prices at expiration
When to Use: When an investor believes that the underlying market will break out of a trading
range but is not sure in which direction. Risk Limited. The maximum loss of a short condor
occurs at the centre of the option spread. Reward Limited. The maximum profit of a short
condor occurs when the underlying stock / index is trading past the upper or lower strike prices.

Valuation of Options
Factors affecting options pricing
 Stock price
 Exercise price
 Time to expiration
 Expected dividend
 Interest rate
 Standard deviation of the stock
Valuation of Call and Put options on dividend and non-dividend paying stock
Put-Call Parity
Put call parity is the relationship between the price of a European call option and the price of a
European put option, when they have the same stock price and expiration date. Under the put
call parity relationship the price of a European put option on non-dividend paying stock should
be equal to the combined value of a call option on the same stock with the same exercise price
and time to expiration.
The put call parity is given as C+Ke-rt = P + S0
1. In June 2014 a 6 month call on a stock with an exercise of Rs.25 sold at Rs.2. The stock
price was Rs.20. The continuously compounded risk free rate of interest was 5%p.a
i. How much would you be willing to pay for a put on this stock with same maturity and
exercise price?
ii. What happens if the actual price is different from what you are willing to pay?
Solution:
i. The put call parity relationship is given as C+ Ke-rt = P + S0
2 + 25 e-0.05 (0.5) = 20 + P
26 .3825 = 20 + P
P = 26.3825 – 20
P = 6.3825.
ii. If the actual price of put option is lesser than theoretical price it implies that the put is
undervalued, it is advisable to buy a put option.
If the actual price of put option is higher than theoretical price it implies that the put is
overvalued it is advisable to sell put option.
2. Following information are available with respect to call and put options on four company
shares. Assuming time to expiration 40 days and continuously compounded interest rate
of 8%p.a. Compute the value of call and put options. Find out is there any arbitrage
opportunity available in any of the stocks.
Exercise Spot Call Put Lot
Company
Price Price Option Option size
RIL 920 921.90 24.60 3.60 250
DLF 250 251.60 5.80 4.60 1,000
ICICI 1,150 1,168.40 30.00 14.60 250
Ranbaxy 460 469.15 13.45 3.60 250

Solution:
Let us find out the values of RIL
C = 24.6 K = 920 r = 0.08 t = 40 days P = 3.6 S0 = 921.9
C+Ke-rt = P + S0
24.6 + 920 e-0.08 (40/365) = 3.6 + 921.9
24.6 + 911.96 = 925.50
936.57 = 925.50
The Value of call option is higher than put option value. The investor can make arbitrage
profit by borrowing the money and buy the stock, buy a put and sell a call option.
The arbitrage process:

1. Buy the put option and pay Rs.3.60
2. Sell the call option and receive 24.60
3. Buy stock on spot market for Rs.921.90
4. The above strategy will give Rs.21 (24.60 - 3.60)
5. Borrow Rs.900.9 (921.9 - 21) for 40 days at 8% p.a
The total amount to be repaid with interest after 40 days will be:
= 900.9 e0.08 (40/365)
= 908.83
If stock price is higher on expiry call will be exercised by counter party. The profit for
the investor will be exercise price minus loan to be repaid.
Rs.11.17 (920 – 908.83). Total profit will be Rs. 11.17 * 250 = 2792.5
Let us find out the values of DLF
C = 5.8 K = 250 r = 0.08 t = 40 days P = 4.6 S0 = 251.6
C+ Ke-rt = P + S0
5.8 + 250 e-0.08 (40/365) = 4.6 + 251.6
5.8 + 247.82 = 256.20
253.62 = 256.20
The value of call option is lesser than put option value. The investor can make arbitrage
profit by buying a call, selling a put option and selling in spot market.

1. Buy the call option and pay Rs.5.8
2. Sell the put option and receive Rs. 4.6
3. Sell stock on spot market for Rs.251.6
4. The above strategy will give Rs.250.4 (251.6-58+4.6)
5. Invest Rs.250.4 for 40 days at 8% p.a
The total amount to be received with interest after 40 days will be:
= 250.4 e0.08 (40/365)
= 252.60
On expiration If stock price is higher than the exercise price then the put option will not
be exercised by the counter party, then profit will be amount available with investor less
exercise price of put option.

252.60 – 250 = 2.6

Total gain will be 2.6 * 1000 = Rs. 2,600
Let us find out the values of ICICI
C = 30 K = 1150 r = 0.08 t = 40 days P = 14.6 S0 =

1168.4
C + Ke-rt = P + S0
30 + 1150 e-0.08 (40/365) = 14.6 + 1168.4
30 + 1139.96 = 1183
1169.96 = 1183
The value of call option is lesser than put option value. The investor can make arbitrage
profit by buying a call, selling a put option and selling in spot market.

1. Buy the call option and pay Rs.14.6
2. Sell the put option and receive Rs. 30
3. Sell stock on spot market for Rs.1168.4
4. The above strategy will give Rs.-15.40 (14.60 - 30)
5. Invest Rs.1153 (1168.4 - 15.40) for 40 days at 8% p.a
The total amount to be received with interest after 40 days will be:
= 1153 e0.08 (40/365)
= 1163.15
On expiration If stock price is higher than the exercise price then the put option will
not be exercised by the counter party, then profit will be amount available with investor
less exercise price of put option.
1163.15 – 1150 = 13.15
Total gain will be 13.15 * 250 = Rs.3287.5
Find out the values of Ranbaxy

Binomial Model
3. A Share is traded at Rs.320. Assuming that the end of 6 months, the price will be either
be Rs.350 or Rs.310. Compute the premium on a European call option with an exercise
price of Rs.300. The risk free rate of interest with continuous compounding is 12% per
annum. Also compute the hedge ratio.
Solution
C = Value of Call option

Cu = Value of call option when (S1 > S0) i.e S1- K = 350 – 300 = 50
Cd = Value of call option when (S2 < S0) i.e Max(0, S1-E) = Max (0,310-300) = 10
(1.06 – 0.9687) (1.0937 – 1.06)

50 + 10
(1.0937 – 0.9687) (1.0937 – 0.9687)
C=
1.06
(50*0.7304) + (10*0.2696)
C=
1.06
C = 36.9962
Hedge Ratio

4. The current stock price of a stock is Rs,340. A call option is available with a strike price
of Rs.370. The continuously compounded interest rate is 12% p.a and the time to
expiration is 3 months. There is a chance of the stock price moving up by 15% or going
down by 10%. Using the single period Binomial model you are required to:
i. Determine the value of call option
ii. Determine the hedge ratio and how to interpret the ratio for arbitrage operations.
iii. If the call option is now available for Rs.9 how would you make an arbitrage profit?
Solution:
C = Value of Call option

S1 If price goes up (340 +15% of 340) = Rs.391
S1 If price goes down (340 – 15% of 340) = Rs.306
Cu = Value of call option when (S1 > S0) i.e S1- K = 391 – 370 = 21
Cd = Value of call option when (S2 < S0) i.e Max(0, S1-K) = Max (0,306-370) = 0
Hedge Ratio

Interpretation of hedge ratio:
The hedge ratio gives the ratio of options to spot positions that achieves an objective of
minimizing or eliminating risk. The hedge ratio of 0.2470 implies that for every one call
option 0.2470 of the stock risk can be eliminated. Hence to avoid entire risk 4 (1/0/2470)
call options can be used.
If the call option is available for Rs.9 then the arbitrage process of profit will be
Since the actual call option price less than theoretical price an investor has to buy call and
sell the stock.
Buy 4 call options and pay Rs. 9 X 4 = 36.

Short the stock at spot price and receive Rs.340.
The cash available with the investor will be Rs. 304 (340 - 36). Deposit Rs.304 for 3
months at 12% p.a the amount at the end of 3 months with continuous compounding will
be Rs.313.25.
After 3 months if the stock price is Rs.391 then exercise call option and purchase for
exercise price of Rs.370 that will result into a profit of Rs.21 (391-370) per call. For four
call Rs.84. Total amount available will be Rs.397.25 (313.25 + 84) buy stock at Rs.391.
Balance available of Rs. 6.25 per share will be the arbitrage profit.
After 3 months if the stock price is Rs.306 then purchase from the spot market and forgo
call option that will result into a profit of Rs.7.25 per share.
5. Using the binomial pricing model, obtain the hedge ratio, α, and the call price from the
following data:
Share price - Rs.70, Exercise price = Rs.75, u = 1.2, d = 0.9, i = 1.2 and N = 3.
Solution:

6. An Investor has purchased a four month call option the equity share of a stock for Rs.224,
exercise price of Rs.240, option premium Rs.10. At the end of four months, the investor
expects the price of shares to be in the following range of Rs.180 to 340 with varying
probabilities.
Expected price 200 220 250 300 340
Probability 0.1 0.25 0.3 0.25 0.1
From the above, you are required to answer the following:
i. What is the expected value of share price four months hence? What is the value of
call option at its expiration, if the expected value of share price prevails at the end of
four months?
ii. Determine the expected value of option price at maturity, assuming that the call option
is held to this time. Why does it differ from the option value determined in part (i)
above?
iii. What is the theoretical value of the option, at the beginning of four month period?
Give comments on the market value of the call option in relation to its theoretical
value.
iv. What is the maximum gain to the call writer and when will it be possible?
Solution:
(i) Expected value of share at the end of 4 months
Expected Probable
Probability
price share price
200 0.10 20.00
220 0.25 55.00
250 0.30 75.00
300 0.25 75.00
340 0.10 34.00
Expected price 259.00
Gain = 259 – 240 = 19.
(ii) Expected value of call option

Expected Exercise Gain Probability Probable
price price from call Value
200 240 0 0.10 -
220 240 0 0.25 -
250 240 10 0.30 3.00
300 240 60 0.25 15.00
340 240 100 0.10 10.00
Expected call option value 28.00
The reason for differences prices in the above two situation is that in part –I the price is
calculated based on probable prices which include call options with out of the money
position, lso where in part II the probable price with in the money position are only
considered.
(iii) Theoretical value of call = Max (S0 - K, 0) = Max (224-240, 0) = 0
The market value of call option is out of the money in the beginning but with the increase
in stock price the present position will get converted into in the money when stock price
exceeds exercise price.

(iv) The maximum gain to call writer is the amount of premium received i.e Rs.10. It is
possible when the call option is not exercised by option holder, i.e if the stock price is
Rs.240 or less.

Black and Scholes Model

Black and Scholes Model is used to calculate the theoretical price of European put and call
option, ignoring any dividends paid during the option’s lifetime. While the original Black-
Scholes model did not take into consideration the effect of dividends paid during the life of the
option, the model can be adapted to account for dividends by determining the ex-dividend date
value of the underlying stock.
The B-S model is based on following assumptions.
1. The options are European and can only be exercised at expiration: This model assumes
that the options can be exercised on maturity; hence it is applicable to European options as
there is no possibility of early exercise. The model cannot be used to value American
options as they have flexibility of exercise. However the valuation will be same for
American style options if they are exercised on expiration of near expiration.
2. No dividends are paid out during the life of the option: It is assumed that the underlying
asset is not expected to pay dividend during the life of the option. Hence the model is
applicable to valuation of options on non-dividend paying stocks, however the model can
be modified to incorporate dividend in o it. The incorporation of dividend in the model
involves deducting present value of dividend from the stock price.
3. Efficient market (Market movements cannot be predicted): Efficient market is

characterized by the following.
a. There are no transaction cost
b. All securities are infinitely divisible
c. An investor can purchase or sell any fraction of the underlying security or options.
d. There are no taxes on gains.
4. The risk-free rate and volatility of the underlying are known and remains constant
over the life of the option.
5. Follows a lognormal distribution: That is, returns on the underlying are normally
distributed. Normal distribution of stock prices is not reasonable. A normal distribution
assumes both positive and negative values but stock prices cannot be negative. That is why
a lognormal distribution is chosen. If stock prices are log normally distributed, then the
natural logarithm of stock prices will follow a normal distribution.
6. There are no risk less arbitrage opportunities.
Option Greeks
Option greens are the tools to measure the sensitivity of option prices to the changes in the
underlying parameters on which the value of option or an instrument or portfolio of financial
instruments is dependent. The name is used because the most common of these sensitivities
are often denoted by Greek letters collectively these have also been called the risk sensitivities,
risk measures or hedge parameters.
Delta: Delta refers to the amount by which the price of an option changes for a unit change in
the price of the underlying security or index. The call delta value would always be greater than
zero and lesser than one. The delta for a put will be near to -1.

Delta of the call option is given by δ = N(d1)

Delta of a put option is given by δ = N(d1) – 1
Gamma: Gamma shows the relationship between option delta and stock price. An amount by
which an option delta will change in response to a unit change in the underlying stock price or
a index. The gamma of a call option and a put option are identical or same. The Gamma may
be Positive or Negative.
The Gamma of a call option is given by
𝑍(𝑑1 )
𝛾=
𝑆0 𝜎√𝑡
2
𝑒 −𝑑1
𝑍(𝑑1 ) = 2
√2𝜋
Π = 3.142
The Gamma of a put option is given by
= Put delta +1 (Gamma of a call)
Theta: Theta shows the relationship between option price and time to expiration. Theta
measures the sensitivity of option price to the changes in the passage of time. The value of a
Theta is always negative.
Theta of call option is given by
𝑆0 𝑍(𝑑1 )𝜎
𝜃𝑐𝑎𝑙𝑙 = − − 𝑟 𝐾𝑒 −𝑟𝑡 𝑁(𝑑2 )
2√ 𝑡
Theta of a put option is given by
𝑆0 𝑍(𝑑1 )𝜎
𝜃𝑝𝑢𝑡 = − + 𝑟 𝐾𝑒 −𝑟𝑡 𝑁(−𝑑2 )
2√ 𝑡
N(-d ) = 1 – N(d )
2 2
Vega: Vega is also known as Kappa (κ) or Lambda (λ). Vega indicates the relationship
between the standard deviation underlying stock prices and option premium. Vega measures
the rate of change of the value of an option with respect to the volatility of underlying asset.
Vega is always positive and identical for both call and put options. High Vega indicates that
option prices are very sensitive to small change in sigma and low Vega suggests that option
prices are less vulnerable to the changes in standard deviation.
Vega of a call and put option`

ν = S0 √t Z(d1)

Rho: Rho indicates the relationship between the interest rate and option price. This refers to
the rate of change of the value of the option with respect to a percentage change in (1%) interest
rate. Always call option will have positive Rho and put option will have negative Rho.
Rho of a call option is given by

ρ = Kte–rt N(d2)
Rho of a put option is given by

ρ = Kte–rt N(-d2)
N(-d ) = 1 – N(d )
2 2
1. Calculate the delta of an at-the-money six-month European call option on a non-dividend-

paying stock when the risk-free interest rate is 10% per annum and the stock price volatility
is 25% per annum.
Solution:
In this case, S0  K , r  01 ,   025 , and T  05 . Also,
ln( S0  K )  (01  0252  2)05

d1   03712
025 05
The delta of the option is N (d1 ) or 0.64.
2. Calculate the value of call and put option using B/S model given the following information.
Current market price of the share Rs. 75,
Volatility (standard deviation) 0.45,
Exercise price Rs. 80,
Risk free interest rate 12%,
Time to expiry 6 months.
Solution:
C = S0 N(d1) – K e –rt N(d2)
Where:
C = Value of call option
S0 = Current stock Price or spot price
K = Exercise price
N = Cumulative standard normal distribution
t = Time to expiration
r = Risk free rate of interest
σ = Standard deviation of stock returns
e = exponential term (2.7183)

d2 = d1 - σ√t
= 0.1448 - .45√.5
= 0.1448 – 0.3182
= - 0.1734
N(d1) = 0.5557
N(d2) = 0 .4325
C = 75 * 0.5557 - 80 e –0.12 * 0.5 * 0.4325

= 41.6775 – 80 * 0.94176 * 0.4325
= 41.6775 – 32.5848
= 9.0927
P = C + Ke –rt - S0
= 9.0927 + 80 e –0.12 * 0.5 – 75
= 9.0937 + 75.3408 -75
= 9.4335
Exercises
1. Compute the value of call option on stock with exercise price of Rs. 80 and spot price of
Rs. 90. The risk free rate of interest of interest is 8% continuously compounded p.a. The
maturity of the option is 6 months and the variance of the return on the stock is 0.49. Also
bifurcate the value of call and put option into intrinsic value and time value.
2. Using the following data calculate (i) call option on an index (ii) put option on an index
(iii) also state whether each of the options is ITM or OTM (iv) Split the option premium
into intrinsic value and time value.
Data:
Spot value of index = 1238, exercise price = 1230, risk free rate of return = 8% p.a.,
standard deviation of the continuously compounded rate of return = 0.42, time to expiration
45 days, continuous dividend rate on the index = 1.8%.
3. The share of a company is traded at Rs. 450. The standard deviation of continuously
compounded rate of return offered by the share is 0.20. The firm is expected to pay
dividend of Rs. 10 per share 30 days from now. Compute the call premium and put
premium on this share for options with exercise price of Rs. 425 and 3 months to maturity.
The risk free rate of return continuously compounded is 8% p.a. Split the premiums into
intrinsic value and time value.
4. The spot price of a share is Rs. 80, the exercise price of a call option with 3 month maturity
is Rs. 75, and the risk free rate of return continuously compounded is 8%. The standard
deviation of rate of return on the stock is 0.40. The values of constants calculated as per

B-S model are: d1 = 0.52 and d2 = 0.32. Compute delta, gamma and Rho for call and put
options.
5. Consider a call option on a stock with the following parameter.

Strike price = Rs. 70, risk free rate of interest = 6%, time to expiration = 90 days, standard
deviation of returns on the stock = 0.40, spot price of the stock = Rs. 60.
Compute (i) price of call option (ii) its delta (iii) gamma (iv) theta (v) Vega (vi) Rho.

Valuation of Futures Options

For call option
FC = e-rt [F X N(d1) - K X N(d2)]
d2 = d1- σ√t
FC = futures call option premium

r = risk-free interest rate
t = time (in years) to option expiration
K = Exercise Price of the option
F = futures price
σ = annual volatility (Standard deviation of the future price)
N(d) = Cumulative normal probability density function evaluated at d
For put option

FP = e-rt [K X N(-d2) - F X N(-d1)]
By using put-call parity
FP= FC + [- e-rt (F – K)]
6. Using the data given below, calculate the theoretical value of (i) call and (ii) put option on
futures:
S&P Nifty future contract price = 1625
Exercise price of the option = 1632
Time to expiration of the option = 60 days
Risk-free interest rate = 7%
Volatility = 28%
Solution:
Calculation of call option price
= 0.02
d2 = 0.02 – 0.28 * √(60/365)

= - 0.09
N(d1) = 0.5080
N(d2) = 0.4642
FC = e- 0.07 (60/365) [1625 X 0.5080 - 1632 X 0.4642]

= Rs.67.14
Calculation of put option value
FP = 67.14 + [- e-0.07 (60/365) (1625 – 1632)]

= 67.14 + [-0.9885 (-7)]
= 67.14 + 6.92
= Rs.74.06
Concept of Exotic Option

An option that differs from common American or European options in terms of the underlying
asset or the calculation of how or when the investor receives a certain payoff. These options
are more complex than options that trade on an exchange, and generally trade over the counter.
An exotic option is any type of option other than the standard calls and puts found on major
exchanges. An investor who buys a call option has essentially bought a standardized right to
purchase a specific amount of an underlying asset at the agreed upon strike price, while a put
option gives the investor the right to sell the specific asset at the strike if the price of the
underlying decreases. These regular options are also known as plain vanilla options. Exotic
options can be quite different as these examples show:
Chooser option: An option that gives the investor the right to choose whether the option is a
put or a call at a certain point during the option’s life. Unlike regular options that are purchased
as a call or put at inception, these exotic options can change during the life of the option.
Barrier option: A type of option whose payoff depends on whether or not the underlying asset
has reached or exceeded a predetermined price. The right to purchase the underlying at an
agreed strike price only kicks in when the price hits the agreed upon barrier. This is unlike a
regular option because the holder of a vanilla option can buy the underlying at the strike price
at any time after inception.
Asian option: Anyone who invests in regular options will attest to their volatility. Asian
options are a good way to reduce this volatility. These exotic options have a payoff that
depends on the average price of the underlying asset over a certain period of time as opposed
to at maturity. Also known as an average option.
The final difference between exotic options and regular options has to do with how they trade.
Regular options consists of call and puts and can be found on major exchanges such as Chicago
board options Exchange. Exotic options are mainly traded over the counter, which means they
are not listed on a formal exchange, and the terms of the options are generally negotiated by
brokers/dealers and are not normally standardized as they are with regular options.
Non Standard American Options.
In a standard American option, exercise can take place at any time during the life of the option
and the exercise price is always the same. The American options thar are traded in the over-
the-counter market sometimes have nonstandard features, for example:
1. Early exercise may be restricted to certain dates. The instrument is then known as a
Bermudan option. (Bermuda is between Europe and America).
2. Early exercise may be allowed during only part of the life of the option. For example,
there may be an initial “lock out” period with no early exercise.
3. The strike price may change during the life of the option.

SWAPS
A swap is an over-the-counter agreement between two companies to exchange cash flows in
the future. The agreement defines the dates when the cash flows are to be paid and the way in
which they are to be calculated. Usually the calculations of the cash flows involves the future
value of an interest rate, an exchange rate, or other marker variables.
 Swaps in simple words means exchange.

 Swaps are private agreements between two companies to exchange cash flows in the future
according to a prearranged formula.
 This is a natural extension of the study of forward and futures contracts.
 The first swap contracts were negotiated in 1981
Mechanics of Interest Rate Swaps
The most common type of swap is a “Plain Vanilla” interest rate swap. In this swap a company
agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal
for a predetermined number of years. In return it receives interest at a floating rate on the same
notional principal for the same period of time.
Uses of Swaps:
 Reducing funding cost: the swap agreement helps the parties to reduce the borrowing cost
substantially, as the parties to the Swaps will borrow at cheaper rates. Without swap cost
of fund would have been high.
 Liability management: The companies can manage their interest rate liability by changing
the payment and receipt streams from fixed to variable and vice versa.
 Speculative positions: Enter into swap take a position that results gaining from either a
drop or rise in interest rates.
Netting of payments amount

Fixed rate agreed upon, floating rate based on Treasury-Bill rate or LIBOR or MIBOR plus a
base point premium. The difference between two rates are netted, the difference is either paid
or received.
Types of Swaps:
 Interest Rate Swaps
 Currency Swaps
 Commodity Swaps
 Equity Swaps
SWAPTIONS
Swaption is an option to enter into an interest rate swap where a specified fixed rate is exchange
for floating. SWAPTIONS are derivative contracts that give the owner the right but not the
obligation to enter into an underlying swap contract.
Currency Swaps
A Swap agreement where interest and principal in one currency are exchanged for interest and
principal in another currency. Under currency swap the amount of principal exchanged in each
currency is specified at the time of entering into contract. Such amount is determined based on
the existing exchange rate between two currencies involved in a currency swap. During the
swap period each party to the swap will pay the interest periodically to other country party at
predetermined percentage on the principal exchanged. At the end of swap tenor the currencies
principal amount is exchanged back.

Valuation of Currency Swaps

The valuation of currency swap involves the determination of cash flows to the parties involved
in a currency swap. If the cash inflows are greater than the outflows the swap has a positive
value to such parties, if cash outflows are greater than the inflows it will be a loss to those
parties.
The valuation of currency can be done in two ways:

 Valuation in terms of bond prices
 Valuation as a portfolio of Forward contracts
Valuation of swap in Indian Rupee to the parties receiving INR and paying foreign currencies
i.e USD
Vswap = BD – S0 Bf
BD = Value of a bond defined by domestic cash flows
Bf = Value of bond in foreign currency
S0 = Spot exchange rate (Number of dollars for per unit of foreign currency)
Similarly the value of Swap in Indian Rupee to the parties who pay INR and receive USD will
be:
Vswap = S0 Bf –BD
1. Company A and B have offered the following rates per annum on a Rs.200 million loan.
Company Fixed Rate Floating Rate
A 12.00% MIBOR + 0.1%
B 13.40% MIBOR + 0.6%
Company A requires floating rate loan and Company B requires fixed rate loan. Design a
swap that will net a Bank acting as intermediary 0.1% per annum and equally attractive to
both the parties. Show the diagram.
Solution:
Difference in fixed rate market is 13.4 – 12 = 1.4%

Difference in floating rate market M + 0.6 – M + 0.1 = M + 0.5
Comparative advantage = 1.4 – M + 0.5 = 0.9%
Intermediary charges 0.1%
Net benefit = 0.9% - 0.1% = 0.8%
Net benefit to each company 0.8/2 = 0.4% each
Net cost to Company A = M + 0.1 – 0.4 = M – 0.3
Net cost to Company B = 13.4 – 0.4 = 13%
Maximum spread is in fixed rate market hence the benefit is adjusted in fixed rate and
floating rate is kept unchanged. The same can be shown with the help of diagram as under:

Cash Flow to Company A

Receives Fixed rate 12.4
Pays Fixed rate 12.0
Pays floating rate M + 0.1
Net Rate M – 0.3
Cash Flow to Company B

Receives floating rate M + 0.6
Pays floating rate M + 0.6
Pays fixed rate 13.0
Net Rate 13.0
2. Company A wishes to borrow US dollars at a fixed rate of interest company B wishes to

borrow Japanese yen at a fixed rate of interest. The amounts required by the two
companies are roughly the same at the current exchange rate. The companies have been
quoted the following interest rates, which have been adjusted for the impact of taxes:
Company Yen US Dollar

A 5% 9.6%
B 6.5% 10.0%
Design a swap that will net a bank, acting as intermediary, 50 basis points p.a and equally
attractive to the two companies and ensure that all the foreign exchange risk is assumed
by the bank.
Solution:
The maximum spread is existing in Yen market (6.5 – 5) 1.5% compared that of US Dollar
market i.e (10-9.6) = 0.4%. Therefore Company A will borrow from Yen market and give
to Company B. On the other hand Company B will borrow from US Dollar market and
give to Company A.
Difference in Yen market is 6.5 - 5 = 1.5%

Difference in US Dollar market 10 – 9.6 = 0.4
Comparative advantage 1.5 – 0.4 = 1.1%
Intermediary charges 0.50%
Net benefit = 1.1% - 0.5% = 0.6%
Net benefit to each company 0.6 /2 = 0.3% each
Net cost to Company A = 9.6 – 0.3= 9.3
Net cost to Company B = 6.5 – 0.3= 6.2%

Cash Flow to Company A

Receives on Yen 5.0
Pays on Yen 5.0
Pays on USD 9.3
Net Rate 9.3
Cash Flow to Company B

Receives USD 10.0
Pays USD 10.0
Pays Yen 6.2
Net Rate 6.2
3. Three companies X, Y and Z have come together to reduce their interest cost. Following
are the requirement of those companies and interest rates offered to them in different
markets.
Company Requirement Fixed $ Floating $ Fixed Euro

X Fixed $ 5.75% LIBOR + 0.9% 6.00%
Y Floating $ 5,25% LIBOR + 0.75% 6.50%
Z Fixed Euro 6.00% LIBOR + 0.6% 6.25%
The amount required by the companies are equal and are for three years on bullet payment
basis. You are required to arrange swap between three parties in such a way so that the
benefit of swap is equally divided among the three companies.
Solution:
 The lower interest rate in Fixed $ market is 5.25% at which company Y can borrow
and lend to company X which is interested in borrowing from fixed $ market.
 The lower interest rate in Floating $ market is LIBOR + 0.6% at which company Z
can borrow and lend to Company Y which is interested to borrowing from floating $
market.
 The lower interest rate in fixed euro market is 6.00% at which company X can borrow
and lend to Company Z which is interested in borrowing from fixed Euro market.
Cost of funds without swap
X company applicable rate in Fixed $ market is 5.75%
Y company applicable rate is Floating $ market is L+0.75%
Z company applicable rate in Fixed Euro market is 6.25%
Total 12.75%
Cost of funds with Swap

X company applicable rate in Fixed Euro market is 6.00%
Y company applicable rate is Fixed $ market is 5.25%
Z company applicable rate in Floating $ market is L + 0.60%
Total 11.85%
Net benefit from swap 12.75 – 11.85 = 0.9%

Benefit to each company 0.9 / 3 = 0.3% each
Net rate for Company X = 5.75 – 0.3 = 5.45%
Net rate for Company Y = LIBOR + 0.75 – 0.3 = L + 0.45%
Net rate for Company Z = 6.25 – 0.3 = 5.95%

Pays 6.0% to lender in Fixed

Euro Market
X pays to Y 5.45% Z pays to X 6%
Y Y pays to Z L + 0.65% Z
Pays 5,25% to lender in Pays L + 0.6% to lender in

Fixed Dollar Market Floating Dollar Market
Cash Flow to Company X

Receives from Z 6.00
Pays on Fixed Euro Market 6.00
Pays to Y 5.45
Net Rate 5.45
Cash Flow to Company Y

Receives from X 5.45
Pays to lender in Fixed Dollar Market 5.25
Pays to Z L + 0.65
Net Rate L + 0.45
Cash Flow to Company Z
Pays to X 6.00
Pays to lender in Floating Dollar Market L + 0.60
Receives from Y L + 0.65
Net Rate 5.95
4. A $100 million interest rate swap has a remaining life of 10 months. Under the terms of
the swap, six-month LIBOR is exchanged for 7% per annum (compounded semi-annually).
The average of the bid–offer rate being exchanged for six-month LIBOR in swaps of all
maturities is currently 5% per annum with continuous compounding. The six-month
LIBOR rate was 4.6% per annum two months ago. What is the current value of the swap
to the party paying floating? What is its value to the party paying fixed?
In four months $3.5 million (  05  007  $100 million) will be received and $2.3 million
(  05  0046  $100 million) will be paid. (We ignore day count issues.) In 10 months
$3.5 million will be received, and the LIBOR rate prevailing in four months’ time will be
paid. The value of the fixed-rate bond underlying the swap is
35e0054 12  1035e00510 12  $102718 million

The value of the floating-rate bond underlying the swap is
(100  23)e005412  $100609 million

The value of the swap to the party paying floating is $102718  $100609  $2109
million. The value of the swap to the party paying fixed is $2109 million.
These results can also be derived by decomposing the swap into forward contracts.
Consider the party paying floating. The first forward contract involves paying $2.3 million
and receiving $3.5 million in four months. It has a value of 12e005412  $1180 million.
To value the second forward contract, we note that the forward interest rate is 5% per
annum with continuous compounding, or 5.063% per annum with semi-annual
compounding. The value of the forward contract is
100  (007  05  005063  05)e0051012  $0929 million

The total value of the forward contracts is therefore $1180  $0929  $2109 million.
5. A Swap was entered by an Indian firm with a bank converting its rupee liability into British
pound, where the firm received 10% on Indian rupee and paid 6% on British pound. The
amount of principals involved are Rs.120 million and £1.5 million fixed at the exchange
rate of Rs.80 per £. The swap has 4 semi-annual payments to follow.
Assume the next payment is due after 6 months from now and term structure in Indian
rupee and British pound is flat at 9.00% and 5.50% respectively, for the next 2 years. If
the current exchange rate is Rs.82.00 per £, what is the value of the swap for the Indian
firm and the bank?
Solution:
The semi-annual payment of interest is 0.05 * 120 = Rs.6 million. The final payment
would be Rs. 126 million, including the principal amount. With a 9% flat term structure
on continuous compounding the PV of the receivable by the firm from the bank would be:
PV of rupee cash flow = 6e-0.09 * 0.5 + 6e-0.09 * 1 + 6e-0.09*1.5 + 126e-0.09*2

= 5.7360 + 5.4836 + 5.2423 + 105.2440
= Rs.121.7059 million
PV of rupee cash flow in pound terms = 121.7059 / 82 = £ 1.4842 million
PV of pound cash flow = 0.045e-0.055 * 0.5 + 0.045e-0.055 * 1 + 0.045e-0.055*1.5 + 1.545e-0.055*2

= 0.0438 + 0.0426 + 0.0414 + 1.3841
= £ 1.5119 million
PV of pound cash flow in rupee terms = 1.5119 * 82 = Rs.123.9735
Value of the swap for Firm Bank

(in millions) Rs. £ Rs. £
Rupee leg -121.71 1.4842 121.71 1.4842
Pound leg 123.97 1.5119 -123.97 -1.5119
6. A firm had entered into a swap arrangement for a notional principal of Rs.1 crore with a
bank, whereby the bank paid a fixed 9% and received MIBOR semi-annually. It has three
more years to go, and had just exchanged the cash flow. The 6-m MIBOR for the next
payment of interest was reset at 8%. The next day, the markets exhibited a fall and the 6-
m MIBOR fell to 7%. Leading the firm to believe that it is overpaying, it wants to cancel

the swap arrangement. How much should the firm ask the bank to pay to cancel the swap
deal? Assume a flat term structure.
Solution:
The Value of the swap for the firm is determined on the basis of discounted cash flows
(DCFs). Since the rates have changed, the discount rate used would be 7% of the prevalent
market rate. The value of the cash outflows on a fixed basis discounted at 7% is Rs.104.99
as shown here:
Present value of cash flow of the fixed leg

Fixed leg payment - cash outflow 9.00%
Present 12-month MIBOR 7.00%
Next interest payment on floating rate 8.00%
Time Years Cash Flow DCF (Rs. At

(Months) (Rs.) 7.00%)
- 4.5
6 0.50 4.5 4.35
12 1.00 4.5 4.20
18 1.50 4.5 4.05
24 2.00 4.5 3.91
30 2.50 4.5 3.78
36 3.00 104.5 84.71
Present value of Fixed leg 105.00
The PV of the inflow at a floating rate would be the next interest payment, decided a period
in advance, plus the face value of Rs.100 discounted at 7%. This amount works out to
Rs.100.42
Value of Floating leg

Interest to be received after 6 months : 4.00
Principal to be received after 6 months :100.00
Total :104.00
Present value at 7% :100.42
The present value of the cash outflow is more by Rs.4.58 for a principal of Rs.100. If the
bank pays Rs.4.58 lakh for the principal amount of Rs.1 crore, the firm may exit the swap.
Exercises
1. Company A and B are offered the following interest rates on a loan of Rs.5 million by their
banks. You are required to construct an interest rate swap for these firms netting 0.5% to
the bank acting as intermediary and equally attractive by A and B. Show the swap cash
flows.

A 15% MIBOR + 2%
B 18% MIBOR + 2.5%

2. Assuming that AAA wants a floating rate, BBB desires a fixed rate, design a swap deal for
AAA and BBB, in such a way that it benefits both companies, when they face the following
terms structure

AAA 10% MIBOR + 25bp
BBB 12% MIBOR + 75bp
3. A Commercial bank wants $ floating rate loan. A manufacturing company wants fixed
rate $ funds. An US financial institution wants $ floating prime rate loans. The cost of
accessing funds in each market is as below:
Fixed Floating LIBOR Floating Prime
CB 12% LIBOR + 0.2% Prime + 0.3%
MC 11% LIBOR + 0.2% Prime + 0.4%
FI 10% LIBOR Prime + 0.8%
Explain how a swap can be structured if the total benefit is to be shared equally.
4. Sun pharma wishes to borrow Rs.20 crore at a fixed rate for 5 years and has been offered
either 11% fixed or six month LIBOR + 1%. CIPLA Ltd wishes to borrow Rs.20 crore at
a floating rate for 5 years and has been offered six-month LIBOR + 0.5% or 10% fixed.
On the basis of above figures:
i) How may they enter into swap arrangement in which each benefit equally?
ii) What risk may this arrangement generate?
5. 2 Firms A and B face the following interest rates
Company $ £
A 8.0% 10.6%
B 10.0% 11.0%
A Wants to borrow in £ and B wants on $. Exchange rate is $ 1.5 / £. Explain how a
currency swap can be constructed.

Interest Rate Markets

Futures in which the underlying asset’s price is dependent only on the level of interest rates. A
futures contract with an underlying instrument that pays interest. An interest rate future is a
contract between the buyer and seller agreeing to the future delivery of any interest-bearing
asset. The interest rate futures allows the buyer and seller to lock in the price of the interest-
bearing asset for future date.
The investor having investment in fixed income instruments will face two types of risk
reinvestment rate risk and price risk. Fixed income securities provide the holder coupon
payments periodically over investment time horizon. These coupon/interest incomes are
reinvested at a particular rate of interest which is unknown; hence it is a risk to the holder of
fixed income securities. Price risk refers to the unknown price at which the holder of fixed
income securities has to sell his securities during investment time horizon if he needs money.
Both reinvestment risk and price risks moves in opposite direction for a given change in interest
rates. An increase in interest rate would increase the reinvestment rate resulting in gains, at the
same time it decreases the price of the investment resulting into losses, at the same time it
increases the price of the investment resulting into gains.
Similarly the borrower and lender will also face interest rate risk, the borrower in floating rate
market will incur loss if interest rate goes up as he need to pay higher interest, on the other the
lender in the floating rate market will incur loss if interest rate fall as he will receive lesser rate
of interest.
The borrow in fixed rate market will not face any risk as he pay interest at predetermined rate,
whereas lender will have risk as he has to reinvest the coupons received at unknown rate.
Interest rate risk can be managed by using derivatives instruments such as interest rate futures,
interest rate options, and interest rate swaps.
In India the forward rate agreements (FRA) and Interest rate swaps are extensively used in over
the counter market to hedge the interest risk. In India mostly Insurance companies, Mutual
funds, Banks, Pension fund, financial institution invest in fixed income securities. The over
the counter market was not encouraging as it lacks transparency and it is illiquid.
Interest Rate Futures contract offers market participants a standardized product taking a view
of the future directions of the market, hedging and creating income strategies. Electronic
trading platform of NSE ensures transparency of prices, volumes and trade data.
Interest Rate Options

An investment tool whose payoff depends on the future level of interest rates. Interest rate
options are both exchange traded and over-the-counter instruments.
Interest rate options from exchanges in the United States are offered on Treasury bond futures,
Treasury note futures and euro dollar futures. An investor taking a long position in interest
rate call options believes that interest rates will rise, while an investor taking a position in
interest rate put options believes that interest rates will fall.
Bond Options
A buyer of call option on bond has the right to buy a bond at exercise price. A buyer of put
option will have a right to sell the bond at exercise price. These underlying bonds are issued
by government. The options on bonds are standardized with respect to contract size, interest
rate on the bond, maturity period of bond, exercise price and expiration date.

Embedded Bond Options

Some bonds contain embedded call options and put options. A callable bond enables a issuer
to buy the bonds back at a fixed price, known as the call price, from the holder of the bond at
a certain time in the future. Thus callable bond has an embedded call option in the bon. The
holder of the bond will gain if the market price of the bond is lesser than the call price. In case
of put on bond the buyer of the bond can demand early redemption at certain price at certain
time in the future. In this case, issuer of the bond issues bond with put option attached to it to
the buyer of the bond.
Interest call and puts

Interest rate options can be written on 90-day Treasury bill rate, Five year Treasury note rate,
and the 10-year Treasury bond rates.
The call buyer expects that the interest rate will increase and will earn if the underlying interest
rate is above the exercise price, while the put buyer anticipates a decrease in interest rate,
resulting in an increase in value of put options.
Types of Rates
The interest rate is an amount the borrower promises to pay to the lender on the money
borrowed. It is always expressed in percentage. There are various types of interest rates. The
interest rate quoted depends on the credit worthiness of the borrower or the default risk faced
by lender. Higher the default risk higher the rate of interest and lower the default risk lower
will be the interest charged to borrower.
Treasury rate
Treasury rate are the return the investor earns on Treasury bill and Treasury notes. The treasury
notes and Treasury bills are issued by government to borrow money from the money market.
As these instruments are issued by the government the default risk considered to be zero, hence
the treasury rates are taken as risk free rate to calculate value of futures and forwards.
Floating rate or LIBOR or MIBOR

The LIBOR stands for London Inter Bank Offer Rate. MIBOR stands for Mumbai Inter Bank
Offer Rate.
LIBOR is the rate at which one bank can borrow from another bank in London bank market.
MIBOR is the rate which one bank can borrow from another bank in the Mumbai bank market.
It is the rate of interest given by one bank on the whole sale deposits made by other banks. The
LIBOR is quoted for different maturities i.e 1 month LIBOR, 3 Month LIBOR, 6 Month
LIBOR and 1 year LIBOR. The 6 month LIBOR denotes the rate at which 6 months deposits
are made.
The participants in derivative market use this rate as true risk free rate to value derivatives.
The bank and financial institutions are the major participants in this market. The AAA rated
banks and financial institution are allowed to borrow and lend in this market.
The bank and financial institutions may also quote the rate as LIBID which stands for London
Inter Bank Bid Rate. LIBID is the rate at which one bank will accept the deposits from other
banks. The quoted LIBOR or MIBOR is subject to fluctuations. These rates are determined on
the basis of demand for funds and supply of funds.
Repo Rates
The interest rate at which repurchase agreements are priced at. It is known as repurchase
agreement. Repo is an agreement in which the owner of securities (FI, investment companies)
agree tl sell them to another company now and buy them back later at higher price. The

difference between the prices at which they are repurchased and the price at which they are
sold is a return from Repo transactions. This return is known as Repo rate. There are to type
of Repos; Overnight and Term repos. The overnight repo is for a day, term repo is for longer
period.
Risk-Free Rate
Zero Rates
The rate of interest earned on an investment that starts today and last for N number of years.
The principal amount along with interest is received at the end of N number of years. There
are no payments received during maturity period of the securities or bond on which Zero rates
are quoted.
If a 5 year zero rate with continuous compounding is 5%, it implies that after 5 years the
investor will receive Rs.128.40 for a principal of Rs. 100.
Bond Pricing.
Bond pricing refers to the calculation of the theoretical value of the bond at any point of time
during its maturity period. The bond pricing gives a rough estimate to the holder of bond and
buyer of the bond that, if at all holder wishes to sell and the other wishes to buy the bond at a
particular point of time at what price it should be sold and bought. The theoretical price of the
bond is nothing but the present value of all the coupons receivable by the holder of bond during
the bond maturity plus the present value of principal received at the end of the bond maturity.
If Rs.100 face value bond has a life of 2 years an expected to pay coupon of 8% every year, the
value of the bond will be (Assuming 1 year zero rate 5% and 2 year zero rate 6.8% with
continuous compounding)
Value of bond = 8e – (0.05 * 1) + 108e – (0.068*2)

Value of bond = 101.8728.
Zero Curve: A Chart showing the zero rate as a function of maturity is known as the zero
curve. A Common assumption is that the zero curve is linear between the points determined
using the bootstrap method. It is also usually assumed that the zero curve is horizontal prior to
the first point and horizontal beyond the last point. By using longer maturity bonds, the zero
curve would be more accurately determined beyond 2 years.
Determining Zero Rates

Zero rates are determined based on the information about the coupon rate, time to maturity and
bond principal. The zero rate expressed in continuous compounding is the discount rate which
equates the present value of all the cash inflows on the bond during its tenure with the present
price of the bond. Each of the cash flows from the bond has to be discounted by the respective
zero rate applicable for the time period. Given the information bond principal Rs.100, time to
maturity 3 months, bond price Rs.97.5 the zero rate will be:
Zero Rate = m ln (1 + (r / m))
Where m = 4 (number of compounding in a year), r = 10.256 (Amount of interest in a year/Bond

price ((2.5 * 4)/97.5)). The income or interest from the bond in three month is Face value of
bond minus bond price. Rs.2.5 (100 - 97.5) and the yearly income is 2.5 * 4 = Rs.10.
Zero Rate = 4 ln (1+0.10256/4)

Zero Rate = 0.10127.

Similarly one can compute zero rate for different maturities, half year, 1 year, 1.5 years and so
on.
Forward Rates
Forward rate is rate of interest for a period of time in the future implies by today’s zero rate.
Forward rate is the rate contracted for a future loan at the current time. Once the loan is secured
with a forward rate interest rate risk is eliminated. Hence it is important to estimate forward
rate.
If an investor invests the money return he will get depends on the period of deposit. If time
period is higher the interest will be higher if period of deposit reduces he is likely get lesser
amount of interest. The forward rate is the incremental rate of interest earned on a deposit for
a period two compared to the previous period one.
Example: A rate of interest for one year and two year deposits are 5% and 6% respectively.
The incremental interest is 1% per year (6-5) and for two years 1*2 = 2%. In the sense that if
investor extends his deposit term by one year he will get 1% additional return for each year for
two year. So the forward rate for the second year will be rate of interest for base period (1 year)
plus incremental interest rate for two years i.e 5% + 2% = 7% forward rate. It is given by
Forward rate = (R2 T2 - R1 T1) / T2 - T1
Where R1 = Rate of interest for period 1, R2 = Rate of interest for period 2; T1 = Time period
1, T2 = time period 2).
Forward rate = ((0.06 * 2) – (0.05 * 1)) / 2-1

Forward rate = 0.07 or 7%
1. The one term deposit attracts an interest rate of 10.5% p.a. continuously compounded,
while the continuously compounded interest rate for 2 years deposit is 11.5%. What is the
implicit forward interest rate in the second year for a 1 year deposit?
Solution:
Forward rate = (R2 T2 - R1 T1) / (T2 - T1)
FR = (0.115 * 2) – (0.105 *1) / 2-1
FR = 0.125 or 12.5%
2. Suppose that the spot (Zero) rates with continuously compounding are as follows:
Maturity (Years) Rate (% p.a)
1 12.00
2 13.00
3 13.70
4 14.20
5 14.50
Calculate forward interest rates for the second, third, fourth and fifth year.
Solution:
Forward rate for second year

FR = (0.13 * 2) – (0.12 *1) / 2-1
FR = 0.14 or 14%
Forward rate for third year
FR = (0.137 * 3) – (0.13 *2) / 3-2

FR = 0.151 or 15.1%
Forward rate for fourth year

FR = (0.142 * 4) – (0.137 *3) / 4-3
FR = 0.157 or 15.7%
Forward rate for fifth year

FR = (0.145 * 5) – (0.142 *4) / 5-4
FR = 0.157 or 15.7%
3. A Rs.10,000 face value Treasury bill that matures in 34 days is priced at Rs.9,907.71, while
the price of a T-bill that matures in 55 days is Rs.9,836.95. Find the forward rate from day
34 to day 55.
Solution:
Find out the zero rate for 34 days and 55 days
Zero rate for 34 days

9907.71e-r*(34/360) = 10000
e-r*(34/360) = (10000/9907.71)
e-r*(34/360) = 1.0093
r = - (ln 1.0093)/(34/360)
r = - (ln 1.0093)/ 0.094444
r = 0.098173
Zero rate for 55 days

9836.95e-r*(55/360) = 10000
e-r*(55/360) = (10000/9836.95)
e-r*(55/360) = 1.016575
r = - (ln 1.016575)/ (55/360)
r = - (ln 1.016575)/ 0.152778
r = 0.107603
Forward rate from day 34 to day 55

FR = (0.107603 * 55) – (0.098173 *34) / 55-34
FR = (5.91818 – 3.337866) / 21
FR = 2.580314 / 21
FR = 0.122872 or 12.29%
4. The following table gives the prices of bonds:

Bond Time to maturity Annual Bond
Principal (Years) Coupon (Rs.) Price (Rs.)
100 0.50 0.00 98.00
100 1.00 0.00 95.00
100 1.50 6.20 101.00
100 2.00 8.00 104.00
(Held the stated coupon is assumed to be paid every 6 month)
i) Calculate zero rate for maturities for 6 months, 18 months and 24 months.
ii) What are the forward rate for the periods, 6 months to 12 months, 12 months to 18
months, 18 months to 24 months?

iii) What are the 6 month, 12 month, 18 month and 24 month per yields for bonds that
provide semi-annual coupon payment?
iv) Estimate the price and yield of a two year bond providing a semi-annual coupon of
7% per annum.
Solution:
i) Zero rate for maturity of six months expressed with continuous compounding are:
= 2ln(1+(t/Bond price)
= 2ln (1 + (2/98)
= 0.040405
Zero rate for maturity of one year expressed with continuous compounding are:
= ln(1+(t/Bond price)
= ln (1 + (5/95)
= 0.05129
Zero rate for maturity of 1.5 years expressed with continuous compounding are:
The 3rd bond lasts 1.5 years, the payments are as follows:
6 months Rs.3.1
1 year Rs.3.1
1.5 years Rs.103.1
From our earlier calculations we know that the discount rate for the payment at the
end of 6 months is 4.0405% and that the discount rate for the payment at the end of 1
year is 5.129%. We also know that the bond’s price Rs.101 must equal the present
value of all the payments received by the bond holder. Suppose the 1.5 year zero rate
is denoted by r it follows that
3.1e-.040405*0.5 + 3.1e-.05129*1 + 103.1e-r*1.5 = 101

= 3.1* .98 + 3.1* 0.95 + 103.1e-r*1.5 = 101
= 3.038 + 2.945+ 103.1e-r*1.5 = 101
= 5.983 + 103.1e-r*1.5 = 101
103.1e-r*1.5 = 101 -5.983
103.1e-r*1.5 = 95.017
e-r*1.5 = 95.017/103.1
e-r*1.5 = 0.9216
r = - (ln0.9216)/1.5
r = 0.054429
Zero rate for maturity of 2 years expressed with continuous compounding are:
The 4th bond lasts 2 years, the payments are as follows:
6 months Rs.4
1 year Rs.4
1.5 years Rs.4
2 years Rs.104
From our earlier calculations we know that the discount rate for the payment at the
end of 6 months is 4.0405% and that the discount rate for the payment at the end of 1
year is 5.129%. We also know that the bond’s price Rs.101 must equal the present
value of all the payments received by the bond holder. Suppose the 1.5 year zero rate
is denoted by r it follows that
4e-.040405*0.5 + 4e-.05129*1 + 4e-0.054429*1.5 + 104e-r*2 =104

= 4*.98 + 4* 0.95 + 4e-r*1.5 + 104e-r*2 = 104
= 3.92 + 3.80+ 3.3864 + 104e-r*2 = 104
= 11.4064 + 104e-r*2 = 104

104e-r*2 = 104 -11.4064
104e-r*1.5 = 92.5936
e-r*1.5 = 92.5936/104
e-r*1.5 = 0.89032
r = - (ln0.89032)/2
r = 0.058085
ii) One year forward rate

= (R2 T2 - R1 T1) / (T2 - T1)
= (5.1293 * 1) – (4.40405 * 0.5) / 1-0.5
= 6.2181
One year six months forward rate

= (5.44298 – 1.5) – (5.1293*1) / 1.5 – 1
= 6.0701
Two year forward rate

= (5.8085 * 2) – (5.4429 * 1.5) / 2 -1.5
= 6.9053
iii) Calculation of par yield.
C = ((100 – 100d)m) / A
d = e –rt
= e – 0.058085 * 2
= 0.8903
A = e-.040405*0.5 + e-.05129*1 + e-0.054429*1.5 + e-0.058085*2
= 0.98 + 0.95 + 0.9216 + 0.89032
= 3.7419
C = ((100-100*0.8903)2)/3.7419
= 5.86
iv) Calculation of Bond price that provide 7% semi-annual coupon for 2 years (7/2 = 3.5%
every six months)
Bond price = 3.5e-.040405*0.5 + 3.5e-.05129*1 + 3.5e-0.054429*1.5 + 103.5e-0.058085*2

Bond price = (3.5 * 0.98) + (3.5 * 0.95) + (3.5 * 0.9216) + (103.5 * 0.89032)
Bond price = 102.1287
The yield of the bond is the discount rate which equates present value of all coupon
receipts and principal with bond price. The yield has to be calculated by interpolation.
Let us assume r = 6 %
3.5e-.06*0.5 + 3.5e-.06*1 + 3.5e-0.06*1.5 + 103.5e-0.06*2 = 101.69
3.3966 + 3.2962 + 3.1988 + 91.7963 = 102.1287
101.6979 = 102.1287
Since the bond price is higher than present value one has to decrease the discount rate
Let us assume r= 5%
3.5e-.05*0.5 + 3.5e-.05*1 + 3.5e-0.05*1.5 + 103.5e-0.05*2 = 102.1287
3.5 * 0.9753 + 3.5 * 09512 + 3.5 * 0.9277 + 103.5 * 0.9048 = 102.1287
103.6365 = 102.1287
The present value of coupon payment is higher than the bond price. The Yield of the
bond lies between 5% and 6%.
P1 - BP Where:
Yield = L + *D P1= Present value at lower rate
P1 - P2
P2= Present Value at higher rate
103.6365 – 102.1287 L = Lower rate
Yield = 5 + *1
103.6365 – 101.6979 D = Difference between higher rate and lower rate
BP = Bond Price
1.5078
Yield = 5 + *1
1.9386
Yield = 5 + 0.3896 * 1
Yield = 5 + 0.7792
Yield = 5.7792
Forward Rate Agreements (FRA)
A Forward Rate Agreement is the forward contract on interest rates and is the basic instrument
that covers risk associated with fluctuations in interest rates.
It is an over the counter agreement, an Over the counter contract between parties that
determines the rate of interest, or the currency exchange rate to be paid or received on an
obligation beginning at a future start date. The contract will determine the rates to be used
along with the termination date and notional value. On this type of agreement, it is only the
differential that is paid on the notional amount of the contract. Typically for agreements
dealing with interest rates, the parties to the contract will exchange a fixed rate for a variable
one. The party paying the fixed rate is usually referred to as the borrower, while the party
receiving the fixed rate is referred as the lender.
Interest Rate Cap

An option that provides a payoff when a specified interest rate is above a certain level. The
interest rate is floating rate that is reset periodically. Interest rate cap is the most popular option
in over the counter market. As we know the floating rate (LIBOR) will change periodically.
If the LIBOR is reset every three months the three months period is known as tenor. The
interest on the note is 3 months LIBOR and for next three months the rate will be equal to the
LIBOR prevailing at that time.
The interest rate Cap is designed to provide insurance against the rate of interest on the floating
rate note going above certain level. This specified level is known as the rate cap.
Interest Rate Floor

An option that provides a payoff when interest rate below a certain level. The interest rate is a
floating rate that is reset periodically. An interest rate floor is a portfolio of put options on
interest rates. The investor investing in securities offering floating rate interest the risk is that
the interest rate may decrease. Hence investor in floating investments would like to protect
themselves from decline in interest rate. The interest rate floor is an effective tool to avoid such
risk.
Interest Rate Collar

A combination of an interest rate cap and an interest rate floor. The cap provides the protection
against the increasing in interest rate hence the borrower will by the interest rate caps. The

interest rate floor provides the protection against fall in interest rate hence the lender will buy
the interest rate floor. The decision to buy a cap or a floor depends on expected interest rate
movements.
If the investor feels that there is a high probability of interest rate moving upward, the better
strategy would be buy a cap and sell a floor. This strategy requires paying premium for the
cap bought and receiving premium from the floor sold. This is done in such way that the
premium received should be higher than or equal to premium paid. The strategy comprising
of buying a cap and writing a floor is called interest rate collar.
On the other hand if the investor expects that the interest rate is likely to go down, the better
strategy would be buy a floor and write a cap. The strategy to be constructed in such a way
that the premium received from writing a cap should be higher than or equal to floor bought.

Commodity Derivatives
Agricultural commodity futures are market-based instruments for managing risks and they help
in orderly establishment of efficient agricultural market. Future markets are used to hedge
commodity price risks. They also serve as a low cost, highly efficient and transparent
mechanism for discovering prices in the future by providing a forum for exchanging
information about supply and demand conditions. The hedging and price discovery functions
of future markets promote more efficient production, storage, marketing and agro-processing
operations and help in improvement in overall agricultural marketing.
The commodities are classified as Agriculture commodities and Non Agricultural

commodities.
Important Agricultural commodities on which futures traded are Rubber, Turmeric, Jeera,
Chana Cotton, Wheat, Barley, Maize, Castor Seeds, Soy Bean, Gur Seeds and Potato etc.,
Non Agricultural commodities include Steel, Copper, Zinc, Aluminium, Nickel, Lead, Crude
Oil, Thermal Coal, Natural Gas, Gold, Silver and Platinum etc.,
At present there are six commodity exchanges recognised by Forward Market Commission,
they are:
MCX (Multi Commodity Exchange)

NCDEX (National Commodity and Derivatives Exchange Ltd.,)
NMCE (National Multi Commodity Exchange of India Ltd,)
ICX (Indian Commodity Exchange Ltd., New Delhi)
UCX (Universal Commodity Exchange Ltd., Navi Mumbai)
ADCX (Ace Derivatives and Commodity Exchange Ltd., Mumbai)
Convenience Yield: The benefit from holding the physical asset are sometimes referred to as
the convenience yield provided by the commodity. The convenience yield reflects the market’s
expectations concerning the future availability of the commodity. The greater the possibility
that shortages will occur, the higher the convenience yield.
Players in Commodities market or Commodity Market Participants
 Hedgers
 Farmers
 Producers
 Intermediaries in Spot Market
 Merchandisers
 Importers
 Exporters
 Consumers
 Investors
 Arbitragers
 Speculators
 Day Traders
 Scalpers
Forward Markets Commissions and Regulation

At present there is a three tier system of regulations of forward/futures trading in India, namely,
Government of India, Forward Markets Commission and Commodity Exchanges.

The FC(R) Act 1952, prohibits options in commodities. For the purpose of forward contracts,
they can be regulated in certain commodities by notifying those commodities u/s 15 of the Act.
Forward trading in certain other commodities can be prohibited by notifying these commodities
u/s 17 of the Act.
Forward Market Commission (FMC):

1. FMC is a regulatory body for commodity futures/forward trade in India. This was set up
under the Forward Contracts (Regulations) Act of 1952. It is responsible for regulating
and promoting futures/forward trade in commodities. The forward Markets Commission’s
Head Quarter is located at Mumbai and Regional Office at Kolkata.
2. The function of FMC are as follows:
a) To advise the Central Government in respect of the recognition or the withdrawal of
recognition from any association or in respect of any other matter arising out of the
administration of the Forward Contracts (Regulations) Act 1952.
b) To keep forward markets under observation and to take such action in relation to them,
as it may consider necessary, in exercise of the powers assigned to it by or under the
Act.
c) To collect and whenever the Commission thinks it necessary, to publish information
regarding the trading conditions in respect of goods to which any of the provisions of
the Act is made applicable, including information regarding supply demand and prices,
and to submit to the Central Government, periodical reports on the working of forward
markets relating to such goods.
d) To make recommendations generally with a view to improving the organization and
working of forward markets.
e) To undertake the inspection of the accounts and other documents of any recognized
association or registered association or any member of such association whenever it
consider it necessary.
3. The Act provides that the Commission shall consist of not less than two but not exceeding
four members appointed by the Central Government, out of them one being nominated by
the Central Government to be the Chairman of the Commission. Currently Commission
comprises there members among whom Shri Ramesh Abhishek, IAS is the Chirman, Dr.
M Mathisekaran, IES and Shri Nagendraa Parakh are the members of the commission.
Powers of the Forward Markets Commission

The Commission has power to deemed civil court for (a) Summoning and enforcing gthe
attendance of any person an examining him on oath; (b) requiring the discovery and production
of any document (c) Receiving evidence on affidavits, and (d) Requisitioning any public record
or copy thereof from any office.
The power of approving memorandum and articles of association and Bye-laws, power to direct
to make or to make articles (Rules) or Bye-laws, power to suspend governing body of
recognised association and power to suspend business of recognised association.
The regulatory measures prescribed by the FMC

Forward Markets Commission provides regulatory oversight in order to ensure financial
integrity (i.e prevent systematic risk of default by one major operator or group of operators),
market integrity (i.e to ensure that futures prices are truly aligned with the prospective demand
and supply conditions) and to protect and promote interest of customers/non-members. The
forward Markets Commission prescribes following regulatory measures:
a) Limit on net open position of an individual operator and at Member level to prevent
excessive speculation.
b) Circuit-lifters or limit on daily price fluctuations to allow cooling of market in the event
of abrupt upswing or downswing in prices.
c) Imposition of margins to prevent defaults by Members/clients.

d) Physical delivery of contacts and penalty for defaults/delivery obligations

e) Daily ark to marketing of the contracts.
The legal and regulatory provisions for customer protection

The FC(R) Act provides that client’s position cannot be appropriated by the member of the
exchange except a written consent is taken three days’ time. Forward Markets Commission is
persuading increasing number of Exchanges to switch over to electronic trading, clearing and
settlement, which is more customer friendly. Commission has also prescribed simultaneous
reporting system for the Exchanges following open out-cry system. These steps facilitate audit
trail and make it difficult for the members to indulge in malpractices like, trading ahead of
clients, etc.. The Commission has also mandated all the exchanges following open outcry
system to display at a prominent place in Exchange pre ises, the name, address, telephone
number of the officer of the Commission who can be contacted for any grievance. The website
of the Commission also has a provision for the customer to make complaint, send comments
and suggestions to the Commission.
Benefits of trading in Commodity Derivatives

Be it currencies, agricultural commodities, live stocks, metals, interest rates or fuels, all of them
are affected by the price movements. A risk is always associated with such price movements
and can mean a lot in the final analysis over the difference between gain or loss to investor
producers, consumers, manufacturers, etc who are open to such price risk.
The various benefits to investor, producers, consumers, and manufacturers are:
 Price risk management

 Price discovery
 High financial leverage
 Commodities as an asset class for diversification of portfolio risk
 Transparent market
 An option for high net worth investors
 Useful to the producers
 Useful for the consumers
 Benefit to Corporate entities
 Useful to exporters
 Improved product quality
 Credit accessibility
 Benefits to farmers and other stakeholders
Commodities Traded
Agricultural Commodities
 Plantation Products
 Rubber
 Spices - Pepper, Turmeric, Jeers, Chilli, Coriander
 Pluses – Chana, yellow peas
 Fibres - Indian 28.5 mm cotton, v-797 kapas
 Cereals – Wheat, Barley, Maize (Yellow/Red) Maize - Feed/Industrial Grade
 Oil and Seeds
 Castor seeds
 Cotton seed oilcake
 Soy bean
 Refined soy oil
 Soybean meal (Export)
 Mustard Seed
 Kachhi Ghani Mustared Oil

 Crude Palm Oil
 RBD Palmolein
 Others
 Guar seeds
 Guar gum
 Gur
 Potato
 Sugar M and S
 Almond
 Mentha Oil
 Metals
 Steel
 Copper
 Zinc
 Aluminium
 Nickel
 Lead
 Energy
 Crude oil
 Thermal coal
 Brent Crude Oil
 Natural Gas
 Gasoline
 Heating Oil
 Precious Metals
 Gold
 Gold (100 Gms)
 Gold International
 Silver
 Silver (5Kg)
 Silver International
 Platinum
Physical Delivery of Commodities

The different types of deliveries are as follows: Delivery is dependent on intention of buyer
and seller and varies with the type of delivery option of a particular contract. The delivery can
be affected only in Exchange accredited or designated Warehouses. The list of warehouse and
the warehouse charges will be available on the website of the exchange. Accredited
warehouses means a warehouse approved and designated by the Exchange for making
deliveries to and take deliveries from for fulfilling contractual obligations resulting from
transactions in commodity contracts executed on exchange platform.
Compulsory delivery: In Compulsory delivery contract, all open interest position of the
Members at expiry of the contract result into deliverable obligations. Though the intention to
give/take delivery is not mandatory in such contracts, the Seller Member, if so desires, can
submit intention to give the delivery along with duly endorsed warehouse receipt and valid
quality certificate.

Seller Option: Delivery is seller option contract is based on seller’s choice on expiry of the
contract. If the seller member gives valid intention to give delivery within the stipulated time
limit as provided in the relevant contract, the Exchange will allocate the delivery to the buyer
Member. Rest of the open positions on expiry of the contract, not settled by way of delivery,
gets closed out at the due date rate.
Both option: When intention of both Buyer and Seller Member to give/take delivery match on
or before the expiry of the contract, then the delivery takes place to the extent of matched
quantity on expiry of the contract. If the intention is received from only one party, then delivery
does not take place and all open interest position of the Members get closed out at DDR.
1. Consider a long position of 10,000 kgs of pepper by a farmer. The farmer wants to hedge
the price risk using future contract. Assume that for every 50 paise change in future price,
there will be 45 paise change in the cash market price of pepper. Quantity in one contract
is 1,000 kgs. Calculate Minimum Variance hedge ratio and number of contract with which
to hedge.
Solution:
Hedge Ratio = (Change in spot Price / Change in Future Price)
= 45/50
= 0.90
Number of contract to be sold
= Total quantity cash * Hedge ratio
= 10,000 Kgs * 0.90
= 9000 kgs or 9 contracts.
2. A 10 month coffee futures are available at Rs.3,000 per bag of 60 kg. The storage cost per
bag is Rs.20 per month. If the continuously compounded interest rate is 9.5% per annum,
what is the future price of the coffee as on date?
Solution:
F = (S0+ s)ert
Where: = Spot price, s = Storage cost
Assuming storage cost is paid at the beginning of the contract

= (3000 + 200) e0.095 (10/12)
= 3463.63
Assuming storage cost is paid at the end of the contract

F = (S0+ s)ert
Present value of storage cost s= se-rt

s=200e – 0.095(10/12)
s=184.78
F = (3000 + 184.78) e 0.095 (10/12)

F = 3446.89.
3. A 6 month gold futures contract of 100 gm is quoting Rs.480 per gram in the spot market
and that it costs Rs.3 per gram for the 6-monthly period to store gold, the cost is incurred
at the end of the period. If risk free rate of interest is 12% per annum compounded
continuously what is the future price.

Solution:
F = (S0+ s)ert
r = 0.12, S0 = 480 * 100 = 48,000, t = 0.5, s = 3 * (100 e-(0.12*0.5) = 282.53.
F = (48000 + 282.53)e 0.12 * 0.5
= 51,268.15
4. The spot price of a commodity is Rs.4,600 per ton. The storage cost is Rs.25 per ton per
month payable at the beginning. If the risk free rate of return continuously compounded
is 8% per annum, what is the price of a 3-month future contract on this commodity (Size
of one future = 1 ton).
Solution:
F = (S0+ s)ert
F = (4600 + 75)e 0.08 * 0.25
F = 4675 * 1.0202
F = 4769.435
5. An investor sold a two-month futures contract on wheat for a contract price of Rs.18.50
per kg. The contract size is 1,000 kgs of wheat. The initial margin required on this contract
is 20% of the contract value and the maintenance margin is 80% of the initial margin. The
futures price per kg of wheat fluctuated during the first 10 days of the contract as follows.
You are required to prepare a margin account for the investor and show the profit/loss at
the end of 10th day assuming that any margin call is honoured immediately.
Day 1 18.90 Day 6 19.75

Day 2 18.65 Day 7 20.10
Day 3 19.10 Day 8 20.50
Day 4 19.40 Day 9 20.15
Day 5 19.15 Day 10 20.00
Solution:
Contract Value 1000 * 18.5 = 18,500
Initial Margin 18,500 * 20% = 3,700
Maintenance Margin 3,700 * 80% = 2960
Margin account for short position

Daily Cumulative Margin Margin
Day Prices
Gain/Loss Gain/Loss Balance Call
18.5 - - 3700
1 18.90 -400 -400 3300
2 18.65 250 -150 3550
3 19.10 -450 -600 3100
4 19.40 -300 -900 2800 900
5 19.15 250 -650 3950
6 19.75 -600 -1250 3350
7 20.10 -350 -1600 3000
8 20.50 -400 -2000 2600 1100
9 20.15 350 -1650 4050
10 20.00 150 -1500 4200
th
On the 10 day the investor is incurring a loss of Rs.1,500 per contract.
6. An investor took short position in one future contract on premium rice at a price of
Rs.22/kg. The size of one contract is 1000 kg. The initial margin requirement on this
contract is 12% of the contract value and the maintenance margin is 75% of the initial
margin. The future price for the first eight days are given below. Prepare a margin account
of the investor. All margin calls are met immediately.
Day 1 21.50 Day 5 22.70
Day 2 22.25 Day 6 22.50
Day 3 22.75 Day 7 23.75
Day 4 22.40 Day 8 23.25
Solution:
Contract Value 1000 * 22 = 22,000
Initial Margin 22,000 * 12% = 2640
Maintenance
Margin 2,640 * 75% = 1980
Margin Account for Short position

Daily Cumulative Margin Margin
Day Prices
Gain/Loss Gain/Loss Balance Call
22 - - 2640
1 21.50 500 500 3140
2 22.25 -750 -250 2390
3 22.75 -500 -750 1890 750
4 22.40 350 -400 2990
5 22.70 -300 -700 2690
6 22.50 200 -500 2890
7 23.75 -1250 -1750 1640 1000
8 23.25 500 -1250 3140

Forward Contract
Long Forward Contract = f = (F0 – K)e-rt or f = S0 – Ke-rt
Short Forward Contract = f = (K - F0)e-rt or f = Ke-rt - S0
Forward contract on an investment asset that provides a known income with present value
I:
f = S0 – I - Ke-rt
Forward contract on an investment asset that provides a known yield at rate y:

f = S0e-y*t - Ke-rt
1. A long forward contract on a non-dividend paying stock was entered into some time ago.
It currently has 6 months to maturity. The risk-free rate of interest with continuous
compounding is 10% per annum. The stock price is Rs.25, and the delivery price is Rs.24.
Find out the value of a forward contract.
Solution:
f = (F0 – K)e-rt
F0 = S0ert
F0 = 25 e 0.10*0.5
= Rs.26.28
f = (26.28 – 24) e -0.10*0.5

= Rs.2.17
2. A Stock is expected to pay two dividends of Rs.15 each at the end of two months and four
months from now. The current market price of the share is Rs.340. The risk free rate of
return continuously compounded is 8% p.a. An investor took short position in a forward
contract in a forward contract on this share with 6 months to maturity. Compute the price
of the forward contract. Three months later if the share is traded at Rs.356 and the risk-
free rate remains unchanged. What is the value of the short position taken by the investor?
Solution:
The forward price
F0 =(S0 – I)ert
= 340 e 0.08 * 05
= 353.88
I = D - rt
PV of dividend expected at the end of two months
= 15 – 0.08 * (2/12)
= 14.80
PV of dividend expected at the end of four months

= 15 – 0.08 * (4/12)
= 14.60
F0 = (340 – 29.4) e 0.08 * 05

= 323.28

The delivery price K in the contract is Rs.323.28. The value of short position after 3
months:
f = Ke-rt - S0
= 323.28e – 0.08 * 0.25 – (356 – 14.90)
= 316.87 – 341.1
= - 24.50
3. Calculate the 6-month forward price of an asset that pays no income, when the spot price
of the asset is Rs.114 and interest rate is 7%. After one month, what will be the value of
this forward contract, if interest rate rise to 8.5% and the spot price of the asset declines to
Rs.109? What is the value of this forward contract in the present value terms?
4. A one-year long forward contract on a non-dividend-paying stock is entered into when the
stock price is $40 and the risk-free rate of interest is 10% per annum with continuous
compounding.
a) What are the forward price and the initial value of the forward contract?
b) Six months later, the price of the stock is $45 and the risk-free interest rate is still 10%.
What are the forward price and the value of the forward contract?
Solution:
a) The forward price, F0 , is given by equation (5.1) as:
011
F0  40e  4421
or $44.21. The initial value of the forward contract is zero.
b) The delivery price K in the contract is $44.21. The value of the contract, f , after six
months is given by equation (5.5) as:
f  45  4421e0105
 295
i.e., it is $2.95. The forward price is:
45e0105  4731 or $47.31.

Credit Default Swaps

Credit derivatives
Credit derivative is the instruments of derivative market used to hedge against the credit risk
exposure. The credit derivative is the tools used by two parties to transfer the credit risk. Most
of the credit derivatives are over the counter contracts hence they are customised according to
the party’s requirements. There are large number of economic entities includes banks,
insurance companies, fund managers, pension funds and corporations.
Bond prices and the probability of default

There is an inverse relationship between probability of default and bond prices. If the default
probability decreases the bond price increases and if the default probability increase the bond
price decreases. The probability of default for a company can be estimated from the prices of
the bonds it has issued. The usual assumption is that the only reason a corporate bond sells for
less than a similar risk free bond is the possibility of default.
Assume that a bond earns a 2% return higher than the similar risk free bond, and the expected
recovery rate in the event of default is 40%. The bond holder is likely to incur a loss of 2% per
year from defaults. With the given information one can find the approximate probability of
default per year with a condition that there is no other earlier default.
Default rate per year (Hazard rate) = Loss per year / (1- Recovery rate)
Default rate per year (Hazard rate) = 0.02 / (1-0.4)
= 0.0334 or 3.34%
Recovery rate is nothing but the amount the holder of bond will receive in the event of credit
default.
The most popular credit derivative is a Credit Default Swap (CDS). This is a contract that
provides insurance against the risk of a default by particular company. The company is known
as the reference entity and a default by the company is known as credit event. The buyer of
the insurance obtains the right to sell bonds issued by the company for their face value when a
credit event occurs and the seller of the insurance agrees to buy the bonds for their face value
when a credit event occurs. The total face value of the bonds that can be sold is known as the
credit default swap’s national principal.
The buyer of the CDS makes periodic payments to the seller until the end of the life of the CDS
or until a credit event occurs. These payments are typically made in arrears every quarters, but
deals where payments are made every month, 6 month or 12 months also occur and sometimes
payments are made in advance. The settlement in the event of a default involves either physical
delivery of the bonds or a cash payments.
Let us consider an example how a typical deal is structured. Suppose that two parties enter
into a 5-year credit default swap on March 20th 2013. Assume that the notional principal is
$100 million and the buyer agrees to pay 90 basis points per annum for protection against
default by the reference entity, with payments being made quarterly in arrears.

The CDS shown in the above figure. If the reference entity does not default the buyer receives
no payoff and pays 22.5 basis points (a quarter of 90 basis points) on $100 million on June 20
2013 and every quarter thereafter until March 20, 2018. The amount paid each quarter is
0.00225* 100,000,000 or $2,25,000.
1. Suppose that the risk-free zero curves is flat at 7% p.a with continuous compounding and
that defaults can occur halfway through each year in a new 5-year credit default swap.
Suppose that the recovery rate is 30% and the default probabilities each year conditional
on no earlier default is 3%, estimate the credit default swap payoff. Assume payments are
made annually and probability of default is 0.0300, 0.0291, 0.0282, 0.274 and 0.0266.
Solution:
Calculation of the present value of expected payoff
Time Probability Recovery Default Expected Discount PV of expected
of default Rate Rate Pay off factor Payoff
0.5 0.0300 0.3 0.7 0.0210 0.9656 0.0203
1.5 0.0291 0.3 0.7 0.0204 0.9003 0.0183
2.5 0.2820 0.3 0.7 0.1974 0.8395 0.1657
3.5 0.2740 0.3 0.7 0.1918 0.7827 0.1501
4.5 0.0266 0.3 0.7 0.0186 0.7298 0.0136
Total 0.3680
a) Expected pay off = Probability of default * Default rate

b) Discount factor = e –rt
c) PV of expected pay off = Expected Pay off * disc factor

Currency Futures
7. The two-month interest rates in Switzerland and the United States are 2% and 5% per
annum, respectively, with continuous compounding. The spot price of the Swiss franc is
$0.8000. The futures price for a contract deliverable in two months is $0.8100. What
arbitrage opportunities does this create?
Solution:
The theoretical futures price is
F = S0 e(rd – rf)t
F= 08000e(005002)212  08040
The actual futures price is too high. This suggests that an arbitrageur should buy Swiss
francs and short Swiss francs futures.
8. The current USD/euro exchange rate is 1.4000 dollar per euro. The six month forward
exchange rate is 1.3950. The six month USD interest rate is 1% per annum continuously
compounded? Estimate the six month euro interest rate.
If the six-month euro interest rate is rf then
( 0.01r f )0.5
1.3950  1.4000e
So that
 1.3950 
0.01  r f  2 ln    0.00716
 1.4000 
rf = 0.01716. The six-month euro interest rate is 1.716%.
9. In Singapore foreign exchange market NDFs are quoted in RMB for settlement in US
dollar. An exporter based in Hong Kong has RMB 1 million receivable after three months.
The RMB is likely to depreciate. NDF is being offered at RMB 8.2 per dollar, which the
exporter books. What amount would the exporter pay/receive if on the settlement date,
the fixing rate is RMB 8.3 per dollar?
Solution:
The exporter sells RMB (Buy USD) at an exchange rate of RMB 8.2 per dollar. Therefore
the notional principal is USD (10,00,000/8.2) = $1,21,991.20
On settlement the fixing rate is 8.3. The exporter would receive from the bank what is
necessary to cover the shortfall he would have on RMB receivables when converted to US
dollars at spot rate.
= $1,469.20

10. Dollar futures with expiry in 60 days from now at MCX-SX are trading at Rs.48.65. In
the spot market, the rate is Rs.47.75. Risk-free rate in India and USA are estimated to be
9% and 5%. If the estimates are assumed correct, what action would you take to earn
profit?
Solution:
The fair value of the future is
F = 47.75 e(0.09 – 0.05)(60/365)
F = 48.0650
The future is overpriced, therefore it must be sell.
11. The following data from financial markets is available:

Spot exchange rate (rupee per dollar) : 49.7500
90-day future : 51.4000
Rupee interest rate (T-bill yield) : 12%
Dollar interest rate (T-bill yield) : 8%
Based on the above data, find out the fair price of the future contract. Is there any arbitrage
opportunity? If yes, how can the arbitrage be executed?
Solution:
The fair value of the future using continuous compounding interest is given by
F = 49.75 e(0.12 – 0.08)(90/365)
F = 50.2413
The actual future trading at Rs.51.40 as against the fair price of Rs.50.2413 is overpriced.
Therefore we need to sell dollar futures. Hence we borrow rupee now and make arbitrage
profit as given below:
Cash flows
Particulars
USD INR
Borrow rupees at 12% 1000
Convert to dollar using the spot market 20.1005 -1000
Invest the dollar at 8% for 90 days -20.1005
Sell the dollars in futures maturing after 90 days, worth
Rs.1053.55
Total 0 0
At Maturity
Receive invested dollar 20.5009
Delivery dollar against futures -20.5009
Receive rupees against futures (20.5009 * 51.40) 1,053.55
Pay rupee borrowed at 12% 1030.03
Total 23.52
At the maturity of the futures contract, the arbitrageur can make a profit of Rs.23.52 for
every Rs.1,000 borrowed.

Value at Risk
Value at Risk (VaR) is an attempt to provide a single number summarizing the total risk in a
portfolio of financial assets. It has become widely used by corporate treasurers and fund
managers as well as by financial institutions. Bank regulators also use VaR in determining the
capital a bank is required to keep for the risks it is bearing.
VaR is the most widely accepted measure of market risk all over the world, and the Indian
market is no exception to this norm. Also as with any other market, it is the banking-related
segments of the capital markets that are more regulated from the risk perspective as compared
to equity segment of the capital markets.
The VaR Measure
While using the VaR measure we are interested in making statements of the following form.
We are X percent certain that we will not lose more than V dollars in the next N days.
VaR has two parameters: the time horizon (N) and the confidence level (X). In general when
N days is the time horizon and X% is the confidence level. VaR is the loss corresponding to
the (100 – X) th percentile of the distribution of the changes in the value of the Portfolio over
the next N days. VaR is an attractive measure because it is easy to understand. In essence it
asks the simple question “How much the investor lose if worst things happen?” This is the
question all senior managers want answered.
Historical Simulation
Historical simulation is an important tool to estimate Value at Risk. Under this method the
past data are used to know what might happen in future.
The Historical Simulation involves the following steps, assuming 1 day time horizon, 99%
confidence level for recent past n number (501 days) of days
 Identify the factors affecting the portfolio i.e stock price, exchange rate, interest rate
inflation etc.
 Collect the past data on changes in the value/price of identified market variable for the past
n number of days.
 This provides n number of alternatives scenarios for what can happen between today and
tomorrow.
 Percentage change in variable from day 0 to day 1, day 1 to day 2 and so on for n number
of scenarios are built.
 For each scenario the change in the value of portfolio from today to tomorrow is calculated.
 Estimate the probability distribution of daily changes in the value of portfolio.
 The fifth worst daily change is the first percentile of the distribution
 The estimate of VaR is the loss at this first percentile point.
 So, the company is 99% sure that it will not incur loss greater than the VaR estimate.
 Historical simulation enables us know the value of portfolio for the change variables under
n number of scenarios.
Model Building Approach
The main alternative to historical simulation is to make assumptions about the probability
distributions of return on the market variables and calculate the probability distribution of the

change in the value of the portfolio analytically. This is known as the model building approach
or the variance-covariance approach.
As we know in the option pricing the standard deviation is quoted in terms of years i.e volatility
per year. The calculation of VaR under model building approach the volatility is expressed in
terms of volatility per day. The volatility per day can be calculated using the following formula
assuming the number of trading days in a year as 252 days.
Approximately the daily volatility will be 6% of annual volatility

The model assumes the following:
The daily volatility and correlation between portfolios of assets are given
The expected change in a market variable over the time period considered zero. Though it not
true it is a reasonable assumption.
The expected change in the price of a market variable over a short time period is generally
small when compared with the standard deviation of the change.
Single Asset VaR

Under Model Building approach the VaR can be computed for single asset.
1. Considering the following information VaR can be computed as under
Value of the asset Rs.10 lakhs
Time horizon N=10 days
Confidence level X = 99%
Volatility per year σ = 40%
Solution:
= 0.0252 or 2.52%
The standard deviation of the daily change in the value of asset is 2.52% of 10,00,000 is
Rs.25,200.
1 day 99% VaR of the asset is 25,200 * 2.58 = Rs.29,716 (2.58 is table value at 99%
confidence level)
It implies that we are 99% certain that the loss will not exceed Rs.65,016 in a day.
Similarly the 10 days VaR is 1 day VaR * √10

65,016 * √10 = Rs.2,05,599
It implies that we are 99% certain that the loss will not exceed Rs.2,05,599. in 10 days.

Two asset or portfolio VaR

Under the model building approach the VaR can be determined for a portfolio of assets as
below:
Where:
σx y = Standard deviation of portfolio
σx = Standard deviation of asset X
σy = Standard deviation of asset Y
ρ = Correlation between asset X and Y
For the portfolio of assets the VaR will get reduced substantially compared to the VaR of
individual assets, this is known as benefit of diversification. If the return of two assets were
perfectly correlated then the VaR of portfolio will be equal to the VaR of the individual asset
in a portfolio.
Linear Approach
Linear approach assumes that the daily change in the value of a portfolio is linearly related to
the daily returns from market variables. The returns from the market variables are normally
distributed. The Linear model is used to a portfolio with no derivatives consisting of positions
in stocks, bonds, foreign exchange and commodities. In this case the change in the value of
the portfolio is linearly dependent on the percentage changes in the prices of the assets in the
portfolio. For calculating VaR all assets prices are measured in the domestic currency. A
derivative that can be handling by Linear model is a forward contract to buy a foreign currency.
Assume if the contract maturing at time T. It can be regarded as the exchange of a foreign zero
coupon bond maturing at time T for a domestic zero coupon bond maturing at time T. For the
purpose of calculating VaR the forward contract is therefore treated as long position in the
foreign bond combined with a short position in the domestic bond. Each bond can be handled
using a cash flow mapping procedure.
Cash flow mapping a procedure for representing an instrument as a portfolio of Zero coupon
bonds for the purpose of calculating Value at Risk.
Quadratic Model
Gamma measures the curative of the relationship between the portfolio value and an underlying
market variable. When Gamma is positive the probability distribution leads to be positively
skewed, when Gamma is negative it tends to be negatively skewed. It shows the relationship
between the value of a long call option and the price of the underlying asset. A long call is an
example of an option position with a positive Gamma. Negative Gamma shows the relationship
between the value of a short call position and the price of the underlying asset.
Monte Carlo Simulation

We can implement the model building approach using Monte Carlo simulation to generate the
probability distribution for the ∆p (Change in portfolio).

To calculate 1 day VaR of portfolio, the steps are:

1. Value the portfolio today in the usual way using current values of market variables.
2. Sample once from the multivariate normal probability distribution of the ∆x
3. Use the values of the ∆x that the sample to determine the value of each market variable at
the end of the one day.
4. Revaluate the portfolio at the end of the day in the usual way.
5. Subtract the value calculated in step 1 from the value in step 4 to determine a sample ∆p
6. Repeat step 2 to 5 many time to build up probability distribution for ∆p
7. The VaR is calculated as the appropriate percentile of probability distribution of ∆p
8. The VaR is calculated as the appropriate percentile of the probability distribution of ∆p.
If one determine the 5000 samples values of portfolio the way described above. The one
day 99% VaR is the change in value portfolio (∆p) for the 50th worst outcome; The 1 day
95% VaR is the value of change in value of portfolio (∆p) for the 250th worst outcome and
so on. The N day VaR is 1 day VaR multiplied by √N12
Stress Testing and Back Testing

Stress Testing
It involves estimating how the portfolio would have performed under some of the most extreme
market moves seen in last 10 to 20 years. Stress test can be considered as a way of taking into
account extreme events that do occur from time to time but that are virtually impossible. (Such
as the collapse of the stock market on October 19th 1987, American stocks lost more than 20%
in one day, or January 2008 market fall) The scenarios used in stress testing are sometimes
generated by senior managers in that they are asked to meet periodically and brain storm to
develop extreme scenarios that might occur given the prevailing economic environment and
global uncertainties.
In India higher intraday fall was on 22nd January 2008 where Sensex was down by 2273 points.
The total loss to the investor was Rs.6 lakh crores. Stress test will consider such extreme events
to know the performance of portfolio.
Back Testing
It involves how well the VaR estimates would have performed in the past. It involves looking
at how often the loss in a day exceeded the VaR that would have been calculated for that day.
If it has occurred the methodology is suspect. An important reality check is back testing
suppose we are calculating the 1-day 99% VaR and on 7% of days the losses are higher than
the VaR, it implies that methodology followed to estimate VaR need to be relooked.
1. A portfolio of shares consists of investment in shares of A valued at Rs.4,00,000 and in

shares of B valued at Rs.2,50,000. The daily standard deviation of returns of A and B are
3% and 3.5% respectively. The correlation coefficient between the returns of these two
stocks is 0.65. Compute the 10 day VaR of the portfolio at 95% confidence level. By
what amount has the diversification reduced VaR?
Solution:
One day standard deviation of price of A company shares = 4,00,000 * 0.03 = Rs.12,000
One day standard deviation of price of B company shares = 2,50,000 * 0.035 = Rs.8,750
One day standard deviation of price of portfolio =

10 days 95% Value at Risk of portfolio = 18,896 * 1.96 √10 = 1,17,118

1.96 is the table value given at the end of 95% confidence level.
10 days 95% Value at Risk of A = 12,000 * 1.96 √10 = Rs.74,377
10 days 95% Value at Risk of B = 8,750 * 1.96 √10 = Rs.54,233
Benefit of diversification = (74,377 + 54,233) - 1,17,118 = Rs.11,492
2. Suppose that the daily change in the value of a portfolio is, to a good approximation,
linearly dependent on two factors, calculated from a principal components analysis. The
delta of a portfolio with respect to the first factor is 6 and the delta with respect to the
second factor is -4. The standard deviations of the factor are 20 and 8, respectively. What
is the 5-day 90% VaR?
Solution:
The factors calculated from a principal components analysis are uncorrelated. The daily
variance of the portfolio is
62  202  42  82  15 424

and the daily standard deviation is 15 424  $12419 . Since N (1282)  09 , the 5-day
90% value at risk is
12419  5 1282  $35601
3. A portfolio consists of Rs.4,00,000 invested in shares of company A and Rs.6,00,000

invested in shares of company B. The daily volatilities measured by standard deviation
for these two stocks are 1% and 2% respectively. The stock returns are normally
distributed. The correlation coefficient between the returns of these stocks is 0.40.
Compute the 10 day 99% VaR of the portfolio. By what amount has the diversification
reduced VaR? (Use model building approach)
4. A portfolio consists of Rs.4,00,000 invested in shares of Seatel and Rs.6,00,000 invested

in shares of Pyramid. The annual volatilities of these two assets are 30.4% and 22.4%
respectively. The coefficient of correlation between their returns is 0.60. Compute the 15
day 97.5% VaR for the portfolio. Explain by what amount the diversification reduced
VaR?
5. Consider a position consisting of a $1,00,000 in asset A and $1,00,000 investment in B.

Assume that the daily volatilities of both assets are 1% and that the coefficient of
correlation between their returns is 0.3. What is the 5-day 99% VaR for the portfolio?

Important Theory Questions
3 Marks
1. What do you mean by derivatives?

2. What is lot size and tick size?
3. What is a financial derivative?
4. What is meant by Index arbitrage
5. What is calendar spread?
6. What is plain vanilla swap?
7. What is currency swap?
8. What is financial swap?
9. What is a comparative advantage argument in a swap?
10. What are limits on futures? When will the trading on futures stop?
11. Define basis
12. Differentiate between forwards and futures.
13. What do you mean by strip or strap? When are these strategies adopted?
14. Under what circumstance are i) a short hedge ii) long hedge appropriate?
15. Explain the differences between writing a call option and buying a put option.
16. What is time decay in an option contract?
17. What is put-call parity?
18. How naked calls are different from covered calls?
19. What do you mean by in-the money, out of the money and at the money for call and put
options?
20. Define condors.
21. What is the difference between long forward position and short forward position?
22. What is a Forward rate agreement (FRA)?
23. What are collateralized debt obligations?
24. What are repo rates?
25. What is convenience yield?
26. What do you mean by Value at Risk (VaR)?
27. Explain with an example what do you mean by stress testing of VaR?
28. What are the parameters of VaR?
29. Explain the terms position traders, day traders and scalpers.
30. Define warrants
31. Differentiate between American and European options.
32. What is gamma risk?
33. What is hedge ratio?
34. What is hedging?
35. What is margin?
36. What do you mean by insurance premium and insurance rate?
37. Write any three important functions of commodity futures.
38. What is stress testing in risk measure?
39. What are credit derivatives?
40. Define credit spread.
41. Define credit risk?
42. What are the types of interest rates?

43. Define call option and put option

44. Define SWAP
45. Define short selling
46. What are the risk control techniques?
47. What are interest rate futures contracts?
48. What is credit default swaps?
49. What are zero rates?
50. What do you mean by intrinsic value and time value of options?
51. What is a straddle?
52. Differentiate between stress testing and back testing.
53. What is a butterfly spread?
54. What is open interest?
55. Differentiate between exchange traded and over the counter derivatives.
56. What is impact cost?
57. What is bull spread? How is it different from bear spread?
58. What is total return swap?
59. Distinguish between maintenance margin and variation margin.
60. What do you understand by the term market maker?
61. What are the characteristic features of an arbitrage transaction?
62. What is pure risk? Give two examples for the same.
63. Briefly explain: i) Straddle ii) Strips and straps iii) Strangles
64. Define basis. When is basis said to have i) strengthened ii) weakened?
65. Differentiate between risk and uncertainty.
66. What are treasury rates?
67. Why is risk identification important for a firm?
68. What are the assumptions of Black and Scholes model?
69. What is commodity futures?
70. What are the caps, floors and cellars?
71. What do you mean by LIBOR?
72. What is legal liability exposure?
73. What is netting?
74. What is meant by convergence?
75. What do you mean by swaption?
76. Name various sources of risk.
77. What is Zero curve?
78. What is Cross hedging?
79. How a strangle strategy created?
80. When will call and put option be exercised?
81. What is clearing house?
82. A lender gives a loan on which he quotes the interest rate as 15% per annum with
continuous compounding. Calculate the equivalent rate, if compounding was done
quarterly.
83. The spot price of the Gold is Rs.600 per gram. The storage cost is Rs.25 per gram per
month payable at the beginning. If the risk free rate of return continuously compounded
is 8% per annum, what is the price of a 3 month future contract on Gold (Size of the
contract = 100 gms)?

84. Consider a forward contract on a non-dividend paying share, which is available at Rs.80,
to mature in 3 months’ time. If the risk free rate of interest is 7% per annum compounded
continuously, what is the price of the forward contract?
85. The spot price of a commodity is Rs.4,600/ton. The storage cost is Rs.25/ton/month
payable at the beginning. If the risk free rate of return continuously compounded is 8%
per annum, what is the rice of a 3 month future contract on this commodity? (Size of one
future - 1 ton)
86. The risk-free rate of interest is 7% per annum with continuous compounding and the
dividend yield on a stock index is 3.2% per annum. The current value of the index is 150.
What is the six month futures price?
87. A financial institution quotes an interest rate of 14% per annum with quarterly
compounding. What is the equivalent rate with i) Continuous and ii) Annual
compounding?
88. A call option at a strike price of Rs.176 is selling at a premium of Rs.18. At what price
will it break even for a buyer of the option?
89. What is the lower bound for a price of 6 month call on a non-dividend paying stock , the
stock price is Rs.80 and strike price is Rs.75, the r=10%p.a
90. Raja is bearish about the index. Spot Nifty stands at 4000. He decides to sell one contract
(50 Index) of Nifty call option at a strike price of 4000 for a premium of Rs.50 per index.
Two months later when the contract matures, Nifty closes at 4500. Find out the profit or
loss to the seller of call option.
91. Cash market investment in securities is Rs.12 lakhs. The Beta of the portfolio is one. What
should be done to hedge this portfolio using stock index futures contract if the investor
feels that the market would fall by 20% in 2 months.
5/7 Marks Questions
1. Explain in brief various functions performed by derivatives market.

2. Distinguish between forward and futures.
3. Elucidate in brief the assumptions underlying the Black Scholes model.
4. What are the types of future contract? Elucidate.
5. What is Swap? What are the types of swaps? Elucidate.
6. Distinguish stock derivatives from commodity derivatives.
7. Write a note on credit default swaps and total return swaps.
8. Explain stress testing and back testing.
9. Write a note on any two commodity exchanges in India.
10. Write a note on Treasury bond futures and Treasury note futures.
11. Briefly explain the specification s of futures.
12. Explain the various principles of insurance contract.
13. Explain types of credit derivatives.
14. Write a short notes on bull spread and bear spread.
15. Explain the significance of insurance and financial derivatives instruments in hedging risk.
16. Describes the factors affect the option prices.
17. What is FRA? State the significant characteristics of FRA.
18. What is credit default swap? Explain the features of a swap contract.
19. Explain the features of a forward contract.
20. What are commodity futures? Discuss the benefits of commodity futures.

21. Briefly explain the steps involved in the risk management process.
22. Who are the participants in commodity derivatives market? Discuss their objectives.
23. Who are the different types of players in the derivatives market? Explain their role.
24. “Call writer and put buyers exhibit bearish sentiments”. Explain.
25. Explain the steps involved in quantifying VaR using Monte Carlo simulation.
10 Marks Questions.
1. What do you mean by credit risk and how it can be mitigated?
2. Briefly explain option Greeks.
3. Who are the different types of players in the derivatives market? Explain their role.
4. Why risk identification important for a firm? Briefly explain the steps in the risk
management process.
5. Explain credit default and total return swaps. What are their users?
6. Explain straddle, strip, straps and strangles.
7. An investor receives $1,100 in one year in return for an investment for $1,000 now
calculate the % return p.a with
i. Annual compounding
ii. Monthly compounding’
iii. Quarterly compounding
iv. Daily compounding
8. What are interest derivatives? Explain the salient features of exchange traded interest
futures.
9. What are swaps? What are the different types of swaps? Explain.
10. Discuss major types of pure risks. Explain the methods of managing pure risks.
11. Discuss different types of orders.
All the best

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A Study Material

Sathyanarayana K, Faculty- Finance, (M):984411378 1

Exchange rate of risk

Interest rate risk

Sathyanarayana K, Faculty- Finance, (M):984411378 3

Reverse cash-and-carry arbitrage

Optimum hedge ratio

Sathyanarayana K, Faculty- Finance, (M):984411378 4

Clearing price/Settlement price

Forward premium or discount

Sathyanarayana K, Faculty- Finance, (M):984411378 5

Interest rate parity

Implied repo rate

Treasury bond futures

Sathyanarayana K, Faculty- Finance, (M):984411378 6

Interest rate swap

Sathyanarayana K, Faculty- Finance, (M):984411378 7

Time value of option

Binomial option pricing model

Equivalent portfolio approach

Monte Carlo simulation

Sathyanarayana K, Faculty- Finance, (M):984411378 8

Monte Carlo simulation

Sathyanarayana K, Faculty- Finance, (M):984411378 9

Ratio range forward

Covered call writing

Naked call writing

Sathyanarayana K, Faculty- Finance, (M):984411378 10

Derivatives are Instruments in Respect of which Trading is carried out as a Right on an

Assets Traded in Derivatives

Depending on how the pay offs are structured, it could be a:

Features of Forward Contracts

Sathyanarayana K, Faculty- Finance, (M):984411378 11

Long Position Short Position

Issues with Forward Contracts

“A Future Contract is a promise to buy/sell a certain quantity of Standardized goods/asset on

Payment Sells Future Contract

Future Buyer Clearing Future Seller

Buys Future Contract Payment

Sathyanarayana K, Faculty- Finance, (M):984411378 12

Specification of a Future Contract

Distinction between Forwards and Futures

Trading Underlying vs. Trading Single Stock Futures

Sathyanarayana K, Faculty- Finance, (M):984411378 13

Call Option Put Option

Sathyanarayana K, Faculty- Finance, (M):984411378 14

MTM & Margin call

MTM of Mr. Shyam (Short Nifty)

Date Price Date Price

Sathyanarayana K, Faculty- Finance, (M):984411378 15

MTM of Mr. John (Short SBIN)

Sathyanarayana K, Faculty- Finance, (M):984411378 16

Contract Value 2,30,000

Traded Settle Daily Cumulative Margin A/c Margin

Day Price Day Price

Sathyanarayana K, Faculty- Finance, (M):984411378 17

For Long Position

0 29,500 29,754 6,350 6,350 81,350

For Short Position