DBA 5035

DBA 5035
MASTER OF
BUSINESS ADMINISTRATION
FINANCIAL DERIVATIVES
MANAGEMENT
CENTRE FOR DISTANCE EDUCATION

ANNA UNIVERSITY
CHENNAI – 600 025
FINANCIAL DERIVATIVES MANAGEMENT
SYLLABUS
UNIT-I
Introduction: Derivatives – Definition – Types – Forward Contracts – Futures Contracts – Options – Swaps –
Differences between Cash and Future Markets – Types of Traders – OTC and Exchange Traded Securities– Types
of Settlement – Uses and Advantages of Derivatives – Risks in Derivatives.
UNIT-II
Futures Contract: Specifications of Futures Contract – Margin Requirements – Marking to Market – Hedging
using Futures – Types of Futures Contracts – Securities, Stock Index Futures, Currencies and Commodities –
Delivery Options – Relationship between Future Prices, Forward Prices and Spot Prices.
UNIT-III
Options: Definition – Exchange Traded Options, OTC Options – Specifications of Options – Call and Put Options
– American and European Options – Intrinsic Value and Time Value of Options – Option payoff, options on
Securities, Stock Indices, Currencies and Futures – Options Pricing Models – Differences between Future and
Option Contracts.
UNIT-IV
SWAPS: Definition of SWAP – Interest Rate SWAP – Currency SWAP – Role of Financial Intermediary –
Warehousing – Valuation of Interest Rate SWAPs and Currency SWAPs Bonds and FRNs – Credit Risk.
UNIT-V
Derivatives in India: Evolution of Derivatives Market in India – Regulations – Framework – Exchange Trading in
Derivatives – Commodity Futures – Contract Terminology and Specifications for Stock Options and Index
Options in NSE – Contract Terminology and Specifications for Stock Futures and Index Futures in NSE –
Contract Terminology and Specifications for Interest Rate Derivatives.
FINANCIAL DERIVATIVES MANAGEMENT
SCHEME OF LESSONS
Page No.
UNIT I
Lesson 1 Introduction to Derivatives 7
Lesson 2 Traders and their Settlement 34
UNIT II
Lesson 3 Futures Contract 57
Lesson 4 Currencies and Commodities 96
UNIT III
Lesson 5 Options 127
Lesson 6 Options Pricing and Payoff 150
UNIT IV
Lesson 7 Swaps 189
Lesson 8 Valuation of Swaps 212
UNIT V
Lesson 9 Derivatives in India 237
Lesson 10 Stock and Index Futures and Interest Rate Derivatives 257
Model Question Paper 279
Lesson 1 - Introduction to Derivatives
Notes
UNIT I
LESSON 1 - INTRODUCTION TO DERIVATIVES
CONTENTS
Learning Objectives
Learning Outcomes
Overview
1.1 Derivatives – Meaning and Definition
1.1.1 Various Definitions of Derivatives
1.1.2 General Characteristics of Derivatives
1.1.3 Origin and Evolution of Derivatives
1.2 Types of Derivatives
1.2.1 Forwards Contract
1.2.2 Futures Contract
1.2.3 Options
1.2.4 Swaps
1.3 Differences between Cash and Future Markets
1.3.1 Cash Market
1.3.2 Futures Market
Summary
Keywords
Self-Assessment Questions
Further Readings
LEARNING OBJECTIVES
After studying this lesson, you should be able to:
 Define the term derivatives
 Explain the different types of derivatives
 Differentiate between cash and futures market
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Financial Derivatives Management
Notes LEARNING OUTCOMES

Upon completion of the lesson, students are able to demonstrate a good
understanding of:
 the fact that derivatives are financial contracts and its value/price is
dependent on the behaviour of the price of one or more basic underlying
assets.
 the datum that the clearing house protects itself from default and for this it
requires its counterparties to settle gains and losses or mark to market their
positions on a daily basis.
 the fact that for a specific commodity, the price in the cash market is
usually less than its price in the futures market. This is because there are
carrying costs, such as storage and insurance, involved in holding a
commodity until it can be delivered at some point in the future.
OVERVIEW
In recent decades, financial markets have been marked by excessive volatility.
As foreign exchange rates, interest rates and commodity prices continue to
experience sharp and unexpected movements, it has become increasingly
important that corporations exposed to these risks be equipped to manage them
effectively. Price fluctuations make it hard for businesses to estimate their
future production costs and revenues. Derivative securities provide them a
valuable set of tools for managing this risk. Risk management, the managerial
process that is used to control such price volatility, has consequently risen to
the top of financial agendas. It is here that derivative instruments are of utmost
utility.
As instruments of risk management, these generally do not influence the
fluctuations in the underlying asset prices. However, by locking-in asset prices,
derivative products minimize the impact of fluctuations in asset prices on the
profitability and cash flow situation of risk-averse investors.
The word ‘derivatives’ originated in mathematics and refers to a variable that
has been derived from another variable.
Example: A measure of distance in kilometers could be derived from a

measure of distance in miles by dividing by 1.61, or similarly a measure of
temperature in Celsius could be derived from a measure of temperature in
Fahrenheit. In financial sense, a derivative is a financial product which had
been derived from a market for another product.
In this lesson, you will learn about the derivatives, types of derivatives-forward
contracts, future contracts, options and swaps. At the end of the lesson you
would be studying about the difference between cash and futures market.
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1.1 DERIVATIVES – MEANING AND DEFINITION Notes

A derivative security is a financial contract whose value is derived from the
value of underlying asset, such as a stock price, a commodity price, an
exchange rate, an interest rate, or even an index of prices.
1.1.1 Various Definitions of Derivatives
Derivatives are financial contracts whose value/price is dependent on the
behaviour of the price of one or more basic underlying assets (often simply
known as the underlying). These contracts are legally binding agreements,
made on the trading screen of stock exchanges, to buy or sell an asset in future.
The asset can be a share, index, interest rate, bond, rupee dollar exchange rate,
sugar, crude oil, soyabean, cotton, coffee and what you have.
Thus, a ‘derivative’ is a financial instrument, or contract, between two parties
that derived its value from some other underlying asset or underlying reference
price, interest rate, or index.
A derivative by itself does not constitute ownership; instead it is a

promise to convey ownership.
The Underlying Securities for Derivatives are:

 Commodities (Castor seed, Grain, Coffee beans, Gur , Pepper, Potatoes
 Precious Metals (Gold, Silver)
 Short-Term Debt Securities ( Treasury Bills)
 Interest Rate
 Common Shares/Stock
 Stock Index Value ( NSE Nifty)
In the Indian context, the Securities Contracts (Regulation) Act, 1956 (SC(R)
A) defines “derivative” as to include –
 A security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or any other form of
security;
 A contract which derives its value from the prices, or index of prices, of
underlying securities. Derivatives are securities under the SC(R) A and
hence the trading of derivatives is governed by the regulatory framework
under the SC(R) A.
Example: You have purchased a gold futures on May 2003 for delivery
in August 2003. The price of gold on May 2003 in the spot market is ` 4500
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Notes per 10 grams and for futures delivery in August 20()3 is ` 48(X) per 10 grams.
Suppose in July 2003 the spot price of the gold changes and increased to
` 48(X) per 10 grams. in the same line value of financial derivatives or gold
futures will also change.
1.1.2 General Characteristics of Derivatives
Derivatives defined as per Accounting Standard SFAS133 is ‘a financial
derivative or other contract with the following features:
 It has one or more underlying assets and its value changes in response to
changes in price of the underlying. There are derivatives on agricultural
and livestock products, metals, energy, currencies, stocks, stock indexes,
interest rates etc.
 Requires negligible initial investment compared to other types of financial
contracts that have a similar response to changes in market conditions
 Should provide for net settlement i.e., offsetting of initial contract position.
This way it permits higher profits as well as possibility of greater losses.
Some of the common features of Derivatives are:
 The instrument relates to the future contracts and settlement of terms
between the parties involved, normally called maturity period in case of
Forwards Contract.
 The parties involved may be obliged to exercise their contracts or offset
them (Forwards, Futures); or may have rights (like option buyers).
 The contracts are fulfilled or transacted through a recognized exchange
(Futures contracts) through the clearing house or they may be private bi-
lateral contracts (Forwards, Swaps) or over-the counter contracts (Options).
The exchange traded derivatives are quite liquid and have low transaction
costs as against tailor made contracts.
Example: Dow Jones, S&P 500, Nikki 225, NIFTY Option, S&P
Junior that are traded on New York Stock Exchange, Tokyo Stock
Exchange and so on.
 Financial derivatives are carried off-balance sheet. The size of the
derivative contract is based upon its notional amount. The notional amount
is the amount used to calculate the pay-off.
Example: In the option contract, the potential loss and potential

pay-off, both may differ from the value of underlying shares because the
payoff of derivative products varies from the pay off that their notional
amount might advocate.
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 Derivatives are also termed as deferred delivery or deferred payment Notes

instrument. It implies that it becomes easy to take short or long position in
derivatives as compared to other assets or securities. Further, it is possible
to mix them to match specific i.e. they are more easily complaisant to
financial engineering.
 Derivatives are mostly secondary market instruments and have little
applications in mobilizing fresh capital by the corporate world, however,
warrants and convertibles are exception in this regard.
 Inspite of being in the market, the standardized general and exchange-
traded derivatives are being increasingly advanced, however, still, there are
so many privately negotiated customized, over-the counter(OTC) traded
derivatives are in prevalence. They unveil the trading parties to operational
risk, counter-party risk and legal risk. Further, there may also be
uncertainty about the regulatory status of such derivatives.
 The derivative instruments sometimes, because of their off-balance sheet
nature, can become useful to clear up the balance sheet.
Example: A fund manager who is prohibited from taking particular

currency can purchase a structured note whose coupon is tied to the
performance of a particular currency pair.
 They help in transferring risks from risk adverse people to risk oriented
people.
 They help in the discovery of future as well as current prices.
 They catalyze entrepreneurial activity.
 They increase the volume traded in markets because of participation of risk
adverse people in greater numbers.
 They increase savings and investment in the long run.
1.1.3 Origin and Evolution of Derivatives
The derivatives markets have existed for centuries as a result of the need for
both users and producers of natural resources to hedge against price
fluctuations in the underlying commodities. Although trading in agricultural
and other commodities has been the driving force behind the development of
derivatives exchanges, the demand for products based on financial
instruments—such as bond, currencies, stocks and stock indices—have now far
outstripped that for the commodities contracts. In 1848, future contracts came
into existence with the establishment of Chicago Board of Trade.
In the year 1898, the butter and egg dealers of Chicago Produce Exchange
joined hands to form Chicago Mercantile Exchange for trading futures to hedge
their risks of price volatility. Gradually the exchange also provided the futures
markets for other commodities like pork bellies (1961), live cattle (1964), live
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Notes hogs (1966) and feeder cattle (1971). This success in trading in the
commodities paved its way in the trading of foreign currencies (1972), T-bond
futures (1975) and equity index futures (1982). Futures contracts were initially
traded on agricultural commodities. In 1864, Chicago Board of Trade (CBOT)
began trading on these products involving gold, silver, and food items.
Trading in financial futures like stock futures originated with International
Monetary Markets (IMM) in 1972, followed by Interest rate futures being
introduced in CBOT in 1975. Stock index futures were introduced in the USA
in 1982. In the global scenario, the five leading futures markets and their
underlying securities are depicted in Table 1.1.
Table 1.1: Major Futures Market Globally
Name of Futures Market Major Contracts Traded

Chicago Board of Trade(CBOT), Chicago Commodities, Metals
International Monetary Market (IMM), Currencies, Debt, Stock Index
Chicago
International Petroleum Exchange, London Petroleum
New York Mercantile Exchange,(NYMEX) Commodities & Metals
Singapore International Monetary Exchange Commodities, Currency, Debt, Index
The first trading in Swaps occurred in 1981 between World Bank &
IBM (Currency Swap).
Options trading occurred later than futures trading. Until 1973, options on
equity stock were traded on the OTC (Over-the-Trade Counter) market only.
The major boost came in 1973 when Chicago Board Options Exchange
(CBOE) was established entirely dedicated for trading of options contracts in
standardized forms. The Chronology of Instruments of Global Derivatives
Industry is depicted in Table 1.2.
Table 1.2: The Global Derivatives Industry: Chronology of Instruments
Year Financial Instruments

1972 Foreign Currency Futures
1973 Equity Futures; futures on Mortgage-backed bonds
1974 Equity futures, Equity options
1975 T-bill futures on mortgage backed bonds
1977 T-bond Futures
1979 Over-the-Counter Currency Options
1980 Currency Swaps
Contd...
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Notes
1981 Equity Index futures; Options on T-bond futures; Bank CD Futures; T-note
Futures; Euro-dollar Futures; Interest-rate Swaps
1982 Exchange listed Currency Options
1983 Interest-rate Caps and Floor; Options on T-note, Futures; Currency Futures:
Equity Index Futures
1985 Euro Dollar Options; Swap Options; Futures on US Dollar & Municipal
Bond Indices
1987 Average Options, Commodity Swaps, Bond Futures, Compound Options,
OTC Compound Options, OTC Average Options
1989 Three-month Euro-DM Futures Captions ECU; Interest-rate Futures on
Interest rate Swaps
1990 Equity Index Swaps
1991 Portfolio Swaps
1992 Differential Swaps
1993 Captions; Exchange listed FLEX Options
1994 Credit Default Options
1995 Credit Derivatives
1996-98 Exotic Derivatives
2003-04 Energy Derivatives, Weather Derivatives
1.2 TYPES OF DERIVATIVES

Derivative contracts are traded both on established exchanges (like NSE,
Chicago Board of Options Exchange) and Over-the-Counter market (OTC).
OTC market is usually a telephone and computer linked network of
dealers/brokers spread far away geographically and orders are placed and
executed electronically or over phone. Figure 1.1 depicts the broad
classification of derivative instruments.
Financial Derivatives
Forwards Futures Options Swaps
Figure 1.1: Types of Derivative
1.2.1 Forwards Contract

A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today’s pre-agreed
price. The rupee-dollar exchange rate is a big forward contract market in India
with banks, financial institutions, corporate and exporters being the market
participants. Forward contracts are generally traded on OTC.
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Notes There are two major types of forward commitments:

 Forward contracts, or forwards, are OTC-traded derivatives with
customized terms and features.
 Futures contract, or futures, are exchange-traded derivatives with
standardized terms.
Features of Forward Contract
 Highly customized - Counterparties can ascertain and specify the terms and
characteristics to fit their specific needs, including when delivery will take
place and the exact identity of the underlying asset.
 All parties are exposed to counterparty default risk - This is the risk that the
other party may not make the required delivery or payment.
 Transactions take place in large, private and largely unregulated markets
comprising of banks, investment banks, government and corporations.
 Underlying assets can be a stocks, bonds, foreign currencies, commodities
or some combination thereof. The underlying asset could even be interest
rates.
 They tend to be held to maturity and have little or no market liquidity.
 Any commitment between two parties to trade an asset in the future is a
forward contract.
Example of Forwards Contract
Example: Take for an example that you have just taken up sailing and
like it so well that you expect you might buy your own sailboat in 12 months.
Your sailing buddy, John, owns a sailboat but expects to upgrade to a newer,
larger model in 12 months. You and John could enter into a forward contract in
which you agree to buy John's boat for $150,000 and he agrees to sell it to you
in 12 months for that price. In this scenario, as the buyer, you have entered a
long forward contract. Conversely, John, the seller will have the short forward
contract. At the end of one year, you find that the current market valuation of
John's sailboat is $165,000. Because John is obliged to sell his boat to you for
only $150,000, you will have effectively made a profit of $15,000. (You can
buy the boat from John for $150,000 and immediately sell it for $165,000.)
John, unfortunately, has lost $15,000 in potential proceeds from the
transaction.
Like all forward contracts, in this example, no money exchanged hands when
the contract was negotiated and the initial value of the contract was zero.
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1.2.2 Futures Contract Notes

A futures contract is an agreement between two parties to buy or sell an asset at
a certain time in the future at a certain price. Futures contracts are special types
of forward contracts in the sense that the former are standardized exchange-
traded contracts. Unlike forward contracts, the counterparty to a futures
contract is the clearing corporation on the appropriate exchange.
Features of Futures Contract
 Terms and conditions are standardized.
 Trading happens on a formal exchange wherein the exchange provides a
place to engage in these transactions and sets a mechanism for the parties to
trade these contracts.
 There is no default risk because the exchange acts as a counterparty,
guaranteeing delivery and payment by use of a clearing house.
 The clearing house protects itself from default by requiring its
counterparties to settle gains and losses or mark to market their positions
on a daily basis.
 Futures are highly standardized, have deep liquidity in their markets and
trade on an exchange.
 An investor can offset his or her future position by engaging in an opposite
transaction before the stated maturity of the contract.
Example of Futures Contract
Example: Let's assume that in September the spot or current price for
hydroponic tomatoes is $3.25 per bushel and the futures price is $3.50. A
tomato farmer is trying to secure a selling price for his next crop, while
McDonald's is trying to secure a buying price in order to determine how much
to charge for a Big Mac next year. The farmer and the corporation can enter
into a futures contract necessitating the delivery of 5 million bushels of
tomatoes to McDonald's in December at a price of $3.50 per bushel. The
contract locks in a price for both parties. It is this contract - and not the grain
per se - that can then be bought and sold in the futures market.
In this situation, the farmer is the holder of the short position (he has agreed to
sell the underlying asset - tomatoes) and McDonald's is the holder of the long
position (it has agreed to buy the asset). The price of the contract is 5 million
bushels at $3.50 per bushel.
The profits and losses of a futures contract are calculated on a daily basis. In
our example, suppose the price on futures contracts for tomatoes increases to
$4 per bushel the day after the farmer and McDonald's enter into their futures
contract of $3.50 per bushel. The farmer, as the holder of the short position,
has lost $0.50 per bushel because the selling price just increased from the
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Notes future price at which he is obliged to sell his tomatoes. McDonald's has
profited by $0.50 per bushel.
On the day the price change happens, the farmer's account is debited $2.5
million ($0.50 per bushel x 5 million bushels) and McDonald's is credited the
same amount. Because the market moves daily, futures positions are settled
daily as well. Gains and losses from each day's trading are deducted or credited
to each party's account. At the expiration of a futures contract, the spot and
futures prices normally converge
1.2.3 Options
An option represents the right (but not the obligation) to buy or sell a security
or other asset during a given time for a specified price (the “strike price”).
Features of Options
Both put and call options have three basic characteristics: exercise price,
expiration date and time to expiration.
 The buyer has the right to buy or sell the asset.
 To obtain the right of an option, the buyer of the option must pay a price to
the seller. This is called the option price or the premium.
 The exercise price is also called the fixed price, strike price or just the
strike and is determined at the beginning of the transaction. It is the fixed
price at which the holder of the call or put can buy or sell the underlying
asset.
 Exercising is using this right the option grants you to buy or sell the
underlying asset. The seller may have a significant commitment to buy or
sell the asset if the buyer exercises his right on the option.
 The expiration date is the final date that the option holder has to exercise
her right to buy or sell the underlying asset.
 Time to expiration is the amount of time from the purchase of the option
until the expiration date. At expiration, the call holder will pay the exercise
price and receive the underlying securities (or an equivalent cash
settlement) if the option expires in the money. The call seller will deliver
the securities at the exercise price and obtain the cash value of those
securities or receive equivalent cash settlement in lieu of delivering the
securities.
 Defaults on options work the same way as they do with forward contracts.
Defaults on over-the counter option transactions are based on
counterparties, while exchange-traded options use a clearing house.
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Two Types of Options Notes

Options are of two types – calls and puts.
 Call option: Calls give the buyer the right but not the obligation to buy a
given quantity of the underlying asset, at a given price on or before a given
future date.
Call option that gives the right to buy in its contract gives the particulars of
 The name of the company whose shares are to be bought
 The number of shares to be purchased.
 The purchase price or the exercise price or the strike price of the shares
to be bought.
 The expiration date, the date on which the contract or the option
expires.
Example: Example of Call Option

IBM is trading at 100 today. (June 1, 2014)
The call option is as follows:Strike price = 120, Date = August 1,
2014,Premium on the call = $3
In this case, the buyer of the IBM call today has to pay the seller of the
IBM call $3 for the right to purchase IBM at $125 on or before August 1,
2014. If the buyer decides to exercise the option on or before August 1,
2014, the seller will have to deliver IBM shares at a price of $125 to the
buyer.
 Put option: Puts give the buyer the right, but not the obligation to sell a
given quantity of the underlying asset at a given price on or before a given
date.
Put option contract contains:
 The name of the company shares to be sold.
 The number of shares to be sold.
 The selling price or the striking price
 The expiration date of the option.
Example: Example of Put Option

IBM is trading at 100 today (June 1, 2014)
Put option is as follows:Strike price = 90, Date = August 1, 2014, Premium
on the put = $3.00
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Notes In this case, the buyer of the IBM put has to pay the seller of the IBM call
$3 for the right to sell IBM at $90 on or before August 1, 2014. If the buyer
of the put decides to exercise the option on or before August 1, 2014, the
seller will have to purchase IBM shares at a price of $90.
1.2.4 Swaps
Swaps are private agreements between two parties to exchange cash flows in
the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. Swaps generally are traded OTC through swap
dealers, which generally consist of large financial institution, or other large
brokerage houses. There is a recent trend for swap dealers to mark to market
the swap to reduce the risk of counterparty default.
Swaps are not debt instruments to raise capital, but a tool used for
financial management.
Features of Swaps
Swap is a combination of forwards by two counterparties. It is arranged to reap
the benefits arising from the fluctuations in the market –either currency market
or interest rate market or any other market for that matter.
The following are the important features of a swap:
 Basically a forward: A swap is nothing but a combination of forwards. So,
it has all the properties of forward contract.
 Double coincidence of wants: Swap requires that two parties with equal
and opposite needs must come into contact with each other. i.e., rate of
interest differs from market to market and within the market itself. It varies
from borrowers to borrowers due to relative credit worthiness of borrowers.
 Comparative Credit Advantage: Borrowers enjoying comparative credit
advantage in floating rate debts will enter into a swap agreement to
exchange floating rate interest with the borrowers enjoying comparative
advantage in fixed interest rate debt, like bonds. In the bond market,
lending is done at a fixed rate for a long duration, and therefore the lenders
do not have the opportunity to adjust the interest rate according to the
situation prevailing in the market.
 Flexibility: In short term market, the lenders have the flexibility to adjust
the floating interest rate (short term rate) according to the conditions
prevailing in the market as well as the current financial position of the
borrower. Hence, the short term floating interest rate is cheaper to the
borrower with low credit rating when compared with fixed rate of interest.
 Necessity of an Intermediary: Swap requires the existence of two
counterparties with opposite but matching needs. This has created a
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necessity for an intermediary to cancel both the parties. By arranging Notes

swaps, these intermediaries can earn income too. Financial companies,
particularly banks, can play a key role in this innovative field by virtue of
their special position in the financial market and their knowledge of the
diverse needs of the customers.
 Settlements: Through a specified principal amount is mentioned in the
swap agreement; there is no exchange of principal. On the other hand, a
stream of fixed rate interest is exchanged for a floating rate of interest, and
thus, there are streams of cash flows rather than single payment.
 Long term agreement: Generally, forwards are arranged for short period
only. Long dated forward rate contracts are not preferred because they
involve more risks like risk of default, risk of interest rate fluctuations etc.
But, swaps are in the nature of long term agreement and they are just like
long dated forward rate contracts. The exchange of a fixed rate for a
floating rate requires a comparatively longer period.
Four Commonly Used Swaps
The four commonly used swaps are:
Interest rate swaps
These entail swapping only the interest related cash flows between the parties
in the same currency.
Features of Interest Rate Swaps
The “swap rate” is the fixed interest rate that the receiver demands in exchange
for the uncertainty of having to pay the short-term LIBOR (floating) rate over
time. At any given time, the market’s forecast of what LIBOR will be in the
future is indicated in the forward LIBOR curve.
At the time of the swap agreement, the total value of the swap’s fixed rate
flows will be equal to the value of expected floating rate payments stated by
the forward LIBOR curve. As forward expectations for LIBOR change, so will
the fixed rate that investors demand to enter into new swaps. Swaps are
typically quoted in this fixed rate, or alternatively in the “swap spread,” which
is the difference between the swap rate and the U.S. Treasury bond yield (or
equivalent local government bond yield for non-U.S. swaps) for the same
maturity.
In many ways, interest rate swaps look like other recognizable forms of
financial transactions, and it is helpful to think of swaps in these terms:
 Exchanging Loans. Early interest rate swaps were literally an exchange of
loans, and this model still facilitates an intuitive way to think about swaps.
Consider two parties that have taken out loans of equal value, but one has
borrowed at the prevailing fixed rate and the other at a floating rate tied to
LIBOR. The two agree to exchange their loans, or swap interest rates.
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Notes Since the principal is the same, there is no need to exchange it, leaving only
the quarterly cash flows to be exchanged. The party that switches to paying
a floating rate might demand a premium or cede a discount on the original
fixed borrower’s rate, depending on how interest rate expectations have
changed since the original loans were taken out. The original fixed rate,
plus the premium or minus the discount, would be the equivalent of a swap
rate.
 The Financed Treasury Note: Obtaining fixed rate payments in a swap is
identical to borrowing cash at LIBOR and using the proceeds to buy a U.S.
Treasury note. The buyer of the Treasury will receive fixed payments, or
the “coupon” on the note, and be liable for floating LIBOR payments on
the loan. The concept of a “financed Treasury” illustrates a notable
characteristic that swaps share with Treasuries: both have a discrete
duration, or interest rate sensitivity, that depends on the maturity of the
bond or contract.
Example of Interest Rate Swap
Example: Suppose Party A holds a 10-year ` 10, 000 home loan that
has a fixed interest rate of 7 %, and Party B holds a 10-year ` 10, 000 home
loan that has an adjustable interest rate that will change over the “life” of the
mortgage. If Party A and Party B were to exchange interest rate payments on
their otherwise identical mortgages, they would have engaged in an interest
rate swap.
Currency swaps
These entail swapping both principal and interest between the parties, with the
cash flows in one direction being in a different currency than those in the
opposite direction. Swaps may involve cross-currency payments (U.S. Dollars
vs. Mexican Pesos) and crossmarket payments.
Example: U.S. short-term rates vs. U.K. short-term rates.

Features Currency Swaps
The Currency Swap helps the customers to control exchange rate risks over the
medium and long terms and convert debts/assets denominated in one currency
into debts/assets denominated in another currency, so as to avoid exchange rate
risks and reduce costs.
Example: A firm having liabilities denominated in Japanese yen

generates income flows only in US dollars, and the appreciation of yen will
add to its debts. Therefore, the firm may lock the exchange rate through
Currency Swap with ABC, so as to offset the appreciation of yen. Swap
20 ANNA UNIVERSITY
products provide a good liquidity. The customer can close positions in quick Notes
response to the market changes, enabling dynamic management of risks.
Currency swaps have three main uses:
 To secure cheaper debt (by borrowing at the best available rate irrespective
of currency and then swapping for debt in desired currency using a back-to-
back-loan)
 To hedge against (reducing exposure to) exchange rate fluctuations.
 To defend against financial turmoil by permitting a country beset by a
liquidity crisis to borrow money from others with its own currency.
Example of Currency Swap
Example: Take for an example that a corporation needs to borrow $10

million euros and the best rate it can negotiate is a fixed 6.7%. In the U.S.,
lenders are offering 6.45% on a comparable loan. The corporation could take
the U.S. loan and then find a third party willing to swap it into an equivalent
euro loan. By doing so, the firm would obtain its euros at more favorable
terms. Cash flow streams are often structured so that payments are
synchronized, or occur on the same dates. This allows cash flows to be netted
against each other (so long as the cash flows are in the same currency).
Typically, the principal (or notional) amounts of the loans are netted to zero
and the periodic interest payments are scheduled to accrue on that same dates
so they can also be netted against one another.
Commodity Swaps
A commodity swap is an agreement whereby a floating (or market or spot)
price dependent on an underlying commodity is traded for a fixed price over a
specified period
Features of Commodity Swaps
 In commodity swaps, the cash flows to be exchanged are linked to
commodity prices. Commodities are physical assets such as metals, energy
and agriculture. For example: In a commodity swap, a party may agree to
exchange cash flows linked to prices of oil for a fixed cash flow.
 A Commodity swap is identical to a Fixed-Floating Interest rate swap. The
difference is that in an Interest rate swap the floating leg is dependent on
standard Interest rates such as LIBOR, EURIBOR etc. but in a commodity
swap the floating leg is dependent on the price of underlying commodity
like Oil, Sugar etc. No Commodities are exchanged during the trade.
 Commodity swaps are used for hedging against Fluctuations in commodity
prices or Fluctuations in spreads between final product and raw material
prices
ANNA UNIVERSITY 21
Notes
Example: Cracking spread which indicates the spread between
crude prices and refined product prices significantly affect the margins of
oil refineries.
On the other side, a producer wishes to fix his income and would agree to
pay the market price to a financial institution, in return for obtaining fixed
payments for the commodity.
 A company that uses commodities as input may find its profits becoming
very volatile if the commodity prices become volatile. This is particularly
so when the output prices may not change as frequently as the commodity
prices change. In such cases, the company would enter into a swap
whereby it receives payment linked to commodity prices and pays a fixed
rate in exchange.
The vast majority of commodity swaps include oil.
Example: Take for an example, a commodity swap consisting of a

notional principal of 1,00,000 barrels of crude oil. One party agrees to
make fixed semi-annual payments at a fixed price of ` 2,500/bbl, and
obtain floating payments.
On the first settlement date, if the spot price of crude oil is ` 2,400/bbl, the
pay-fixed party must pay (` 2,500/bbl)*(1, 00,000 bbl) = ` 2,50,000,000.
The pay-fixed party also obtains (` 2,400/bbl)*(1, 00,000 bbl) =
` 2,40,000,000.
The net payment made (cash out flow for the pay-fixed party) is then
` 10,000,000.
In a different scenario, if the price per barrel will have increased to
` 2,550/bbl than the pay-fixed party would have obtained a net inflow of
` 5,000,000.
Equity Swaps
An equity swap is a financial derivative contract (a swap) where a set of future
cash flows are agreed to be exchanged between two counterparties at set dates
in the future. The two cash flows are normally stated as "legs" of the swap; one
of these "legs" is usually pegged to a floating rate such as LIBOR. This leg is
also commonly stated as the "floating leg". The other leg of the swap is
dependent on the performance of either a share of stock or a stock market
index. This leg is commonly stated as the "equity leg". Most equity swaps
consist of a floating leg vs. an equity leg, although some exist with two equity
legs.
22 ANNA UNIVERSITY
Features of Equity Swaps Notes

 An equity swap includes a notional principal, a specified tenor and
predetermined payment intervals. The notional amount (or notional
principal amount or notional value) on a financial instrument is the nominal
or face amount that is used to calculate payments made on that instrument.
 Equity swaps are typically traded by Delta One trading desks. Delta One
products are a class of financial derivative that have no preferences and as
such have a delta of (or very close to) one - that is to say that for a given
percentage move in the price of the underlying asset there will be a nearly
identical move in the price of the derivative. Delta one products often
constitutes a number of underlying securities and as such give the holder an
easy way to gain exposure to a basket of securities in a single product.
Examples include equity swaps, forwards, futures and ETFs.
 Typically equity swaps are entered into in order to avoid transaction costs
(including Tax), to avoid locally dependent dividend taxes, limitations on
leverage (notably the US margin regime) or to get around rules governing
the particular type of investment that an institution can hold.
 Equity swaps, if effectively used, can remove investment barriers and help
an investor create leverage identical to those seen in derivative products.
 Investment banks that offer this product usually take a riskless position by
hedging the client's position with the underlying asset.
Example: The client may trade a swap - say Vodafone. The bank
credits the client with 1,000 Vodafone at GBP1.45. The bank pays the
return on this investment to the client, but also buys the stock in the same
quantity for its own trading book (1,000 Vodafone at GBP1.45). Any
equity-leg return paid to or due from the client is offset against realised
profit or loss on its own investment in the underlying asset. The bank
makes its money through commissions, interest spreads and dividend rake-
off (paying the client less of the dividend than it receives itself). It may also
use the hedge position stock (1,000 Vodafone in this example) as part of a
funding transaction such as stock lending, repo or as collateral for a loan.
Example of Equity Swap
Example: Parties may agree to make periodic payments or a single

payment at the maturity of the swap ("bullet" swap).
Take a simple index swap where Party A swaps £5,000,000 at LIBOR + 0.03%
(also called LIBOR + 3 basis points) against £5,000,000 (FTSE to the
£5,000,000 notional).
In this case Party A will pay (to Party B) a floating interest rate (LIBOR
+0.03%) on the £5,000,000 notional and would receive from Party B any
ANNA UNIVERSITY 23
Notes percentage increase in the FTSE equity index applied to the £5,000,000
notional.
In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of
precisely 180 days, the floating leg payer/equity receiver (Party A) would owe
(5.97%+0.03%)*£5,000,000*180/360 = £150,000 to the equity payer/floating
leg receiver (Party B).
At the same date (after 180 days) if the FTSE had appreciated by 10% from its
level at trade commencement, Party B would owe 10%*£5,000,000 = £500,000
to Party A. If, on the other hand, the FTSE at the six-month mark had fallen by
10% from its level at trade commencement, Party A would owe an additional
10%*£5,000,000 = £500,000 to Party B, since the flow is negative.
For mitigating credit exposure, the trade can be reset, or "marked-to-market"
during its life. In that case, appreciation or depreciation since the last reset is
paid and the notional is increased by any payment to the floating leg payer
(pricing rate receiver) or decreased by any payment from the floating leg payer
(pricing rate receiver).
Equity swaps have many applications. For example, a portfolio manager with
XYZ Fund can swap the fund's returns for the returns of the S&P 500 (capital
gains, dividends and income distributions.) They most usually happens when a
manager of a fixed income portfolio wants the portfolio to have exposure to the
equity markets either as a hedge or a position. The portfolio manager would
enter into a swap in which he would obtain the return of the S&P 500 and pay
the counterparty a fixed rate generated form his portfolio. The payment the
manager obtains will be equal to the amount he is getting in fixed-income
payments, so the manager's net exposure is solely to the S&P 500. These types
of swaps are usually inexpensive and require little in term of administration.
Other Types of Financial Derivatives
Options, include warrants
Warrants
Options generally have lives of upto one year, the majority of options traded on
options exchanges having a maximum of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter. Warrants are an
instrument which gives investors the right - but not the obligation - to buy or
sell the underlying asset at a pre-set price on or before a specified date.
Warrants and options are identical in such a case that the two contractual
financial instruments permit the holder special rights to buy securities. Both are
discretionary and have expiration dates. The word warrant simply means to
"endow with the right", which is only slightly different from the meaning of
option.
Warrants are often attached to bonds or preferred stock as a sweetener,
permitting the issuer to pay lower interest rates or dividends. They can be used
24 ANNA UNIVERSITY
to modify the yield of the bond and make them more attractive to potential Notes
buyers. Warrants can also be used in private equity deals. Frequently, these
warrants are detachable and can be sold independently of the bond or stock.
In the case of warrants issued with preferred stocks, stockholders may need to
detach and sell the warrant before they can receive dividend payments. Thus, it
is sometimes beneficial to detach and sell a warrant as soon as possible so the
investor can earn dividends.
Warrants are actively traded in some financial markets such as Deutsche Börse
and Hong Kong. In Hong Kong Stock Exchange, warrants accounted for
11.7% f the turnover in the first quarter of 2009, just second to the callable
bull/bear contract..
There are, however, some key differences between warrants and options:
 Options are contracts, warrants are financial products. Options are
contracts created and traded on the options market. When you buy an
option, you are buying a contract that entitles you to buy the underlying
asset at a specified value. If you want to trade in options, you must
conclude a special agreement with your stockbroker. Warrants are traded
on the stock market, and you do not have to conclude an agreement to trade
them. They are not created by the exchange like options, but by banks
aiming to meet the demands of the market.
 Standardized and non-standardized contracts. Option contracts are
standardized, which means that nearly all options that are issued have to
comply with specific rules regarding their lifetime, contract size, exercise
price and trading unit.
 Warrants are more flexible. They do not have to comply with any
standards for their maturity, strike price or parity. Banks can issue warrants
with any specifications they like when there is sufficient demand. This
means there are many different types of warrants in circulation, with a wide
variety of times to maturity, exercise prices, contract sizes and parities.
 Underlying values. Warrants are issued on many different types of
securities (such as currencies, international shares, etc.) whereas the
options market focuses on domestic shares, indices and bonds.
 Options are always available. An unlimited number of contracts can be
created in every option series, and the number of options in circulation does
not affect the price. The number of warrants issued per series, however, is
limited, and this can affect the warrant price.
Features of Warrants
Warrants have identical characteristics to that of other equity derivatives, such
as options, for instance:
ANNA UNIVERSITY 25
Notes Exercising: A warrant is exercised when the holder informs the issuer their
intention to purchase the shares underlying the warrant.
The warrant parameters, such as exercise price, are fixed shortly after the issue
of the bond. With warrants, it is significant to consider the following main
characteristics:
 Premium: A warrant's "premium" specifies how much extra you have to
pay for your shares when buying them through the warrant as against
buying them in the regular way.
 Gearing (leverage): A warrant's "gearing" is the way to ascertain how
much more exposure you have to the underlying shares using the warrant
as against the exposure you would have if you buy shares through the
market.
 Expiration Date: This is the date the warrant expires. If you plan on
exercising the warrant you must do so before the expiration date. The more
time remaining until expiry, the more time for the underlying security to
appreciate, which, in turn, will increase the price of the warrant (unless it
depreciates). Therefore, the expiry date is the date on which the right to
exercise ceases to exist.
 Restrictions on exercise: Like options, there are different exercise types
associated with warrants such as American style (holder can exercise
anytime before expiration) or European style (holder can only exercise on
expiration date).
Warrants are longer-dated options and are generally traded over-the-counter.
Example: Take for an example that illustrates one of the potential

benefits of warrants. Say that XYZ shares are currently priced on the market
for $1.50 per share. In order to purchase 1,000 shares, an investor would need
$1,500. However, if the investor opted to buy a warrant (representing one
share) that was going for $0.50 per warrant, he or she would be in possession
of 3,000 shares using the same $1,500.
Because the prices of warrants are low, the leverage and gearing they offer is
high. This means that there is a potential for larger capital gains and losses.
While it is common for both a share price and a warrant price to move in
parallel (in absolute terms) the percentage gain (or loss), will significantly
differ because of the initial difference in price. Warrants generally exaggerate
share price movements in terms of percentage change.
Example: Let us look at another example to illustrate these points. Say

that share XYZ gains $0.30 per share from $1.50, to close at $1.80. The
percentage gain would be 20%. However, with a $0.30 gain in the warrant,
from $0.50 to $0.80, the percentage gain would be 60%.
26 ANNA UNIVERSITY
In this example, the gearing factor is calculated by dividing the original share Notes
price by the original warrant price: $1.50 / $0.50 = 3. The "3" is the gearing
factor - essentially the amount of financial leverage the warrant offers. The
higher the number, the larger the potential for capital gains (or losses).
Warrants can provide important benefits to an investor during a bull market.
They can also provide some protection to an investor during a bear market.
This is because as the price of an underlying share begins to drop, the warrant
may not realize as much loss because the price, in relation to the actual share,
is already low.
LEAPS
The acronym LEAPS means Long-term Equity Anticipation Securities. LEAPS
are publicly traded options contracts with expiration dates that are longer than
one year. Structurally, LEAPS are no different than short-term options, but the
later expiration dates provide the opportunity for long-term investors to obtain
exposure to prolonged price changes without necessitating to use a
combination of shorter-term option contracts. The premiums for LEAPs are
higher than for standard options in the same stock because the increased
expiration date gives the underlying asset more time to make a consequential
move and for the investor to make a healthy profit.The ability to buy a call/put
option that expires one or two years in the future is very attractive because it
gives the holder exposure to the long-term price movement without the
necessity to invest the larger amount of capital that would be necessitated to
own the underlying asset outright. These long-term options can be purchased
not only for individual stocks, but also for equity indexes (such as the S&P
500).
Baskets
Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average of a basket of assets. Equity index options
are a form of basket options. Basket is a single unit of at least 15 stocks that are
used in program trading. Baskets are traded on both the NYSE and the CBOE
for institutions and index arbitrageurs. Both instruments permit for the
composite purchase of all of the stocks in the S&P 500 in a single trade.
Baskets were created after the stock market crash in 1987 to better facilitate
institutional trading on the index.
Learning Activity
Highlight the initial developments of derivatives in India, and
write a short summary on it.
ANNA UNIVERSITY 27
Notes 1.3 DIFFERENCES BETWEEN CASH AND FUTURE

MARKETS
In futures market you can short-sell without having stock and you can carry
your position for a long time, which is not possible in the cash segment
because of rolling settlement. Conversely, you can buy futures and carry the
position for a long time without taking delivery, unlike in the cash segment
where you have to take delivery because of rolling settlement. Further, futures
positions are leveraged positions, meaning you can take a ` 100 position by
paying a ` 25 margin and daily marking-to-market loss, if any. This can
enhance the return on capital employed.
Taking a leveraged position proves to be risky, you can even lose

your full capital in case the price moves against your position.
1.3.1 Cash Market

The marketplace for instantaneous settlement of transactions comprising of
commodities and securities. In a cash market, the exchange of goods and
money between the seller and the buyer takes place in the present, as compared
to the futures market where such an exchange takes place on a definite future
date.
Also known as the spot market, since such transactions are settled "on the
spot."
Cash market transactions can take place either on a regulated exchange or
over-the-counter (OTC). In contrast, transactions consisting of futures are
conducted exclusively on exchanges, while forward transactions, such as
currency forwards, are generally executed on the OTC market.
For a specific commodity, the price in the cash market is usually less than its
price in the futures market. This is because there are carrying costs, such as
storage and insurance, involved in holding a commodity until it can be
delivered at some point in the future.
Advantages of SPOT Market
 No commission: In Spot Market, sometimes the brokerage is free since
most of Forex trading is made through online service. The major cost is the
bid/ask spread, which is very cheap.
 Superior liquidity: Spot market has very large trading volume and the
transaction sizes, with more than $3.98 trillion average daily turnover
globally, as compared to other financial market. High liquidity makes it
easy and flexible for investors to enter or exit Forex trading
28 ANNA UNIVERSITY
 High leverage: Using leverage permits investors to make a fortune with Notes
relatively small investment. In some forex platforms, such as IKON group,
the leverage can be as high as 1:500, which provides traders m chances and
bigger room for profit.
 24 hours trading: Spot market is a non-stop (on weekdays) 24-hour
market, unlike most of the Forex Futures exchanges, permitting its traders
to trade whenever they want and to react to breaking Forex news
immediately.
 Profitability: Here is no organizational biasness in the Spot market and
every investor has the equal prospects for profit in it.
Disadvantages of SPOT Market
 High Leverage: Although high leverage can be an advantage to attract
traders to the Spot market, it can at times also act as a demerit. With such
high levels of leverage accessible to traders in the Spot market, there also
comes an equally high level of risk. High leverage is very risky for Spot
market beginners because there is a chance for new traders to make
mistakes and in case they do mistake when they are using high leverage,
they will certainly wipe out their account. So for sure, beginners must not
use high leverage but instead they can use some less leverage.
 24 hours market: Although Spot Forex market operates 24 hours on
weekdays and makes it possible for the Spot market trader to trade
whenever they want, it can be instead difficult for Spot market traders as
well. Because it is impossible for individual traders to keep track of the
Spot market 24 hours a day, so if the market condition changes while they
are resting, Spot market traders might have to suffer expected losses after
they woke up. Trading Spot Forex may have negative effect on personal
living style due to its ongoing operating feature.
1.3.2 Futures Market
An auction market in which participants purchase and sell commodity/future
contracts for delivery on a definite future date. Trading is carried on through
open yelling and hand signals in a trading pit. Volume in the futures market
usually increases when the stock market outlook is uncertain.
Advantages of Futures Market
 Futures are highly leveraged investments. To own a futures contract, an
investor only has to put up a small fraction of the value of the contract
(usually around 10%) as margin. In other words, the investor can trade a
much larger amount of the commodity than if she bought it completely, so
if she has anticipated the market movement correctly, her profits will be
multiplied (ten-fold on a 10% deposit). This is an excellent return as
against buying a physical commodity such as copper or wheat.
ANNA UNIVERSITY 29
Notes  Speculating with futures contracts is basically a paper investment. The

actual commodity being traded in the contract is only exchanged on the
rare occasion that delivery of the contract takes place. Since the average
individual investor is a speculator, a futures trade is purely a paper
transaction and the term "contract" is only used the futures contract has an
expiration date.
 Liquidity. Since there are huge amounts of futures contracts traded every
day, futures markets are very liquid. This guarantees that market orders can
be placed very quickly as there are always buyers and sellers of a
commodity. For this reason, it is unusual for prices to suddenly jump or fall
dramatically, especially on the nearer contracts (those which will expire in
the next few weeks or months).
 Commission charges are small compared to other investments and are
paid after the position has ended. Commissions vary widely depending on
the level of service given by the broker.
Limitations of Futures Market
Although futures are an important tool in maintaining stable prices in the
economy, the risks in these trades are also quite high, specially because of
leverage. Speculators, in particular, must be very cautious when investing in
futures because of the uncertainty and potential of huge losses.
These risks are dealt to some extent by the various limitations and regulations
that are levied on futures trading.
 Restrictions on Traded Commodities: Only specific types of commodities
can be the basis for futures trading. The shelf life, the price volatility and
the state of the commodity (processed or unprocessed) ascertains whether it
can be used in a futures contract.
 Ticks: There is a minimum price movement (upwards or downwards) that
can take place for futures of an underlying commodity. This is known as a
tick. The contract liquidation prices are also regulated by price change
limits.
 Position limits: A futures trader is also limited by the number of futures
contracts he can hold. This regulation makes sure that no single investor
can influence the market of a particular commodity.
 Government restrictions: There are some certain government restrictions
on futures trading. The Commodity Exchange Act governs futures trading
in the US. The Commodity Futures Trading Commission (CFTC) is an
independent agency, which administers the regulations outlined in this Act.
The CFTC also inspects the working of the National Futures Association.
The NFA is a self-regulated body which sets out the code of conduct for
futures traders to follow. Brokers can only transact futures trades if they are
registered with the CFTC and the NFA. This mandatory registration
30 ANNA UNIVERSITY
provides the CFTC some degree of control over how business is conducted Notes
within the broker’s offices. Legal action can be taken by the CFTA against
brokers found violating the regulations. Investors may also be obstructed
from futures trading if it is found that they have infringed any of the legal
regulations outlined by these regulatory bodies.
Difference between Cash Market and Futures Market
The main differences between the cash segment of the capital market and the
futures segment which have been discussed as :
 Ownership: When you purchase shares in the cash market and take
delivery, you are the owner of these shares or you are a shareholder, until
you sell the shares. You can never be a shareholder when you trade in the
derivatives segment of the capital market.
 Holding period: When you purchase shares in the cash segment, you can
hold the shares for life. This is not true in the case of the futures market,
where you have to settle the contract within three months at the very
maximum.
 Dividends: When you purchase shares in the cash segment, you normally
take delivery and are a owner. Hence, you are entitled to dividends that
companies pay. No such luck when you purchase any derivatives contract.
 Risk: Both, cash and futures markets pose risk, but the risk in the case of
futures can be higher, because you have to settle the contract within a
specified period and book losses. In the case of shares purchased in the
cash market, you can hold onto them for an indefinite period and can hence
sell when prices are higher.
 Investment objective varies: You purchase a contract in the derivatives
market to hedge risk or to speculate. Individuals purchasing shares in the
cash market are investors.
 Lots vs shares: In the derivatives segment you purchase a lot, while in the
cash segment you purchase shares.
Example: You expect a ` 100 stock to go up by ` 10. One way is to

buy the stock in the cash segment by paying ` 100. You make ` 10 on
investment of ` 100, giving about 10% returns. Alternatively, you take
futures position in the stock by paying about ` 30 toward initial and mark-
to-market margin. You make ` 10 on investment of ` 30 i.e. about 33%
returns.
Learning Activity
Write a short note differentiating future markets with forward
markets.
ANNA UNIVERSITY 31
Notes
1. The value of derivatives depends on their underlying
asset price movements.
2. Futures often are settled in cash or cash equivalents,
rather than requiring physical delivery of the
underlying asset. Parties to a Futures contract may buy
or write options on futures.
SUMMARY
 A derivative security is a financial contract whose value is derived from the
value of something else, such as a stock price, a commodity price, an
exchange rate, an interest rate, or even an index of prices.
 Derivative contracts are traded both on established exchanges (like NSE,
Chicago Board of Options Exchange) and Over-the-Counter market (OTC).
 OTC market is usually a telephone and computer linked network of
dealers/brokers spread far away geographically and orders are placed and
executed electronically or over phone.
 The types of financial derivatives are- forward contracts; futures contracts;
options and swaps.
 In futures market you can short-sell without having stock and you can carry
your position for a long time, which is not possible in the cash segment
because of rolling settlement.
 Conversely, you can buy futures and carry the position for a long time
without taking delivery, unlike in the cash segment where you have to take
delivery because of rolling settlement
KEYWORDS
Derivative: A derivative is a financial instrument, or contract, between two
parties that derived its value from some other underlying asset or underlying
reference price, interest rate, or index. A derivative by itself does not constitute
ownership; instead it is a promise to convey ownership.
Forwards Contract: A forward contract is a customized contract between two
entities, where settlement takes place on a specific date in the future at today’s
pre-agreed price.
Futures Contract: A futures contract is an agreement between two parties to
buy or sell an asset at a certain time in the future at a certain price.
Interest Rate Swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
Options: An option represents the right (but not the obligation) to buy or sell a
security or other asset during a given time for a specified price (the “strike
price”).
32 ANNA UNIVERSITY
Swaps: Swaps are private agreements between two parties to exchange cash Notes
flows in the future according to a prearranged formula.
SELF-ASSESSMENT QUESTIONS
Short Answer Questions
1. What do you mean by derivatives?
2. Briefly discuss the three most popular derivative instruments.
3. State the characteristics of derivatives.
4. What are forward contracts?
5. Define future contracts.
6. Define Options.
7. Define Swaps.
8. What are Interest Rate Swaps? Give an example.
9. What are Currency Swaps? Give an example.
10. State the difference between Cash and Futures Market.
Long Answer Questions
1. Explain the origin and evolution of derivatives.
2. ‘Future contracts are obligations, whereas options are rights’. Do you
agree? Explain in detail.
3. Bring out the similarities and dissimilarities between Forwards, Futures,
Options and Swaps.
4. ‘Derivatives are effective risk management tools’. Comment on the
statement.
5. Can you think of a cash market in which options or futures could be useful
but does not yet exist?
FURTHER READINGS
Kolb, W. Robert and Overdahl, A. James (2009), Financial

Derivatives Pricing and Risk Management, John Wiley & Sons.
Kumar, S.S.S (2007), Financial Derivatives, PHI Learning Pvt.
Ltd.
Verma, Rama, Jayanth (2008), Derivatives and Risk Management,
Tata McGraw Hill Education.
Whaley, E. Robert (2007), Derivatives: Markets, Valuation and
Risk Management, John Wiley & Sons.
ANNA UNIVERSITY 33
Notes
LESSON 2 - TRADERS AND THEIR
SETTLEMENT
CONTENTS
Learning Objectives
Learning Outcomes
Overview
2.1 Types of Traders
2.1.1 Hedgers
2.1.2 Speculator
2.1.3 Arbitrageurs
2.2 OTC and Exchange Traded Securities
2.2.1 Development of Derivative Markets in India
2.2.2 Development and Regulation of Derivative Markets in India
2.2.3 Regulatory Objectives
2.3 Types of Settlement
2.3.1 Physical Settlement
2.3.2 Cash Settlement
2.3.3 Offsetting Position
2.4 Uses and Advantages of Derivatives
2.4.1 Uses of Derivatives
2.4.2 Advantages of Derivatives
2.5 Risks in Derivatives
Summary
Keywords
Further Readings
LEARNING OBJECTIVES
 Describe the types of traders
34 ANNA UNIVERSITY
Lesson 2 - Traders and their Settlement
 Understand the OTC and exchange traded securities Notes

 Explain the types of settlement
 Determine the uses and advantages of derivatives
 Examine the risks in derivatives
LEARNING OUTCOMES
understanding of:
 the concept that derivatives can be used by both the issuer and equity
holder to create new types of ownership with different risk reward payoffs
and by investors.
 the fact that through speculation one can increase short-term volatility (and
thus, risk). It can be done to inflate prices and can cause bubbles.
 the datum that swaps can be used to hedge certain risks such as interest rate
risk, or to speculate on changes in the expected direction of underlying
prices.
OVERVIEW
Let’s revise the previous lesson, before proceeding any further. You studied
about the derivatives-their definition, types of derivatives-forward contracts,
futures contracts, options and swaps. Further, you had also learnt about the
differences between Cash and Futures Market.
The development and growth of derivative products in the last 20 years have
been one of the most extraordinary and important feature of the financial
market place. Derivatives came into existence because of the prevalence of risk
in every business and they are an important tool used in hedging.
Derivatives can be used by both the issuer and equity holder to create new
types of ownership with different risk reward payoffs and by investors.
Seeking to speculate on ownership prices or to hedge existing holdings against
adverse price fluctuations in all instances the value of derivatives is dependent
upon assets on whose price the derivative is based.
The new aspect about derivatives in recent years is the volume of trade, the
wide choice of products, the growing number and variety of users and the
range of purposes for which they are being used. Simply put, derivatives have
flourished because of a series of recent developments that have transformed
them into a cheap and efficient way of moving risk within the economic
system.
In this lesson, you will learn about the types of traders, OTC and exchange
traded securities, the types of settlement, the uses and advantages of
ANNA UNIVERSITY 35
Notes derivatives. At the end of the lesson you would be studying about the risks in
derivatives.
2.1 TYPES OF TRADERS

Those who trade or participate in derivative/underlying security transaction
may be broadly classified into three categories:
 Hedgers (Those who desire to off-load their risk exposure on a position)
 Speculators (Those willing to absorb risk of hedgers for a cost)
 Arbitragers (Those who wish to have riskless gain in the transaction of
hedgers and speculators)
Example: Suppose Mr. A is currently possessing 50 shares of SBI

currently trading at ` 1,000 per share. Mr. A has purchased those at ` 950
before 3 months. Mr. A has 3 possibilities or courses of actions: to sell
now, wait for further appreciation of price, hedge the long position (holds
shares) and pay a small price for that. If Mr. A sells now, he is just like any
other investor who wants to book a definite known profit on investment.
If Mr. A waits, he is speculating on his position which may expose him to
uncertain gain/loss. If Mr. A decides to hedge, he can use one of the
derivative instruments –forwards, futures, options or swaps.
Let us discuss in detail, the three market participants in derivative trading.
2.1.1 Hedgers
Hedgers are those traders who wish to eliminate price risk associated with the
underlying security being traded. The objective of these kinds of traders is to
safeguard their existing positions by reducing the risk. They are not in the
derivatives market to make profits.
Apart from equity markets, hedging is common in the foreign

exchange markets where fluctuations in the exchange rate have to be taken
care of in the foreign currency transactions or could be in the commodities
market where spiraling oil prices have to be tamed using the security in
derivative instruments.
Example: An investor holding shares of ITC and fearing that the share
price will decrease in future, takes an opposite position (sell futures contracts)
to minimize the extent of loss if the share will to dwindle.
36 ANNA UNIVERSITY
Hedgers minimize their risk by taking an opposite position in the market to Notes
what they are trying to hedge. The ideal situation in hedging would be to
generate one effect to cancel out another.
Example: Let us assume that a company specializes in manufacturing

jewellery and it has a major contract due in six months, for which gold is one
of the company's main inputs. The company is worried about the volatility of
the gold market and believes that gold prices may increase considerably in the
near future. In order to protect itself from this uncertainty, the company could
buy a six-month futures contract in gold. This way, if gold experiences a 10%
price increase, the futures contract will lock in a price that will offset this gain.
As one can notice that, although hedgers are protected from any losses, they
are also restricted from any gains. Based on a company's policies and the type
of business it runs, it may prefer to hedge against certain business operations
for reducing fluctuations in its profit and protect itself from any downside risk.
2.1.2 Speculator
While hedgers might be adept at managing the risks of exporting and
producing petroleum products around the world, there are parties who are
adept at managing and even making money out of such exogenous risks. Using
their own capital and that of clients, some individuals and organizations will
accept such risks in the expectation of a return.
Unlike investing in business along with its risks, speculators have

no clear interest in the underlying activity itself. For the possibility of a
reward, they are willing to accept certain risks.
They are traders with a view and objective of making profits. These are people
who take positions (either long or short positions) and assume risks to profit
from fluctuations in prices. They are willing to take risks and they bet upon
whether the markets would go up or come down.
In the previous example (ITC), it is also possible to short futures without
actually owning shares in spot market. The speculator does so because he
expects ITC to fall and by entering into short futures, he gains if price falls.
The speculator is not required to pay the entire value i.e., (No. of futures
contracts x shares under each contract x delivery price). Only margin money
which accounts for 5-10 % of total transacted value is paid upfront by
speculator. Thus, futures are highly levered instruments.
Example: If margin money required is 10%, the speculator can take 10

contracts by paying the price of 1 contract.
ANNA UNIVERSITY 37
Notes Technically, anyone who buys or shorts a security with the presumption of a
favorable price change is a speculator.
Example: If a speculator believes XYZ Company stock is overpriced,

they may short the stock, wait for the price to fall, and make a profit. It's
possible to speculate on virtually every security, though speculation is specially
focused on the commodities, futures, and derivatives markets.
But to understand speculation, one must understand how it varies from
hedging.
Example: Let's take an example: let's assume part of your investment

portfolio includes shares of Company XYZ, which produces autos. Because the
auto industry is cyclical, Company XYZ shares will probably decline if the
economy starts to decline.
If you want to protect this investment – that is, you want to hedge your
investment – one way to do that is to purchase defensive stocks. You may
choose "noncyclicals," or companies that sell basic necessities like toothpaste
or toilet paper. During economic slumps, these stocks tend to hold or increase
their value, which could offset the loss in value of the XYZ shares.
A speculator wouldn't follow this strategy. If a speculator purchased food-
company stocks, he would do so because he simply believes the stock is going
to increase.
Speculation can increase short-term volatility (and thus, risk). It can inflate
prices and can cause bubbles, as was the case in the 2005-2006 real estate market
in the United States. Speculators who were betting that home prices would
continue to increase purchased houses (often using leverage) intending to "flip"
them for a profit. This increased the demand for housing, which raised prices
further, eventually taking them beyond the "true value" of the real estate in many
markets. The frenzied selling that occur is typical for speculative markets.
2.1.3 Arbitrageurs
The third players are known as arbitrageurs. From the French for arbitrage or
judge, these market participants look for mis-pricing and market mistakes, and
by taking advantage of them; they disappear and never become too large. If you
have even purchased a produce of a green grocer only to discover the same
produce somewhat cheaper at the next grocer, you have an arbitrage situation.
Arbitrage is the process of simultaneous purchase of securities or

derivatives in one market at a lower price and sale thereof in another market
at a relatively higher price.
38 ANNA UNIVERSITY
Notes
Example: On maturity if the pepper futures contracts is ` 650 per k.g.
and the spot price is ` 642, then the arbitragers will buy pepper in spot and
short sell futures, thereby gaining riskless profit of 650-642 i.e., ` 8 per k.g.
Here, the two markets are spot and futures market. Thus, riskless profit making
is the prime goal of arbitrageurs.
Therefore, arbitrage opportunities exist when the prices of similar assets are
settled at different levels. This opportunity permits an investor to attain a profit
with zero risk and limited funds by simply selling the asset in the overpriced
market and simultaneously buying it in the cheaper market.
This buying and selling of the asset will push the cheaper asset's price up and
the higher asset price down. This process will continue until the asset price is
equal in both markets.
Achieving this equilibrium through buying and selling is stated as the law of
one price. This law may look like it has been violated at times, but this usually
is usually not the case once you factor in financing or delivery costs associated
with the different markets.
Example: On exchange A IBN is trading at $25 and on exchange B

IBN is trading at $30 dollars. If you buy IBN on exchange A and
simultaneously sell it on exchange B, you can net a profit of $5 with out any
risk or any outlay of cash.
As people continue to buy on exchange A, the price of IBN will increase and
all of the selling of IBN on exchange B will force the price down until
equilibrium has been reached. This is how arbitrage works to make the
marketplace efficient.
Three Conditions of Arbitrage
Arbitrage is possible when one of three conditions is met:
 The same asset does not trade at the same price on all markets ("the law of
one price").
 Two assets with identical cash flows do not trade at the same price.
 An asset with a known price in the future does not today trade at its future
price discounted at the risk-free interest rate (or, the asset has significant
costs of storage; as such, for example, this condition holds for grain but not
for securities).
Learning Activity
Analyze the arbitrage opportunity used by vegetable vendors in
different markets. Compare their margins obtained with respect to
other intermediaries in vegetable distribution.
ANNA UNIVERSITY 39
Notes 2.2 OTC AND EXCHANGE TRADED SECURITIES

OTC (over-the-counter) contracts, such as forwards and swaps, are bilaterally
negotiated between two parties. The terms of an OTC contract are flexible, and
are often customized to fit the specific requirements of the user. OTC contracts
have substantial credit risk, which is the risk that the counterparty that owes
money defaults on the payment. In India, OTC derivatives are generally
prohibited with some exceptions: those that are specifically allowed by the
Reserve Bank of India (RBI) or, in the case of commodities (which are
regulated by the Forward Markets Commission), those that trade informally in
'havala' or forwards markets.
An exchange-traded contract, such as a futures contract, has a standardized
format that specifies the underlying asset to be delivered, the size of the
contract, and the logistics of delivery. They trade on organized exchanges with
prices determined by the interaction of many buyers and sellers. In India, two
exchanges offer derivatives trading: the Bombay Stock Exchange (BSE) and
the National Stock Exchange (NSE). However, NSE now accounts for virtually
all exchange-traded derivatives in India, accounting for more than 99% of
volume in 2003-2004.
OTC Derivatives
 Swaps: A swap is a derivative in which two counterparties exchange cash
flows of one party's financial instrument for those of the other party's
financial instrument. The benefits in question depend on the type of
financial instruments involved.
Example: In the case of a swap involving two bonds, the benefits in

question can be the periodic interest (coupon) payments associated with
such bonds. Specifically, two counterparties agree to exchange one stream
of cash flows against another stream. These streams are called the legs of
the swap. The swap agreement defines the dates when the cash flows are to
be paid and the way they are accrued and calculated. Usually at the time
when the contract is initiated, at least one of these series of cash flows is
determined by an uncertain variable such as a floating interest rate, foreign
exchange rate, equity price, or commodity price.
The cash flows are calculated over a notional principal amount. Contrary to
a future, a forward or an option, the notional amount is usually not
exchanged between counterparties. Consequently, swaps can be in cash or
collateral.
Swaps can be used to hedge certain risks such as interest rate risk, or to
speculate on changes in the expected direction of underlying prices.
 Forward Rate Agreements: A forward rate agreement (FRA) is a forward
contract, an over-the-counter contract between parties that determines the
40 ANNA UNIVERSITY
rate of interest, or the currency exchange rate, to be paid or received on an Notes

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. It is paid on the effective date. The reference rate is
fixed one or two days before the effective date, dependent on the market
convention for the particular currency. FRAs are over-the counter
derivatives. FRAs are very similar to swaps except that in a FRA a
payment is only made once at maturity. Instruments such as interest rate
swap could be viewed as a chain of FRAs.
Example: Let us assume that Company A enters into an FRA with

Company B in which Company A will receive a fixed rate of 5% for one
year on a principal of $1 million in three years. In return, Company B will
receive the one-year LIBOR rate, determined in three years' time, on the
principal amount. The agreement will be settled in cash in three years.
If, after three years' time, the LIBOR is at 5.5%, the settlement to the
agreement will require that Company A pay Company B. This is because
the LIBOR is higher than the fixed rate. Mathematically, $1 million at 5%
generates $50,000 of interest for Company A while $1 million at 5.5%
generates $55,000 in interest for Company B. Ignoring present values, the
net difference between the two amounts is $5,000, which is paid to
Company B.
 Exotic Options: An exotic option is an option which has features making it
more complex than commonly traded vanilla options. Like the more
general exotic derivatives they may have several triggers relating to
determination of payoff. An exotic option may also include non-standard
underlying instrument, developed for a particular client or for a particular
market. Exotic options are more complex than options that trade on an
exchange, and are generally traded over the counter (OTC).
Examples of exotic options include Asian options (strike price is based on
the projected average price of the underlying asset over a specific interval)
and compound options (underlying asset is another option). Exotic options
should not be confused with plain vanilla options, which only contain a
specific strike price, expiration date, and underlying asset.
 Exotic Derivatives: Exotic derivatives are financial products with
complicated underlying contracts. Derivatives are based on the value of
underlying assets and can vary in complexity, allowing people to control
risk by buying, selling, and trading derivative contracts. In the case of
exotic derivatives, the structure of the contract is not straightforward, and
may be customized for a specific investor or market. This contrasts with
vanilla derivatives, which have straightforward terms.For investors, exotic
derivatives create more options. People concerned with controlling and
ANNA UNIVERSITY 41
Notes managing risk may find vanilla derivatives poorly suited or inadequate for
their needs, depending on the type of risk involved. Having access to more
complex contracts can allow for greater control and will also expose people
to the possibility of larger profits
Example: Exotic Derivatives that fall into the options category

would generally include the following exotic option types: Knock Out
Options, Knock In Options, Average Rate Options, Average Strike
Options, Binary Options and Basket Options. In some cases, Exotic
Derivatives will have discontinuous payoff profiles, as with Knock Out and
Knock In Options. In other cases, they might depend on the value of more
than one underlying asset, like with Basket Options. Still other types of
Exotic Options have an averaging process applied to either their strike price
or to their underlying, as with Average Strike or Average Rate Options.
Exchange Traded Derivatives
 Future contracts: A futures contract is a contract between two parties
where both parties agree to buy and sell a particular asset of specific
quantity and at a predetermined price, at a specified date in future.The
payment and delivery of the asset is made on the future date termed as
delivery date. The buyer in the futures contract is known as to hold a long
position or simply long. The seller in the futures contracts is said to be
having short position or simply short.The underlying asset in a futures
contract could be commodities, stocks, currencies, interest rates and bond.
The futures contract is held at a recognized stock exchange. The exchange
acts as mediator and facilitator between the parties. In the beginning both
the parties are required by the exchange to put beforehand a nominal
account as part of contract known as the margin.
Since the futures prices are bound to change every day, the differences in
prices are settled on daily basis from the margin. If the margin is used up,
the contractee has to replenish the margin back in the account. This process
is called marking to market. Thus, on the day of delivery it is only the spot
price that is used to decide the difference as all other differences had been
previously settled. Futures can be used to hedge against risk or speculate
the prices.
Hedgers do not usually seek a profit by trading commodities futures but
rather seek to stabilize the revenues or costs of their business operations.
Their gains or losses are usually offset to some degree by a corresponding
loss or gain in the market for the underlying physical commodity.
Example: If you plan to grow 500 bushels of wheat next year, you
could either grow the wheat and then sell it for whatever the price is when
you harvest it, or you could lock in a price now by selling a futures contract
42 ANNA UNIVERSITY
that obligates you to sell 500 bushels of wheat after the harvest for a fixed Notes
price. By locking in the price now, you eliminate the risk of falling wheat
prices. On the other hand, if the season is terrible and the supply of wheat
falls, prices will probably rise later – but you will get only what your
contract entitled you to. If you are a bread manufacturer, you might want to
purchase a wheat futures contract to lock in prices and control your costs.
However, you might end up overpaying or (hopefully) underpaying for the
wheat depending on where prices actually are when you take delivery of
the wheat.
 Options: A financial derivative that represents a contract sold by one party
(option writer) to another party (option holder). The contract offers the
buyer the right, but not the obligation, to buy (call) or sell (put) a security
or other financial asset at an agreed-upon price (the strike price) during a
certain period of time or on a specific date (exercise date).
 Call options give the option to buy at certain price, so the buyer would
want the stock to go up.
 Put options give the option to sell at a certain price, so the buyer would
want the stock to go down.
Options are extremely versatile securities that can be used in many
different ways. Traders use options to speculate, which is a relatively risky
practice, while hedgers use options to reduce the risk of holding an asset.
In terms of speculation, option buyers and writers have conflicting views
regarding the outlook on the performance of an underlying security.
Example: It is because the option writer will need to provide the

underlying shares in the event that the stock's market price will exceed the
strike, an option writer that sells a call option believes that the underlying
stock's price will drop relative to the option's strike price during the life of
the option, as that is how he or she will reap maximum profit.
This is exactly the opposite outlook of the option buyer. The buyer believes
that the underlying stock will rise, because if this happens, the buyer will
be able to acquire the stock for a lower price and then sell it for a profit.
Example: Let's say IBM stock is currently trading at $100 per

share. Now let's say an investor purchases one call option contract on IBM
with a $100 strike and at a price of $2.00 per contract. Note: Because each
options contract represents an interest in 100 underlying shares of stock,
the actual cost of this option will be $200 (100 shares x $2.00 = $200).
ANNA UNIVERSITY 43
Notes Here's what will happen to the value of this call option under a variety of
different scenarios:
 When the option expires, IBM is trading at $105.
The call option gives the buyer the right to purchase shares of IBM at $100
per share. In this scenario, the buyer could use the option to purchase those
shares at $100, then immediately sell those same shares in the open market
for $105. This option is therefore called in the money. Because of this, the
option will sell for $5.00 on the expiration date (because each option
represents an interest in 100 underlying shares, this will amount to a total
sale price of $500). Because the investor purchased this option for $200,
the net profit to the buyer from this trade will be $300.
 When the option expires, IBM is trading at $101.
Using the same analysis, the call option will now be worth $1 (or $100
total). Since the investor spent $200 to purchase the option in the first
place, he or she will show a net loss on this trade of $1.00 (or $100 total).
This option would be called at the money because the transaction is
essentially a wash.
 When the option expires, IBM is trading at or below $100.
If IBM ends up at or below $100 on the option's expiration date, then the
contract will expire out of the money. It will now be worthless, so the
option buyer will lose 100% of his or her money (in this case, the full $200
that he or she spent for the option).
The differences between options traded on exchanges and OTC options,
outlined in Table 2.1 are important for both the option buyer and seller. The
advantage of exchange-listed options on futures is the generally superior
liquidity in the market—the disadvantage is that the contract terms are rigid.
The reverse is true for OTC options. The terms of the option can be tailor-made
to the objectives of the option customer, but it is not always as easy to trade in
or out of these options. Both exchange and OTC options serve their purpose in
the marketplace and are a complement to each other. It is up to the buyers and
sellers of options to determine which vehicle is most appropriate, given their
trading needs or goals.
Table 2.1: Difference between Exchange Traded Options and OTC Options
Exchange Options OTC Options
Traded by open outcry on an exchange floor Traded principal to principal
Available only for a limited selection of Available for a wide variety of underlying
underlying markets products
Uniform, standardized contracts Individually negotiated contracts
Credit/default risk vs the exchange’s Credit/default risk must be evaluated and
clearinghouse monitored for each customer
44 ANNA UNIVERSITY
2.2.1 Development of Derivative Markets in India Notes

Derivatives markets have been in existence in India in some form or other for a
long time. In the area of commodities, the Bombay Cotton Trade Association
started futures trading in 1875 and, by the early 1900s India had one of the
world's largest futures industry. In 1952, the government banned cash
settlement and options trading and derivatives trading shifted to informal
forwards markets. In recent years, government policy has changed, allowing
for an increased role for market-based pricing and less suspicion of derivatives
trading. The ban on futures trading of many commodities was lifted starting in
the early 2000s, and national electronic commodity exchanges were created.
In the equity markets, a system of trading called 'badla' involving some
elements of forwards trading had been in existence for decades. However, the
system led to a number of undesirable practices and it was prohibited off and
on till the Securities and Derivatives OUP.
Volatility is measured as the yearly standard deviation of the daily exchange
rate series. Exchange Board of India (SEBI) banned it for good in 2001.
A series of reforms of the stock market between 1993 and 1996 paved the way
for the development of exchange-traded equity derivatives markets in India. In
1993, the government created the NSE in collaboration with state-owned
financial institutions. NSE improved the efficiency and transparency of the
stock markets by offering a fully automated screen-based trading system and
real-time price dissemination. In 1995, a prohibition on trading options was
lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded
derivatives. The report of the L.C. Gupta Committee, set up by SEBI,
recommended a phased introduction of derivative products, and bi-level
regulation (i.e., self-regulation by exchanges with SEBI providing a
supervisory and advisory role). Another report, by the J. R. Verma Committee
in 1998, worked out various operational details such as the margining systems.
In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R) A, was
amended so that derivatives could be declared 'securities.' This allowed the
regulatory framework for trading securities to be extended to derivatives. The
Act considers derivatives to be legal and valid, but only if they are traded on
exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999.
A system of market-determined exchange rates was adopted by India in March
1993. In August 1994, the rupee was made fully convertible on current
account. These reforms allowed increased integration between domestic and
international markets, and created a need to manage currency risk.
2.2.2 Development and Regulation of Derivative Markets in India
The SEBI Board in its meeting on June 24, 2002 considered some important
issues relating to the derivative markets, including:
 Physical settlement of stock options and stock futures contracts.
ANNA UNIVERSITY 45
Notes  Review of the eligibility criteria of stocks on which derivative products are
permitted.
 Use of sub-brokers in the derivative markets.
 Norms for use of derivatives by mutual funds.
The recommendations of the Advisory Committee on Derivatives on some of
these issues were also placed before the SEBI Board. The Board desired that
these issues be reconsidered by the Advisory Committee on Derivatives (ACD)
and requested a detailed report on the aforesaid issues for the consideration of
the Board.
In the meantime, several other important issues like the issue of minimum
contract size, the segregation of the cash and derivative segments of the
exchange and the surveillance issues in the derivatives market were also placed
before the ACD for its consideration.
The Advisory Committee, therefore, decided to take this opportunity to present
a comprehensive report on the development and regulation of derivative
markets including a review of the recommendations of the L.C.Gupta
Committee (LCGC).
Four years have elapsed since the LCGC Report of March 1998. During this
period there have been several significant changes in the structure of the Indian
capital markets which include, dematerialisation of shares, rolling settlement
on a T+3 basis, client level and Value at Risk (VaR) based margining in both
the derivative and cash markets and proposed demutualization of exchanges.
Equity derivative markets have now been in existence for two years and the
markets have grown in size and diversity of products. This, therefore, appears
to be an appropriate time for a comprehensive review of the development and
regulation of derivative markets.
2.2.3 Regulatory Objectives
It is inclined towards positive regulation designed to encourage healthy activity
and behaviour. It has been guided by the following objectives:
 Investor Protection: Attention needs to be given to the following four
aspects:
 Fairness and Transparency: The trading rules should ensure that
trading is conducted in a fair and transparent manner. Experience in
other countries shows that in many cases, derivatives brokers/dealers
failed to disclose potential risk to the clients. In this context, sales
practices adopted by dealers for derivatives would require specific
regulation.
46 ANNA UNIVERSITY
Notes
In some of the most widely reported mishaps in the derivatives

market elsewhere, the underlying reason was inadequate internal control
system at the user-firm itself, so that overall exposure was not controlled
and the use of derivatives was for speculation rather than for risk hedging.
These experiences provide useful lessons for us for designing regulations.
 Safeguard for clients' moneys: Moneys and securities deposited by

clients with the trading members should not only be kept in a separate
clients' account but should also not be attachable for meeting the
broker's own debts. It should be ensured that trading by dealers on own
account is totally segregated from that for clients.
 Competent and honest service: The eligibility criteria for trading
members should be designed to encourage competent and qualified
personnel so that investors/clients are served well. This makes it
necessary to prescribe qualification for derivatives brokers/dealers and
the sales persons appointed by them in terms of a knowledge base.
 Market integrity: The trading system should ensure that the market's
integrity is safeguarded by minimising the possibility of defaults. This
requires framing appropriate rules about capital adequacy, margins,
clearing corporation, etc.
 Quality of markets: The concept of "quality of markets" goes well beyond
market integrity and aims at enhancing important market qualities, such as
cost-efficiency, price-continuity, and price-discovery. This is a much
broader objective than market integrity.
 Innovation: While curbing any undesirable tendencies, the regulatory
framework should not stifle innovation which is the source of all economic
progress, more so because financial derivatives represent a new rapidly
developing area, aided by advancements in information technology.
2.3 TYPES OF SETTLEMENT

Settlement is the act of consummating the contract, and can be done in one of
the three ways: physical form, cash settlement, and offsetting position.
2.3.1 Physical Settlement
Prior to modern financial market technologies and methods such as
depositories and securities held in electronic form, securities settlement had
involved the physical movement of paper instruments, or certificates and
transfer forms. Payment was usually made by paper check upon receipt by the
registrar or transfer agent of properly negotiated certificates and other requisite
documents. Physical settlement securities still exist in modern markets today
mostly for private (restricted or unregistered) securities as opposed to those of
ANNA UNIVERSITY 47
Notes publicly (exchange) traded securities, however, payment of money today is

typically made via electronic funds transfer (in the U.S., a bank wire transfer
made through the Federal Reserve's Fedwire system). Physical/paper
settlement involves higher risks, inasmuch as paper instruments, certificates,
and transfer forms are subject to risks electronic media are not more or less
such as loss, theft, counterfeit, and forgery (see indirect holding system).
Physical delivery takes place at the end of the contract the holder of the
position will either have to deliver the physical commodity if short or take
delivery if long. It is estimated that only 2% of all futures contracts are actually
delivered. All Physically Delivered contracts have both a First Notice Day and
a Last Trading Day. Most brokers, if not all, will notify traders if they are in a
contract and First Notice Day is approaching.
If a trader wants to deliver or take delivery of a commodity, they will
coordinate with their broker, the clearing firm and the exchange in order to do
so. If the trader does not want to take delivery, they can “retender.”
2.3.2 Cash Settlement
A settlement method used in certain future and option contracts whereby, upon
expiry or exercise, the seller of the financial instrument does not deliver the
actual but transfers the associated cash position. For sellers not wishing to take
actual possession of the underlying cash commodity, cash settlement is a more
convenient method of transacting futures and options contracts.
Example: the purchaser of a cotton future that is cash settled, rather

than being required to take ownership of physical bundles of cotton, pays the
difference between the spot price of cotton and the futures price.
At the end of the contract the holder of the position is simply debited or
credited the difference between their entry price and the final settlement. If you
are long the Emini S&P 500 from 1700.00 and when the contract expires, the
final settlement is 1705.00, you are up 5.00 points, which is $250. On your
statement the long Emini S&P position is offset from the settlement and your
account is credited with a $250 gain.
While traders who are in Cash Settled contracts are not a risk for delivery, they
should understand when the contracts come off the board. If a trader is long the
Emini S&P 500, and wants to continue holding that position, it is best to roll
the position before expiration.
2.3.3 Offsetting Position
This type of settlement is evidenced in 90% of futures settlement worldwide.
Affecting an offsetting futures transaction means entering into a reverse trade
of the initial position. The initial buyer(long) liquidates his position by selling
(going short) a similar future contract, and initial seller(short) goes for
48 ANNA UNIVERSITY
buying(long) an identical contract. Offsetting is a process of carrying forward Notes

the transaction by changing sides.
2.4 USES AND ADVANTAGES OF DERIVATIVES

2.4.1 Uses of Derivatives
Derivatives have many uses. A treasurer is a risk-averse organization may
simply purchase a currency option to hedge his currency risk, whilst another
treasurer in a profit-centred organization may well sell the same option to
speculate. The stories are legendary of various companies and individuals
losing their shirts in the currency market due to “unforeseen” circumstances.
What this really means is that they tried to guess the way the currency was
going to move and they got it wrong!
The other uses of derivatives are as follows:
 Derivatives possess a combination of novel characteristics not found in any
form of assets.
 It is comfortable to take a short position in derivatives than in other assets.
An investor is said to have a short position in a derivatives product if he is
obliged to deliver the underlying asset in specified future date.
 Derivatives traded on exchanges are liquid and involves the lowest possible
transaction costs and are useful in implementing asset allocation strategies
on account of their property of low cost of diversification and leverage.
 Derivatives can be closely matched with specific portfolio requirements
and can also be seen as risk sharing; derivatives provide more efficient
allocation of economic risks.
 The margin requirements for exchange-traded derivatives are relatively
low, reflecting the relatively low level of credit-risk associated with the
derivatives.
 Derivatives are traded globally having strong popularity in financial
markets.
 Derivatives maintain a close relationship between their values and the
values of underlying assets; the change in values of underlying assets will
have effect on values of derivatives based on them. Since risk is involved
and is related to information, hence derivatives market also affect the
information structure of the financial system, which itself is a major
determinant of the dynamics and the stability of the economic system.
 In a Treasury bond futures contract, the derivatives are straightforward.
2.4.2 Advantages of Derivatives
The derivatives market is advantageous because it performs a number of
economic functions.
ANNA UNIVERSITY 49
Notes  Discovery of Prices: Prices in an organized derivatives market reflect the

perception of market participants about the future and lead the prices of
underlying to the perceived future level. The prices of derivatives converge
with the prices of the underlying at the expiration of the derivative contract.
Thus derivatives help in discovery of future as well as current prices.
 Transfer of Risks: The derivatives market helps to transfer risks from those
who have them but may not like them to those who have an appetite for
them i.e. from Hedgers to Speculators.
 Liquidity and Volume Trading: Third, derivatives, due to their inherent
nature, are linked to the underlying cash markets. With the introduction of
derivatives, the underlying market witness higher trading volumes because
of participation by more players who would not otherwise participate for
lack of an arrangement to transfer risk.
 Trading Catalyst: An important incidental benefit that flows from
derivatives trading is that it acts as a catalyst for new entrepreneurial
activity. The derivatives have a history of attracting many bright, creative,
well-educated people with an entrepreneurial attitude. They often energize
others to create new businesses, new products and new employment
opportunities, the benefits of which are immense.
 Risk Control by Hedging: Derivatives are powerful tools for risk control.
By the very nature of their product line, insurance companies are logical
users of derivatives-providing means to hedge against adversities of
unfavourable market movements in return for a premium. In fact,
derivatives such as Treasury bond futures and interest rate swaps and
option, are natural tools for insurance companies to use in managing a pool
of assets.
 Creating investments synthetically: Derivatives can be used by investors to
synthetically create investments that do not exist in the market place to
achieve a particular investment goal.
2.5 RISKS IN DERIVATIVES

Non-financial firms need to watch out for three main risks when using
derivatives. They are:
 Market risk: The possibility that the value of the derivative will change.
This is essentially no different from the risk involved in buying an equity or
bond, or holding a currency–except that the market risk may be magnified
many times if the derivative is leveraged; indeed some of the most famous
disasters, including Procter & Gamble’s losses, were associated with
leveraged products. The other difference compared with equities, bonds
and so on is that the value of an option changes increasingly quickly as it
becomes more likely to be exercised.
50 ANNA UNIVERSITY
 Basis risk: The derivative used may not be a perfect match with whatever it Notes
is intended to hedge so that when the value of the underlying asset falls, the
value of the derivative may not rise by the expected amount.
 Credit or “Counterparty” risk: Lastly, there is credit or “counterparty”
risk. Here the institution concerned will get into trouble and be unable to
pay up. Bear in mind, however, that the credit risk on buying a derivative is
less than that on, say, making a loan, as the cost of replacing a derivative
contract is only the amount to which the market has moved against the
buyer since the original contract was drawn up, whereas for the loan it is
the entire amount lent.
Derivatives bought from banks are exposed to bigger credit risks

than those bought from exchanges.
This is because exchanges guarantee contracts, and, unlike banks, ensure

they can cover them by requiring traders to stump up cash (“post-margin”)
to cover potential losses in advance. However, this increases the possibility
that a firm might face liquidity problems.
 Interest rate risk: Entities involved in the lending business are exposed to
the risk of fluctuation in the interest rates. An institution like a bank with
floating interest attached to its liabilities and assets having fixed rates, faces
the risk of decline in interest rates. This risk can be managed by writing an
interest rate swap. In this type of a product, the financial institution swaps
the liability of the floating rate for fixed rates.
The basis of the floating rate may experience unpredicted changes which
exposes the firms to a risk known as the basis risk. For example, a business
has loans which are floating with reference to the LIBOR, whereas the
assets are floating with reference to US treasuries. In such cases, the
business may think of swapping the basis by entering into a basis swap.
 Foreign Exchange Risk: In the modern globalised world trade, the firms
involved in international trade have risk related to the export earning or
import outflows, which is dependent on the exchange rate. Also in many
cases, businesses have assets or liabilities denominated in foreign currency.
However, the exchange rate keeps on fluctuating. This exposes the firm to
a risk of its valuation getting affected adversely by adverse changes in
exchange rates. Firms cater to this risk by entering into foreign exchange
derivative.
 Commodity price risk: The entities involved in commodity trading, or
having any position on commodities face risk of changes in commodity
prices. Such risks are also sheltered by derivatives in commodities.
 Financial instruments value risk: In the modern world, huge sums are
invested in different financial instruments. However, the value of the
ANNA UNIVERSITY 51
Notes instruments and in turn, the value of the investment keeps on changing.
Extensive use of derivative in order to manage this risk is prevalent in the
market.
 Weather risks: One of the not so new risks that have been identified by
businesses is the risk of unfavourable weather. In some way or the other,
weather has a role to play in the profitability of a firm. Companies like
power corporations face the risk of warmer winters whereas companies like
beach resorts face a risk of more rains. To safeguard against the different
impacts of weather can be managed using different derivative instruments.
Even something like risk of changes in weather is hedged and transferred.
There is a variety of weather derivatives, that is, instruments that pay off
based on weather changes.
Learning Activity
Analyze the Harshad Mehta and Ketan Parekh stock market scam.
What lessons did BSE and NSE learnt for regulating their market
mechanism and promoting fair transparency in their stock
investments?
Derivative Crises of the Early and Mid-1990s
D uring the derivative crises of the early and mid-1990s, big firms like
Gibson Greetings and Proctor & Gamble has to bear immense
losses as a result of derivatives speculation, while Orange Country
and Calif were forced to file for bankruptcy as their treasurer’s failed in
their derivatives bets. It was the time when many felt that the corporate
treasurers and others were lured in derivatives betting by Wall Street
salesmen who had a little more understanding about these products than the
customers. But these days’ derivatives rarely make news.
According to Wharton accounting professor, Wayne Guay, the way
derivatives are being used in the market has matured. He feels that twenty
years ago derivatives were not at all common in the market, but today many
derivatives contracts are standardized, well understood and economically
priced. In order to understand the amount of risk faced by companies
through their derivatives bets, Guay and SP Kothari, an accounting
professor at MIT’s Sloan School if Management examined the non-financial
firms that used derivatives.
The result revealed that for most of the firms the quantity of derivatives that
they used was quite insignificant when compared to how big these
companies were.
Contd...
52 ANNA UNIVERSITY
Questions: Notes
1. Comment on the changing trends of derivatives in the last decade.
2. ‘The Indian derivatives market has witnessed a number of changes in
the recent past. After the introduction of futures and options on
individual stocks, the market is all set to get a face-lift with the
introduction of currency options’. Comment.
1. Speculators may be either day traders or position

traders. The former speculate on the price movements
during one trading day, while the latter attempt to gain
keep their position for longer time period to gain from
price fluctuations.
2. Contract performance is guaranteed by a clearing
house, which is a wholly owned subsidiary of the NSE.
Margin requirements and daily marking-to-market of
futures positions substantially reduce the credit risk of
exchange-traded contracts, relative to OTC contracts.
3. The economic liberalization of the early nineties
facilitated the introduction of derivatives based on
interest rates and foreign exchange.
SUMMARY
 Those who trade or participate in derivative/underlying security transaction
may be broadly classified into three categories- hedgers, speculators and
arbitrageurs.
 In India, OTC derivatives are generally prohibited with some exceptions:
those that are specifically allowed by the Reserve Bank of India (RBI) or,
in the case of commodities (which are regulated by the Forward Markets
Commission), those that trade informally in 'havala' or forwards markets.
 An exchange-traded contract, such as a futures contract, has a standardized
format that specifies the underlying asset to be delivered, the size of the
contract, and the logistics of delivery. They trade on organized exchanges
with prices determined by the interaction of many buyers and sellers. In
India, two exchanges offer derivatives trading: the Bombay Stock
Exchange (BSE) and the National Stock Exchange (NSE).
 Derivatives markets have been in existence in India in some form or other
for a long time. In the area of commodities, the Bombay Cotton Trade
Association started futures trading in 1875 and, by the early 1900s India
had one of the world's largest futures industry.
ANNA UNIVERSITY 53
Notes  In 1952, the government banned cash settlement and options trading and
derivatives trading shifted to informal forwards markets. In recent years,
government policy has changed, allowing for an increased role for market-
based pricing and less suspicion of derivatives trading. The ban on futures
trading of many commodities was lifted starting in the early 2000s, and
national electronic commodity exchanges were created.
 Regulatory objectives of derivatives include-investor protection, quality of
markets and innovation.
 Settlement is the act of consummating the contract, and can be done in one
of the three ways: physical form, cash settlement, and offsetting position.
 The advantages of derivatives include-discovery of prices, transfer of risks,
liquidity and volume trading, trading catalyst, risk control by Hedging and
creating investments synthetically.
 Non-financial firms need to watch out for three main risks when using
derivatives. They are market risk, basis risk and credit or counterparty risk.
KEYWORDS
Credit Risk: The risk of loss due to non-payment by counterparty is known as
credit risk.
Exchange-traded Contract: An exchange-traded contract, such as a futures
contract, has a standardized format that specifies the underlying asset to be
delivered, the size of the contract, and the logistics of delivery.
Market Risk: The risk associated with interest rates exchange rates and equity
prices.
Over the Counter Contract: An over-the counter contract or security is written
or created by a bank (or sometimes corporate or other financial institutions),
and tailored to suit the exact requirements of the client.
Settlement Date: The date on which the parties to a swap make payments.
Offsetting Position: This type of settlement is evidenced in 90% of futures
settlement worldwide. Affecting an offsetting futures transaction means
entering into a reverse trade of the initial position. The initial buyer(long)
liquidates his position by selling (going short) a similar future contract, and
initial seller(short) goes for buying(long) an identical contract. Offsetting is a
process of carrying forward the transaction by changing sides.
1. Who are hedgers?
2. Who are called speculators?
54 ANNA UNIVERSITY
3. Who are called arbitrageurs? Notes

4. What do you understand by Over-the-Counter contracts?
5. What do you mean by Exchange-traded contracts?
6. “Settlement is the act of consummating the contract, and can be done in
one of the three ways: physical form, cash settlement, and offsetting
position”. Explain in detail.
7. Explain the uses of derivatives.
8. What are the advantages of derivatives?
9. What do you mean by market integrity?
10. Discuss the risks associated with trading in derivatives.
1. Examine and discuss in detail, the three market participants in derivative
trading.
2. Analyze the development and regulation of derivative markets in India.
Also, discuss the regulatory objectives in detail.
3. Differentiate in detail between Over-the-counter and exchange traded
securities.
4. Explain the uses and advantages of derivative trading in detail.
5. “Non-financial firms need to watch out for three main risks when using
derivatives”. Explain in detail.
FURTHER READINGS
Bansal, Manish and Bansal, Navneet (2007), Derivatives and

Financial Innovations, Tata McGraw Hill Education.
Chance, Don and Brooks, Roberts (2012), Introduction to
Derivatives and Risk Management, 9th edition, Cengage Learning.
Chisholm, Andrew (2011), Derivatives Demystified: A Step-by-
Step Guide to Forwards, Futures, Swaps & Options, 2nd edition,
John Wiley & Sons.
Madhumathi, R. and Ranganatham, M. (2012), Derivatives and
Risk Management, Pearson Education India.
ANNA UNIVERSITY 55
Notes
56 ANNA UNIVERSITY
Lesson 3 - Futures Contract
Notes
UNIT II
LESSON 3 - FUTURES CONTRACT
CONTENTS
Learning Objectives
Learning Outcomes
Overview
3.1 Specifications of Futures Contract
3.1.1 Characteristics of Futures Contracts
3.1.2 Standardization of Futures Contract
3.1.3 Specifications of Future Contract
3.2 Margin Requirements
3.3 Marking to Market
3.3.1 The Process of Marking-to-Market
3.3.2 Long –Futures
3.3.3 Short-Futures
3.4 Hedging using Futures
3.4.1 Features of Hedging
3.4.2 Hedging using Futures
3.5 Types of Futures Contracts
Summary
Keywords
Further Readings
LEARNING OBJECTIVES
 Understand the specifications of futures contract
 Describe the margin requirements
 Explain what is marking to market
 Examine Hedging using Futures
 Determine the types of future contracts
ANNA UNIVERSITY 57

understanding of:
 the application of the long futures position, as it is used when a
manufacturer wishes to lock in the price of a raw material that he will
require sometime in the future
 the fact that spot prices continually change -- they fluctuate according to
varying supply and demand. To mitigate the risk of continuously changing
prices, investors created derivatives.
 the datum that every futures contract represents a specific quantity. It is not
negotiated by the parties to the contract. One can buy or sell a number of
futures contracts to match one’s required quantity.
OVERVIEW
In the previous lesson you had studied about the types of traders, OTC and
exchange traded securities, the types of settlement, the uses and advantages of
derivatives and the risks associated with derivatives.
Futures are standardized contracts traded on exchanges through a clearing
house and avoid counter party risk through margin money, and much more.
What we know as the futures market of today originated from some humble
beginnings. Trading in futures originated in Japan during the eighteenth
century and was primarily used for the trading of rice and silk. It wasn’t until
the 1850s that the U.S started using futures markets to buy and sell
commodities such as cotton, corn and wheat. Today’s futures market is a
global marketplace for not only agricultural goods, but also for currencies and
financial instruments such as treasury bonds and securities (securities futures).
It’s a diverse meeting place of farmers, exporters, importers, manufacturers and
speculators.
In this lesson, you will learn about the specifications of futures contract,
Margin Requirements, Marking to Market, Hedging using Futures. And lastly,
the types of future contracts - securities, stock index futures.
3.1 SPECIFICATIONS OF FUTURES CONTRACT

Let us first understand about futures contract and their characteristics and
standardization before proceeding further.
A futures contract is a type of derivative instrument, or financial contract, in
which two parties agree to transact a set of financial instruments or physical
commodities for future delivery at a particular price. If you buy a futures
contract, you are basically agreeing to buy something that a seller has not yet
produced for a set price. But participating in the futures market does not
58 ANNA UNIVERSITY
necessarily mean that you will be responsible for receiving or delivering large Notes
inventories of physical commodities - remember, buyers and sellers in the
futures market primarily enter into futures contracts to hedge risk or speculate
rather than to exchange physical goods (which is the primary activity of the
cash/spot market). That is why futures are used as financial instruments by not
only producers and consumers but also by speculators.
A future contract is a standardized agreement between the seller (short
position) of the contract and the buyer (long position), traded on a futures
exchange, to buy or sell a certain underlying instrument at a certain date in
future, at a pre-set price. The future date is called the delivery date or final
settlement date. The pre-set price is called the futures price. The price of the
underlying asset on the delivery date is called the settlement price.
Futures is a standard contract in which the seller is obligated to

deliver a specified asset (security, commodity or foreign exchange) to the
buyer on a specified date in future and the buyer is obligated to pay the
seller the then prevailing futures price upon delivery. Pricing can be based
on an open cry system, or bids and offers can be matched electronically.
The futures contract will state the price that will be paid and the date of
delivery.
Futures contracts, unlike forwards, are traded on organized exchanges. They

are traded in three primary areas:
 Agricultural Commodities
 Metals and Petroleum, and
 Financial Assets (individual stocks, indices, interest rate, currency)
3.1.1 Characteristics of Futures Contracts

Following are the salient features of futures contracts:
 Futures are highly standardised contracts that provide for performance of
contracts through either deferred delivery of asset or final cash settlement;
 These contracts trade on organized futures exchanges with a clearing
association that acts as a middleman between the contracting parties;
 Contract seller is called ‘short’ and purchaser ‘long’. Both parties pay
margin to the clearing association. This is used as performance bond by
contracting parties;
 Margins paid are generally marked to market-price everyday;
 Each futures contract has an associated month that represents the month of
contract delivery or final settlement. These contracts are identified with
their delivery months like July-Treasury bill, December $/DM etc.
ANNA UNIVERSITY 59
Notes  Every futures contract represents a specific quantity. It is not negotiated by

the parties to the contract. One can buy or sell a number of futures contracts
to match one’s required quantity. Because of this feature, 100% hedging is
not possible. There may be over or under-hedging to some extent.
3.1.2 Standardization of Futures Contract
Futures contracts are highly standardised, to ensure that they are liquid. The
standardization usually involves specifying:
 The underlying this can be anything from a barrel of crude oil to a short-
term interest rate;
 The type of settlement, either cash settlement or physical settlement;
 The amount and units of the underlying asset per contract. This can be the
notional amount of bonds, a fixed number of barrels of oil, units of foreign
currency, the notional amount of the deposit over which the short term
interest rate is traded, etc.;
 The currency in which the futures contract is quoted;
 The grade of the deliverable. In the case of bonds, this specifies which
bonds can be delivered. In the case of physical commodities, this specifies
not only the quality of the underlying goods but also the manner and
location of delivery;
 The delivery month;
 The last trading date;
 Other details such as commodity tick, the minimum permissible price
fluctuation.
3.1.3 Specifications of Future Contract
Table 3.1 describes the specification of a futures contract in individual
stock/indices.
Table 3.1: Contract Specification: Stock/Index Futures
Criteria Contract specification (Stock/Index futures)

Underlying Individual securities/ Index
Exchange of trading National Stock Exchange of India Limited
Security descriptor N FUTSTK ______/ N FUTIDX NIFTY
Contract size 100 or multiples there of(minimum value of ` 2 lakh)/lot size
shall be 200 and multiples thereof (minimum value ` 2 lakh)
Price steps ` 0.05
Price bands Not applicable
Trading cycle The futures contracts will have a maximum of three month
trading cycle—the near month (one), the next month (two) and
the far month (three). New contract will be introduced on the next
trading day following the expiry of near month contract.
Contd...
60 ANNA UNIVERSITY
Last Trading/Expiry The last Thursday of the expiry month or the previous trading day Notes
date if the last Thursday is a trading holiday.
Settlement basis Mark to market and final settlement will be cash settled on T+1
basis.
Trading Hours 9.55 A.M. to 3.30 P.M. (Monday- Friday, excluding holidays)
Daily Settlement price Closing price of the futures contracts for the trading day.
Final settlement price Closing value of the underlying stock on the last trading day. For
index—weighted average price for the last half-an-hour’s trades.
Margins Upfront initial margins on a daily basis.
Future Contract Specifications in Detail

 Underlying: Each futures contract represents a specific underlying asset to
be delivered on the delivery date. Besides commodities, other instruments
such as interest rates, currencies and stock indices are also traded in the
futures exchanges.
 Exchange of Trading: The futures exchange where the futures contract is
traded. Some of the world's largest futures exchanges include:
 Chicago Mercantile Exchange (CME)
 New York Mercantile Exchange (NYMEX)
 Tokyo Commodity Exchange (TOCOM)
 Multi-Commodity Exchange (MCX)
 Security descriptor: Each futures contract traded in a futures exchange is
identified by a unique ticker symbol.
 Contract Size: The contract size states the amount and unit of the
underlying commodity represented by each futures contract (E.g. 1000
barrels of crude oil or 50 troy ounces of platinum).
 Price steps: Price steps or Tick size is the minimum price difference
between the two quotes of a similar nature. The tick size is 0.1 point of the
BSE Sensex, which is equivalent to ` 5. In case of Nifty, tick size is 0.05
which is equal to ` 10.
 Price bands: A value-setting method in which a seller indicates an upper
and lower cost range, between which buyers are able to place bids. The
price band's floor and cap provides guidance to the buyers.
 Trading Cycle: Trading Cycle for each derivatives contract will have a
standard period during which the derivatives contract will be available for
trading which shall be notified by the Futures & Options Segment of the
Exchange from time to time.
 Last Trading/Expiry date: Trading shuts down some time before the
delivery date to give the futures contract seller sufficient time to prepare
the underlying products for delivery. Futures positions which have not been
ANNA UNIVERSITY 61
Notes closed out (offset) before end of the last trading day will have to be settled
by making or taking delivery of the underlying product.
 Settlement basis: Settlement of securities is a business process whereby
securities or interests in securities are delivered, usually against (in
simultaneous exchange for) payment of money, to fulfill contractual
obligations, such as those arising under securities trades.
Example: In the U.S., the settlement date for marketable stocks is

usually 3 business days or T+3 after the trade is executed, and for listed
options and government securities it is usually 1 day after the execution. In
Europe, settlement date has recently been adopted as 2 business days
settlement cycles T+2.
 Trading Hours: The period of time during which a financial market
commences each day.
Example: Trading commences at U.S. stock exchanges at 9:30 a.m.

and closes at 4 p.m. Eastern Time, Monday through Friday. ECNs extend
the trading day by providing limited trading before and after the regular
trading hours. The trading hours for futures and options exchanges vary by
product and exchange.
 Daily Settlement price: In derivatives markets, the price used for
determining profit or loss for the day, as well as margin requirements. The
settlement price is the average price at which a contract trades, calculated at
both the open and close of each trading day. Additionally, it is important
because it determines whether a trader may be required to post additional
margins. It is generally set by defined procedures that differ slightly among
each exchange and the instrument traded.
Typically, the settlement price is set by determining the weighted average
price over a certain period of trading, typically shortly before the close of
the market.
Example: On the Chicago Mercantile Exchange, the settlement

prices of certain equity futures are determined by a volume weighted
average of pit trading activity in the 30 seconds between 3:14:30 p.m and
3:15:00 p.m. CDT.
 Final settlement price: Last price paid for a financial or commodity
derivative on any trading day. It is a computed price based on the
(1) closing offer and bid price, (2) last actual traded price, and (3) weighted
average of prices traded during the closing minutes of the trading day. Also
called closing price or settle price.
 Margins: To ensure the smooth running of the futures market, participants
in a futures contract are required to post a performance bond of sorts as a
62 ANNA UNIVERSITY
form of guarantee. This is known as the margin. The amount of margin Notes
required can vary depending on the perceived volatility of the underlying
asset.
In the stock market, a margin is a loan that is made to the investor. It helps
the investor to reduce the amount of her own cash that she uses to purchase
securities. This creates leverage for the investor, causing gains and losses to
be amplified. The loan must be paid back with interest.
 Margin % = Market Value of the stock - Market value of the debt
divided by the market value of the stock
 An initial margin loan in the U.S can be as much as 50%. The market
value of the securities minus the amount borrowed can often be less
than 50%, but the investor must keep a balance of 25-30% of the total
market value of the securities in the margin account as a maintenance
margin.
A margin in the futures market is the amount of cash an investor must
put up to open an account to start trading. This cash amount is the
initial margin requirement and it is not a loan. It acts as a down
payment on the underlying asset and helps ensure that both parties
fulfill their obligations. Both buyers and sellers must put up payments.
 Initial Margin: This is the initial amount of cash that must be deposited
in the account to start trading contracts. It acts as a down payment for
the delivery of the contract and ensures that the parties honor their
obligations.
 Maintenance Margin: This is the balance a trader must maintain in his
or her account as the balance changes due to price fluctuations. It is
some fraction - perhaps 75% - of initial margin for a position. If the
balance in the trader's account drops below this margin, the trader is
required to deposit enough funds or securities to bring the account back
up to the initial margin requirement. Such a demand is referred to as a
margin call. The trader can close his position in this case but he is still
responsible for the loss incurred. However, if he closes his position, he
is no longer at risk of the position losing additional funds.
Terminology in Futures Contract
Some of the important terminologies used in futures contract trading and
specification are explained as below.
 Asset: This is the most important specification in futures contract. The
exchange must stipulate the quality and grade of commodity. The issue of
quality does not arise in financial assets like stocks, Japanese yen, etc.
An investment asset can be defined as an asset that is held by the owner for
investment purposes. The number of investors holding that asset should be
significantly numbered. In the financial world, financial instruments like
ANNA UNIVERSITY 63
Notes the stocks and bonds are precise examples of the investment assets. People
invest their money in these assets with an objective of value appreciation
and income generation. Commodities were unknown as investment asset
for a considerable period, except the case of gold and silver. They are
conventionally treated as investment assets. We must understand that
investment assets may not be held exclusively for investment. Take the
case of silver, which has a number of industrial uses. But still they are held
by significant numbers of investors solely for investment. Hence, we
include it in the category of investment asset. Forwards contracts in
commodities can be used as investment assets. But a majority of the
commodity forwards were not considered as investment assets and this is
reflected in the trading pattern of commodities forwards. There may be
several reasons identified for this. One reason may be that they are
significantly separate from conventional financial instruments. The
underlying asset is not a long-lived corporations but an asset that has
limited short life. Also, many commodities have manifested seasonality in
price levels and volatilities. Further, commodity forwards across the world
face a major problem of inaccurate and incomplete data for analysis.
A consumption asset on the other hand is defined as an asset that is held
primarily for consumption. The force driving its demand is the
consumption need. People do not store it as a store of value but keep it to
be used. Commodities like copper, oil, wheat etc. are purchased and kept to
be used by the purchaser. This is an example of consumption assets. If it is
expected that the demand from the electronic sector, that uses huge volume
of copper is going up, the resultant demand of copper is also expected to go
up. More people need it for the production activity and hence, demand is
up. This causes the price to go up as temporarily, the supply cannot adjust
to the increased demand. The driving force is the consumption.
 Contracts Size: Contract Size is the amount of asset that has to be delivered
under one contract. In NSE, SBI Futures contract specify delivery of 100
shares or multiples there of (minimum value of ` 2 lakh) and similarly for
other stocks and indices. The contract size differs with derivatives contracts
and types of underlying assets. The contract size of most equity option
contracts is 100 shares. However, the contract size for commodities and
financial instruments such as currencies and interest rate futures varies
widely.
Example: the contract size for a Canadian dollar futures contract is

C$100,000, while the size of a soybean contract traded on the Chicago
Board of Trade is 5,000 bushels.
The size of a gold futures contract on the COMEX is 100 ounces.
Therefore, each $1 move in the price of gold translates into a $100 change
in the value of the gold futures contract.
64 ANNA UNIVERSITY
 Delivery Months: These refer to those months when futures will mature Notes
i.e., expiry of delivery dates. Moreover, the exchange usually specifies the
period during the delivery month when delivery can be made. In NSE, the
last Thursday of the expiry month or the previous trading day if the last
Thursday is a trading holiday. To name a specific contract in a financial
futures market, the month code will follow the contract code, and in turn be
followed by the year.
Example: CLZ3 is the December 2013 NYMEX crude oil contract.

CL denotes crude oil (crude light), Z corresponds to the December delivery
month, and 3 refers to 2013.
 Trading Cycle: The futures contracts will have a maximum of three month
trading cycle —the near month (one), the next month (two) and the far
month (three). New contract will be introduced on the next trading day
following the expiry of near month contract. The index futures contracts on
the NSE have one-month, two-months and three-months expiry cycles
which expire on the last Thursday of the month. Thus, a January expiration
contract expires on the last Thursday of January and a February expiration
contract ceases trading on the last Thursday of February. On the Friday
following the last Thursday, a new contract having a three-month expiry is
introduced for trading.
 Price Limit: These are bounds on the maximum price variation permitted
in a day’s trading. The exchange sets a daily price movement limit of the
underlying asset, which normally matched the initial margin money
collected against the future contract. When the price increases by amount
equalling daily price limit, it is said ‘limit up’ and when declines by the
same value, it is referred to as ‘limit down’.
The exchange may temporarily discontinue futures trading for the

day on a particular contract if the contract is limit up or limit down. This
mechanism is similar to circuit breakers in stock market trading.
 Limit Up: The maximum amount by which the price of a futures

contract may advance in one trading day. Some markets close trading
of these contracts when the limit up is reached, others allow trading to
resume if the price moves away from the day's limit. If there is a major
event affecting the market's sentiment toward a particular commodity, it
may take several trading days before the contract price fully reflects
this change. On each trading day, the trading limit will be reached
before the market's equilibrium contract price is met.
 Limit Down: This is when the price decreases and is stuck at the lower
price limit. The maximum amount by which the price of a commodity
futures contract may decline in one trading day. Some markets close
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Notes trading of contracts when the limit down is reached, others allow
trading to resume if the price moves away from the day's limit. If there
is a major event affecting the market's sentiment toward a particular
commodity, it may take several trading days before the contract price
fully reflects this change. On each trading day, the trading limit will be
reached before the market's equilibrium contract price is met.
 Locked Limit: Occurs when the trading price of a futures contract
arrives at the exchange's predetermined limit price. At the lock limit,
trades above or below the lock price are not executed.
Example: If a futures contract has a lock limit of $5, as soon as

the contract trades at $5 the contract would no longer be permitted to
trade above this price if the market is on an uptrend, and the contract
would no longer be permitted to trade below this price if the market is
on a downtrend. The main reason for these limits is to prevent investors
from substantial losses that can occur as a result of the volatility found
in futures markets.
 Position Limit: This, specified by the futures exchanges, refers to
maximum number of contracts that a speculator may hold. The purpose is
to check excessive speculation and unchecked price volatility. The Chicago
Board Options Exchange is one entity that calculates position limits for
options exchanges.
Position limits are created for the purpose of maintaining stable and fair
markets. Contracts held by one individual investor with different brokers
may be combined in order to accurately gauge the level of control held by
one party.
Wall Street reform regulations enacted in the aftermath of the financial
crisis of 2008 required the Commodity Futures Trading Commission to
establish position limits for commodity futures and swaps.
Position limits generally fall into one of the following 4 categories:
1. All Months Limit - apply to the account holder's positions summed
across all delivery months for a given contract (e.g. positions in CBOT
Oat futures contract for the Mar, May, Jul, Sep and Dec delivery
months combined).
2. Single Month Limit - apply to the account holder's positions in any
given futures delivery month (e.g. positions in CBOT Oat futures
contract for any of the Mar, May, Jul, Sep and Dec delivery months).
Note that in certain instances, the limit may vary by delivery month.
3. Spot Month Limit - apply to the account holder's positions in the
contract month currently in delivery.
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Notes
Example: the March contract month for a product having
delivery months of March, June, September and December, while
considered a nearby month at the start of the year, does not become a
spot month contract for position limit purposes until the date it actually
enters delivery. Most spot month limits become effective at the close of
trading on the day prior to the First Notice Date (e.g., if the First Notice
Date for a Dec contract is the last trading date of the prior month, then
the spot month limit would apply as of the close of business on Nov
29th). In other instances, the limit goes into effect or tightens during the
last 3-10 days of trading.
4. Expiration Month Limit - expiration month limits apply to the account
holder's positions in the contract currently in its last month of trading.
Most expiration month limits become effective at the open of trading on
the first business day of the last trading month. If the contract ceases
trading before delivery begins, then the expiration month may precede
the delivery month. (e.g., if the last trade date for a Dec contract is Nov
30th, then the expiration month limit would apply as Nov 1st). In other
instances, the limit goes into effect or tightens during the last 3-10 days
of trading.
 Spot price: The price at which an asset trades in the spot market. The spot
price is the current market price at which an asset is bought or sold for
immediate payment and delivery. It is differentiated from the forward price
or the futures price, which are prices at which an asset can be bought or
sold for delivery in the future.
Example: On November 29, 2010, the spot price of gold was

$1,367.40 per ounce on the New York Commodities Exchange (COMEX).
That was the price at which one ounce of gold could be purchased at that
particular moment in time. The spot price for a bushel of wheat was about
$648 on the same day.
On November 29, 2010, the futures price for an ounce of gold to be
delivered in December 2011 was $1,373.20. The futures price for
December 2011 delivery of a bushel of wheat was about $764.
Large differences between the spot price and the futures price can exist
because the market is always trying to look ahead to predict what prices
will be. Futures prices can be either higher or lower than spot prices,
depending on the outlook for supply and demand of the asset in the future.
The spot price is important in and of itself because it is the price at which
buyers and sellers agree to value an asset. But spot price becomes an even
more important concept when it's viewed through the eyes of the $3 trillion
derivatives market.
ANNA UNIVERSITY 67
Notes Spot prices are continually changing -- they fluctuate according to varying
supply and demand. To mitigate the risk of continuously changing prices,
investors created derivatives. Derivatives such as forwards, futures and
options allow buyers and sellers to "lock in" the price at which they buy or
sell an asset in the future. Locking in prices with derivatives is one of the
most common ways investors reduce risk.
 Futures price: The price at which the futures contract trades in the futures
market. Futures can be used either to hedge or to speculate on the price
movement of the underlying asset.
Example: In March, a speculator bullish on soybeans purchased

one May Soybeans futures at $9.60 per bushel. Each Soybeans futures
contract represents 5000 bushels and requires an initial margin of $3500.
To open the futures position, $3500 is debited from his trading account and
held by the exchange clearinghouse.
Come May, the price of soybeans has gone up to $10 per bushel. Since the
price has gone up by $0.40 per bushel, the speculator can exit his futures
position with a profit of $0.40 x 5000 bushels = $2000.
 Expiry date: It is the date specified in the futures contract. This is the last
day on which the contract will be traded, at the end of which it will cease to
exist. The last day (in the case of American-style) or the only day (in the
case of European-style) on which an option may be exercised. For stock
options, this date is the Saturday immediately following the third Friday of
the expiration month; brokerage firms may set an earlier deadline for
notification of an option holder's intention to exercise. If Friday is a
holiday, the last trading day will be the preceding Thursday.
Example: if you buy a gold futures contract DEC 11 (termination

date: December 28th, 2011), this means that on December 28th, 2011 you
will have to settle accounts with the other party to the contract. One party
will pay the difference between the agreed price and the actual market price
of gold and the other party will receive that difference. This settlement is
obligatory.
 Basis: In the context of financial futures, basis can be defined as the futures
price minus the spot price. There will be a different basis for each delivery
month for each contract. In a normal market, basis will be positive. This
reflects that futures prices normally exceed spot prices. The basis can be a
positive or negative number. A positive basis is said to be "over" as the
cash price is higher than the futures price. A negative basis is said to be
"under" as the cash price is lower than the futures price.
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Notes
Source: http://www.theoptionsguide.com/futures-basis.aspx
Figure 3.1: Cash Price Vs Future Price for August Crude Oil Calculations
The basis changes from time to time. If the basis gains in value (say from -4
to -1), we say the basis has strengthened. On the other hand, if basis drops in
value (say from 8 to 2), we say the basis has weakened.
Short term demand and supply situations are generally the main factors
responsible for the change in the basis. If demand is strong and the available
supply small, cash prices could rise relative to futures price, causing the basis
to strengthen. On the other hand, if the demand is weak and a large supply is
available, cash prices could fall relative to the futures price, causing the basis
to weaken.
However, although the basis can and does fluctuate, it is still generally less
volatile than either the cash or futures price.
 Cost of carry: The relationship between futures prices and spot prices can
be summarized in terms of what is known as the cost of carry. This
measures the storage cost plus the interest that is paid to finance the asset
less the income earned on the asset. In interest rate futures markets, it refers
to the differential between the yield on a cash instrument and the cost of the
funds necessary to buy the instrument.
If long, the cost of carry is the cost of interest paid on a margin account.
Conversely, if short, the cost of carry is the cost of paying dividends, or
rather the opportunity cost; the cost of purchasing a particular security
rather than an alternative. For most investments, the cost of carry generally
refers to the risk-free interest rate that could be earned by investing
currency in a theoretically safe investment vehicle such as a money market
ANNA UNIVERSITY 69
Notes account minus any future cash-flows that are expected from holding an
equivalent instrument with the same risk (generally expressed in percentage
terms and called the convenience yield). Storage costs (generally expressed
as a percentage of the spot price) should be added to the cost of carry for
physical commodities such as corn, wheat, or gold.
The cost of carry model expresses the forward price (or, as an
approximation, the futures price) as a function of the spot price and the cost
of carry.
F  Se(r sc)*t
where
F is the forward price,
S is the spot price,
e is the base of the natural logarithms,
r is the risk-free interest rate,
s is the storage cost,
c is the convenience yield, and
t is the time to delivery of the forward contract (expressed as a fraction
of 1 year).
The same model in currency markets is known as interest rate parity.
Example: a US investor buying a Standard and Poor's 500 e-mini

futures contract on the Chicago Mercantile Exchange could expect the cost
of carry to be the prevailing risk-free interest rate (around 5% as of
November, 2007) minus the expected dividends that one could earn from
buying each of the stocks in the S&P 500 and receiving any dividends that
they might pay, since the e-mini futures contract is a proxy for the
underlying stocks in the S&P 500. Since the contract is a futures contract
and settles at some forward date, the actual values of the dividends may not
yet be known so the cost of carry must be estimated.
 Initial margin: Initial margin is the cash deposit required to be put forward
when opening a new futures position which is determined based on a
percentage of the full contract value. Opening a futures position means to
go long or go short on futures contracts. Initial margin applies in futures
trading no matter if you are long or short a futures position. This is unlike
in options trading where you actually receive money instead of pay money
when putting on a short options position.
Initial margin is calculated based on a percentage of the total value covered
under the futures contracts. This percentage varies according to the futures
market that you are trading. In single stock futures trading, the required
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initial margin is 20% of the value of the contract in the USA. Initial margin Notes
for more index futures and commodities futures around the world are
calculated using a system known as "SPAN Margin" which may vary from
day to day.
Example: (I)Initial Margin Example:

Assuming you go long on the futures contracts for XYZ stock trading at
$10 covering 100 shares.
Total value covered under futures contract = $10 x 100 = $1000
Initial margin required = $1000 x 20% = $200
Initial margin is a deposit made. This means that it remains your money
unless deducted due to losses. As all futures contracts are marked to market
daily, which means that they settle their wins and losses on a daily basis in
order to control risk, wins are added onto your initial margin deposit while
losses are deducted from your initial margin deposit.
Example: (II) Initial Margin Example:

Following up from the above example. Assuming at the end of the first
trading day, XYZ stock rises to $10.10.
Total Profit = ($10.10 - $10) x 1000 = $0.10 x 1000 = $100
Margin balance = $200 + $100 = $300
As you can see in the example above, XYZ rises $0.10 on the first day of
trade and the very same day, those profits on that 1000 shares are added
directly onto your margin balance. Here you can see the leverage effect of
futures trading as well, making a big 50% profit on your invested capital of
$200 on a mere $0.10 gain on the stock. However, leverage cuts both ways.
Lets see what happens when the stock falls.
Example: (III) Initial Margin Example:

Following up from the above example. Assuming at the end of the second
trading day, XYZ stock drops to $9.90.
Total loss = ($10.10 - $9.90) x 1000 = $0.20 x 1000 = $200
Margin Balance = $300 - $200 = $100
 Marking-to-market: In the futures market, at the end of each trading day,
the margin account is adjusted to reflect the investor’s gain or loss
depending upon the futures closing price. This is called marking–to–
market.
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Notes
Example: Suppose an investor owns 100 shares of a stock
purchased for $40 per share. However, that stock has increased in price,
now trades at $60. The "mark-to-market" value of the shares is equal to
(100 shares × $60), or $6,000, whereas the book value might (depending on
the accounting principles used) be $4,000, based on the price paid for those
stocks.
Similarly, if the stock falls to $30, the mark-to-market value is $3,000. In
this case, the investor has lost $1,000 of the original investment. If the
stock was purchased on margin, this might trigger a margin call and the
investor would have to come up with an amount sufficient to meet the
margin requirements for his account.
 Maintenance margin: This is somewhat lower than the initial margin. This
is set to ensure that the balance in the margin account never becomes
negative. If the balance in the margin account falls below the maintenance
margin, the investor receives a margin call and is expected to top up the
margin account to the initial margin level before trading commences on the
next day. The maintenance margin is the lowest amount an account can
reach before needing to be topped up by fresh deposits.
Example: if your margin account drops to a certain level because of

a series of daily losses, the broker gets a margin call requesting him to
make an additional deposit into your account to bring the margin back up to
the initial amount. He is required to make a margin deposit.
3.2 MARGIN REQUIREMENTS

Let us now discuss the margin requirements for futures trading in detail.
Although the value of a contract at time of trading should be zero, its price
constantly fluctuates. This renders the owner liable to adverse changes in
value, and creates a credit risk to the exchange, which always acts as
counterparty. To minimise this risk, the exchange demands that contract
owners post a form of collateral, formally called performance bond in the US,
but more commonly known as margin.
Margin is the money deposited by an investor with the broker,

when the investor enters into a futures contacts. The purpose is to provide a
financial security for ensuring that the investors will perform the contract
obligations.
Both the investors i.e., short position and long position holders have to deposit
margin money. The quantum of margin differs from contract to contract and
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from broker to broker. Usually, the exchange sets the minimum margin limit, Notes
but brokers may charge their clients (investors) in excess depending on the
financial condition of investors.
There are three types of margins namely, initial margin; maintenance margin;
and variation margin.
 Initial Margin: is the money to be deposited while entering into a futures
contract. This is approximately equal to the maximum daily price variation
allowed by the futures exchange on the underlying assets. Initial margin is
paid by both the buyer and the seller. It represents the loss on that contract,
as determined by historical price changes, which is not likely to be exceeded
on a usual day’s trading. The initial margin ranges from 8 % to 10% of the
underlying asset for index futures, while it is -20 % for stock futures.
 Maintenance Margin: is the minimum amount to be maintained in the
margin account. Because a series of adverse price changes may exhaust the
initial margin, a further margin, usually called variation or maintenance
margin, is required by the exchange. This is calculated by the futures
contract, i.e. agreeing on a price at the end of each day, called the
“settlement” or mark-to-market price of the contract. For most futures
contract, maintenance margin is about 70-80% of the initial margin.
Example: Suppose an investor wants to go long on two contracts of

HLL futures. Each contract is of 100 shares. The maturity is three months
ahead and current price of HLL is ` 120. Initial margin (calculated as 5 %
of value) is 5 % of 2x100x120 = ` 4,800. Maintenance margin (at 75 % of
initial margin) is ` 3, 600.
Since futures are settled daily, the margin account balance changes
depending on the price of underlying asset (spot price of HLL, in our case).
Let us say, tomorrow HLL price is 105. The investor losses ` 5 per share
(120-115) amounting to total of ` 1, 000 and margin balance is now ` 3,
800 (above maintenance margin). If two days later, the price further falls to
` 112, the investor loses ` 3 per shares amounting to ` 300. Now the
margin account has ` 3,500 (below maintenance margin). The investor
receives a ‘margin call’ from the broker. The margin call is an order to the
investor to replenish the margin account to initial margin level i.e., to
deposit ` 1, 300 (` 4800-3500) immediately. What happens if the investor
does not take heed of the margin call?
 Variation Margin: This is the difference between initial margin and the
margin balance, when a margin call is initiated (` 1, 300 in our case). If the
investor fails to deposit this variation margin, the broker may close out the
account by entering into an offsetting position. In our example, the broker
enters into short futures and the loss sustained is adjusted by the margin
money remaining. The investor then loses his right on the futures contract
and the margin money.
ANNA UNIVERSITY 73
Notes 3.3 MARKING TO MARKET

In futures contracts, a small payment known as ‘initial margin’ is required to
be deposited with the organised futures exchange. Due to fluctuations in the
price of underlying asset, the balance in the margin account may fall below
specified minimum level or even become negative at the end of each trading
session. All outstanding contracts are appraised at the settlement price of that
session, which is called ‘marking to market.’ This means adjusting the margin
accounts of both the parties. A member incurring cost should make payment of
profit to the counter party and the value of future contracts is set to zero at the
end of each trading session. The daily settlement payments are known as
‘variation margin’ payments.
Example: Futures Trading –Marking to Market

Suppose an Australian futures speculator buys one SPI futures contract on the
Sydney Futures Exchange (SFE) at 11:00 am on June 6. At that time, the
futures price is 2300. At the close of trading on June 6, the futures price has
fallen to 2290 (what causes futures prices to move is discussed below).
Underlying one futures contract is $25 x Index, so the buyer’s position has
changed by $25(2290-2300) =-$250. Since the buyer has bought the futures
contract and the price has gone down, he has lost money on the day and his
broker will immediately take $250 out of his account. This immediate
reflection of the gain or loss is known as marking to market.
Where does the $250 go? On the opposite side of the buyer’s buy order, there
was a seller, who has made a gain of $250 (note that futures’ trading is a zero-
sum game—whatever one party loses, the counterparty gains). The $250 is
credited to the seller’s account. Suppose, at the close of trading the following
day, the futures price is 2310. Since the buyer has bought the futures and the
price has gone up, he makes money. In particular, $25(2310-2290) = +$500 is
credited to his account. This money, of course, comes from the seller’s
account.
3.3.1 The Process of Marking-to-Market
The process of Marking-to-market is described as follows:
 At the initiation of the trade, a price is set and money is deposited in the
account.
 At the end of the day, a settlement price is determined by the clearing
house. The account is then adjusted accordingly, either in a positive or
negative manner, with funds either being drawn from or added to the
account based on the difference in the initial price and the settlement price.
 The next day, the settlement price is used as the base price.
74 ANNA UNIVERSITY
 As the market prices change through the next day, a new settlement price Notes
will be determined at the end of the day. Again, the account will be
adjusted by the difference in the new settlement price and the previous
night's price in the appropriate manner.
 If the account falls below the maintenance margin, the investor will be
required to add additional funds into the account to keep the position open
or allow it to be closed out. If the position is closed out the investor is still
responsible for paying for his losses. This process continues until the
position is closed out.
In certain cases, the exchanges separate the Mark-to-Market (M-to-M) profit or
loss from the margin. Margin is charged in a percentage term of the value of
the underlying position. The value is calculated based on the closing price of
the contract. If the closing price has gone up as compared to yesterday’s
closing price, the value has gone up for a contract. This implies the profit for a
long position holder but a loss for a short position holder.
This difference in value is called as the Mark-to-Market profit or Loss . if the
change in value is a profit, the holder of a position receives the equivalent
amount from the exchange. However, if the change is a loss, then the holder of
the position has to pay it to the exchange.
In many cases, where it has been used in most of the international commodity
exchanges, the net loss or profit is adjusted in the margin account only. But in
case of Indian commodity exchanges, the profit or loss, referred as mark-to-
market profit or loss is paid or received on a daily basis, whereas margin
balance is out of the pre-deposited amount of the member. In Indian cases, no
member can trade beyond 100% of his margin deposit or have M-to-M loss
more than 75% of the deposit, whichever is less.
Example: An investor takes a long position in 2 December gold futures

contracts on February 10. The contract size is 1 Kg. He initiated the position at
a price of ` 15000/per 10 gms. The exchange rules require him to deposit a
margin of ` 50,000/contract(` 1,00,000 in total). Also the maintenance margin
is ` 35000/contract (` 70,000) in total.
The margin account will be adjusted to reflect the daily loss.
Date Price Change M-to-M Cumulative Margin Updated Margin
(per 10 gm) Gain/loss balance Call
10-Feb 15000 0 0 0 100000 70000
11-Feb 14950 -50 -10000 -10000 90000 90000 0
12-Feb 14872 -78 -15600 -25600 74400 74400 0
13-Feb 14820 -52 -10400 -36000 64000 70000 6000
14-Feb 14850 30 6000 -30000 76000 76000 0
15-Feb 14830 -20 -4000 -34000 72000 72000 0
16-Feb 14875 45 9000 -25000 81000 81000 0
17-Feb 14890 15 3000 -22000 84000 84000 0
ANNA UNIVERSITY 75
Notes In the above example, if the margin is assumed to be 4 %

Date Price (per 10 gm) Change M-to-M Gain/loss Cumulative Margin
10-Feb 15000 0 0 0 120,000.00
11-Feb 14950 -50 -10000 -10000 119,600.00
12-Feb 14872 -78 -15600 -25600 118,976.00
13-Feb 14820 -52 -10400 -36000 118,560.00
14-Feb 14850 30 6000 -30000 118,800.00
15-Feb 14830 -20 -4000 -34000 118,640.00
16-Feb 14875 45 9000 -25000 119,000.00
17-Feb 14890 15 3000 -22000 119,120.00
Example: You purchased the following futures contract today at the

settlement price listed in the Wall Street Journal. Answer the questions below
regarding the contract.
(i) What is the total value of the futures contract?

(ii) If there is a 10% margin requirement how much do you have to deposit?
(iii)Suppose the price of the futures contract changes as shown in the following
table.
(iv) Enter the relevant information into the table. Show your calculations.
(v) Explain why the account is marked-to-market daily.
The answers are shown below.
The total value of the contract is $9,174, as shown in the table. If there is a
10% margin requirement, you will have to deposit $917.40 in cash or
securities.
The contract is marked to market daily and profits or losses are posted in the
account. The contract keeps pace with market activity and doesn't change value
76 ANNA UNIVERSITY
all at once at the maturity date. The marking-to-market process protects the Notes
clearinghouse because the margin percentage is calculated daily and if it falls
below the maintenance margin a margin call can be issued. If the investor
doesn't meet the call the clearinghouse can close out enough of the trader's
position to restore the margin.
3.3.2 Long Futures
The long futures position is an unlimited profit, unlimited risk position that can
be entered by the futures speculator to profit from a rise in the price of the
underlying.
The long futures position is also used when a manufacturer wishes to lock in
the price of a raw material that he will require sometime in the future
Long Futures Position Construction
Buy 1 Futures Contract
Source: http://www.theoptionsguide.com/long-futures.aspx
To construct a long futures position, the trader must have enough balance in his
account to meet the initial margin requirement for each futures contract he
wishes to purchase.
Source: http://www.theoptionsguide.com/long-futures.aspx
Figure 3.2: Long Futures
Unlimited Profit Potential

There is no maximum profit for the long futures position. The futures trader
stands to profit as long as the underlying futures price goes up.
The formula for calculating profit is given below:
 Maximum Profit = Unlimited
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Notes  Profit Achieved When Market Price of Futures > Purchase Price of Futures
 Profit = (Market Price of Futures - Purchase Price of Futures) x Contract
Size
Unlimited Risk
Large losses can occur for the long futures position if the underlying futures
price falls dramatically.
The formula for calculating loss is given below:
 Maximum Loss = Unlimited
 Loss Occurs When Market Price of Futures < Purchase Price of Futures
 Loss = (Purchase Price of Futures – Market Price of Futures) x Contract
Size + Commissions Paid
Breakeven Point
The underlier price at which break-even is achieved for the long futures
position, the position can be calculated using the following formula.
 Breakeven Point = Purchase Price of Futures Contract
Example: Long Futures Contract

Suppose June Crude Oil futures is trading at $40 and each futures contract
covers 1000 barrels of Crude Oil. A futures trader enters a long futures position
by buying 1 contract of June Crude Oil futures at $40 a barrel.
Case 1: June Crude Oil futures rises to $50
If June Crude Oil futures instead rallies to $50 on delivery date, then the long
futures position will gain $10 per barrel. Since the contract size for Crude Oil
futures is 1000 barrels, the trader will achieve a profit of $10 x 1000 = $10000.
Case 2: June Crude Oil futures drops to $30
If June Crude Oil futures is trading at $30 on delivery date, then the long
futures position will suffer a loss of $10 x 1000 barrel = $10000 in value.
Daily Mark-to-Market and Margin Requirement
The value of a long futures position is marked-to-market daily. Gains are
credited and losses are debited from the future trader's account at the end of
each trading day.
If the losses result in margin account balance falling below the required
maintenance level, a margin call will be issued by the broker to the futures
trader to top up his or her account in order for the futures position to remain
open.
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3.3.3 Short Futures Notes

The short futures position is an unlimited profit, unlimited risk position that
can be entered by the futures speculator to profit from a fall in the price of the
underlying.
The short futures position is also used by a producer to lock in a price of a
commodity that he is going to sell in the future.
Short Futures Position Construction
Sell 1 Futures Contract
Source: http://www.theoptionsguide.com/short-futures.aspx
To create a short futures position, the trader must have enough balance in his
account to meet the initial margin requirement for each futures contract he
wishes to sell.
Figure 3.3 : Short Futures
Unlimited Profit Potential

There is no maximum profit for the short futures position. The futures trader
stands to profit as long as the underlying asset price goes down.
The formula for calculating profit is given below:
 Maximum Profit = Unlimited
 Profit Achieved When Market Price of Futures < Selling Price of Futures
 Profit = (Selling Price of Futures - Market Price of Futures) x Contract Size
Unlimited Risk
Heavy losses can occur for the short futures position if the underlying asset
price rises dramatically.
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Notes The formula for calculating loss is given below:

 Maximum Loss = Unlimited
 Loss Occurs When Market Price of Futures > Selling Price of Futures
 Loss = (Market Price of Futures - Selling Price of Futures) x Contract Size
+ Commissions Paid
Break Even Point
The underlier price at which break-even is achieved for the short futures
position position can be calculated using the following formula.
Breakeven Point = Selling Price of Futures Contract
Example :Short Futures Contract

Suppose June Crude Oil futures is trading at $40 and each futures contract
covers 1000 barrels of Crude Oil. A futures trader enters a short futures
position by selling 1 contract of June Crude Oil futures at $40 a barrel.
Case 1: June Crude Oil futures drops to $30
If June Crude Oil futures is trading at $30 on delivery date, then the short
futures position will gain $10 per barrel. Since the contract size for Crude Oil
futures is 1000 barrels, the trader will net a profit of $10 x 1000 = $10000.
Case 2: June Crude Oil futures rises to $50
If June Crude Oil futures instead rallies to $50 on delivery date, then the short
futures position will suffer a loss of $10 x 1000 barrel = $10000 in value.
Daily Mark-to-Market and Margin Requirement
The value of a short futures position is marked-to-market daily. Gains are
credited and losses are debited from the future trader's account at the end of
each trading day.
If the losses result in margin account balance falling below the required
maintenance level, a margin call will be issued by the broker to the futures trader
to top up his or her account in order for the futures position to remain open.
3.4 HEDGING USING FUTURES

Let us first discuss the concept of hedging and its features. To hedge something
is to construct a protective fence around it. Applied to financial markets,
hedging means eliminating the risk in an asset or a liability. Applied to stock
market, hedging means eliminating the risk in an investment portfolio.
Hedging is the process of reducing exposure to risk. Thus, a hedge is any act
that reduces the price risk of a certain position in the cash market. Futures
contacts are the primary tools of effective hedging and they enable the market
participants to change their risk exposure from unexpected adverse price
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fluctuations. Futures act as a hedge when a position is taken in them which is Notes
just opposite to that taken by the investor in the existing cash position. Thus,
hedgers sell futures (short futures) when they have already a long position on
the cash asset, and they buy futures (long futures) in the situation of having a
short position (advance sell) on the cash.
3.4.1 Features of Hedging
The main features of hedging are described below.
 Hedging means buying and selling futures contracts to offset the risks of
changing cash market prices. In order to hedge a position, a derivatives
player needs to take an equal and opposite position in the futures market to
the one held in the cash market.
 Firms hedge because of tax advantages.
Example: Low income firms that are below the highest corporate
tax rate, can particularly benefit from the interaction being also reduce the
probability of bankruptcy. This is not necessarily valuable to the
shareholders expected costs that are incurred if the firm does go Bankrupt.
Finally, a firm may choose to hedge because its manager’s livelihoods may
be heavily tied to the performance of the firm. The firm managers may
benefit from reducing the firms risk.
 Hedging also is a tool used to offset the market (systematic) risk of stock
portfolios.
 Hedging is extremely important for the proper functioning, long-term
liquidity, and open interest of a futures market. Thus, viable futures
contracts are linked to commercial hedging activity.
3.4.2 Hedging using Futures
Future contracts can be used to hedge a company’s exposure to a price of a
commodity. A position in the futures markets is taken to offset the effect of the
price of the commodity on the rest of the company business.
It is important to recognize that futures’ hedging does not

necessarily improve the overall financial outcome.
There are a number of reasons why hedging using futures contracts works less
than perfectly in practice.
 The asset whose price is to be hedged may not be exactly the same as the
asset underlying the futures contract.
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Notes  The hedger may be uncertain as to the exact date when the asset will be
bought or sold.
 The hedge may require the futures contracts to be closed out well before its
expiration date.
Issues in Hedging Using Futures
The three basic issues in deciding a suitable hedging strategy using futures
contracts are as described below.
 When to use a long futures and when to use a short futures?
 Which futures contract to use?
 What is the appropriate optimal size of the futures position?
Hedging Strategies Using Futures
Essentially, futures contracts try to predict what the value of an index or
commodity will be at some date in the future. Speculators in the futures market
can use different strategies to take advantage of rising and declining prices.
The most common are known as “going long,” and “going short”, also referred
to as Long Hedge and Short Hedge respectively.
Going Long-Buy Futures
When an investor goes long — that is, enters a contract by agreeing to buy and
receive delivery of the underlying at a pre-determined price — it means that he
or she is trying to get profit from an anticipated increase in future price. The
pay-off profile of ‘going long’ is depicted in Figure 3.4.
Example: Let’s say that, with an initial margin of ` 2,000 in June,

Ramesh, the speculator buys one September contract of gold at ` 350 per gram,
for a total of 1,000 grams or ` 3, 50,000. By buying in June, Ramesh is ‘going
long’, with the expectation that the price of gold will rise by the time the
contract expires in September. By August, the price of gold increases by ` 2 to
` 352 per grams and Ramesh decides to sell the contract in order to realize a
profit. The 1,000 gram contract would now be worth ` 3, 52,000 and the profit
would be ` 2, 000. Given the very high leverage (remember the initial margin
was ` 2, 000), by going long, Ramesh made a 100% profit. Of course, the
opposite would be true if the price of gold per gram had fallen by ` 2. The
speculator would have realized a 100% loss. It’s also important to remember
that throughout the time the contract was held by Ramesh, the margin may
have dropped below the maintenance margin level. He would have thus had to
respond to several margin calls, resulting in an even bigger loss or smaller
profit.
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Profit Notes
Futures Price
Stock Price
Loss
Figure 3.4: Pay-off Profile of ‘Going Long’

The salient features of going long strategy are:
 Situation: Bullish outlook for the market. Price of the underlying expected
to increase.
 Risk: Unlimited as the price of the underlying, and hence of futures, falls,
until it reaches zero.
 Profit: Unlimited, Depends on the upward price movement.
 Break-even: The price of the underlying (on maturity) equal to the futures
price contracted.
Going Short-Sell Futures
A speculator who goes short—that is, enters into a futures contract by agreeing
to sell and deliver the underlying at a set price—is looking to make a profit
from declining price levels. By selling high now, the contract can be
repurchased in the future at a lower price, thus generating a profit for the
speculator. The pay-off profile of ‘going short’ is depicted in Figure 3.5
Profit
Futures Price
Stock Price
Loss
Figure 3.5: Pay-off Profile of ‘Going short’

The salient features of going short strategy are:
 Situation: Bearish outlook for the market. Price of the underlying expected
to fall.
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Notes  Risk: Unlimited as the price of the underlying, and hence of futures,
increase.
 Profit: Unlimited. Depends on the downward price movement until the
price of the underlying reaches zero.
 Break-even: The price of the underlying (on maturity) equal to the futures
price contracted.
Let’s say that Sonali did some research and came to the conclusion that the
price of oil was going to decline over the next six months. She could sell a
contract today, in November, at the current higher price, and buy it back within
the next six months after the price has declined. This strategy is called going
short and is used when speculators take advantage of a declining market.
Suppose that, with an initial margin deposit of ` 3, 000, Sonali sold one May
crude oil contract (one contract is equivalent to 1,000 barrels) at ` 25 per
barrel, for a total value of ` 25, 000. By March, the price of oil had reached
` 20 per barrel and Sonali felt it was time to cash in on her profits. As such, she
bought back the contract which was valued at ` 20, 000. By going short, Sonali
made a profit of ` 5, 000! But again, if Sonali’s research had not been
thorough, and she had made a different decision, her strategy could have ended
in a big loss.
Long Hedging–Short Spot and Long Futures
Hedges where long position is taken in a futures contract are known as long
hedges. A long hedge is appropriate when a company knows it will have to
purchase a certain asset in the future and wants to lock in a price now.
A company that knows that it is due to buy an asset in the future can hedge by
taking a long futures position. This is known as long hedge. A long hedge is
initiated when a futures contract is purchased in order to reduce the price
variability of an anticipated future long position. Equivalently a long hedge locks
in the interest rate of price of a cash security that will be purchased in the future
subject to small adjustment due to the basis risk. A long hedge is also known as
an anticipatory hedge, because it is effectively a substitute position for a future
cash transaction. The pay-off profile of long hedging is depicted in Figure 3.6.
Long Futures
Profit
Stock Price
Loss Short Spot
Figure 3.6: Pay-off profile of Long Hedging
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The salient features of Long Hedging strategy in futures are: Notes

 Situation: Bullish outlook. Prices expected to rise.
 Risk: No upside risk. Strategy meant to protect against rising markets.
 Profit: No profits, no loss. In case of price increase, loss on the spot
position offset by gain on futures position. In case of price fall, gain on the
spot position offset by loss on futures position.
Example: Suppose that a tyre manufacturing company knows it will

require 1,000 quintals of rubber on May 15. It is, say, January 15 today.
The spot price of rubber is ` 5350 per quintal and the May futures price is `
5210 per quintal. The company can hedge its position by taking a long
position in 10 May futures contracts and closing its position on May 15.
The strategy has the effect of locking in the price of the rubber that is
required at close to ` 5, 210 per quintal.
Suppose the price of rubber on May 15 proves to be ` 5, 260 per quintal.
Since May is the delivery month for the futures contract, this should be
very close to the futures price. The company gains on the futures contracts
= 1000 × (` 5, 260-5,210) = ` 50, 000. It pays 1,000 × ` 5, 260 = ` 52,
60,000 for the rubber. The total cost is therefore ` 52, 60,000 – ` 50, 000 =
` 52, 10,000 or ` 5, 210 per quintal.
For an alternative outcome, suppose the futures price is ` 5,050 per quintal
on May 15. The company loses approximately: 1,000 (`5, 210 – ` 5, 050) =
`1, 60,000 on the futures contract and pays ` 1, 000 × `5, 050 = ` 50,
50,000 for the rubber. Again the total cost is ` 52, 10,000 or ` 5, 210 per
quintal.
Let us take another example.
Example: A greeting card company anticipated a large inflow of

funds at the end of January when retail outlets pay for the stock of cards
sold during the holiday’s season in December. The management intends to
puts ` 1 crore of these funds into a long-term bond because of the high
yields on these investments. The current date is November 1 significantly
by the time the firm receives the funds on February 1. Thus, unless a long
hedge is initiated now, the financial manager believes that the return on
investment will be significantly lower (the cost of the bonds significantly
higher) than is currently available via the futures market.
The primary objective of the long hedge is to benefit from the high long term
interest rates, even though funds are not currently available for investment.
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Notes Disadvantages of Long Hedge

The disadvantages of a long hedge are as follows:
 If the financial manager incorrectly forecasts the direction of future interest
rates and a long hedge is initiated, then the firm still locks in the futures
yield rather than fully participating in the higher returns available because
of the higher interest rates.
 If rates increase instead, to fall then bond prices will fall causing immediate
cash outflow due to margin calls. This cash outflow will be offset only over
the life of the bond via a higher yield on investment. Thus the net
investment is the same but the timing of the accounting profits differs from
the investment decision.
 If the futures market already anticipates a fall in interest rates similar to the
decrease forecasted by financial manager, then the futures price reflects this
lower rate, negating any return benefit from the long hedge. Specifically,
one hedges only against unanticipated changes that the futures market has
not yet forecasted. Hence, if the eventual cash price increases only to a
level below the current futures rice, then a loss occurs on the long hedge.
Consequently, an increase in return from a long hedge in comparison to the
future cash market investment occurs only if the financial manager is a
superior forecaster of future interest rates. However, long hedge does lock-
in the currently available long-term futures rate, thereby reducing the risk
of unanticipated changes in this rate.
 Financial institutions are prohibited from employing long hedges, since
their regulatory agencies believe that long hedges are similar to
speculation, and these agencies do not want financial institutions to be
tempted into affecting the institution’s return with highly leveraged
“speculative” futures positions.
Stock futures can be used as an effective risk–management tool. Take the
case of an investor who holds the shares of a company and gets
uncomfortable with market movements in the short run. He sees the value
of his security falling from ` 450 to ` 390. In the absence of stock futures,
he would either suffer the discomfort of a price fall or sell the security in
anticipation of a market upheaval. With security futures, he can minimize
his price risk. All he needs do is enter into an offsetting stock futures
position; in this case, take on a short futures position. Assume that the spot
price of the security he holds is ` 390. Two-month futures cost him ` 402.
For this he pays an initial margin. Now if the price of the security falls any
further, he will suffer losses on the security he holds. However, the losses
he suffers on the security will be offset by the profits he makes on his short
futures position. Take for instance that the price of his security falls to
`350. The fall in the price of the security will result in a fall in the price of
futures.
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Futures will now trade at a price lower than the price at which he entered Notes
into a short futures position. Hence his short futures position will start
making profits. The loss of ` 40 incurred on the security he holds, will be
made up by the profits made on his short futures position.
Short Hedging –Long Spot and Short Futures
A short hedge is one that involves a short position in futures contracts. A short
hedge is appropriate when a hedger already owns an asset and expects to sell it
at some time in future. It can also be used when a hedger does not own an asset
right now, but knows that the asset will be owned at some time in the future.
A hedger who holds the commodity and is concerned about a decrease in its
price might consider hedging it with a short position in futures. If the spot price
and futures price move together, the hedge will reduce some of the risk. This is
called short hedge because the hedger has a short position. A company that
knows it is due to sell an asset at a particular time in the future can hedge by
taking short futures position. This is known as a short hedge. The pay-off
profile of short hedging is depicted in Figure 3.7.
Profit Hedging
Stock Price
Loss
Short Futures
Figure 3.7: Pay-off Profile of Short Hedging

The salient features of short hedging strategy in futures are:
 Situation: Bearish outlook. Prices expected to fall. Protection needed
against risk of falling prices.
 Risk: No downside risk. Strategy meant to protect against falling markets.
 Profit: No profits, no loss. In case of price increase, loss on the spot
position is offset by gain on futures position. In case of price increase, gain
on the spot position is offset by loss on futures position.
Example: An exporter knows that he will receive U.S. dollars in

two months. The exporter will realize a gain if the U.S. dollar increases in
value relative to the rupee and loss if the dollar decreases in value to the
rupee. A short futures position leads to a loss if dollar appreciates and a
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Notes gain if it depreciates in value. It has the effect of offsetting the exporter’s
risk.
If the spot price decreases, the futures price also will decrease since the hedger
is short the futures contract. The futures transaction produces a profit that at
least partially offsets the loss on the spot position. This is called a short hedge.
Another type of short hedge can be used in anticipation of the future sale of an
asset. It is taken out in anticipation of a future transaction in the spot market.
This type of hedge is known as an anticipatory hedge.
Process of Hedging Through Futures
Let us consider the following case of a corn producer. A rice producer uses the
futures market to lock in a price for produce. The farmer here is a hedger, he is
not concerned about how the cash price and the futures price move, because
both the futures prices and the cash price tend to move together assuring a gain
in one market to cover the loss in the other market. Futures contract for rice is
traded for December, March, May, July and September delivery at NCDEX
(National Commodity Derivative Exchange). The contracts are for 5,000 kgs.
of rice. To begin with, the producer must decide when and how much to
purchase in the futures market. Trading futures requires depositing initial
margin and meeting margin calls if the market moves against the futures
position taken by the hedger. In the case of options, the buyer need not put up
margin money, but he will have to pay an option premium. The minimum loss
in this case is the option premium paid.
Suppose on June 30th the rice producer predicts that his produce will be
500,000 kgs. after three months. He wants to eliminate the price risk, i.e. he
wants to lock in the future price of his produce. Now, the October futures
contracts are trading at ` 3.22/kg., and each contract consists of 5,000 kgs.
This price is acceptable to the producer, so he sells 100 rice futures contracts at
this price. Now on the day of maturity of the contract, if the price goes below
` 3.22, he is safe. On the other hand if the spot price of the corn goes above
` 3.22, the producer loses the additional profit. Here the futures eliminate
downside risk, but limits upside profit potential. After selecting the futures
commodity and expiration month, the hedger must decide whether to be long
or short.
The basic steps in hedging strategy using futures contracts are:
 Deciding to use what kind of derivatives and if futures contract, then
should it be long futures or short futures.
 Deciding the type and nature of Futures contract to be used for hedging the
spot position. Keeping in view that most hedging is cross hedging, this
requires deciding the futures contracts to use whose underlying asset is
perfectly correlated with price movement in original asset.
 Selection of a contract month. This depends upon such period where the
futures and spot prices are highly correlated. In practice, hedging with the
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near month futures contract is preferable because it minimizes the basis Notes
variation (basis = spot price- futures price).
Learning Activity
Write a short essay, assessing the fundamental factors which a
financial manager looks for while ‘going long’ in case of trading in
Gold futures contract and in case of ‘going short’ for trading in Oil
futures contract.
3.5 TYPES OF FUTURES CONTRACTS

Futures contracts may be classified into two categories:
1. Commodity Futures: Where the underlying is a commodity or physical
asset such as wheat, cotton, butter, eggs etc. Such contracts began trading
on Chicago Board of Trade (CBOT) in 1860s. In India too, futures on soya
bean, black pepper and spices have been trading for long.
2. Financial Futures: Where the underlying is a financial asset such as
foreign exchange (also called currency futures), interest rates (i.e. financial
futures on debt instruments), shares, Treasury bills or stock index (stock
market averages).
Financial futures are different from commodity futures in several ways.
The most important difference is that many financial futures are not
deliverable. The fact that very few contracts are actually delivered led
many exchanges to consider eliminating the delivery feature all together.
Till date this has not happened in commodity futures, but many financial
futures are created as non-deliverable instruments. Stock index futures and
interest rate futures are such futures. In place of delivery, these contracts
are cash settled on specific final delivery dates.
Futures are further categorized into securities and stock index
1. Securities: Securities are financial assets.
Example: Shares and bonds

Securities can be defined as claims on another person or corporation; they
will usually be fairly standardized and governed by the property or
securities laws in an appropriate country.
2. Stock Index Futures: Stock index futures are one of the varieties of futures
contracts. The first stock index futures contract based on value line index
were introduced by Kansas City Board of Trade (KCBT) on 24th February,
1982. The S&P 500 Index Futures Contract, introduced by the Chicago
Mercantile Exchange (CME), followed them two months later. At present,
S&P 500 Index Futures is the most actively traded futures contract. The
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Notes following stock index futures are the most actively traded financial
derivatives the world over.
Table 3.2: Most Actively Traded Stock Index Futures World Over
1. India - BSE SENSEX, NSE CNX NIFTY
2. US - DJIA, S&P 500, NYSE, RUSSELL 2000, NASDAQ 100
3. Japan - NIKKEI
4. Germany - DAX
5. UK - PTSE 100
6. France - CAC 40
7. Switzerland - SMI
8. Spain - IBEX 35
9. Canada - TSE 35
10. Hong Kong - HANGSENG
11. Malaysia - KUALALUMPUR
12. South Korea - KOSPI 2000
 Trading in Stock Index Futures: Trading in Sensex or Nifty futures is

just like trading in any other security. An investor is able to buy or sell
futures on the BSE – Bolt terminal or the NSE – NEAT screen with his
broker. The order will have to be punched in the system and the
confirmation will be immediate like the existing system. Since the tick
size and market lot size in futures is similar to individual stock, the feel
of trading in stock index futures is the same as trading on stocks.
Separate bids and ask quotations are available like shares. You simply
have to punch in your order of the required quantity at a price you wish
to buy, sell or execute the same at the market price. Upon execution of
the order you would receive a confirmation of the same. A trader can
carry the stock index futures contract till maturity or square it off at any
time before expiry.
 Pricing of Stock Index Futures: Contract theoretical or fair price of a
stock index futures contract is derived from the well-celebrated cost of
carry model. Accordingly, stock index futures price depends upon:
 Spot index value
 Cost of carry or interest rate
 Carry return i.e. dividends expected on securities comprising the
index.
 Speculation in Stock Index Futures Trading: An investor can speculate
by trading in stock index futures based on his expectations of market
rise or market fall. Suppose an investor expects the market to rise then
he can buy stock index futures.
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 Hedging with Stock Index Futures: Hedging technique is very useful in Notes
the case of high net worth entities such as mutual funds having a
portfolio of securities. For instance, if the investor wants to reduce the
loss on his holding of securities due to uncertain price movements in
the market, he can sell futures contracts.
Reasons for Popularity of Stock index Futures
Stock index futures are the most preferred derivatives in India owing to the
under noted reasons:
 The portfolio hedging is given priority by the institutional and other
enormous equity-holders.
 The most cost-efficient hedging is the stock index futures.
 Stock index is almost beyond the scope of manipulation, whereas it is very
easy to manipulate the individual stock price as is seen in recent complaints
made by the Reliance Industries Ltd. and the State Bank of India, that some
interested parties have been manipulated their share prices.
 The most liquidity featured stock index futures are the most popular in
India and abroad.
 The remote possibility of bankruptcy in stock index futures has been
guaranteed by the clearinghouse effects.
 The individual stock futures are always used for manipulating their prices
in cash market.
 The less volatility featured stock index futures have lowered the
requirement of capital adequacy and margin in comparison to individual
stock futures.
 The regulatory framework for stock index futures ensures less complexity
and thereby, growing popularity for equity derivatives.
Advantages of Stock index futures
Stock index futures offer implementation advantages and incremental returns
to portfolios only because of the fact that some useful strategies are available
for institutions using stock index futures. They are:
 The benefit of the lowest possible transaction costs is attractive.
 The actual disposing of equity holdings may be made gradually subject to
the market conditions.
 The low commission rate on stock index futures trading and the high level
of liquidity in stock index futures market offers the potential for significant
savings.
 Stock index futures offer an attractive strategy for maintaining the desired
stock market exposure of the portfolio at all points of time.
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Notes  Stock index futures are strategically used for insuring against market risks.
 Stock index futures offer an effective ‘beta ‘control to the portfolio
manager for having advantages of (1) the optimal stock mix; (2)
considerable lower transaction costs; and (3) achieving the portfolio target
‘beta’ through buying targeted futures.
 Stock index futures offer the most productive as well as effective asset
allocation strategy to the portfolio manager in order to maximise the
investors’ wealth by minimising the market risks.
 The market volatility can effectively managed by stock index futures by
making transactions with greater speed with lower implementation cost.
 The market disruptions caused by the external investment managers can
effectively be reduced with the strategic use of stock index futures.
 The most important advantage of stock index futures is that less money
needs to be involved to alter the asset-mix due to the leveraged impact of
contracts.
Learning Activity
Compare and assess the benefits of trading in the following stock
Indexes (1) BSE SENSEX (2) NSE CNX NIFTY (3) S&P 500.
Whose margin level is higher and which index has low transaction
cost? Which one stands most popular in futures trading? Write a
short summary analyzing the same.
1. Margin requirements are waived or reduced in some

cases for hedgers who have physical ownership of the
covered commodity or spread traders who have
offsetting contracts balancing the position.
2. Just as an investor is required to maintain margin
account with a broker, the broker (a member of
clearing house) in turn has to maintain a margin
account with the clearing house. This is known as
clearing margin. The only difference is that clearing
margin stipulates no maintenance margin for the
margin, is always maintained at the initial margin
daily.
SUMMARY
 A future contract is a standardized agreement between the seller (short
position) of the contract and the buyer (long position), traded on a futures
exchange, to buy or sell a certain underlying instrument at a certain date in
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future, at a pre-set price. The future date is called the delivery date or final Notes
settlement date. The pre-set price is called the futures price. The price of
the underlying asset on the delivery date is called the settlement price.
 Futures contracts, unlike forwards, are traded on organized exchanges.
They are traded in three primary areas: Agricultural Commodities; metals
and Petroleum, and financial assets (individual stocks, indices, interest rate,
and currency).
 The criteria for contract specification includes-underlying, exchange of
trading, security descriptor, contract size, price steps, price bands, trading
cycle, last trading/expiry date, settlement basis, trading hours, daily
settlement price, final settlement price and margins.
 The quantum of margin differs from contract to contract and from broker to
broker. Usually, the exchange sets the minimum margin limit, but brokers
may charge their clients (investors) in excess depending on the financial
condition of investors. There are three types of margins namely, initial
margin; maintenance margin; and variation margin.
 Future contracts can be used to hedge a company’s exposure to a price of a
commodity. A position in the futures markets is taken to offset the effect of
the price of the commodity on the rest of the company business. It is
important to recognize that futures’ hedging does not necessarily improve
the overall financial outcome.
 Essentially, futures contracts try to predict what the value of an index or
commodity will be at some date in the future. Speculators in the futures
market can use different strategies to take advantage of rising and declining
prices. The most common are known as “going long,” and “going short”,
also referred to as Long Hedge and Short Hedge respectively.
 Futures contracts may be classified into two categories- commodity futures
and financial futures.
 Futures are further categorized into securities and stock index
KEYWORDS
Contracts Size: is the amount of asset that has to be delivered under one
contract.
Financial Futures: Where the underlying is a financial asset such as foreign
exchange (also called currency futures), interest rates (i.e. financial futures on
debt instruments), shares, Treasury bills or stock index (stock market
averages).
Futures Contract: A futures contract is a type of derivative instrument, or
financial contract, in which two parties agree to transact a set of financial
instruments or physical commodities for future delivery at a particular price.
ANNA UNIVERSITY 93
Notes Margin: Margin is the money deposited by an investor with the broker, when
the investor enters into a futures contact.
Marking-to-market: In the futures market, at the end of each trading day, the
margin account is adjusted to reflect the investor’s gain or loss depending upon
the futures closing price. This is called marking–to–market.
Stock Index: A stock index futures contract is a contract to buy or sell the face
value of the underlying stock index where the face value is defined as being the
value of index multiplied the specified monetary amount.
1. Define Futures.
2. Describe the salient features of futures contract.
3. What does standardization include in futures contract?
4. Discuss any five terminologies used in futures contract.
5. What do you mean by margin requirements?
6. Discuss the three types of margin requirements.
7. What is Marking to Market?
8. What do you mean by Hedging?
9. State the types of futures contract.
10. What do you mean by Stock Index Futures?
1. Describe the specification of a futures contract in individual stock/indices.
2. “The quantum of margin differs from contract to contract and from broker
to broker”. Explain the three types of margin requirements and give an
example.
3. “Speculators in the futures market can use different strategies to take
advantage of rising and declining prices”. Explain in detail every hedging
strategy using futures with a suitable diagram and examples.
4. “In futures contracts, a small payment known as ‘initial margin’ is required
to be deposited with the organised futures exchange”. Explain marking to
market concept with an example.
5. On August 20, pepper prices at Ahmedabad are as follows:
Market ` per quintal
Spot ` 9500 per quintal
94 ANNA UNIVERSITY
Futures (Matures on 20/11) ` 9791 per quintal Notes

Storage cost is estimated at ` 100 per month. On October 20, prices are as
follows:
Market ` per quintal
Spot (November) ` 9200 per quintal
Futures (November) ` 9260 per quintal
Mr. X takes the following transactions:
August 20: Sell one quintal grain for October delivery at `9700.
August 20: Buy one quintal November grain futures at ` 9791.
October: Sell one quintal November grain futures at ` 9260.
Buy one quintal spot grain at ` 9200.
Show the transaction profile of Mr. X.
FURTHER READINGS
Bellalah, Mondher (2010), Derivatives, Risk Management &

Value, World Scientific Publishing Co. Pte. Ltd.
Hull, C, John and Basu, Sankarshan (2010), Options, Futures and
Other Derivatives, 7th edition, Pearson Education India.
ANNA UNIVERSITY 95
Notes
LESSON 4 - CURRENCIES AND COMMODITIES
CONTENTS
Learning Objectives
Learning Outcomes
Overview
4.1 Commodities and Currency Derivatives-introduction
4.2 Commodities Market in India
4.3 Delivery Options of Currencies and Commodities
4.3.1 Delivery Options of Currencies
4.3.2 Delivery Options of Commodities
4.4 Relationship between Future Prices
4.4.1 Currency Futures
4.4.2 Commodity Futures
4.4.3 Benefits of Commodity Futures
4.4.4 Legal Framework-Policy Liberalization
4.5 Forward Prices a Spot Prices
4.5.1 Spot Market and Forward Market
4.5.2 Relationship between Spot, futures and forward prices with
emphasis on pricing mechanism of futures
Summary
Keywords
Further Readings
LEARNING OBJECTIVES
 Understand the Commodities and Currency Derivatives
 Analyze the Commodity Market in India
 Describe the delivery Options of Currencies and Commodities
 Explain the relationship between Futures Prices
 Determine the Forward Prices and Spot Prices
96 ANNA UNIVERSITY
Lesson 4 - Currencies and Commodities
LEARNING OUTCOMES Notes

understanding of:
 the working concept of NSE's through automated screen based trading,
modern, fully computerized trading system for providing investors across
the length and breadth of the country a safe and easy way to invest.
 the fact that unlike the physical market, futures markets trades in
commodity are largely used as risk management (hedging) mechanism on
either physical commodity itself or open positions in commodity stock
 the datum that the spot market is a market for immediate exchange of
currencies, where transactions of buying and selling are done for immediate
delivery.
OVERVIEW
In the previous lesson you had studied about specifications of futures contract,
Margin Requirements, Marking to Market, Hedging using Futures and the
types of future contracts- securities, stock index futures.
Ever since the dawn of civilization, commodity trading has occupied an
integral place in the lives of mankind. The very reason for this lies in the fact
that commodities represent the fundamental elements of utility for human
beings. The term, commodity, refers to any material, which can be bought and
sold. Commodities in a market's context refer to any movable property other
than actionable claims, money and securities. Over the years, commodities
markets have been experiencing tremendous progress, which is evident from
the fact that the trade in this segment is standing as the boon for the global
economy today. The promising nature of these markets has made them an
attractive investment avenue for investors.
In the early days, people followed a mechanism for trading called barter
system, which involves exchange of goods for goods. This was the first form of
trade between individuals. The absence of a commonly accepted medium of
exchange had initiated the need for the barter system. People used to buy those
commodities, which they lacked and sell those commodities, which they had in
excess. The commodities trade is believed to have its genesis in ancient
Sumeria. The early commodity contracts were carried out using clay tokens as
medium of exchange. Animals are believed to be the first commodities, which
were traded, between individuals. The internationalization of commodities
trade can be better understood by observing the commodity market integration
occurred after the European voyages of discovery. The development of
international commodities trade is characterized by the increase in volumes of
trade across the nations and the convergence and price related to the identical
commodities at different markets. The major thrust for the commodities trade
was provided by the changes in demand patterns, scarcity and the supply
potential, both within and across the nations.
ANNA UNIVERSITY 97
Notes NSE was the first exchange to have obtained an in-principle approval from
SEBI for setting up currency derivative segment. The launch of currency
futures trading platform took place on 29th August 2008. Currency futures on
USD-INR were introduced for trading and consequently the Indian rupee was
permitted to trade against other currencies such as euro, pound sterling and the
Japanese yen. Currency Options was introduced on October 29, 2010.
Currency Derivatives segment of NSE facilitates trading in derivative
instruments like Currency Futures on 4 currency pairs, Currency Options on
US Dollars and Interest Rate Futures on 10 Y GS 7 and 91 D T-Bill.
In this lesson, you will learn about the Commodities and Currency Derivatives-
Introduction, Commodity Market in India, delivery Options of Currencies and
Commodities, the relationship between Futures Prices, Forward Prices and
Spot Prices.
4.1 COMMODITIES AND CURRENCY DERIVATIVES-

INTRODUCTION
Let us first understand what is a commodity and commodity trading before
proceeding any further.
 Commodity trading: Any types of good that is unbranded and is commonly
traded in the market come under commodities.
 Commodity trading: Commodity markets are quite like equity markets.
The commodity market also has two constituents i.e. spot market and
derivative market. In case of a spot market, the commodities are bought
and sold for immediate delivery. In case of a commodities derivative
market, various financial instruments having commodities as underlying
are traded on the exchanges. It has been seen that traditionally in India,
people have hedged their risks with gold and silver.
 Currency Derivatives: Currency derivatives or currency future (also
known as FX future) is a futures contract for exchanging one currency for
another at a definite date in the future at a price i.e. an exchange rate which
is fixed on the purchase date. The price of a future contract in terms of INR
per unit of other currency e.g. US dollars is definite at NSE.
Currency future contracts permit investors for hedging as against

foreign exchange risk. There arises availability of currency future
derivatives on four currency pairs viz US Dollars (USD), Euro (EUR),
Great Britain Pound (GBP) and Japanese Yen (JPY). Presently, currency
options are available on US Dollars.
98 ANNA UNIVERSITY
Trading and Settlement of Currency Derivatives Notes

NSE's automated screen based trading, modern, fully computerized trading
system has been designed for providing investors across the length and breadth
of the country a safe and easy way to invest. The NSE trading system called
'National Exchange for Automated Trading' (NEAT) is a fully automated
screen based trading system, which accepts the principle of an order driven
market.
 Clearing and Settlement: National Securities Clearing Corporation
Limited (NSCCL) is the clearing and settlement agency for all deals which
are carried out on the Currency Derivatives segment. NSCCL operates as
legal counter-party to all deals on NSE's Currency Derivatives segment and
guarantees settlement.
 Risk Management in Currency Derivatives: NSCCL has brought a
comprehensive risk management system, which is constantly upgraded to
pre-empt market failures. The Clearing Corporation assures that trading
member obligations are proportional with their net worth.
4.2 COMMODITIES MARKET IN INDIA

India, a commodity-based economy, where two-thirds of the one billion
population depend on agricultural commodities, surprisingly has an
underdeveloped commodity market. Unlike the physical market, futures
markets trades in commodity are largely used as risk management (hedging)
mechanism on either physical commodity itself or open positions in
commodity stock For instance, a jeweler can hedge his inventory against
perceived short-term downturn in gold prices by going short in the future
markets.
Commodity Derivative markets started in India in Cotton in 1875 and in
oilseeds in 1900 at Bombay. Forward trading in raw jute and jute goods started
at Calcutta in 1912. Forward Markets in wheat had been functioning at Hapur
in 1913 and in bullion at Bombay since 1920. In 1919, the then Government of
Bombay passed the Bombay Contract Control (War Provision) Act and set up
the Cotton Contracts Board. With a view to restricting speculative activity in
cotton market, the Government of Bombay issued an ordinance in September
1939 prohibiting option business. The Bombay Options in Cotton Prohibition
Act, 1939, later replaced the ordinance. In 1943, the Defense of India Act was
utilized on large scale for the purpose of prohibiting forward trading in some
commodities and regulating such trading in others on an all-India basis. In the
same year, oilseeds forward contracts prohibition order was issued and forward
contracts in oilseeds were banned. Similarly, orders were issued banning
forward trading in food-grains, spices, vegetable oils, sugar and cloth. These
orders were retained with necessary modifications in the Essential Supplies
Temporary Powers Act 1946, after the Defense of India Act had lapsed. With a
ANNA UNIVERSITY 99
Notes view to evolving the unified systems, the Government of Bombay enacted the
Bombay Forward Contract Control Act 1947.
Commodities actually offer immense potential to become a separate asset class
for market-savvy investors, arbitrageurs and speculators. Retail investors, who
claim to understand the equity markets, may find commodities an
unfathomable market. But commodities are easy to understand as far as
fundamentals of demand and supply are concerned.
Retail investors should understand the risks and advantages of

trading in commodities futures before taking a leap.
Historically, pricing in commodities futures has been less volatile compared

with equity and bonds, thus providing an efficient portfolio diversification
option.
In fact, the size of the commodities markets in India is also quite significant.
Of the country's GDP of ` 13, 20,730 crore (` 13,207.3 billion), commodities-
related (and dependent) industries constitute about 58%. Currently, the various
commodities across the country clock an annual turnover of ` 1, 40,000 crore
(` 1,400 billion). With the introduction of futures trading, the size of the
commodities market is likely to grow manifold from here on.
The Indian economy is witnessing a mini revolution in commodity derivatives
and risk management. Commodity options trading and cash settlement of
commodity futures had been banned since 1952; and until 2002, commodity
derivatives market was virtually non-existent, except for some negligible
activity on an OTC basis. As on September 2005, the country had 3 national
level electronic exchanges and 21 regional exchanges for trading commodity
derivatives. As many as eighty (80) commodities have been allowed for
derivatives trading. The value of trading has been booming and was slated to
cross the $ 1 trillion mark in 2006 and, if all goes well, seems set to touch $ 5
trillion in a few years. This unit analyses questions such as: how did India pull
it off in such a short time since 2002? Is this progress sustainable? What are the
obstacles that need urgent attention, if the market is to realize its full potential?
4.3 DELIVERY OPTIONS OF CURRENCIES AND

COMMODITIES
Delivery options refer to the feature of a futures contract giving the short the
right to make decisions about what, when and where to deliver.
The following delivery options have been discussed:
4.3.1 Delivery Options of Currencies
Currencies deal at a stipulated exchange rate of a concerned country. An
exchange rate can be defined as the number of units of one Currency that must
100 ANNA UNIVERSITY

be given to acquire one unit of a Currency of another country. It is the price Notes
paid in the home Currency to purchase a certain quantity of funds in the
Currency of another country.
Example: It takes about ` 48.10 to purchase one US dollar and ` 8.10

to purchase one Euro. The exchange rate is the link between different national
currencies that makes international price and cost comparisons possible.
The Foreign Exchange Market includes both the Spot and Forward Exchange
Rates.
The Spot rate is the rate paid for delivery within two business days
after the day the transaction takes place.
If the rate is quoted for delivery of foreign Currency at some future date, it is
called the forward rate. In the forward rate, the exchange rate is established at
the time of the contract, though payment and delivery are not required until
maturity.
Foreign Exchange Quotations
The exchange rate quotation states the number of units of a price Currency that
can be bought in terms of one unit of another.
Quotes in Basis Point
For most currencies, foreign exchange quotations are given to the fourth
decimal place-That is to one-hundredth of one percent or 1/10,000. This is
usually called a 'pip'. For a few currencies like Japanese yen and the Italian lira
that are relatively small in absolute value, quotes may be carried to two
decimal places and a 'pip' is 1/100 of the Currency unit. In a foreign Currency
market a 'pip' or a 'tick' (as it is also sometimes called) is the smallest amount
by which a price can move. 'Pip' is the term commonly used in the markets.
In practice, foreign exchange quotations for currencies generally follow two
conventions. The two methods are referred to as the Direct (American) and
Indirect (European) methods of quotation.
 Direct/American Quotation: The most common way of stating a foreign
exchange quotation is in terms of the number of units of home Currency
needed to buy one unit of foreign Currency. This is known as the Direct
Quote. Direct Quotations are also known as American quotes. The prices of
Currency Futures Contracts traded on the Chicago Mercantile Exchange are
quoted using the Direct method. Direct exchange rate quotations are most
frequently used by banks in dealing with their non-bank customers.
ANNA UNIVERSITY 101

Notes Direct quotation: 1 foreign Currency unit = x home Currency units

India quotes its exchange rates in terms of the amount of rupees that can be
exchanged for one unit of foreign Currency.
Example: If the Indian rupee is the home Currency and the foreign
Currency is the dollar, then the exchange rate between the rupee and the
dollar might be stated as
$ 1/ ` 49.6100
This means that for one Dollar, one can buy 49.6100 Rupees.
If the home Currency is dollar, a Direct quotation of the exchange rate
between dollar and the Euro is
1.0 /$1.32421, indicating that the dollar cost of one Euro is $1.32421.
 Indirect/European Quotation: Indirect quotations refer to the Price of
foreign Currency in terms of one unit of home Currency. In this method, also
known as the European Terms, the rate is quoted in terms of the number of
units of the foreign Currency for one unit of the domestic Currency.
Indirect quotation: 1 home Currency unit = x foreign Currency units
Example: An Indirect quotation, for the exchange rate between the

dollar and the rupee will be ` 1/$.0201572/, indicating that one rupee can
purchase .0202572 dollars.
Both Direct and Indirect quotes are in use. In the US, it is common to use the
Direct Quote for domestic business. For international business, banks generally
use European Terms.
Table 4.1 gives the Direct and Indirect Quote for some currencies as on
26-04-09.
Table 4.1: Spot Rates for a Number of Currencies (In Rupees) as on 26/4/09
Currency Direct Quote Indirect Quote
Pound Sterling 72.9419 .0137095
US dollar 49.6100 .0201572
Canadian dollar 40.9900 .0243962
Singapore dollar 33.2975 .0300323
Euro 65.6938 .0152221
New Zealand dollar 28.3769 .0352399
China Yuan 7.26620 .137623
Malaysian dollar 13.7978 .0724754
IMF,SDR 74.2572 .0134667
Japanese Yen .509991 1.96082
Australian dollar 35.8337 .0279067
102 ANNA UNIVERSITY

 Short Dates and Broken Date Contracts: Short dated and broken date Notes
contracts are terms used in foreign exchange trading and Euromarkets in
connection with the delivery of Currency.
Foreign exchange contracts are normally based on standard quoted periods,
such as one, two or three months forward. If the foreign exchange trading
takes place on a nonstandard date.
Example: 25 days instead of 30 days or 47 days instead of 60 days

it would be termed a 'broken date' contract.
A short dated contract would be contract where the value date for the
transaction is before the Spot value date. Normally a Spot transaction is
settled within two business days after the day of the transaction. If the
transaction is for a shorter maturity and the contract is settled on the day or
the next day, it would be termed a short dated contract. Normally, these
transactions are used for rolling over the maturity positions in foreign
exchange contracts.
 Cross Rates of Exchange: An exchange rate between two currencies that is
derived from the exchange rates of those currencies with a third Currency
is known as a cross rate of exchange. A cross rate can be obtained by
multiplying two exchange rates by each other so as to eliminate a third
Currency that is common to both rates. The most common use of cross rate
calculations is to determine the exchange rate between two currencies that
are quoted against the US dollar but not against each other.
Table 4.2: Currency Cross Rates as on 26-04-09
AUD CAD CHF CNY EUR GBP JPY SGD USD
AUD 0.872968 0.820121 4.913210 0.543922 0.491420 69.904255 1.071780 0.719891
CAD 1.145517 0.939463 5.628167 0.623072 0.562930 80.076527 1.227743 0.824647
CHF 1.219332 1.064438 5.990836 0.663222 0.599204 85.236519 1.306856 0.877786
CNY 0.203533 0.177678 0.166922 0.110706 0.100020 14.227817 0.218143 0.146521
EUR 1.838499 1.604951 1.507792 9.032932 0.903474 128.518904 1.970467 1.323518
GBP 2.034921 1.776421 1.668881 9.997993 1.106838 142.249619 2.180988 1.464920
JPY 0.014305 0.012488 0.011732 0.070285 0.007781 0.007030 0.015332 0.010298
SGD 0.933027 0.814503 0.765195 4.584158 0.507494 0.458508 65.222560 0.671677
USD 1.389100 1.212640 1.139230 6.824940 0.755562 0.682631 97.104000 1.488810
Symbols Used: AUD- Australian Dollar, GBP - British Pound, JPY- Japanese
Yen, Eur - European Currency, CAD - Canadian Dollar, CHF - Swiss Franc,
CNY - Chinese Yuan Renminbi, SGD - Singapore Dollar, USD - US Dollar
ANNA UNIVERSITY 103

Notes 4.3.2 Delivery Options of Commodities

Wholesale Price Index
The Wholesale Price Index (WPI) has been the most commonly accepted price
index in India. It signals the ups and downs of the commodity prices, in all
trades and transactions taking place across the country. The updated WPI is
available in every week, with the time lag between two weeks being reduced to
the minimum possible level. It catches the price movements in an extensive
manner. For all these qualities, it is the most prevalent price index in India. It is
also viewed as an indicator of the inflation rate of our economy.
Commodity Export Scenario
India masters the global castor oil trade with its castor seed and oil products.
The yearly export of commercial castor oil from India turns out to be around
2-2.4 lakh tons. India is known to be the fifth largest producer of aluminum in
the globe. Indian aluminum has huge export potential as its production far
exceeds its domestic demand.
The export market for Indian organic agricultural products is expanding
rapidly. India's organic tea is world-famous for its taste and flavour. Tea,
coffee, spices, rice, wheat, pulses, oil seeds, fruits and vegetables, cashew nut,
cotton, herbal products are the major organic products being exported from
India.
Thus, the commodity market in India is growing rapidly with huge export
potential. Though it is temporarily lagging behind the service sector in the
matter of exports, it is sure to catch up within a few years.
Current Developments in this Market
The government has now allowed national commodity exchanges, similar to
the BSE & NSE, to come up and let them deal in commodity derivatives in an
electronic trading environment. These exchanges are expected to offer a
nation-wide anonymous, order-driven, screen-based trading system for trading.
The Forward Markets Commission (FMC) will regulate these exchanges.
Consequently, four commodity exchanges have been approved to commence
business in this regard. They are:
 Multi Commodity Exchange of India Ltd. (MCX) located at Mumbai
 National Commodity and Derivatives Exchange Ltd. (NCDEX) located at
Mumbai
 National Board of Trade (NBOT) located at Indore
 National Multi Commodity Exchange (NMCE) located at Ahmedabad.
104 ANNA UNIVERSITY

Need for an Exchange traded Commodity Derivatives Market Notes

The biggest advantage of having an exchange-based platform is the reach.
A wider reach ensures greater participation, which results into a more efficient
price discovery mechanism. In fact, it comes to a stage where the derivative
market guides the spot market in terms of pricing.
This can be well understood by looking at the following example:
Example: Imagine a soya wholesaler in Madhya Pradesh who, having

bought the crop from the farmer, wishes to sell it to the oil refiners. To sell his
crop he has to go to the local market at Indore. The price that he will get for his
crop would be solely dependent upon the demand supply condition prevailing
at that point of time at that market place. Also, as the number of players is less,
there are chances of the prices being biased. In contrast, the prices in the
futures market are determined not only by the local demand supply conditions
but also by the global scenario. Add to that the view taken on a commodity by
various sets of people depending upon different parameters such as technical
analysis, political news, exchange rates etc. The price that is, thus, quoted can
be safely regarded as the most efficient price.
Opportunities the commodity derivatives provide to investors
Futures contract in the commodities market, similar to equity derivatives
segment, will facilitate the activities of speculation, hedging and arbitrage to all
class of investors.
1. Speculation: It facilitates speculation by providing opportunity to people,
although not involved with the commodity, to trade on the views in the
movement of commodity prices. The speculative position is taken with a
small margin amount that is paid to the exchange, and the contract can be
squared-off anytime during the trading hours.
2. Hedging: For the people associated with the commodities, the futures
market can provide an effective hedging mechanism against price
movements.
Example: An oil-seed farmer may go short in oil-seed futures, thus

'locking' his sale price and in the process hedging against any adverse price
movements. On the other hand, a processor of oil seeds may buy oil-seed
futures and thus assure him a supply of oil-seeds at a predetermined price.
Similarly the oil-seed processor may go short in oil futures, which may be
bought by a wholesaler of oil.
Also, there is a saying that "gold shines when everything fails." Thus, gold
can be used as a hedging tool against other investments.
ANNA UNIVERSITY 105

Notes 3. Arbitrage: Traders may exploit arbitrage opportunities that arise on

account of different prices between the two exchanges or between different
maturities in the same underlying.
Learning Activity
Write a short note examining the risks associated with currencies
and commodities future, while at the time of their delivery
positions. How it can be mitigated? Take instances and analyze the
same.
4.4 RELATIONSHIP BETWEEN FUTURE PRICES

Here, we would be studying relationship of currency and commodity with
future prices.
4.4.1 Currency Futures
In 1972, trading first began at the International Money Market (IMM) of the
Chicago Mercantile Exchange (CME) in the currency of futures contract.
Trading activity in currency futures has expanded rapidly at the CME. While
only two million contracts were traded in 1978, the figure was nearly
30 million contracts in 1994.
Although trading in futures contracts as financial instruments is relatively a
recent phenomenon, trading in future contracts on commodities has been going
on for many years. Futures on commodities evolved, principally, to protect
farmers from the risk of price fluctuation in the commodities they produced.
The modern day futures markets originated in the USA in the 19th century to
facilitate grain trade. Much of the early history is directly linked to the city of
Chicago and the needs of farmers and grain merchants.
Over the years, regulation, formalization and standardization of these contracts
have made them successful. About a century of experience, along with
incorporating substantial changes and developing new products, has allowed
them to remain responsive to the price risk management of the businessmen.
The introduction of options in 1982 has expanded the trading opportunities
available to the participants. Trading in foreign currencies had begun in 1972
and in T-binds in 1977 and it was not until the late 1970s that trading in
financial instruments took off. The introduction of index futures in 1982 and
oil futures in the early 1980s completed the transformation.
Futures contract represents an institutionalized, standardized form of forward
contracting. They are traded on an organized exchange which is a physical
place or trading floor where listed contracts are traded face to face.
The important point to understand about foreign currency futures is that when
one has a futures contract, one does not own foreign exchange. A futures
contract, in fact, represents a pure bet on the direction of price (exchange rate)
106 ANNA UNIVERSITY

movement of the underlying currency. This means that the futures price is not a Notes
monetary amount you pay to anyone – rather, it is the variable about which one
is betting. And the bet can be that either the price will go up or it will go down.
Thus, if we buy a futures contract (go long) and the futures price goes up, we
make money. If the futures price goes down, we lose money. If an investor’s
Foreign Exchange (FX) portfolio consisted of a long position in FX futures, he
would be betting that the price would go up. If you sell a futures contract (go
short) and the futures price goes down, you make money. If the futures price
goes up, you lose money. Thus, if the total FX portfolio consisted of a short
position in FX futures, the investor would be betting that the prices would go
down.
Futures trading in countries such as the United States take place

only on government regulated exchanges. Buyers or sellers of futures
contracts place orders through brokers or exchange members.
These orders are communicated to the exchange floor and then transferred to a
trading pit where the price (or prices) for a given number of contracts are
negotiated by open outcry between floor brokers or traders. A futures trade will
result in a futures contract between two sides – someone going long at the
negotiated price and someone going short at that same price. Thus, if there
were no transaction costs, futures trading would represent a zero-sum game:
what one side wins will exactly match what the other side loses. The futures
price itself will change minute by minute; it is a market price that adjusts itself
to bring about equilibrium between the number of long positions and the
number of short positions. If more people want to go long than go short at the
current futures price, the futures price will be driven up until equilibrium
between desired short and long positions is reached. If desired short positions
are greater than desired long positions at the current futures price, the price will
be driven down. The number of two-sided futures bets in existence at any time
is called the open interest.
4.4.2 Commodity Futures
Commodity future is a derivative instrument for the future delivery of a
commodity on a fixed date at a particular price. The underlying in this case is a
particular commodity.
If an investor purchases an oil future, he is entering into a contract to buy a
fixed quantity of oil at a future date. The future date is called the contract
expiry date. The fixed quantity is called the contract size. These futures can be
bought and sold on the commodity exchanges.
The commodities include agricultural commodities like wheat, rice, tea, jute,
spices, soya, groundnut, coffee, rubber, cotton, etc, precious metals – gold and
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Notes silver, base metals – iron ore, lead, aluminum, nickel, zinc etc, and energy
commodities – crude oil and coal.
The number of retail investors participating in the market is increasing
gradually after the introduction of commodities futures. The expected growth
rate of commodity market is 40% annually over the next five years.
4.4.3 Benefits of Commodity Futures
 To producer: A producer of a commodity can sell the futures of the
commodity, thereby ensuring that he can sell a particular quantity of his
commodity at a particular price at a particular date.
 To investors: An investor has alternative investment instruments where he
can take a position as to future price and the spot price at a particular date
in future and buys and sells options. He is not interested in taking deliveries
of the commodities.
 To commodity trader: A commodity trader can use these to ensure that he
is protected against any adverse changes in the prices. He can enter into a
futures contract for purchase of a certain quantity of the underlying at a
particular price on a particular date, or he can enter into a futures contract
for sale of a particular quantity on a particular date at a particular price and
be assured of the margins because both his purchase price as well as the
sale price are fixed. Traders do a good arbitrage in gold and silver.
Whenever they find gold moving up, they short silver and similarly
whenever they find silver moving up and gold likely to move down, they
hedge.
 To exporters: Futures trading is very useful to the exporters as it provides
an advance indication of the price likely to prevail, help the exporter in
quoting a realistic price and thereby secure export contracts in a
competitive market. Having entered into an export contract, it enables
exporters to hedge theirs risk by operating in futures market.
Option trading in commodity is, however, presently prohibited.
4.4.4 Legal Framework-Policy Liberalization
Forward trading was banned in 1960 except for pepper, turmeric, castor seed
and linseed. Futures trading in castor seed and linseed were suspended in 1977.
Apparently, on the basis of the recommendations made by Khusro Committee,
forward trading in Potato and Gur was allowed in the early 1980s and in castor
seed in 1985. After the process of liberalization of the economy began in 1990,
the government set up a committee under the chairmanship of Prof. K. N.
Kabra in 1993 to examine the role of futures trading in the context of
liberalization and globalization. The Kabra Committee recommended allowing
futures trading in 17 commodity groups. It also recommended strengthening of
Forward Markets Commission and amendments to Forward Contracts
(Regulation) Act, 1952. The major amendments include allowing options in
108 ANNA UNIVERSITY

goods, increase in the outer limit for delivery, payment from 11 days to Notes
30 days for the contract to remain ready delivery contract and registration of
brokers with the Forward Markets Commission. The government accepted
most of these recommendations and futures trading have been permitted in all
recommended commodities except bullion and basmati rice. Additional staff
was provided to the FMC and the post of Chairman was upgraded to the level
of Additional Secretary to the Government of India. The recommendations to
set up Regional office at Lucknow, Delhi and Kochi were kept in abeyance for
the time being. In the para 44 of the National Agricultural Policy announced by
the government in the year 1999, it was stated that the government would
enlarge the coverage of futures market to minimize the wide fluctuations in
commodity prices, as also for hedging their risk. It was mentioned that an
endeavour would be to cover all important agricultural products under futures
trading in the course of time. An expert committee on agricultural marketing
headed by Shankerlal Guru recommended linkage of spot and forward markets,
introduction of electronic warehouse receipt system, inclusion of more and
more commodities under futures trading and promotion of national system of
warehouse receipt. The sub-group on forward and futures markets formed
under the chairmanship of Dr. Kalyan Raipuria, Economic Adviser,
Department of Consumer Affairs to examine the feasibility of implementing
the recommendations made by the Expert Committee chaired by Shankerlal
Guru recommended that the commodity specific approach to the grant of
recognition should be given up. Those exchanges, which meet the criteria to be
stipulated by the Government, should be able to trade contracts in any
permitted commodity. In his budget speech of 28th February 2002, the Finance
Minister announced expansion of futures and forward trading to cover all
agricultural commodities. The economic survey for the year 2000-2001
indicated the government's intention to allow futures trading in bullion. The
policy statements of the government indicate its resolve to introduce reforms in
commodity sector. A number of initiatives were also taken to decontrol the
spot markets in commodities. The number of commodities listed as essential
commodities has been pruned down to 17.
Accordingly, the FMC imposed some of the regulatory measures being
implemented in the developed markets like:
 Daily mark-to-market margining;
 Time stamping of trades
 Notation of contracts and creation of trade guarantee fund;
 Back-office computerization for the existing single commodity Exchange
and online trading for the new Exchanges;
 Demutualization for the new exchanges;
 One-third representation of independent directors on the boards of existing
exchanges.
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Notes 4.5 FORWARD PRICES AND SPOT PRICES

Before understanding forward prices and spot prices, let us first understand
about spot market and forward market.
4.5.1 Spot Market and Forward Market
The Foreign Exchange Market includes both the Spot and forward exchange
market. The Spot rate is the rate paid for delivery within two business days
after the day the transaction takes place. If the rate is quoted for delivery of
foreign Currency at some future date, it is called the forward rate.
Spot Market
The Spot Market is a market for immediate exchange of currencies. It is the
market where transactions of buying and selling are done for immediate
delivery. In real practice, cash settlement is made after two working (business)
days, excluding holidays. In some cases, it takes less than two days also.
Example: The trades between US dollar and Canadian dollar or

Mexican peso are settled one business day after the deal, rather than two
business day since Canada is in the same time zone as the United States. The
price of foreign exchange in the Spot Market is referred to as the Spot rate.
A Spot transaction can be defined as an agreement to buy or sell a specified
amount of a foreign Currency within two business days of the transaction.
The Spot exchange market is an over-the-counter (OTC) market. This market
is a worldwide linkage of Currency traders, non-bank dealers, foreign
exchange brokers who are connected to one another via a network of
telephones, computer terminals and automated dealing systems. The largest
vendors of screen monitors used in the Currency trading are Reuters,
Bloomberg etc.
Forward Market
A Forward Market is a market for exchange of foreign currencies at a future
date. In the Forward Market, trades are made for delivery at some future date,
according to an agreed upon delivery date, exchange rate and amount. The
price of foreign Currency for future delivery is known as a forward rate. Thus,
the forward rate, once contracted, will be valid for settlement irrespective of
the actual Spot rate on the Maturity Date of the forward contract.
A forward transaction is defined as an agreement to buy or sell a specified
amount of a foreign Currency any time in the future. A forward contract
usually represents a contract between a large money center bank and a well-
known customer having a well-defined need to hedge exposure to fluctuations
in exchange rates. Forward Contracts are usually defined, so that the exchange
can occur in 30, 90 or 180 days. Also, the contract can be customized to Call
110 ANNA UNIVERSITY

for the exchange of any desired quantity of Currency at any future date Notes
acceptable to both parties to the contract.
Some transactions may be entered into on one day but not completed until
sometime in the future.
Example: A French exporter of perfume might sell perfume to a US

importer with immediate delivery but not require payment for 30 days. The US
importer has an obligation to pay the required francs in 30 days, so he or she
may enter into a contract with a trader to deliver dollars for francs in 30 days at
a forward rate - the rate today for future delivery.
Thus, the forward rate is the rate quoted by foreign exchange traders for the
purchase or sale of foreign exchange in the future. There is a difference
between the Spot rate and the forward rate known as the 'spread' in the Forward
Market. In order to understand how Spot and forward rates are determined, we
should first know how to calculate the spread between the Spot and forward
rates.
Example: Suppose the Spot Japanese yen of August 6, 2009, sold at

$0.006879 while 90 day forward yen was priced at $0.006902. Based on these
rates, the Swap rate for the 90 day forward yen was quoted as a 23 point
premium (0.006902 - 0.006879). Similarly, because the 90 day British pound
was quoted at $1.6745 while the Spot pound was $1.7015, the 90 day British
pound sold at a 2.70 point discount.
The Need for a Forward Market
The actual need for the existence of a Forward Market is not Speculation.
Today, there is no clear-cut line of distinction between Hedging and
speculating. However, there are a couple of characteristic of people who use
the Forward Market in order to cover for time lags. The first group includes
exporters and importers. As receipts and payments do not usually coincide
time-wise, these people buy forward the Currency that they will have to pay
and sell forward the Currency that they will receive. In this way they overcome
undesirable market fluctuations and take care of future cash flows. The second
group consists of people who use the Forward Market to preserve the value and
nature of their assets without speculating against future trends. These operators
use both the Spot and Forward Market through Swaps.
Forward Premiums and Discounts
 If the forward rate is higher than the existing Spot rate in the Forward
Market, the Currency is trading at a forward premium.
 If the forward rate is lower than the existing Spot rate in the Forward
Market, the Currency is trading at a forward discount.
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Notes Forward rates typically differ from Spot rates for any given Currency, that
reflects a premium or discount on the Currency. Forward Premiums and
discounts can be expressed as a basis point spread. If the rupee Spot rate in
terms of the dollar is ` 49.6172 /$ and the 6 month forward rate is 49.6141 / $,
then the rupee is selling at a 6 month forward discount of .0031 or 31 basis
points. A foreign exchange rate is generally expressed by way of a whole
number integer followed by 4 decimal points like 0.0007. Each of the numbers
is called a basis point. Thus, if an exchange rate changes from 3.5510 to
3.5580, the Currency is said to have changed by 70 basis points.)
Forward Premiums are also quoted as an annualized percentage deviation from
the current Spot rate.
The formula for this calculation is:

FR– SR
Premium/Discount = × 4×100 , where n is the number of periods
SR
per year.
Example: If the SR and FR are given for 90 days, n = 4. Multiplying by

4 converts the periodic forward premium or discount into an annualized rate.
Similarly, a 6 month forward premium or discount is annualized by
multiplying by 2; a one month is multiplied by n = 12.
Example: Assume the following foreign exchange quotations are given

for a 90 day contract. Calculate the premium or discount on an annualized
basis.
Solution:
SR = $ 0.8576 / £
FR = $ 0.8500 / £
.8500 – .8576
Forward Discount = × 4 ×100 = 3.54% p.a
.8576
Example: The Danish Kroner is quoted in New York at $0.18536/DKr

Spot, $0.18524/DKr 30 days forward, $0.18510/DKr 90 days forward, and
$0.18485/DKr 180 days forward. Calculate the forward discounts or Premiums
on the Kroner.
Solution:
Forward Rate – Spot Rate 12
Premium(Discount) = ×100×
Spot Rate n
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Where n depends on the duration of forward rate contract Notes

In the above cases the quotes have been made in Indirect method.
Spot Rate = $0.18536/DKr
Case 1: 30 Days Forward
30 Days forward rate = $0.18524/DKr
Premium (Discount) = {(0.18524 - 0.18536)/ 0.18536} × 100 × 12/1
= – 9.375 %
Thus the 30 days discount percentage for Danish Kroner is 9.375%
Case 2: 90 days forward
90 days forward rate = $0.18510/DKr
Premium (Discount) = {(0.18510 - 0.18536)/ 0.18536} × 100 × 12/3
= – .561 %
Thus the 90 days discount percentage for Danish Kroner is 0.561 %
Case 3: 180 days forward
180 days forward rate = $0.18485/DKr
Premium (Discount) = {(0.18485 – 0.18536)/0.18536} × 100 × 12/6
= – .550 %
Thus the 180 days discount percentage for Danish Kroner is 0.550 %
Example: For the following Spot and forward quotes, calculate forward
Premiums/discount on Japanese yen as (a) an annualized percentage premium.
Spot ($/*) Forward ($/*) Days Forward
0.009056355 0.008968508 30
0.009056355 0.008772955 90
0.009056355 0.008489201 180
0.009056355 0.007920280 360
Solution:
Forward Premium/Discount = (Forward rate – Spot rate)/Spot rate × 100
Days Forward Discount - Annualized (%)
30 –11.64 %
90 –12.51%
180 –12.52%
360 –12.54 %
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Notes 4.5.2 Relationship between Spot, Futures and Forward Prices with
Emphasis on Pricing Mechanism of Futures
Basis of Price Mechanism of Futures
 Price Discovery: Due to its highly competitive nature, the futures market
has become an important economic tool to determine prices, based on
today's and tomorrow’s estimated amount of supply and demand. As the
needs and expectations of hedgers and speculators converge on the
exchange floor, trades are made and price information is provided to the
world. This price information is used as a benchmark to determine the
value of a particular commodity on a given day and time. The benefits of
futures exchanges reach every sector of the world where changing market
conditions create economic risk.
Futures market prices depend on a continuous flow of information from
around the world and thus require a high amount of transparency. There are
several factors such as weather, war, demographic changes, cropping
pattern, government regulations etc., have a major effect on supply and
demand, and hence the present and future price of a commodity. This kind
of information and the way people discount it constantly changes the price
of a commodity. This process is known as price discovery.
In commodity markets, the spot prices provide vital clues. The spot price is
the price prevailing at the leading underlying market in India. This may
make the actual price in the farmer’s region, different from this one. Also,
the price is of the best available quality of a particular variety in the market.
The price of your produce may be arrived at by this way. First add the
approximate transportation cost and the cost of transportation loss if your
produce had travelled to the mandi quoting the spot price. Second, you
should discount the price by the difference in the quality of your product to
that of the standard.
Farmers are exposed to the fluctuations in the commodity prices in the
markets. The tendency for production patterns to shift based on the present
prices fetched is seen in India. However, the impact of factors like weather
generates volatility. Farmers cannot change the level of production quickly
when prices change. Production stays at a given level even in falling prices.
On the other hand, lower prices generally do not help to increase the
purchases of foods and other commodity-based products significantly.
Today, the fluctuation of spot prices widely affects the interest of different
parties, mainly the farmers. Sometimes the commodity value chains is
controlled by a small group who can bring down commodity prices and eat
up the share of the price that should go to the farmers. Another reason for
farmers facing problem in respect of prices is inadequate quality storage
felicities. He cannot hold back the goods as he cannot effectively store it.
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 Price-Risk Transfer: Futures markets are also used to transfer and reduce Notes
risk in trading activity. It is the primary economic function of futures
markets. It is also referred to as hedging. Hedging is buying and selling
futures contracts to offset the risks of changing cash market prices. This
risk-transfer mechanism has made futures contracts an important tool
around the world. Risks are reduced because the price is pre-set, therefore
letting participants know how much they will need to buy or sell. This
helps reduce the ultimate cost to the retail buyer, because with less risk
there is less chance of manufacturers jacking up prices to make up for
profit losses in the cash market.
Price risk exists in all business. In agriculture, for instance, a prolonged
drought may affect a farmer’s crop supply as well as the income he
receives. The drought also may affect the price paid by grain companies for
wheat, maize, soybeans, and pulses. Those prices, in turn, may directly
impact consumer prices for cereals, edible oils, bread, meat, and poultry.
For manufacturers, diminished supply due to factors like an extended
transportation strike or that of raw material suppliers can result in a sharp
price increase of a specific manufactured product. These economic factors
may directly affect the price manufacturers and consumers pay for an array
of commodities, ranging from grains and pulses to jewellery.
Example: A wheat miller enters into a contract to sell flour to a

bread manufacturer four months from now. The price is agreed upon today
though the flour would only be delivered after four months. The miller is
worried about the rise in the price of wheat during the course of four
months even if he does not possess the wheat right now, which he will
process into floor. A rise in the price of wheat would result in losses on the
contract to the miller.
To safeguard him against the risk of rising prices of wheat, the miller buys
wheat futures contracts that call for the delivery of wheat in four months
time. After the expiry of four months, as feared by the miller, the price of
wheat has risen. The miller purchases the wheat in the spot market at a
higher price. However, since he has hedged in the futures market, he can
now sell his contract in the futures market at a gain since there is an
increase in the futures market as well.
He thus offsets his purchase of wheat at a higher cost by selling the futures
contract thereby protecting his profit on the sale of the floor.
 Futures Provide the Leverage: It is said that the futures trading is much
more than physical markets. How does it happen? It is referred to as
leverage, which refers to being able to use a relatively small amount of
cash, to enter into a futures contract that is worth much more than the
amount initially paid, which is the deposit into the margin account. It is
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Notes said that in the futures market price changes are highly leveraged, meaning
a small change in a futures price can translate into a huge gain or loss.
Futures positions have this leverage because the margins. Margins are set
by the exchanges at a relatively small value compared to the cash value of
the contracts in question. This makes the futures market useful but also
very risky. The smaller the margin in relation to the cash value of the
futures contract, the higher the leverage. So for an initial margin of 5%,
you may be able to enter into a long position in a futures contract for 20
times of the investment. As the investment is to be just 5% of the total
value, it is referred as highly leveraged investments.
The fact about the futures market, which is reinstated here, is that the
futures market can be extremely risky, if not handled properly. This is
clearer when we understand the arithmetic of leverage. They can produce
two results: great profits or even greater losses.
Now if the price of the futures contract moves up even slightly, the profit
gain will be large in comparison to the initial margin. But if the price goes
down by a small amount, it will yield huge losses in comparison to the
initial margin deposit. It is like 100% profit or losses on the price
movement for the whole quantity as against a limited percentage of
margins.
Example: A long futures contract with a margin deposit of 5%is

opened when the spot price is ` 1300 per quintal. Value of contract is
` 130000.Thia means that a single rupee movement on the commodity
yields an ` 100 profit or loss. The margin is just ` 6500.
If after a couple of months, the commodity has realized a gain of 8%, this
would mean the price of the commodity has gone up by ` 104 to stand at
1404. This price move will generate a profit of 10400 (` 104 x 100); a
profit of 160%!
On the other hand, if the price fell by 8%, it would result in a loss of
` 10400, 160% of the initial margin deposit made to trade the contract. This
means you still have to pay ` 3900 out of your pocket to cover your losses.
This is a risky arithmetic of leverage. Hence the percentage gains and
losses are much more aggressive in futures contracts due to low margins
and high leverage.
 Predictable Pricing: The demand for certain commodities like edible oils
is highly price-elastic. The manufacturers thus have to ensure that the
prices are stable in order to protect their market share with the free entry of
imports. Futures contracts will enable predictability in domestic prices. The
manufacturers can, as a result, smooth out the influence of changes in their
input prices very easily. With no futures market, the manufacturer can be
caught between severe short-term price movements of oils and the
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necessity to maintain price stability, which could only be possible through Notes
sufficient financial reserves that could otherwise be utilized for making
other profitable investments.
Relationship between Forward Prices and Expected Forward Spot Prices
One question each trade asks him is about the relation of forwards price to the
expected future spot prices. They always try to find if the forwards price is an
unbiased estimate. As per Keynes and Hicks, the traders trade in the forward or
the futures prices only if they expect a positive profit. But in case of hedgers
they are ready to accept a negative expected profit as their objective is risk-
reduction. Now if in a case, if speculators that are long are more than that are
short, the forwards price will tend to be less than the expected future spot price.
This will lead to a positive value for them as the expiry approaches. But in case
of speculators on the short side more, the forwards price will tend to be greater
than the expected future spot price.
The risk return relationship specifies that the difference between the expected
future spot and the forward price will depend on the risk premium acceptable
in the economy. Hence to find a market where the difference between the
expected future spot and the forward price is zero, there is no systematic risk.
On the other hand, if the systematic risk is positive, the forward price will be
lesser than expected future spot. But id the systematic risk is negative, it will
be higher.
Comparison between Futures and Forward Prices
One thing we need to know is whether the futures and forward prices are same
or are different. Normally they are used interchangeably, but in fact there are
several critical issues to be understood. In the real world, interest rates vary
unpredictably. In such cases, the forward and futures prices are in theory no
longer the same. If the price of the underlying asset, S, is strongly positively
correlated with interest rates and increases, a long futures position makes an
immediate gain because of the daily settlement procedure. The positive
correlation suggests that interest rates may also have increased. The gain can
be invested at a higher rate of interest. But when S decreases, there will be an
immediate loss. Since interest rates have also gone down, the loss will be
financed at a lower rate of interest.
But if a person holds a forward contract rather than a futures contract, he will
not be affected that way and the fluctuation of interest rate movements will not
affect him. This implies that a long futures contract will be more attractive than
a long forward contract, resulting in the futures prices being higher than
forward prices in cases of high positive correlation between spot prices and
interest rates. But if the spot price is negatively correlated, forward prices will
be higher.
In practice, this difference in too small and is often ignored. But there are other
issues that also contribute to the difference. Issues like taxes, transactions
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Notes costs, and the treatment of margins may cause the difference. But the
differences in general are too small and for most purposes, it is reasonable to
assume that forward and futures prices are the same. For long-term futures and
forwards, with the life of the contract the differences between forward and
futures contracts become significant.
The Concept of Cost of Carry and Pricing based on it
The relationship between futures prices and spot prices is structured around the
cost of carry. Cost of carry is defined as the cost that the holder of the asset
required to incur for carrying the asset till maturity date. The components that
make up the cost of carry can be defined as storage cost, interest and other
related costs.
This is based on the concept that if a trader needs to give delivery after a time
period, the trader will need to carry the inventory till the delivery date.
Obviously the caring of the inventory will require some cost. These costs are
called as cost of carry. In a conventional system, the cost of carry is made up of
following costs-
 Storage cost-
 Financing cost
 Other incidental costs like insurance etc.
The storage cost is the cost that the trader needs to incur for maintaining the
inventory. This typically includes costs like the warehouse rent, the cost of
fumigation, expenses like grading fees, transportation to warehouse etc. The
financing cost is the interest cost. The fund of the trader is blocked in the
inventory and he has to either pay for the interest on it or lose an opportunity of
earning interest. In either of the cases, it is a cost to the holder. This is added as
a cost of carry. Along with these, there may be other cost like the insurance
cost, or similar which are also included.
The cost of carry is the logical difference between the spot price and the
futures prices. If this difference is large or small then the market will act and
the prices will correct itself. The cost of carry is the estimated cost of holding
the asset till maturity.
Example: If the price of silver is about ` 18000/ per kg, in the spot
market and ` 19000/ in for the one month futures, the cost of carry appears to
be ` 1000 per kg, this includes the cost of buying physical silver, the cost of
insurance, transportation, and vault charges for one month. However if all
these costs are higher than ` 1000, the trader will sell the silver in spot market
and buy the futures. He will save the holding cost. Such acts will be done by all
the people who identify the mispricing. This will lead to increased supply in
spot and pressure in futures. The result will be an increase in futures price and
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fall of the spot. This increases the cost of carry component and market is Notes
corrected.
The futures prices based on the spot and cost of carry is calculated as under-
F= S (SRT–t/365) + G
Here,
F = Futures price,
S= spot price
R = financing cost or interest rate
T= Delivery time
t= time when futures is entered
G= Storage cost
However, the cost of carry model has some assumptions:
 There is no transaction cost involved in trading futures or spot
 There is unlimited ability to borrow or lend funds
 Interest rates are constant
 No credit risk exist in the system
 Storage can be for indefinite period without change on quality
 There are no taxes.
The above calculation is called as full carry. But the formula fails to
incorporate the convenience yield.
In case we need to incorporate the convenience yield in the same formula, the
formula for calculating future price will be-
F= S(SRT-t/365) + G – Y
where y is the convenience yield.
Convergence of Spot and Futures Prices
When the delivery month of a futures contract approaches, the futures price
tend to converges to the spot price of the underlying asset. On the maturity day,
the futures price is equal to the spot price. This is because the futures price is
nothing but the expected spot. As the delivery day approaches, the number of
days left go on reducing. This results in more clarity and less days for the
adjustment for variations. Hence it moves closer to spot price. Also assuming
the cost of carry concept, the number of days for the holding goes on reducing.
This results in lesser difference in the spot and futures.
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Notes But why this is so, can be understood by using the following example. Let us
assume that futures price is above the spot price during the delivery period.
Traders then have a clear arbitrage opportunity:
 Short a futures contract.
 Buy the asset.
 Make delivery.
As traders exploit this arbitrage opportunity, sale pressure on futures will make
the futures price will fall. Also, the purchase from the spot will push it up. This
will bring them into equilibrium. But if the futures price is below the spot price
during the delivery period, interested buyers will get a long futures contract
and get the delivery from futures. This lead the futures price to rise and match
up with the spot.
Figure 4.1 : Convergence of Spot and Futures Price
4.5.3 Types of Market

Contango Market
Based on the common pricing formula for futures, the prices of a future date
should be higher than the present date, It technical language, the futures price
should be higher than the spot price. This assumes that the demand and the
supply forces remain constant. This is a normal market situation and is referred
as contango (or "at a premium"). The price differential depends on the positive
"interest rate" and the cost-of-carry. However, the carrying costs change over a
period of time. As the futures contract approaches the expiry date, the costs
start to get reduced. In a contango market, the buyer of futures bears the cost of
carry and the person with a short position receives it.
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Notes
Figure 4.2: Contango Market
Backwardation
Whereas contango is the normal market situation, sometimes, prices show a
reverse pattern. This is more prominent in the case of consumption
commodities and the disruption of supply and demand balance. If the present
demand gets a shoot-up and the excising supply is not able to meet it, the cash
prices shoot up. However, this disruption is temporary and in due course, the
supply will adjust to the demand. This expectation prevents the future from
shooting up. In such situations, the cash prices may go above the futures prices.
This is called as an inverted market or a backwardation. It is observed more in
trade of metals and oil. On these markets, backwardation occurs quite
frequently.
Example: The copper prices showed this trend for about half of the
time from 1989 to 2005. However in case of gold, the situation of
backwardation is rarely seen. Buyers of gold normally can easily postpone
purchases of the metal when cash prices are high since demand is more from
the investment objective, but base metals and crude oil being consumption
assets, the postponement cannot happen and hence, backwardation is
prominent. The rationale behind backwardation is the convenience yield.
Holding the futures contract does not give the benefit of physical shortages.
The stock is just in books. It cannot help to keep the production process
running.
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Notes
Figure 4.3: Backwardation

Commodity futures are different from the commodity forward in the sense that
it is traded on exchanges. Over the years, governments have preferred trading
futures rather than forwards. This is because futures being exchange-based
transactions are more regulated. The development of the market has been to a
large extent due to the effective regulations that have been put in place.
A balanced regulation can be a great factor for success in a futures market.
Learning Activity
Empirical tests which have been performed across the countries
suggest that forward rates are not very good predictors of future
Spot rates. Statistically test whether the forward rate is an unbiased
predictor of the future Spot rate for one, three and six month’s
interval.
1. A Clearing Member (CM) of NSCCL has the

responsibility of clearing and settlement of all deals
carried out by Trading Members (TM) on NSE, who
clear and settle such deals through them.
2. Forward rates are usually quoted for fixed periods of
30, 60, 90 or 180 days from the day of the contract.
SUMMARY
 Commodity markets are quite like equity markets. The commodity market
also has two constituents i.e. spot market and derivative market. In case of
a spot market, the commodities are bought and sold for immediate delivery.
122 ANNA UNIVERSITY

 In case of a commodities derivative market, various financial instruments Notes

having commodities as underlying are traded on the exchanges. It has been
seen that traditionally in India, people have hedged their risks with gold
and silver.
 The price of a future contract in terms of INR per unit of other currency
e.g. US dollars is definite at NSE. Currency future contracts permit
investors for hedging as against foreign exchange risk. There arises
availability of currency future derivatives on four currency pairs viz US
Dollars (USD), Euro (EUR), Great Britain Pound (GBP) and Japanese Yen
(JPY). Presently, currency options are available on US Dollars.
 Delivery options refer to the feature of a futures contract giving the short
the right to make decisions about what, when and where to deliver.
 Currencies deal at a stipulated exchange rate of a concerned country. An
exchange rate can be defined as the number of units of one Currency that
must be given to acquire one unit of a Currency of another country. It is the
price paid in the home Currency to purchase a certain quantity of funds in
the Currency of another country.
 The exchange rate quotation states the number of units of a price Currency
that can be bought in terms of one unit of another. In practice, foreign
exchange quotations for currencies generally follow two conventions. The
two methods are referred to as the Direct (American) and Indirect
(European) methods of quotation.
 Short dated and broken date contracts are terms used in foreign exchange
trading and Euromarket in connection with the delivery of Currency. A
cross rate can be obtained by multiplying two exchange rates by each other
so as to eliminate a third Currency that is common to both rates. The most
common use of cross rate calculations is to determine the exchange rate
between two currencies that are quoted against the US dollar but not
against each other.
 Wholesale Price Index is one of the delivery options of the commodities.
The updated WPI is available in every week, with the time lag between two
weeks being reduced to the minimum possible level. It catches the price
movements in an extensive manner. For all these qualities, it is the most
prevalent price index in India. It is also viewed as an indicator of the
inflation rate of our economy.
 Futures contract in the commodities market, similar to equity derivatives
segment, will facilitate the activities of speculation, hedging and arbitrage
to all class of investors.
 The important point to understand about foreign currency futures is that
when one has a futures contract, one does not own foreign exchange. A
futures contract, in fact, represents a pure bet on the direction of price
(exchange rate) movement of the underlying currency. This means that the
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Notes futures price is not a monetary amount you pay to anyone – rather, it is the
variable about which one is betting.
 Commodity future is a derivative instrument for the future delivery of a
commodity on a fixed date at a particular price. The underlying in this case
is a particular commodity.
 The Foreign Exchange Market includes both the Spot and forward
exchange market. The Spot rate is the rate paid for delivery within two
business days after the day the transaction takes place. If the rate is quoted
for delivery of foreign Currency at some future date, it is called the forward
rate.
KEYWORDS
Commodity Futures: Futures contracts in which the underlying is a traditional
agricultural, metal, or petroleum product.
Commodity: Any goods that are unbranded and are commonly traded in the
market come under commodities.
Currency Derivatives: Currency derivatives or currency future (also known as
FX future) is a futures contract for exchanging one currency for another at a
definite date in the future at a price i.e. an exchange rate which is fixed on the
purchase date.
Forward Market: A Forward Market is a market for exchange of foreign
currencies at a future date.
Spot Market: The Spot Market is a market for immediate exchange of
currencies.
Wholesale Price Index: The Wholesale Price Index has been the most
commonly accepted price index in India. It signals the ups and downs of the
commodity prices, in all trades and transactions taking place across the
country.
1. What is commodity trading?
2. What do you mean by currency derivatives?
3. Explain the delivery options of currencies.
4. Explain American and European quotations of foreign exchange.
5. What do you mean by cross rates of exchange?
6. Define Wholesale Price Index.
124 ANNA UNIVERSITY

7. Why there is a need for an Exchange traded Commodity derivatives Notes

market?
8. What kind of opportunities the commodity derivatives provide to investors?
Explain.
9. Discuss the benefits of commodity futures.
10. Differentiate between Short Dates and Broken Date contracts.
1. “Delivery options refer to the feature of a futures contract giving the short
the right to make decisions about what, when and where to deliver”.
Examine the delivery options related to currencies and commodities.
2. Examine the relationship of currency and commodity with future prices.
3. Analyze in detail Commodity markets in India.
4. “The Foreign Exchange Market includes both the Spot and forward
exchange market”. Explain in detail in relation in spot prices and forward
prices with suitable examples.
5. A trader works for a New York bank. The Spot exchange rate against the
Canadian dollar is US $0.9968 and the one month and one year forward
rates are respectively US $ 0.9985 and US $ 1.0166. Twelve months
interest rates in the USA and Canada may be taken as 6.45% and 4.46%
respectively.
(a) What is the forward premium as an annual percentage?
(b) Which Currency is at a premium? Why?
(c) The trader becomes party to some inside information which suggests
that US interest rates will rise by 1 per cent per annum during the next
month. The bank has a rule that in the foreign exchange markets ‘buy
equals sell’. This means that for any Currency the total of long
positions must equal the total of short positions but this aggregation
disregards maturity.
(d) Indicate the mechanics of two operations by which you may trade in
expectation of profit for the bank should the inside information turn out
to be well-informed.
FURTHER READINGS

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Notes Kevin, H. (2014), Commodity and Financial Derivatives, PHI

Learning Pvt. Ltd.
Kulkarni, Bharat (2011), Commodity Markets & Derivatives, 1st
edition. Excel Books India.
Kumar, S.S.S (2007), Financial Derivatives, PHI Learning Pvt.
Ltd.
126 ANNA UNIVERSITY

Lesson 5 - Options
Notes
UNIT III
LESSON 5 - OPTIONS
CONTENTS
Learning Objectives
Learning Outcomes
Overview
5.1 Exchange Traded Options and OTC Options
5.2 Specifications of Options
5.3 Call and Put Options
5.4 American and European Options
5.4.1 American Options
5.4.2 European Options
5.5 Intrinsic Value and Time Value of Options
5.5.1 Intrinsic Value
5.5.2 Time Value
Summary
Keywords
Further Readings
LEARNING OBJECTIVES
 Understand Exchange Traded options and OTC options
 Determine the specification of Options
 Explain Call and Put Options
 Know about the American and European Options
 Analyze Intrinsic and Time Value of Options
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understanding of:
 the concept of Interest rate option and its application as an investment tool
whose payoff depends on the future level of interest rates. These options
are both exchange traded and over-the-counter instruments.
 the fact that a callable bull/bear contract, or CBBC in short form, is a
derivative financial instrument that provides investors with a leveraged
investment in underlying assets, which can be a single stock, or an index.
 the datum that the exchanges specify the strike price interval for different
levels of underlying prices and it's relation to the market value of the
underlying asset affects the moneyness of the option and is a major
determinant of the option's premium.
OVERVIEW
In the previous lesson you had studied about Commodities and Currency
Derivatives-Introduction, Commodity Market in India, delivery Options of
Currencies and Commodities, the relationship between Futures Prices, Forward
Prices and Spot Prices.
In finance, an option is a contract whereby one party (the holder or buyer) has
the right but not the obligation to exercise a feature of the contract (the option)
on or before a future date (the exercise date or expiry). The other party (the
writer or seller) has the obligation to honour the specified feature of the
contract. Since the option gives the buyer a right and the seller an obligation,
the buyer has received something of value. The amount the buyer pays the
seller for the option is called the option premium.
Most often the term "option" refers to a type of derivative which gives the
holder of the option the right but not the obligation to purchase (a "call
option") or sell (a "put option") a specified amount of a security within a
specified time span (Specific features of options on securities differ by the type
of the underlying instrument involved).
Though both futures and options are contracts or agreements between two
parties, yet there lies some point of difference between the two. Futures
contracts are obligatory in nature where both parties have to oblige the
performance of the contracts, but in options, the parties have the right and not
the obligation to perform the contract. In option one party has to pay a cash
premium (option price) to the other party (seller) and this amount is not
returned to the buyer whether no insists for actual performance of the contract
or not. In future contract no such cash premium is transferred by either of the
two parties. In futures contract the buyer of contract realizes the gains/profit if
price increases and incurs losses if the price falls and the opposite in case of
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Lesson 5 - Options
vice-versa. But the risk/rewards relationship in options are different. Option Notes
price (premium) is the maximum price that seller of an option realizes. There is
a process of closing out a position causing ceasation of contracts but the option
contract may be any number in existence.
Example: Now let’s use an example that you may actually be involved
with in the futures markets. Assume you think Gold is going to go up in price
and December Gold futures are currently trading at $1,400 per ounce and it is
now mid-September. So you purchase a December Gold $1,500 Call for
$10.00 which is $1,000 each ($1.00 in Gold is worth $100). Under this
scenario as an option buyer the most you are risking on this particular trade is
$1,000 which is the cost of the option. Your potential is unlimited since the
option will be worth whatever December Gold futures are above $1,500. In the
perfect scenario, you would sell the option back for a profit when you think
Gold has topped out. Let’s say gold gets to $1,550 per ounce by mid-
November (which is when December Gold options expire) and you want to
take your profits. You should be able to figure out what the option is trading at
without even getting a quote from your broker or from the newspaper. Just take
where December Gold futures are trading at which is $1,550 per ounce in our
example and subtract from that the strike price of the option which is $1,400
and you come up with $150 which is the options intrinsic value. The intrinsic
value is the amount the underlying asset is though the strike price or “in-the-
money.”
$1,550 Underlying Asset (December Gold futures)
— $1,400 Strike Price
$150 Intrinsic Value
Each dollar in the Gold is worth $100, so $150 dollars in the Gold market is
worth $15,000 ($150X$100). That is what the option should be worth. To
figure your profit take $15,000 - $1,000 = $14,000 profit on a $1,000
investment.
$15,000 option’s current value
— $1,000 option’s original price
$14,000 profit (minus commission)
Of course if Gold was below your strike price of $1,500 at expiation it would
be worthless and you would lose your $1,000 premium plus the commission
you paid.
In this lesson, you will learn about the Exchange Traded options-Definition
and OTC options, specification of Options, Call and Put Options, American
and European Options. At the end of the lesson you will be studying about
Intrinsic and Time Value of Options.
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Notes 5.1 EXCHANGE TRADED OPTIONS AND OTC OPTIONS

Let us first understand the definition of options before proceeding further.
An option is a contract that gives the buyer the right, but not the obligation, to
buy or sell an underlying asset at a specific price on or before a certain date.
An option, just like a stock or bond, is a security. It is also a binding contract
with strictly defined terms and properties.
Example: Let’s take an example of equity stock option. Suppose that a

party has 1000 shares of Reliance Industries Limited whose current price is
` 4000 per share and other party agrees to buy these 1000 shares on or before a
fixed date (i.e. suppose after 4 month) at a particular price say it is become
` 4100 per share. In future within that specific time period he will definitely
purchase the shares because by exercising the option, he gets ` 100 profit from
purchase of a single share. In the reverse case suppose that the price goes
below ` 4000 and declines to ` 3900 per share, he will not exercise at all the
option to purchase a share already available at a lower rate. Thus option gives
the holder the right to exercise or not to exercise a particular deal. In present
time options are of different varieties like- foreign exchange, bank term
deposits, treasury securities, stock indices, commodity, metal etc.
Example: Let us say that you discover a house that you would love to
purchase. Unfortunately, you do not have the cash to buy it for another three
months. You talk to the owner and negotiate a deal that gives you an option to
buy the house in three months for a price of ` 200,000. The owner agrees, but
for this option, you pay a price of ` 3,000. Now, consider two theoretical
situations that might arise:
It has been discovered that the house is of historical importance and as a result,
the market value of the house skyrockets to ` 10,00,000. Because the owner
sold you the option, he is obligated to sell you the house for ` 2,00,000. In the
end, you stand to make a profit of ` 7,97,000 (` 10,00,000 – ` 2,00,000 –
` 3,000).
While touring the house, you discover that the house is not in proper living
conditions. Though you originally thought you had found the house of your
dreams, you now consider it worthless. On the upside, because you bought an
option, you are under no obligation to go through with the sale. Of course, you
still lose the ` 3, 000 price of the option, which is non-refundable.
This example demonstrates two very important points.
First, when you buy an option, you have a right but not an obligation to do
something. You can always let the expiration date go by, at which point the
option becomes worthless. If this happens, you lose 100% of your investment
(option premium), which is the money you used to pay for the option.
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Lesson 5 - Options
Second, an option is merely a contract that deals with an underlying asset. For Notes
this reason, options are called derivatives, which mean an option derives its
value from something else. In our example, the house is the underlying asset.
How Options Work by using the following example:
Example:A Brazilian company is committed to export coffee to

Germany and will be requiring the coffee in three months' time. It purchases an
option giving it the right to buy such coffee at a rate of 110 cents per pound.
If the market rate at the time of export is better is better — say, 106 cents per
pounds, than the rate to which it is entitled under the option (110), it simply
discards the option, losing only the premium, and buys from the market at 106.
But if the market moves against it to 112, it takes up ("exercises") its rights
under the option and buys at 110 cents per pounds.
Option Buyer Option Seller
Profit Unlimited Limited
Loss Limited Unlimited
This makes it clear that the seller of the option has in a very different position.
The maximum loss that the buyer can have is the amount of the premium, but
enjoys virtually unlimited profit potential (exclusively from the option
transaction). The seller stands in an equal and opposite position. This implies
he has a virtually unlimited possible loss and a maximum possible profit equal
to the amount of the premium. Then why would anyone sell the option? The
answer is that there will always be someone who will take on — at a price —
the risks that others do not want. The sellers do so because they are confident
that they have the expertise to manage those risks and secure profits from
doing so. Simply put, they believe the outcome is going to be in their favour
and the profit is more certain.
FX options are traded in two distinct markets.
 OTC: The largest, by far, is the OTC market (OTC just means ‘direct
between counterparties’) which comprises banks, American securities
houses and corporates. There is no central marketplace as such. All
transactions are conducted over the telephone or through the Reuter’s
Dealing System and are open 24 hours a day. Telex is rarely used these
days except as a form of written confirmation for deals already concluded.
The market participants deal with each other, either directly or through an
OTC broker, quoting volatility rates as the dealing price (rather than in
currency prices). The brokers act to bring counterparties together but have
no part in the transaction itself. As in the spot FX markets, a fee is levied
on both counterparties by the broker for such deals. Trades concluded
directly are commission free (so there are no fees when a corporate deals
with its bank).
ANNA UNIVERSITY 131

Notes Options type over-the-counter includes:

 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.
Example: Interest rate options from exchanges in the United

States are offered on Treasury bond futures, Treasury note futures and
eurodollar 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.
 Currency cross-rate options: The currency exchange rate between two
currencies, both of which are not the official currencies of the country
in which the exchange rate quote is given in. This phrase is also
sometimes used to refer to currency quotes which do not involve the
U.S. dollar, regardless of which country the quote is provided in.
Example: If an exchange rate between the Euro and the

Japanese Yen was quoted in an American newspaper, this would be
considered a cross rate in this context, because neither the euro or the
yen is the standard currency of the U.S. However, if the exchange rate
between the euro and the U.S. dollar were quoted in that same
newspaper, it would not be considered a cross rate because the quote
involves the U.S. official currency.
 Options on swaps or swaptions: A swaption is an option granting its
owner the right but not the obligation to enter into an underlying swap.
Although options can be traded on a variety of swaps, the term
"swaption" typically refers to options on interest rate swaps.
There are two types of swaption contracts:
(i) A payer swaption gives the owner of the swaption the right to enter
into a swap where they pay the fixed leg and receive the floating
leg.
(ii) A receiver swaption gives the owner of the swaption the right to
enter into a swap in which they will receive the fixed leg, and pay
the floating leg.
 Exchange Listed or Exchange Traded options: The other market for FX
options is the exchange listed markets of the various stock and futures
exchanges around the world. The principal centres are Philadelphia, where
the stock exchange lists options on spot FX and Chicago, where the
Mercantile Exchange lists options on its FX futures contracts. In both
cases, quotations are in the form of currency (rather than volatility).
132 ANNA UNIVERSITY

Lesson 5 - Options
Access to the market is through brokers who impose commissions for each Notes
contract traded.
Exchange traded market operates on the floor of the exchange

where brokers gather to reflect their clients’ orders with market makers or
specialists providing the prices.
The markets have specified opening and closing times for each currency
contract. Also, the exchanges have widened the availability by extending
trading hours.
Exchange-traded options comprises of:
 Stock Options: A stock option is a contract between two parties in which
the stock option buyer (holder) purchases the right (but not the obligation)
to buy/sell 100 shares of an underlying stock at a predetermined price
from/to the option seller (writer) within a fixed period of time.
 Bond Options and other Interest Rate Options: A bond option is an option
to buy or sell a bond at a certain price on or before the option expiry date.
These instruments are typically traded exchange traded options :
 A European bond option is an option to buy or sell a bond at a certain
date in future for a predetermined price.
 An American bond option is an option to buy or sell a bond on or
before a certain date in future for a predetermined price.
Interest rate options give buyers the right, but not the obligation, to
synthetically pay (in the case of a cap) or receive (in the case of a floor) a
predetermined interest rate (the strike price) over an agreed period.
Example: Interest rate options from exchanges in the United States

are offered on Treasury bond futures, Treasury note futures and eurodollar
futures.
 Stock Market Index options or, simply, Index Options: Stock market
index option is a type of option, which is a financial derivative. Index
options may be tied to the price of either broad-based indexes like the S&P
500 Index or the Russell 3000 Index or to narrow-based indexes, which is
an index that is limited to a particular industry like the mining industry or
the semiconductor industry.
 Options on Futures Contracts: An option on a futures contract gives the
holder the right to enter into a specified futures contract. If the option is
exercised, the initial holder of the option would enter into the long side of
the contract and would buy the underlying asset at the futures price. A short
option on a futures contract lets an investor enter into a futures contract as
the short who would be required to sell the underlying asset on the future
ANNA UNIVERSITY 133

Notes date at the specified price. Essentially, the futures specified in the option
contract allows someone to enter into the specified futures contract when
the option expires.
 Callable Bull/Bear Contract: A callable bull/bear contract, or CBBC in
short form, is a derivative financial instrument that provides investors with
a leveraged investment in underlying assets, which can be a single stock, or
an index. CBBC is usually issued by third parties, mostly investment
banks, but neither by stock exchanges nor by asset owners. It was first
introduced in Europe and Australia in 2001, and it is now popular in United
Kingdom, Germany, Switzerland, Italy, and Hong Kong.
CBBC has two types of contracts, callable bull contract and callable bear
contract, which are always issued in the money. By investing in a callable
bull contract, investors are bullish on the prospect of the underlying asset
and intend to capture its potential price appreciation. Conversely, investors
buying a callable bear contract are bearish on the prospect of the
underlying asset and try to make a profit in a falling market.
CBBC is typically issued at a price that represents the difference between
the spot price of the underlying asset and the strike price of the CBBCs,
plus a small premium (which is usually the funding cost). The strike price
can be equal to or lower (bull)/higher (bear) than the call price. The call
price is also referred to as "stop loss", "trigger point", "knockout point" or
"barrier" by different traders.
However, CBBC will expire at a predefined date or will be called
immediately by the issuers when the price of the underlying asset reaches a
call price before expiry
Exchange Traded vs. OTC Options
 OTC options are available in a larger number of currencies while exchange
traded options are only available in limited number of currencies. OTC
options are available cross currencies (i.e., without the standard quotation
against the dollar).
 For OTC options, unlike the exchange traded ones, initial and maintenance
margins are not required.
 OTC’s quotations may be obtained outside the limited trading periods and
strike prices of an exchange. Normally, they are available for any exercise
date up to one year and even beyond. Exchange traded options are normally
available for 3, 6, 9 month periods.
Corporate customers prefer to trade directly with their bank on a

principal to principal relationship and access to prices is readily available to
them.
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Lesson 5 - Options
 OTC prices are determined by the banks while the exchange traded option Notes
prices are determined by the market. The prices on an exchange are
basically the same regardless of the financial strength of the purchaser. An
individual can obtain the same price as a large corporate buyer.
 OTC markets, however, lack a ready two way liquidity and marketability
and this may impact on an individual bank’s premium quotations over
exchange traded ones where, because of their uniformity, the options are
freely marketable and matchable.
 Close out procedures on an exchange traded option are available simply by
making further trades. These procedures for OTC are more cumbersome
and repurchase procedure requires acceptance of the original grantor’s
current price which may not be competitive.
 Exchange traded standardised options are less likely to be the subject of
error in negotiation and their terms and conditions are subject to exchange
regulation.
 OTC option deals do not have to wait for the market to open and clearing
house to function, the option purchaser accepts a direct credit with the
writer, though these may be acceptable risks, as the counterparties are
usually banks with which the customer has a relationship established.
Table 5.1: Comparison of the Two Markets
Feature Over The Counter Exchange Listed
Amount Any, subject to a minimum Fixed by contract size or a multiple
thereof
Maturity Overnight to five years Fixed day each month for first three
months then quarter months to one year
Strike Any, within reason Only those listed per schedule
Strike quotation As in the FX market, although Generally in US cents per currency,
exchange-type available Resulting in the reciprocal of the rate
quoted in the FX market
Currency Any pair that has active spot and Only those listed
forward market
Margins None, but credit line required Yes, on sales only
Price quotation Professional (interbank) in volatility US dollars per currency or foreign
terms. Other as requested, usually% currency per currency for cross-rate
contracts
Style American or European American or European(PHLX)
European(IMIM)
Access Trade with a bank Order placed with a broker
Commissions None, if dealt directly with bank Broker, exchange fees
5.2 SPECIFICATIONS OF OPTIONS

In view of the terms of the options as specified in a term sheet, every financial
option is a contract between two counterparties. Option contracts may be quite
ANNA UNIVERSITY 135

Notes tedious, however, at minimum they generally consists of the following

specifications:
 Buyer of an option: The option buyer is the person who acquires the rights
conveyed by the option: the right to purchase the underlying futures
contract if the option is a call or the right to sell the underlying futures
contract if the option is a put.
 Writer of an option: The option seller (also known as the option writer or
option grantor) is the party that conveys the option rights to the option
buyer. In other words, 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.
 Option Class: All calls and puts on a given underlying security or index
represent an “option class.” In other words, all calls and puts on XYZ stock
are one class of options, while all calls and puts on ZYX index are another
class.
 Option Series: All options of a given type (calls or puts) with the same
strike price and expiration date are classified as an “option series.”
Example: All XYZ June 110 calls would be an individual series,

while all XYZ June 110 puts would be another series.
 Underlying Asset: The underlying asset is the security which the option
seller has the obligation to deliver to or purchase from the option holder in
the event the option is exercised. In the case of stock options, the
underlying asset refers to the shares of a specific company. Options are also
available for other types of securities such as currencies, indices and
commodities.
 Contract Multiplier: The contract multiplier states the quantity of the
underlying asset that needs to be delivered in the event the option is
exercised. For stock options, each contract covers 100 shares.
 Contract Size of Equity Options: The contract size of an option refers to
the amount of the underlying asset covered by the options contract. For
each unadjusted equity call or put option, 100 shares of stock (usually, but
this may differ from stocks to stocks) will change hands when one contract
is exercised by its owner. These 100 shares of underlying stock are also
referred to as the contract’s “unit of trade.”
 Contract Size of Index Options: The contract size of a cash-settled index
option is determined by its multiplier. The multiplier determines the
aggregate value of each point of the difference between the exercise price
of the option and the exercise settlement value of the underlying interest.
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Lesson 5 - Options
Notes
Example: A multiplier of 100 means that for each point by which a
cash-settled option is in the money upon exercise, there is a $100 increase
in the cash settlement amount.
 Option price: Option price is the price which the option buyer pays to the
option seller. It is also referred to as the option premium.
 Option Style: An option contract can be either american style or european
style. The manner in which options can be exercised also depends on the
style of the option. American style options can be exercised anytime before
expiration while european style options can only be exercise on expiration
date itself. All of the stock options currently traded in the marketplaces are
american-style options.
 Expiration date: The date specified in the options contract is known as the
expiration date, the exercise date, the strike date or the maturity. Option
contracts are wasting assets and all options expire after a period of time.
Once the stock option expires, the right to exercise no longer exists and the
stock option becomes worthless. The expiration month is specified for each
option contract. The specific date on which expiration occurs depends on
the type of option. For instance, stock options listed in the United States
expire on the third Friday of the expiration month.
 Strike Price (K): Also known as the “exercise price,” this is the stated price at
which the buyer of a call has the right to purchase a specific futures contract or
at which the buyer of a put has the right to sell a specific futures contract.
Generally, to simplify matters, the exchanges specify the strike price
interval for different levels of underlying prices, meaning the difference
between one strike price and the next strike price over and below it. It's
relation to the market value of the underlying asset affects the moneyness
of the option and is a major determinant of the option's premium.
Example: The strike price interval for Bharat Heavy Electricals is `

10. This means that there would be strike prices available with an interval
of ` 10. Typically, the investor can see options on Bharat Heavy Electricals
with strike prices of ` 150, ` 160, ` 170, ` 180, `. 190 etc.
Following (Table 5.2) are the strike price intervals specified by exchanges.
Table 5.2: Strike Price Intervals for Options
Price level of Underlying Strike Price Interval (in `)
Less than or equal to 50 2.5
Above 50 to 250 5.0
Above 250 to 500 10.0
Above 500 to 1000 20.0
Above 1000 to 2500 30.0
Above 2500 50.0
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Notes As the price of underlying moves up or down, the exchanges introduce

more strike prices in keeping with the strike price interval rules. At any
point in time, there are at least five strike prices (one near the stock price,
two above the stock price and two below the stock price) available for
trading in one-, two- and three-month contracts.
 American options: American options are options that can be exercised at
any time upto the expiration date. Most exchange-traded options are
American.
 European options: European options are options that 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.
 Index options: These options have the index as the underlying. Some
options are European while others are American. Like index futures
contracts, index options contracts are also cash settled.
 Stock options: Stock options are options on individual stocks. Options
currently trade on over 500 stocks in the United States. A contract gives the
holder the right to buy or sell shares at the specified price.
 Option Premium: The “price” an option buyer pays and an option writer
receives is known as the premium. Premiums are arrived at through open
competition between buyers and sellers according to the rules of the
exchange where the options are traded.
A basic knowledge of the factors that influence option premiums

is important for anyone considering options trading. The premium cost can
significantly affect whether the investor realize a profit or incur a loss.
The premium is the price at which an option trades, and is paid by the buyer to
the writer (seller) of the contract. The premium paid by the buyer is non-
refundable payment for the rights inherent in the long contract. The writer
(seller) of an option contract keeps the premium received, whether assigned or
not, and is in turn obligated to fulfill the short contract’s obligations if
assignment is received.
 Moneyness: In finance, moneyness is a measure of the degree to which a

derivative is likely to have positive monetary value at its expiration, in the
risk-neutral measure. In other words, Moneyness is a term describing the
relationship between the strike price of an option and the current trading
price of its underlying security.
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Lesson 5 - Options
There are three positions in an option: Notes

 In-the-money;
 At-the-money; and
 Out-of-the-money
 In-the-money option: An in-the-money (ITM) option is an option that
would lead to a positive cashflow 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. In-the-money options are
generally more expensive as their premiums consist of significant
intrinsic value on top of their time value.
 Out-of-the-money option: An out-of-the-money (OTM) option is an
option that would lead to a negative cashflow 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.
An out-of-the-money option currently has no intrinsic value —e.g. a

call option is out-the-money if the strike price (“the strike”) is higher than
the current underlying price. An in-the-money option conversely does have
intrinsic value. The strike price of an in-the-money call option is lower than
the current underlying price.
With zero intrinsic value, their entire premium is composed of only

time value. Out-of-the-money options are cheaper than in-the-money
options as they possess greater likelihood of expiring worthless.
 At-the-money option: An at-the-money (ATM) option is an option that
would lead to zero cashflow 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). In other words, an option is at-the-
money if the strike price, i.e., the price the option holder must pay to
exercise the option, is the same as the current price of the underlying
security on which the option is written. ATM options possess no intrinsic
value and contain only time value which is greatly influenced by the
volatility of the underlying security and the passage of time.
Often, it is not easy to find an option with a strike price that is exactly
equal to the market price of the underlying. Hence, close-to-the-money
or near-the-money options are bought or sold instead.
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Notes
Example: Suppose the current stock price of SBI is ` 1,000. A
call or put option with a strike of ` 1,000 is at-the-money. A call option
with a strike of ` 800 is in-the-money (1000 – 800 = 200 > 0). A put
option with a strike at ` 800 is out-of-the-money (800 – 1000 = – 200 <
0). Conversely, a call option with a ` 1200 strike is out-of-the-money
and a put option with a ` 1,200 strike is in-the-money.
 Intrinsic Value of an option: The option premium can be broken down into
two components – intrinsic value and time value. The intrinsic value of a call
is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic
value is zero. Putting it another way, the intrinsic value of a call is Max [0,
(St- K)] which means the intrinsic value of a call is the greater of 0 or (St-
K). Similarly, the intrinsic value of a put is, Max [0, (K- St)] i.e. the greater
value of 0 or (K- St). . St is the spot price at time t; K is the strike price.
 Time Value of an option: The time value of an option is the difference
between its option premium and its intrinsic value. Both calls and puts have
time value. An option that is OTM or ATM has only time value. Usually,
the maximum time value exists when the option is ATM. The longer the
time to expiration, the greater is an option’s time value, all else being
equal. At expiration, an option should have no time value.
Determining Option Classifications
Call Option Put Option
In-the-money Market price>Strike price Market price<strike price
At-the-money Market price=Strike price Market price=strike price
Out-of-the-money Market price<Strike price Market price>strike price
5.3 CALL AND PUT OPTIONS

There are two basic types of options—call options and put options.
1. Call option: A call option gives the holder the right but not the obligation
to buy an asset by a certain date for a certain price.
Example: a Reliance Industries Ltd.(RIL) call conveys the right but

not the obligation to buy RIL shares.
2. Put option: A put option gives the holder the right but not the obligation to
sell an asset by a certain date for a certain price.
Example: a Vodafone put conveys the right one but not the
obligation to sell Vodafone shares.
The price of options is decided between the buyers and sellers on the trading
screens of the exchanges in a transparent manner. The investor can see the best
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Lesson 5 - Options
five orders by price and quantity. The investor can place a market limit order, Notes
stop loss order, etc. The investor can modify or delete his pending orders. The
whole process is similar to that of trading in shares.
In simple words, a call option gives the holder the right to buy an asset at a
certain price within or at the end of a specific period of time. Calls are similar
to having a long position on a stock. Buyers of calls hope that the stock will
increase substantially before the option expires.
Similarly, a put option gives the holder the right to sell an asset at a certain
price within or at the end of a specific period of time. Puts are similar to having
a short position on a stock. Buyers of put options hope that the stock will
decrease substantially before the option expires.
An investor with a long equity call or put position may exercise that contract at
any time before the contract expires, up to and including the Friday (in the
Indian stock market) before its expiration. To do so, the investor must notify
his brokerage firm of intent to exercise in a manner, and by the deadline
specified by that particular firm.
Any investor with an open short position in a call or put option may nullify the
obligations inherent in that short (or written) contract by making an offsetting
closing purchase transaction of a similar option (same series) in the
marketplace. This transaction must be made before the assignment is received,
regardless of whether you have been notified by your brokerage firm to this
effect or not.
Example: Example of a call option: An investor buys one European call

option on refined soybean oil futures at a premium of ` 10 per contract on 31
July. The strike price is ` 560 and the option matures on 30 September. The
payoffs for the investor on the basis of fluctuating spot prices at any time are
shown by the payoff table. It may be clear from the graph that even in the
worst case scenario; the investor would only lose a maximum of ` 10 per
contract which he/she had paid for the premium. The upside to it has an
unlimited profits opportunity.
Table 5.3: Payoff from Call Buying/Long
Spot Price (`) Strike price (`) Premium (`) Payoff (`) Net Profit (`)
530 560 10 0 -10
540 560 10 0 -10
550 560 10 0 -10
560 560 10 0 -10
570 560 10 10 0
580 560 10 20 10
590 560 10 30 20
600 560 10 40 30
610 560 10 50 40
620 560 10 60 50
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Notes Payoff from a call option

A call option gives the following payoff to the investor: max (S - Xt, 0). The
seller gets a payoff of:
-max (S - Xt, 0) or min (Xt - S, 0).
Where
S - Spot Price of the asset
Xt - Exercise Price at time 't'
C - Call Option Premium
Payoff - Max (S - Xt, O)
Payoff from a Call Option
Figure 5.1: Payoff from Call Option

Example of a put option: An investor buys one put option on refined soy oil
futures at a premium of ` 10 per contract on 31 July. The strike price is ` 580
and the contract matures on 30 September. The payoff table shows the
fluctuations of net profit with a change in the spot price.
Table 5.4: Payoff from Put Option
Spot Price Strike price Premium Payoff Net Profit
510 580 10 70 60
520 580 10 60 50
530 580 10 50 40
540 580 10 40 30
550 580 10 30 20
560 580 10 20 10
570 580 10 10 0
580 580 10 0 -10
590 580 10 0 -10
600 580 10 0 -10
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Lesson 5 - Options
Payoff from a put option Notes
Figure 5.2: Net Profit from Put Option

A put option gives the following payoff to the investor: max (Xt- S, 0). The
seller gets a payoff of:
-max (Xt- S, 0) or min (S- Xt, 0).
Where
S - Spot Price of the asset
Xt - Exercise Price at time 't'
C - Call Option Premium
Payoff - Max (S - Xt, O)
These two types are not the opposite of each other, nor are they are offsetting
positions. They are completely separate and different contracts. There are
buyers and sellers for both call option and the put options. The thing that
remains common is the buyer always has the right and the seller of the option
always has an obligation. The buyer of the call option has a right to buy and the
seller has the obligation to sell. But in the case of put options, the buyer
reserves the right of selling and the seller has the obligation to buy. To buy the
right, buyers pay a price which is known as premium. This is paid initially
when the option is bought. Buyers of the options can exercise (use) their rights
either on expiry (European options) or at any time prior to the expiry
(American).
The seller of the option collects the premium for his honouring of the rights.
Because of the obligation that the seller has, the gain potential (premium
received) is limited but the loss potential is unlimited. When the option buyer
decides to exercise his right, the option sellers are obligated to fulfil the rights
contained in an option. In an exchange, there are many option buyers and
sellers of identical options; there is a random selection of the option sellers to
determine which option seller will be exercised on. Although option sellers
cannot initiate the exercise process, they can offset their short option position
ANNA UNIVERSITY 143

Notes by buying an identical option at any time through the close of the last trading
day.
Option Buyer Option seller
Call Right to Buy Obligation to sell
Put Right to Sell Obligation to Buy
Learning Activity
Write a short summary of Options, describing various other types
of options available on an exchange along with their usage.
5.4 AMERICAN AND EUROPEAN OPTIONS

Here, we will describe the American and European options.
5.4.1 American Options
An option that can be utilized anytime during its life. American options permit
option holders for utilizing the option at any time prior to and which includes
its maturity date, thus increasing the value of the option to the holder
corresponding to European options, which can only be utilized at maturity. The
majorly exchange-traded options are Americans.
Since investors have the liberty to utilize their American options at any point
during the life of the contract, they are more precious than European options,
which can only be exercised at maturity.
Example: If you have purchased a Ford March Call option in March

2013, expiring in March of 2014, you would have the right to utilize the call
option at anytime upto its expiration date. Had the Ford option been a
European option, you could only utilize the option at the expiry date, in March
2014. During the year, the share price could have been most favourable for
exercise in December of 2013, but you would have to wait to utilize your
option until March 2014, where it could be out of the money and virtually
irrelevant.
5.4.2 European Options
An option that can only be utilized at the end of its life, at its maturity.
European options have a tendency to sometimes trade at a discount to its
comparable American option. This is because American options permit
investors more opportunities for exercising the contract.
European options usually trade over the counter, while American options
normally trade on standardized exchanges. A buyer of an European options
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Lesson 5 - Options
that doesnot wish to wait for maturity for utilizing it can sell the option to close Notes
the position.
5.5 INTRINSIC VALUE AND TIME VALUE OF OPTIONS

Let us discuss about Intrinsic Value and Time Value of Options:
5.5.1 Intrinsic Value
Intrinsic value represents the amount, if any, by which an option contract is in-
the-money. By definition, at- and out-of-the-money options do not have
intrinsic value. In other words, Intrinsic value is the difference between the
exercise price of the option (strike price, K) and the current value of the
underlying instrument (spot price, S). If the option does not have positive
monetary value, it is referred to as out-the-money. If an option is out-the-
money at expiration, its holder will simply “abandon the option” and it will
expire worthless. Because the option owner will never choose to lose money by
exercising, an option will never have a value less than zero.
For a call option: value = Max [(S – K), 0]
For a put option: value = Max [(K – S), 0]
On the graph at the right, the call option’s intrinsic value begins when the
underlying asset’s spot price exceeds the option’s strike price.
5.5.2 Time Value
Time value represents the portion of an option’s total premium that exceeds its
intrinsic value, if it has any. By definition, the premium of at- and out-of-the-
money options is entirely time value. In other words, time value is, as above,
the difference between option value and intrinsic value, i.e. Time Value =
Option Value - Intrinsic Value.
More specifically, an option’s time value captures the possibility, however
remote, that the option may increase in value due to volatility in the underlying
asset. Numerically, this value depends on the time until the expiration date and
the volatility of the underlying instrument’s price. The time value of an option
is always positive and declines exponentially with time, reaching zero at the
expiration date. At expiration, where the option value is simply its intrinsic
value, time value is zero. Prior to expiration, the change in time value with
time is non-linear, being a function of the option price.
Learning Activity
Jot down a list of attitudes that frequently lead to conflict with
others.
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Notes
Time decay (or time “erosion”) is the inevitable phenomenon of
decay, or decrease, of an option premium’s time value due to the passage of
time. The rate of this decay increases as expiration approaches.
At expiration a call or put is worth only its intrinsic value, if it has any.
The pricing of put and call options is shown in Figure 5.3.
Call Premium Put Premium
Maximum premium
Minimum premium
D Time value
P P
r Time value
e
m
i Intrinsic value
u C Q
m E E
Spot price of underlying
Figure 5.3: Pricing of Put and Call options

An option’s premium is the sum of its intrinsic value and time value. Time
value is the amount option buyers are willing to pay for the possibility that the
option may become profitable/or more profitable before expiration due to
favourable changes in the price of the underlying stock. The time value
component of the option premium can change in response to a change in the
volatility of the underlying, the time to expiry, interest rate fluctuations,
dividend payments and the effect of supply and demand for the option.
An option loses its time value as it approaches expiration, and only the intrinsic
value remains at expiration. Time value is also normally higher when stock
price is close to the exercise price. When prices are much higher, time value
for calls is low because the probability of further upward movements may be
restricted; for put options the probability of the high price falling below
exercise price is also limited. Similarly, when prices are far below exercise
price, time value on calls is limited as prices may not rise enough to cross the
exercise price, and for put options the probability of prices falling further is
also limited.
Learning Activity
Look up in the page dealing with options in any newspaper and
explain your observations. Also, compare the premium of one, two
and three month put and call options for some stocks/index of your
choice.
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Lesson 5 - Options
1. The exchanges decide the strike price at which call and Notes
put options are traded.
2. The two components of an option’s total premium are
intrinsic value and time value.
SUMMARY
 An option is a contract that gives the buyer the right, but not the obligation,
to buy or sell an underlying asset at a specific price on or before a certain
date. An option, just like a stock or bond, is a security. It is also a binding
contract with strictly defined terms and properties.
 FX options are traded in two distinct markets- OTC and Exchange traded
contracts.
 The largest, by far, is the OTC market (OTC just means ‘direct between
counterparties’) which comprises banks, American securities houses and
corporates. There is no central marketplace as such. All transactions are
conducted over the telephone or through the Reuter’s Dealing System and
are open 24 hours a day. Telex is rarely used these days except as a form of
written confirmation for deals already concluded.
 The other market for FX options is the exchange listed markets of the
various stock and futures exchanges around the world. The principal
centres are Philadelphia, where the stock exchange lists options on spot FX
and Chicago, where the Mercantile Exchange lists options on its FX futures
contracts. In both cases, quotations are in the form of currency (rather than
volatility).
 The specifications of Options include – buyer of an option, writer of an
option, option class, option series, contract size of Equity Options, Contract
Size of Index Options, Option price, Expiration date, Strike Price(K),
American options, European options, Index options, Stock options, Option
Premium, Moneyness, Intrinsic value of an option and time value of an
option.
 There are two basic types of options—call options and put options. A call
option gives the holder the right to buy an asset at a certain price within or
at the end of a specific period of time whereas a put option gives the holder
the right to sell an asset at a certain price within or at the end of a specific
period of time.
 American options permit option holders for utilizing the option at any time
prior to and which includes its maturity date, thus increasing the value of
the option to the holder corresponding to European options, which can only
be utilized at maturity. The majorly exchange-traded options are
Americans.
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Notes  European options have a tendency to sometimes trade at a discount to its

comparable American option. This is because American options permit
investors more opportunities for exercising the contract.
 Intrinsic value represents the amount, if any, by which an option contract is
in-the-money whereas time value represents the portion of an option’s total
premium that exceeds its intrinsic value, if it has any.
KEYWORDS
American Option: An option that can be utilized anytime during its life
Call Option: A call option gives the holder the right but not the obligation to
buy an asset by a certain date for a certain price.
European Option: An option that can only be utilized at the end of its life, at
its maturity.
Exchange Traded Options: A class of exchange traded derivatives can be
termed as exchange-traded options (also called “listed options”). They have
standardized contracts and get settled through a clearing house with fulfillment
promised by the Options Clearing Corporation (OCC). With the
standardization of contracts, accurate pricing models are normally available.
Over-the Counter Options: In case of over-the-counter options (also called
‘dealer options’), they are traded between two private parties and they are not
listed on an exchange. OTC terms are unrestricted and may be individually
customized in order to meet any business need. Generally, atleast one of the
counterparties to an OTC option is a well-capitalized institution.
Put Option: A put option gives the holder the right but not the obligation to
sell an asset by a certain date for a certain price.
1. What are Options?
2. Define Exchange Traded Options.
3. What are over-the counter options?
4. Differentiate between Exchange Traded Options and Over-the-counter
options.
5. Discuss at least five specifications of options contract.
6. State the difference between call options and put options.
7. What are American options?
8. What are European Options?
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Lesson 5 - Options
9. Define Intrinsic value of options. Notes

10. What do you mean by time value of options?
1. Explain the two distinct markets where foreign exchange options are
traded? Discuss in detail with the comparison of the two markets.
2. “Option contracts may be quite tedious, however, at minimum they
generally consists of some major specifications.” Explain in detail.
3. Analyze the call and put options in respect of buying and selling of an asset
in an exchange. How the two options differ?
4. Distinguish between American Options and European Options.
5. Analyze the pricing of put and call options with a suitable diagram using
intrinsic value and time value of an option.
FURTHER READINGS

Step Guide to Forwards, Futures, Swaps & Options, 2nd edition.
John Wiley & Sons.
Hull, C, John and Basu, Sankarshan (2010), Options, Futures and
Other Derivatives, 7th edition, Pearson Education India.
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Notes
LESSON 6 - OPTIONS PRICING AND PAYOFF
CONTENTS
Learning Objectives
Learning Outcomes
Overview
6.1 Option Payoff
6.2 Options on Securities
6.3 Options on Stock Indices
6.4 Options on Currencies and Futures
6.4.1 Currency Option
6.4.2 Futures Option
6.5 Options Pricing Models
6.5.1 European Call Option and European Put Option
6.6 Differences between Future and Options Contracts
Summary
Keywords
Further Readings
LEARNING OBJECTIVES
 Determine the Option payoff
 Understand Options on Securities
 Explain Stock Indices and Options pricing models
 Describe Currencies option and Futures Option
 Differentiate between Future and Option contracts
LEARNING OUTCOMES
understanding of:
 the fact that the writer of an option gets paid the premium. The payoff from
the option writer is exactly opposite to that of the option buyer.
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Lesson 6 - Options Pricing and Payoff
 the concept that the profit/loss that the buyer makes on the option depends Notes
on the spot price of the underlying. Whatever is the buyer’s profit is the
seller’s loss.
 the datum that the index options offers diversification as investors are
exposed to a large number of securities in one trading instrument. The
degree of exposure differs with the specific index option.
OVERVIEW
In the previous lesson you had studied about the Exchange Traded options-
Definition and OTC options, specification of Options, Call and Put Options,
American and European Options and Intrinsic and Time Value of Options.
Options trading have been done for many centuries by traders using their
instincts to guide the choice of prices. At the dawn of modern financial
economics, researchers faced the challenge of finding a scientific theory which
would yield an explicit solution to the question of how options can be priced.
The identity of the underlying asset impinges upon option pricing via the
volatility of returns on the asset. Options on more volatile assets are more
valuable e.g. the insurance premium would be higher if there was more
uncertainty about an outcome. When the volatility of an asset goes up, options
on that asset become more valuable.
To understand better the significance and option pricing techniques, we have to
go through two important models of option valuation like Black-Scholes model
and the Binomial model.
In this lesson, you will learn about the Option payoff, Options on Securities,
Stock Indices, Currencies option and Futures Option, and Options pricing
models. At the end of the lesson you will be studying about the difference
between future and Option contracts.
6.1 OPTION PAYOFF

The optionality characteristic of options results in a non-linear payoff for
options. In simple words, it means that the losses for the buyer of an option are
limited, however the profits are potentially unlimited. The writer of an option
gets paid the premium. The payoff from the option writer is exactly opposite to
that of the option buyer. His profits are limited to the option premium, however
his losses are potentially unlimited. These nonlinear payoffs are fascinating as
they lend themselves to be used for generating various complex payoffs using
combinations of options and the underlying asset.
Payoff for Buyer of Call Options: Long Call
A call option gives the buyer the right to buy the underlying asset at the strike
price specified in the option. The profit/loss that the buyer makes on the option
depends on the spot price of the underlying. If upon expiration, the spot price
exceeds the strike price, he makes a profit. Higher the spot price, more is the
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Notes profit he makes. If the spot price of the underlying is less than the strike price,
he lets his option expire un-exercised. His loss in this case is the premium he
paid for buying the option. Figure 6.1 gives the payoff for the buyer of a three
month call option on gold (often referred to as long call) with a strike of ` 7000
per 10 gms, bought at a premium of ` 500.
The figure shows the profits/losses for the buyer of a three-month call option
on gold at a strike of ` 7000 per 10 gms. As can be seen, as the prices of gold
rise in the spot market, the call option becomes in-the-money. If upon
expiration, gold trades above the strike of ` 7000, the buyer would exercise his
option and profit to the extent of the difference between the spot gold-close and
the strike price. The profits possible on this option are potentially unlimited.
However if the price of gold falls below the strike of ` 7000, he lets the option
expire. His losses are limited to the extent of the premium he paid for buying
the option.
Figure 6.1: Payoff for Buyer of Call Option on Gold
Payoff for Writer or Call Options: Short Call

A call option gives the buyer the right to buy the underlying asset at the strike
price specified in the option. For selling the option, the writer of the option
charges a premium. The profit/loss that the buyer makes on the option depends
on the spot price of the underlying. Whatever is the buyer’s profit is the seller’s
loss. If upon expiration, the spot price exceeds the strike price, the buyer will
exercise the option on the writer. Hence as the spot price increases the writer of
the option starts making losses. Higher the spot price, more is the loss he
makes. If upon expiration the spot price of the underlying is less than the strike
price, the buyer lets his option expire un-exercised and the writer gets to keep
the premium. Figure 6.2 gives the payoff for the writer of a three month call
option on gold (often referred to as short call) with a strike of ` 7000 per 10
gms, sold at a premium of ` 500.
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Notes
Figure 6.2: Payoff for Writer of Call Option
Payoff for Buyer of Put Options: Long Put

A put option gives the buyer the right to sell the underlying asset at the strike
price specified in the option. The profit/loss that the buyer makes on the option
depends on the spot price of the underlying. If upon expiration, the spot price is
below the strike price, he makes a profit. Lower the spot price, more is the
profit he makes. If the spot price of the underlying is higher than the strike
price, he lets his option expire un-exercised. His loss in this case is the
premium he paid for buying the option. Figure 6.3 gives the payoff for the
buyer of a three month put option (often referred to as long put) with a strike of
2250 bought at a premium of 61.70.
Figure 6.3: Payoff for Buyer of a Put: Long Put
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Notes Payoff for Writer of Put Options: Short Put

A put option gives the buyer the right to sell the underlying asset at the strike
price specified in the option. For selling the option, the writer of the option
charges a premium. The profit/loss that the buyer makes on the option depends
on the spot price of the underlying. Whatever is the buyer’s profit is the seller’s
loss. If upon expiration, the spot price happens to the below the strike price, the
buyer will exercise the option on the writer. If upon expiration the spot price of
the underlying is more than the strike price, the buyer lets his option expire un-
exercised and the writer gets to keep the premium. Figure 6.4 gives the payoff
for the writer of a three month put option (often referred to as short put) with a
strike of 2250 sold at a premium of 61.70.
Figure 6.4: Payoff for Writer of a Put: Short Put

The payoffs from European options depend on the underlying stock price at
expiration. If the stock price at expiration is S and exercise/strike price is E,
cost of buying the call option is C, and put option is P, the payoff is calculated
as follows:
For the buyer of a call:
 if S <E, the call will not be exercised so the payoff is 0 – C
 if S >E, the call will be exercised and payoff is S – E – C,
Therefore the payoff = Max [0, S – E] – C
For the buyer of a put:
 if S >E, the put will not be will be exercised and payoff is 0 – P
 if S <E, the put will be exercised so the payoff is E – S – P
154 ANNA UNIVERSITY

Therefore, the payoff = Max [0, E – S] – P Notes

For the seller of puts and calls the payoff = –(payoff for the buyer)
The payoffs from options can be easily understood with the help of numerical
examples and graphs.
Example: Take the example of ACC from Table 6.1. Exercise price
1000, call premium approx 26 and put premium 20. We can calculate the
payoffs for option buyers and sellers by assuming spot prices for ACC ranging
from 900-1100.
Table 6.1: Payoffs for ACC Put and Call Options
Call option Put option

For Buyer If S>E, Profit = S – E – For Buyer If S<E, Profit= – E – S – P
C If S<C Loss = C If S>C Loss = P
Share
Buyer Seller Buyer Seller
price
900 not exercised -26 26 exercised 80 -80
980 not exercised -26 26 exercised 0 0
1000 Optional -26 26 optional -20 20
1020 Exercised -6 6 not exercised -20 20
1026 Exercised 0 0 not exercised -20 20
1040 Exercised 14 -14 not exercised -20 20
As can be seen from the payoff table, when a call or put option is not
exercised, the sellers profit is equal to the premium received.
When the option is exercised, the premium is reduced from the loss.
ANNA UNIVERSITY 155

Notes 100
80
60
40
20
Payoff Buyer
0
Seller
-20
-40
-60
-80
-100
900 920 940 960 980 1000 1020 1040 1060 1080 1100
Share Price
Figure 6.5: ACC Call Option
100
80
60
40
20
Payoff
Buyer
0
-20
Seller
-40
-60
-80
-100
900 920 940 960 980 1000 1020 1040 1060 1080 1100
Share Price
Figure 6.6: ACC Put Option

The charts depicting payoffs for call and put options and Figures 6.5 and 6.6
reveal that options are a zero – sum game. The payoffs for buyers and sellers of
options are a mirror image – symmetrical and opposite in sign. While drawing
the graph, it is worth noting that the turning point of the payoffs is always at
the exercise price.
Shares and options can be bought individually or in combinations

for hedging and profit making.
Some of the most common combinations are discussed here and payoff
diagrams are given in Figures 6.3 to 6.6.
156 ANNA UNIVERSITY

A Position in a Share and an Option Notes

We use the example of ACC to illustrate the payoffs, the share price of ACC
on 9th November 2006 was approximately ` 998.
Long share long put: Own a stock and buy a put (payoff resembles a long call)
can be seen in Figure 6.7.
Short stock short put: Short sell a stock and sell a put (payoff resembles a
short call) is shown in Figure 6.8.
Long stock short call: Own a stock and sell a call i.e., write a covered call, Figure
6.9 (resembles short put). If the ACC share is bought (or was owned) on 9th
November 2006 at approx ` 1,000 with the intention to sell it at 1,040 in the next
one or two months and make profit of 40. Sell a Nov 1,040 call for ` 9, if the call
is exercised the gain is 49, if not exercised, ` 9 extra was earned on the call.
Short stock long call: Short sell a stock and buy a call option (payoff
resembles a long put) as can be seen in Figure 6.10.
150
100
50
Long Share
Payoff
0 Long Put
Both
-50
-100
-150
900
920
940
960
980
1000
1020
1040
1060
1080
1100
Share Price
Figure 6.7: ACC Long Stock Long Put
150
100
50
Short Share
Payoff
0 Short Put
Both
-50
-100
-150
900 920 940 960 980 1000 1020 1040 1060 1080 1100
Share Price
Figure 6.8: ACC Short Stock Short Put
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Notes 150
100
50 Long Stock
Payoff
0 Short Call
-50 Both
-100
-150
900 920 940 960 980 1000 1020 1040 1060 1080 1100
Share Price
Figure 6.9: ACC Long Stock Short Call (Write a Covered Call)
150
100
50
Short Stock
Payoff
0 Long Call
Both
-50
-100
-150
900 920 940 960 980 1000 1020 1040 1060 1080 1100
Share Price
Figure 6.10: ACC Short Stock Long Call

Option Spreads
Buy an option and sell another option on the same stock. For a price/vertical
spread choose same expiry month, but different exercise prices. Bullish price
spreads are used when prices are expected to rise; buy the call/put with lower
exercise price and sell the one with higher strike price. For bearish spreads
when prices are expected to fall do just the opposite. For time/horizontal/
calendar spreads, the exercise price is the same but expiry months are different.
Bull spreads using ACC call options and put options are depicted in Fig 6.11
When share price is below ` 1000, both options are not exercised, the net
premium paid out = –26 + 9 = –17. When only one option is exercised between
1000 and 1,040, the profit/loss = share price – 1000 – 17, and break-even is at
1017. When share price crosses 1,040 both calls are exercised and profit
=1040-1000 –17= +23. Here the maximum risk is –17 and maximum reward is
23. Risk return combinations need to be studied along with expected market
movements when option spreads are used.
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200 Notes
150
100
50 Buy Call 1000/26
Payoff
0 Sell Call 1040/9

-50 Both
-100
-150
-200
900 940 980 1020 1060 1100 1140 1180
Share Price
Figure 6.11: ACC Bull Spread with Calls – Buy Low Sell High
A bull spread with put options is depicted in Figure 6.12. As can be seen, when
the share price is below 1000, both put options are exercised, the profit/loss =
+1000 –1040 – 20 + 48 = –12. When the share price is between 1000 and 1040
profit/loss = +1000 –share price –20 + 48, and break even is at 1028. When
share price is above 1040 no put option is exercised and profit is the net
premium = +48 – 20 = 28.
100
50
0 Buy Put 1000/20

Payoff
Sell Put 1040/48

-50 Both
-100
-150
900 940 980 1020 1060 1100 1140 1180
Share Price
Figure 6.12: ACC Bull Spread with Puts – Buy Low Sell High
Other Combinations
Straddle top/straddle write: Sell a call and a put on the same share with the
same exercise price and expiration date. These are used when prices are
expected to fluctuate in a narrow range near the exercise price. For a straddle
bottom/straddle purchase, buy a call and a put, when prices are expected to
fluctuate widely in both directions. Straddle top and bottom are shown in
Figure 6.13 and 6.14.
ANNA UNIVERSITY 159

Notes 100
50
0 Sell Call 1000/26
Payoff
-50 Sell Put 1000/20
-100 Both
-150
-200
900 940 980 1020 1060 1100 1140 1180
Share Price
Figure 6.13: ACC Straddle Top – Sell Call Sell Put

200
150
100
Buy Call 1000/26
Payoff
50 Buy Put 1000/20

Both
0
-50
-100
900 940 980 1020 1060 1100 1140 1180
Share Price
Figure 6.14: ACC Straddle Bottom – Buy Call Buy Put

Strips and straps: For a strip, purchase (Figure 6.15) two puts and one call
having the same expiration and exercise price (like a straddle bottom, with
double the profit potential on the lower side). For a strap, buy two calls and one
put having the same expiration and strike price (like a strip with double the
profit potential when prices fluctuate on the higher side).
200
150
100
Buy Call 1000/26
Payoff
50 Buy Two Puts 1000/20

Both
0
-50
-100
900 940 980 1020 1060 1100 1140 1180
Share Price
Figure 6.15: ACC Strip – Buy Call Buy Two Puts
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Strangle: Buy a call and a put with different exercise prices (a long strangle), Notes
or sell a call and a put with different exercise prices (a short strangle). A long
strangle is illustrated in Figure 6.16.
80
60
40
Buy Call 1020
Payoff
20
Buy Put 1000
0
Both
-20
-40
-60
900 920 940 960 980 1000 1020 1040 1060 1080 1100
Share Price
Figure 6.16: Strangle Buy 1 Call and 1 Put

Butterflies involve four trading positions with three different exercise prices.
Long butterfly – buy 1 call with low exercise price, and one with higher
exercise price, sell 2 calls with exercise exactly midway between these two
(Figure 6.17). Alternatively, purchase 2 puts and sell 2 puts with exercise price
exactly midway. For a short butterfly, do just the opposite with either calls or
puts.
150.00
100.00
50.00 Buy Call 960
Payoff
0.00 Sell 2 Calls 1000

-50.00 Buy Call 1040
-100.00 All Four
-150.00
-200.00
900 940 980 1,020 1,060 1,100
Share Price
Figure 6.17: Butterfly Spread – Buy 2 Calls Sell 2 Calls

Iron butterfly: Contains four options with a combination of puts and calls. It is
equivalent to a regular butterfly spread which contains either puts or calls at
three strike prices. A long iron butterfly is a combination of a bull and a bear
spread with calls and puts respectively. This can be seen in Figure 6.18.
ANNA UNIVERSITY 161

Notes
100.00
80.00
60.00
Buy Call 950
40.00
20.00 Sell Call 1000
Payoff
0.00 Sell Put 1000
-20.00 Buy Put 1050
-40.00
All Four
-60.00
-80.00
-100.00
900 940 980 1,020 1,060 1,100
Share Price
Figure 6.18: Iron Butterfly

Box spreads: Any combination of options that has a constant payoff at
expiration.
Example: A long butterfly made with calls combined with a short

butterfly made with puts, or a bull spread with calls combined with a bear
spread with puts will have a constant payoff. In practice, the profit if any is
wiped out by commissions.
Time spreads involve the purchase and sale of options with the same exercise
price in two different expiration months, either both calls or puts. A long
call/put time spread involves selling near and buying far. A short time spread
or put time spread is simply the reverse i.e., buy near and sell far. The
maximum risk of purchasing a time spread is the net premium paid. The cost of
holding a long position is reduced by the premium collected from the option
sold. The maximum value depends on the value of the later month option when
the near option expires. One of the risks of time spreads is that the option sold
may get exercised and assigned. Also, one option in the position expires before
the other, which needs to be kept in mind.
6.2 OPTIONS ON SECURITIES

Options on securities consist of: Equity Option, Bond option, Futures Option,
Index Option and Commodity Option.
 Equity Options: The most common type of equity derivative is equity
option. They gives the right, but not the obligation, to buy (call) or sell
(put) a quantity of stock (1 contract = 100 shares of stock), at a set price
(strike price), within a specified period of time (prior to the expiration
date).
 Bond Options: A bond option is an option for buying or selling a bond at a
specific price on or before the option expiry date. These instruments are
normally traded over-the-counter.
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 A European bond option is an option for buying or selling a bond at a Notes

specific date in future for a predetermined price.
 An American bond option is an option for buying or selling a bond on
or before a particular date in future for a predetermined price.
Normally, one purchases a call option on the bond if one thinks that interest
rates will fall, leading to an increase in bond prices. Similarly, one
purchases the put option if one things that the opposite will be the case.
One outcome of trading in a bond option is that the price of the underlying
bond is “locked-in” for the term of the contract, thereby minimizing the
credit risk linked with the fluctuations in the bond price.
 Futures Option: An option on a futures contract provides the holder the
right to enter into an agreed futures contract. If the option is exercised, the
initial holder of the option would make an entry into the long side of the
contract and would buy the underlying asset at the futures price.
A short option on a futures contract permits an investor to make an

entry into a futures contract as the short who would be supposed to sell the
underlying asset on the future date at the particular price.
 Index Option: Index options provide the investors an exposure to the

securities consisting of a stockmarket index.
They provide them an identical flexibility to that offered by options over
individual stocks, while permitting them to trade on the market view as a
whole, or on the market sector covered by the particular index.
While the value of a share option differs as per the movements in the value
of the underlying shares, an index option differs as per the movements in
the underlying index.
 Commodity Option: A contract allowing the option buyer the right, without
obligation to buy or sell an underlying asset in a commodity form such as
precious metals, oil, or agricultural products at a specified price until a
specified date.
6.3 OPTIONS ON STOCK INDICES

A financial derivative that provides the holder the right, but not the obligation,
to buy or sell a basket of stocks, such as the S&P 500, at an accepted-upon
price and before a specific date. An index option is identical to other options
contracts, the difference being the underlying instruments are indexes.
Index options offers diversification as investors are exposed to a large number

of securities in one trading instrument. The degree of exposure differs with the
ANNA UNIVERSITY 163

Notes specific index option. The famous index options include S&P 500 Index
Options (SPX), Dow Jones Industrial Average Index Options (DJX) and
Nasdaq-100 Index Options (NDX). Index options are typically cash settled.
6.4 OPTIONS ON CURRENCIES AND FUTURES

Let us discuss currency option first and then futures option as under:
6.4.1 Currency Option
A contract that gives the holder the right, but not the obligation, to buy or sell
currency at a particular exchange rate during a particular period of time. For
this right, broker is paid a premium, which will differ based on the number of
contracts purchased. Currency options are one of the best ways for
corporations or individuals for hedging against unfavourable movements in
exchange rates.
Hedging against foreign currency risk can be done by the investors by
purchasing a currency option put or call.
Example: Let us say that an investor believes that the USD/EUR rate is
going to increase from 0.80 to 0.90 stating that it will become more costly for a
European investor to purchase US dollars. In this situation, the investors would
like to purchase a call option on USD/EUR so that he or she could stand to
benefit from an increase in the exchange rate( or the USD rise).
6.4.2 Futures Option
An options contract where the underlying is a single futures contract is known
as futures option. The futures option givers the buyer the right but not the
obligation for assuming a specific futures position at a particular price(or the
strike price) any time before the option expires. The seller of the futures option
must assume the opposite futures position when the buyer exercises this right.
Futures options normally expire near the end of the month that
comes before the delivery month of the underlying futures contract (i.e.
March option expires in February) and very frequently, it is on a Friday.
Strike Price
The price at which the futures position will get started in the trading accounts
of both the buyer and the seller if the futures option is utilized.
Example: At the time of exercising futures option, a futures position

gets commenced at the predetermined strike price in both the buyer and the
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seller’s account. Based on whether a call or a put is exercised, the option buyer Notes
and seller will expect either a long position or a short position.
Table 6.2: Futures Position Assumed upon Option Exercise
Assumption of Buyer Assumption of Seller

Call option Long Futures Position Short Futures position
Put option Short Futures position Long Futures Position
Source: http://www.theoptionsguide.com/futures-option.aspx
It is therefore, necessary to remember that the underlying of a futures options is

the futures contract, not the commodity. Therefore, the option price moves
simultaneously with the futures price and not the commodity price. Irrespective
of the tracking the commodity price closely by the futures price, they are not
identical in any respects. For highly leveraged products like options, the effect
of such tiny differences can be greatly maximized.
6.5 OPTIONS PRICING MODELS

First we need to understand the various factors that affect the price of options
on stocks. We shall look at the impact of changes in each of these factors on
option prices one at a time, assuming that all other factors remain the same. For
a given type and style of option contract, there are six primary factors affecting
its price. They are:
 Current Stock Price: The option price changes as per changing stock price.
In case of a call option the payoff for the buyer is Max (S - Xt, 0) therefore,
more the spot price, more is the payoff and it is favourable for the buyer.
Example: For a call option the option price rises as the stock price
increases and vice-versa. As the current stock price goes up, the higher is the
probability that the call will be in the money. As a result, the call price will
increase. The effect will be in the opposite direction for a put. As the stock
price goes up, there is a lower probability that the put will be in the money. So
the put price will decrease.
 Exercise Price: In the case of a call, as the exercise price increases, the
stock price has to make a larger upward move for the option to go in–the–
money. Therefore, for a call option, as the exercise price increases, options
become less valuable and as the strike price decreases they become more
valuable. The higher the exercise price, the lower the probability that the
call will be in the money. So for call options that have the same maturity,
the call with the price that is closest (and greater than) the current price will
have the highest value. The call prices will decrease as the exercise prices
increase. For the put, the effect runs in the opposite direction. A higher
exercise price means that there is higher probability that the put will be in
the money. So the put price increases as the exercise price increases.
ANNA UNIVERSITY 165

Notes  Volatility: The volatility of a stock price represents the uncertainty attached
to its future movement. This measures the degree to which the price of the
underlying instruments tends to fluctuate over time. Both the call and put
option will increase in price as the underlying asset becomes more volatile.
As volatility increases, the likelihood that the stock will do very well or
very poorly increases. The value of both calls and puts therefore increase as
volatility increases. The buyer of the option receives full benefit of
favourable outcomes but avoids the unfavourable ones (option price value
has zero value).
 Risk free Interest Rates: The risk-free interest rate is the interest rate that
may be obtained in the marketplace with virtually no risk. The affect of the
risk-free interest rate is less clear-cut. It is found that put option prices
decline as the risk-free rate increases whereas the prices of calls always
increase as the risk-free interest rate increases. The higher the interest rate,
the lower the present value of the exercise price. As a result, the value of
the call will increase. The opposite is true for puts. The decrease in the
present value of the exercise price will adversely affect the price of the put
option. All other factors remaining constant, the higher the interest rate the
greater the cost of buying the underlying asset and carrying it to the
expiration date of the call option. Hence, the higher the short risk free
interest rate, the greater the price of a call option.
 Cash Dividends: Dividends have the effect of reducing the stock price on
the ex-dividend date. This has a negative effect on the value of call options
and a positive effect on the value of put options. When dividends are
announced then the stock prices on ex-dividend are reduced. This is
favourable for the put option and unfavourable for the call option. On ex-
dividend dates, the stock price will fall by the amount of the dividend. So
the higher the dividends, the lower the value of a call relative to the stock.
This effect will work in the opposite direction for puts. As more dividends
are paid out, the stock price will jump down on the ex-date which is exactly
what you are looking for with a put.
 Time to Expiration: Generally, both calls and puts will benefit from
increased time to expiration. The reason is that there is more time for a big
move in the stock price. Consider the case of two options that differ only as
far as their expiration date is concerned. The owner of the long-life option
has all the exercise opportunities open to the owner of the short-life option
and more. The long–life option must therefore always be worth at least as
much as the short life option As the time to expiration increases, the
present value of the exercise price decreases. This will increase the value of
the call and decrease the value of the put. Also, as the time to expiration
increases, there is a greater amount of time for the stock price to be reduced
by a cash dividend. This reduces the call value but increases the put value.
Let’s summarize these effects in Table 6.3 as given below. The table shows
all effects on the buyer side of the contract.
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Table 6.3: Determinants of Option Value Notes

Sl.No. Factors Effect of Increase on
Value of Call Option Value of Put Option
1 Current Stock/Spot Price Increase Decrease
2 Exercise Price Decrease Increase
3 Volatility Increase Increase
4 Risk-free Interest Rate Increase Decrease
5 Dividends Decrease Increase
6 Time to Expiration Increase Increase
Now, we would understand what are the options pricing models :

Option pricing theory—also called Black-Scholes theory or derivatives
pricing theory—traces its roots to Bachelier (1900) who invented Brownian
motion to model options on French government bonds. This work anticipated
Einstein’s independent use of the Brownian motion in physics by five years.
The Black-Scholes model gives theoretical values for European put and call
options on non-dividend paying stocks. The key argument is that traders could
risklessly hedge a long options position with a short position in the stock and
continuously adjust the hedge ratio (the delta value—one of the option
sensitivities known as “greeks”) as needed. Assuming that the stock price
follows a random walk, and using the methods of stochastic calculus, a price
for the option can be calculated where there is no arbitrage profit. This price
depends only on five factors: the current stock price, the exercise price, the
risk-free interest rate, the time until expiration, and the volatility of the stock
price. Eventually, the model was adapted to be able to price options on
dividend paying stocks as well.
The availability of a good estimate of an option’s theoretical price contributed
to the explosion of trading in options. Other option pricing models have since
been developed for other markets and situations using similar arguments,
assumptions, and tools, including the Black model for options on futures,
Monte Carlo methods, Path Integrals, and Binomial options models.
In theory, traders could buy cheap options and sell expensive options (relative
to their theoretical prices), in quantities such that the overall delta is zero, and
expect to make a profit. Nevertheless, implementing this in practice may be
difficult because of “stale” stock prices, large bid/ask spreads, market closures
and other symptoms of stock market illiquidity.
If stock market prices do not follow a random walk (due, for

example, to insider trading) this delta neutral strategy or other model-based
strategies may encounter further difficulties. Even for veteran traders using
very sophisticated models, option trading is not an easy game to play.
ANNA UNIVERSITY 167

Notes The Black- Scholes Model

The Black-Scholes model is used to calculate a theoretical call price (ignoring
dividends paid during the life of the option) using the five key determinants of
an option’s price: stock price, strike price, volatility, time to expiration, and
short-term (risk free) interest rate.
The original formula for calculating the theoretical option price (OP) is as
follows:
OP = SM(d1) – Xe-rtN(d2)
Where:
S v2
In ( ) + (r+ ) × t
d1 = X 2
v t
d2 = d1 – v t
The variables are:
S = stock price
X = strike price
t = time remaining until expiration, expressed as a
percent of a year
r = current continuously compounded risk-free
interest rate
v = annual volatility of stock price (the standard
deviation of the short-term returns over one
year).
ln = natural logarithm
N(x) = standard normal cumulative distribution
function
e = the exponential function
or
The Black-Scholes model for valuing a European call is:
C = SN(d1) – Xe–r(T–t) N(d2)
Where,
S
In ( ) + (r+ s 2 / 2(T- t))
D1 = X
s T- t
168 ANNA UNIVERSITY

D2 = d1- s T- t Notes
C = Call option premium
S = Current asset price
X = Exercise price
T-t = Time to expiry in decimals of a year
 = The annualized standard deviation of the
natural log of the asset price relative in
decimals
ln = Natural logarithm
N(d1) = Cumulative standard normal probability
distribution
d1 abd d2 = Standardised normal variables
r = Risk-free rate on interest in decimals
(continuously compounded)
Example 1: The current asset price is 35.0, the exercise price is 35.0,
the risk-free rate of interest is 10%, the volatility is 20% and the time to expiry
is one year. Thus S = 35, X = 35, (T – t) = 1.0, r = 0.1 and  = 0.2.
Solution:
First, we calculate d1, then d2 and, finally, the present value of the exercise
price Xe–r(T – t)
In(35 / 35) + (0.1 + 0.22 / 2) ×1.0
d1 = = 0.60
0.2 1.0
d 2 - d1- 0.2 1.0 = 0.4
Xe–r(T – t) = 35e–(0.1 × 1.0) = 31.66934
Then, the equation for the call looks like this:
c = 35N(0.6) – 31.6693N(0.4)
Here d1 is a standardised normal random variable N(d1) is a cumulative
standardised normal probability distribution. It represents the area under the
standardised normal curve from Z.
By referring to mathematical table given at the end of book on the standardised
normal distribution we can arrive at the values of –N(d1) and N(d2) as follows:
The value of N(d1) when d1 = 0.6 is 0.7257
ANNA UNIVERSITY 169

Notes The value of N(d2) when d2 = 0.4 is 0.6554

When the above values are substituted in the equation, then
c = 35 (0.7257) – 31.6693 (0.6554) – 4.6434
Valuing Put Options with the Black Scholes Model
An alternative form of valuation is to use the Black-Scholes formula for a put,
which is:
P = Xe–r(T – t) [(1 – N(d1)1] – S[1 – N(d1)
Where d1 and d2 are as given in the section deriving a call option.
Note that [1 – N(d2)] is the same as N(–d2) and [1 – N(d1)] is the same as
N(–d1).
Using the same data that we used in valuing the call, the put option value is
calculated as follows:
P = 31.6693 (0.3446) – 35(0.2743) = 1.3127
Example 2: Calculate the value of option from the following

information
S = ` 20, K = ` 20, t = 3 months or 0.25 years
r = 1296 = 0.12,  2 = 0.16
Solution:
Since d1 and d2 are required inputs for Black-Scholes Option Pricing Model.
ln (20/20) + (0.12+(0.16/2)(0.25) 0  0.05
d1 =  = 0.25
0.40(0.50) 0.20
d2 = d1 – 0.20 = 0.05
N(d1) = N(0.25)
N(d2) = N(0.05)
The above two represent area under a standard normal distribution function.
From the Normal Distribution table, we see that value d1 = 0.25 implies a
probability of 0.0987 + 0.5000 = 0.5987, so N(d1) = 0.5987. Similarly, N(d2) =
0.5199. We can use those values to solve the equation in Black-Scholes Option
Pricing Model
C = ` 20 [N(d1)] – ` 20 e(–0.12 × 0.25) [N(d2)]
= ` 20 [N(0.25)] – ` 20(0.9704)[N(0.05)]
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= ` 20(0.5987) – ` 19.41 (0.5199) Notes

= ` 11.97 – ` 10.09
= ` 1.88
Example 3: The stock option has 120 days until expiration and the
strike price is ` 85. The simple rate of interest is 6% p.a. The underlying asset
value is ` 80 and the volatility (standard deviation) is 0.30.Calculate the value
of the stock option.
Solution:
Working notes
1. The number of days to expiration must be converted into years by dividing
by 365
Thus t = 120/365 = 0.329
2. The simple annual interest must be converted to the Black-Scholes
continuously compounded equivalent using the relationship that 1 + R = er,
making r = ln (1 + R).
Now r = ln (1.06) = 0.0583
Now we can find the values of d1and d2 as follows:
ln(80/85) + (0.0583+0.5 × 0.32 ) × 0.329

d1 = = –0.155
(0.3)(0.3295 )
ln(80/85) + (0.0583–0.5 × 0.32 ) × 0.329

d2 = = –0.327
(0.3)(0.3295 )
The next step is to look up the N(d1) and N(d2) values in a table of such values.
Note that N(d1) = N (–0.155) and N(d2) = (–0.327) represent areas under a
standard normal distribution function. From the table given at the end of the
book, we see that the value of d{ = 0.155 implies the area under the normal
curve to the left of –0.155, which is approximately (interpolating from the
table) .438.
The value of N(d2) is found in a similar fashion to be approximately 0.372.
Now, we can insert the above values in Black-Scholes formula, to obtain the
value of the stock option. = 80 × .438 × e(–00583x329) × .372 = ` 4.03
Lognormal Distribution
The model is based on a normal distribution of underlying asset returns, which
is the same thing as saying that the underlying asset prices themselves are
lognormally distributed. A lognormal distribution has a longer right tail
compared with a normal, or bell-shaped, distribution. The lognormal
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Notes distribution allows for a stock price distribution between zero and infinity (i.e.
no negative prices) and has an upward bias (representing the fact that a stock
price can only drop 100% but can rise by more than 100%).
In practice, underlying asset price distributions often depart significantly from
the lognormal.
Example: Historical distributions of underlying asset returns often have

fatter left and right tails than a normal distribution indicating that dramatic
market moves occur with greater frequency than would be predicted by a
normal distribution of returns – i.e. more very high returns and more very low
returns.
A corollary of this is the volatility smile – the way in which at-the-money
options often have a lower volatility than deeply out-of- the-money options or
deeply in-the- money options.
Modified Black-Scholes and binomial pricing models (using implied binomial
trees) are deployed for European and American option pricing with non-
lognormal distributions. These models can be used to gauge the impact on
option prices of non-lognormal price distributions (as measured by coefficients
of skewness (symmetry) and kurtosis (fatness of distribution tails and height of
peaks)), and to calculate and plot the volatility smile implied by these
distributions.
Measuring the degree to which historical asset price distributions diverge from
the lognormal (as measured by coefficients of skewness and kurtosis).
Advantage and Limitation of Black-Scholes Model
Advantage: The main advantage of the Black-Scholes model is speed – it lets
you calculate a very large number of option prices in a very short time.
Limitation: The Black-Scholes model has one major limitation: it cannot be
used to accurately price options with an American-style exercise as it only
calculates the option price at one point in time – at expiration. It does not
consider the steps along the way where there could be the possibility of early
exercise of an American option.
As all exchange traded equity options have American-style exercise (i.e. they
can be exercised at any time as opposed to European options which can only be
exercised at expiration) this is a significant limitation.
The exception to this is an American call on a non-dividend paying asset. In
this case, the call is always worth the same as its European equivalent as there
is never any advantage in exercising early.
Various adjustments are sometimes made to the Black-Scholes price to enable
it to approximate American option prices (e.g. the Fischer Black Pseudo-
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American method), but these only work well within certain limits and they Notes
don’t really work well for puts.
6.5.1 European Call Option and European Put option
A European, put or call, option is like a forward contract. There is an
underlying asset usually taken to be a share of stock, a strike price X, and an
expiration date. At the expiration date, the holder of a call option has the right
to buy a share of the asset at the strike price, while the holder of a put option
has the right to sell a share of the asset at the strike price X. However, at
expiration date, the holder of the option does not have to exercise the option, in
contrast to a forward contract.
An American option is like a European option except the holder of an
American option may exercise the option at any time before the expiration
date.
At the expiration date, the value of a call option for one share of the underlying
asset either American or European equals
C = max(S − X, 0),
where S is the value of one share of the asset and X is the strike price of the
call option.
Similarly the value of a put at expiration is
P = max(X − S, 0).
A plot of the value of a call option is shown below for various values of S.
Source: http://www.math.tamu.edu/~stecher/425/Sp12/putCallOptions.pdf
Figure 6.19: Value of a European Call

The slanted line in the plot is at 45 degrees. That is for any increase in the
value of S, if S > X, we have the same increase in value of the call option. If S
≤ X, then the option is worthless and would be allowed to expire with out
being exercised. The plot of the value of a put option is shown below.
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Notes
Source: http://www.math.tamu.edu/~stecher/425/Sp12/putCallOptions.pdf
Figure 6.20: Value of a European Put

Notice that a portfolio, which consists of a put and a call option with the same
strike price and expiration date has the same value as |S − X|.
It turns out that the values of a put and call option for the same asset with the
same strike price and expiration date are related. This relation is referred to as
Put Call Parity.
Put-Call Parity — the relationship between the prices of a European put option
and a European call option when they have the same maturity date and strike
price. The European options can only be exercised at maturity. This
relationship is expressed in the formula:
Put-Call Parity of European Options
c + K*e–rT = p + S0
where,
c— the European call option price,
p— the European put option price,
S0 — the current stock price,
K— the strike price at maturity,
e— the mathematical constant number with value of approximately
2.71828,
r— the risk-free interest rate,
T— the time to maturity,
–rT
e — the discount rate for the strike price K,
K*e–rT — the present value of the strike price today, which is expressed
sometimes as K*B or PV(K).
The formula above shows that the value of a European put option with a
certain strike price and exercise date can be deducted from the value of a
European call option with the same exercise date and strike price. It is equally
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valid for the European call option derived from the European put option. The Notes
above equation can also be used to calculate the present value of the strike
price K*e–rT and the current stock price S0. Please note that this formula holds
for a non-dividend-paying stock only.
Example 4: Suppose that the stock price is $50, the strike price is $60
and the risk-free interest rate equals 5% per annum. The 6-month European put
option price is $0.8. What is 6-month European call option price?
Solution: Let’s define the provided information in a form suitable for the
calculation:
S0 = 50, K = 60, r = 0.05, T = 0.5, p = 0.8, e = 2.71828, c = ?
By rearranging the Put-Call Parity formula for c, we get the following
expression:
c = p + S0 – K*e–rT
Let’s input numbers:
c = 0.8 + 50 – 60 x 2.71828–0.05×0.5 ≈ 7.72
The price of the 6-month European call option is $7.72. This price is dependent
on the price of the European put option, which is $0.8. As we can see from the
Put-Call Parity, if the price of the put option would be different, then the price
of the call option should also be different. Let’s look at the same example
again. If the price of the put option would be $1.8 instead of $0.8, than the
price of the call option should also be $1 higher and equal to $8.72. At the
same time, if the price of the put option is $0.5 less than original, than the price
of the call option should also be discounted by $0.50. We can draw conclusion
that if one option becomes more expensive on the market (call/put), so the
price of the other option should increase by the same amount. Please note that
the price of both call and put options cannot be explained by the Put-Call
Parity itself and is dependent on the riskiness of the stock – its volatility.
Now let’s look at the similar example where the stock price is lower than the
strike price of the options.
Example 5: Suppose that the stock price is $40, the strike price is $30
and the risk-free interest rate equals 8% per annum. The 18-month European
call option price is $0.5. What is 18-month European put option price?
Solution: Let’s define the provided information in a more convenient way:
S0 = 40, K= 30, r = 0.08, T = 1.5, c = 0.5, e = 2.71828, p = ?
The rearranged Put-Call Parity formula for p:
p = c + K*e–rT – S0
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Notes Inputting numbers into the formula:

p = 0.5 + 30 x 2.71828–0.08×1.5 – 40 ≈ 12.89
The price of the European put option equals $12.89. The large price difference
between the European call and put options ($0.5 and $12.88 respectively) is
influenced by the current stock price and its strike price at maturity. Since in
this example the strike price is $10 lower than the stock price, so the European
call option holder has a lot less benefit from the option than the European put
option holder.
American Call Option and American Put Option
An American option can be exercised at any time, whereas a European option
can only be exercised at the expiration date. This added flexibility of American
options increases their value over European options in certain situations. Thus,
we can say American Options = European Options + Premium where the
Premium is greater than or equal to zero.
For standard American call options without dividends, there are several reasons
why the call should never be exercised before the expiration date. First, for a
given movement in an underlying asset, the profit from holding an in the
money call is equivalent to the profit from holding the underlying asset. The
call option, however, has the added benefit of protecting against the risk of a
downward price movement below the strike price.
Additionally, because of the time value of money, it costs more to exercise the
option today at a fixed strike price K than in the future at K. Finally, there is an
intrinsic time value of the option that would be lost by exercising the option
prior to the expiration date.
Hence, the price of an American and European call option without dividends
should not diverge.
The price of an American call option on an underlying asset that pays
dividends, however, may diverge from its European counterpart. For an
American call with dividends it may be beneficial to exercise the option prior
to expiration. By exercising the call, the owner of the call will be entitled to
dividend payments that they would not have otherwise received. This means
that prior to dividend announcement American options must include a
premium based on some distribution of an expected dividend. Once the
dividend is announced, the premium must be adjusted again to account for this
revised information.
For put options, the price of American and European options can diverge even
for underlying assets that do not pay dividends. This is due to the limit in the
value of the put option P(t)≤K imposed by the fact that the underlying S cannot
have a negative value. For deep in the money puts, it may be optimal to
exercise the put prior to expiration and earn the risk free rate on the profits.
Thus, the price of an American put must reflect the potential profits that can be
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earned by exercising the put prior to expiration and earning the risk free rate on Notes
the profits. Additionally, since European puts cannot be exercised until
expiration and the strike price K is fixed in the future, we can discount the
strike price to today to create a more stringent limit for the price of a European
put:
P(t)≤Kexp[-r(T-t)].
In order to account for the premium added by an American option, it is
necessary to consider time (ti) as a discrete variable. At one time step before
maturity (tT-1), the option will be exercised if h(ST-1) > f(tT-1), where h is the
value of exercising the option and f is the value of holding the option until
maturity. Hence, the price of the option is max(h(ST-1), f(tT-1)).
Example: For an American put, it would be optimal to exercise the put

if (K-ST-1)(1+r)>f(tT-1), and the price would be max[(K-ST-1)(1+r),f(tT-1)].
This logic can then be iterated back through each time period to find the price
for American options for each time period ti. Unfortunately, the Black Scholes
equation cannot be used to find a closed form solution for this iterative process.
Binomial trees provide an efficient way to calculate the price of American
options. A Monte Carlo simulation would theoretically work, but is
computationally inefficient. In a binomial tree, the underlying asset’s price S,
changes in set amounts u>1 and d<1 in each discrete time period.
Source: http://www.eecs.harvard.edu/~parkes/cs286r/spring08/reading5/hw3handout2.pdf
Figure 6.21: Monte Carlo Simulation

Once the price of the underlying has been calculated by moving forwards
through the tree, the price of the option can be calculated by moving
backwards through the tree. By using a discrete time Black Scholes
approximation it is possible to test whether it would be optimal to exercise the
option in every time period; thus allowing the accurate pricing of American
options.
The original Put-Call Parity equation holds only for the European options.
Since the American options can be exercised at any time prior the expiration
date, the same Put-Call parity cannot be used for the American call and put
ANNA UNIVERSITY 177

Notes options. However, it is possible to rearrange this equation into inequality for
the American options too. It will give us upper and lower bounds for the price
of the American put option with the same maturity date and strike price as the
American call option. The formula below defines these limits:
S0 – K ≤ C – P ≤ S0 – K*e–rT
Looking at this expression we can see that the difference between C and P is
the difference between K and K·e–rT. In the following examples we will show
how the limits of the American options should be calculated from this Put-Call
parity.
Example 6: Suppose that we have two American call and put options
with the strike price of $20 and current stock price $22. Both options expire in
3 months and the risk-free interest rate is 9% per year. How much is this
American call option worth more than an American put option with the same
exercise date and strike price?
Solution: We have here:
S0 = 22, K = 20, r = 0.09, T = 0.25, e = 2.71828, C – P = ?
Let’s input the numbers into the Put-Call parity formula for the American
options:
22 – 20 ≤ C – P ≤ 22 – 20*e–0.09×0.25
2 ≤ C – P ≤ 2.44
This shows that the American call option worth more than American put option
by at least $2 and by maximum of $2.44.
If we would know how much an American call option cost, we would be able
to calculate the bounds of the put option price.
Example 7: Let’s consider the situation when the price of the American
call option is $3. In this case C = 3 and
2 ≤ 3 – P ≤ 2.44
or
0.56 ≤ P ≤ 1
In this case, the price of the American put option should lie between $0.56 and
$1 in order to satisfy the Put-Call parity inequality for the American options.
Let’s look at another example when we know in advance the price of the
American call option.
Example 8: Suppose that we have again two American call and put
options with the strike price of $35 and current stock price $30. Both options
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expire in 8 months and the risk-free rate is 11% per annum. The price of the Notes
American put option is $7. What is the price of the American call option?
Solution: We have here:
S0 = 30, K = 35, r = 0.11, T = 8/12, e = 2.71828, P = 7, C = ?
By inputting numbers into the Put-Call parity for the American options
S0 – K ≤ C – P ≤ S0 – K*e–rT
we get the following results
30 – 35 ≤ C – 7 ≤ 30 – 35·e–0.11×8/12
2 ≤ C ≤ 2.53
It shows us the bounds of the American call option price between $2 and
$2.53, when the price of the American put option for the same strike price and
expiration date is $7. Please note that if call and put options would be of the
different maturity date or strike price, we will not be able to use the Put-Call
parity for the American options. It is equally valid for the European options
too.
The Binomial Model
The binomial model breaks down the time to expiration into potentially a very
large number of time intervals, or steps. A tree of stock prices is initially
produced working forward from the present to expiration. At each step it is
assumed that the stock price will move up or down by an amount calculated
using volatility and time to expiration. This produces a binomial distribution,
or recombining tree, of underlying stock prices. The tree represents all the
possible paths that the stock price could take during the life of the option.
At the end of the tree – i.e. at expiration of the option – all the terminal option
prices for each of the final possible stock prices are known, as they simply
equal their intrinsic values.
Next, the option prices at each step of the tree are calculated working back
from expiration to the present. The option prices at each step are used to derive
the option prices at the next step of the tree using risk neutral valuation based
on the probabilities of the stock prices moving up or down, the risk-free rate
and the time interval of each step. Any adjustments to stock prices (at an ex-
dividend date) or option prices (as a result of early exercise of American
options) are worked into the calculations at the required point in time. At the
top of the tree you are left with one option price.
To get a feel for how the binomial model works you can use the on-line
binomial tree calculators: either using the original Cox, Ross and Rubinstein
tree or the equal probabilities tree, which produces equally accurate results
while overcoming some of the limitations of the C-R-R model. The calculators
let you calculate European or American option prices and display graphically
ANNA UNIVERSITY 179

Notes the tree structure used in the calculation. Dividends can be specified as being
discrete or as an annual yield, and points at which early exercise is assumed for
American options are highlighted.
Advantages and Limitations
Advantage: The big advantage the binomial model has over the Black-Scholes
model is that it can be used to accurately price American options. This is
because with the binomial model it is possible to check at every point in an
option’s life (i.e. at every step of the binomial tree) for the possibility of early
exercise (e.g. where, due to a dividend, or a put being deeply in the money, the
option price at that point is less than its intrinsic value).
Where an early exercise point is found it is assumed that the option holder
would elect to exercise, and the option price can be adjusted to equal the
intrinsic value at that point. This then flows into the calculations higher up the
tree and so on.
The on-line binomial tree graphical option calculator highlights those points in
the tree structure where early exercise would have caused an American price to
differ from a European price.
The binomial model basically solves the same equation, using a computational
procedure that the Black-Scholes model solves using an analytic approach and
in doing so, provides opportunities along the way to check for early exercise
for American options.
Limitation: The main limitation of the binomial model is its relatively slow
speed. It’s great for half a dozen calculations at a time but even with today’s
fastest PCs it’s not a practical solution for the calculation of thousands of
prices in a few seconds.
Relationship with Black-Scholes Model
The same underlying assumptions regarding stock prices underpin both the
binomial and Black-Scholes models: that stock prices follow a stochastic
process described by geometric Brownian motion. As a result, for European
options, the binomial model converges on the Black-Scholes formula as the
number of binomial calculation steps increases. In fact the Black-Scholes
model for European options is really a special case of the binomial model
where the number of binomial steps is infinite. In other words, the binomial
model provides discrete approximations to the continuous process underlying
the Black-Scholes model.
Binomial Option Pricing Model
The binomial model has proved over time to be the most flexible, intuitive and
popular approach to option pricing. It is based on the simplification that over a
single period (of possibly very short duration), the underlying asset can only
move from its current price to two possible levels. Among other virtues, the
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model embodies the assumptions of no riskless arbitrage opportunities and Notes

perfect markets. Neither does it rely on investor risk aversion or rationality, nor
does its use require estimation of the underlying asset expected return. It also
embodies the risk-neutral valuation principle, which can be used to shortcut the
valuation of European options. In addition, we show later, that the Black-
Scholes formula is a special case applying to European options resulting from
specifying an infinite number of binomial periods during the time-to-
expiration.
Nonetheless, a binomial tree has several curious, and possibly limiting,
properties.
Example: All sample paths that lead to the same node in the tree have
the same risk-neutral probability. The types of volatility – objective, subjective
and realized – are indistinguishable; and, in the limit, its continuous-time
sample path is not differentiable at any point.
Another way to approach binomial option pricing is through the inverse
problem, implied binomial trees. Instead of presuming we know the underlying
asset volatility in advance to construct the up and down moves in the tree, we
use the current prices of related options to infer the size of these moves.
Binomial trees can also be used to determine the sensitivity of option values to
the underlying asset price (delta and gamma), to the time-to-expiration (theta),
to volatility (vega), to the riskless return (rho), and to the payout return
(lambda). Of these, gamma is particularly important because it measures the
times in the life of the option when replication is likely to prove difficult in
practice. Fugit measures the risk-neutral expected life of the option and can
also be calculated from a binomial tree.
The standard binomial option pricing model for options on assets can easily be
extended to options on futures and options on foreign currencies. In addition,
the model continues to work even if its parameters are time-dependent, asset
price-dependent, or dependent on the prior path of the underlying asset price.
But it fails if its parameters depend on some other random variable. A more
difficult task is to extend the binomial model to value options on bonds.
Learning Activity
Calculate the volatility for 5 stocks that have quotes for 1, 2 and 3
month call and put options. Use the Black and Scholes option
calculator to calculate the theoretical value for these options and
compare with the actual values. For a larger project, compare
accuracy for at the money, deep in the money, and deep put of the
money options. This can also be done to compare pricing of stocks
with high volatility and low volatility.
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Notes 6.6 DIFFERENCES BETWEEN FUTURE AND OPTIONS

CONTRACTS
The basic fundamental difference between options and futures lies in the
obligations they put on their buyers and sellers. The buyer is given by an
option, the right but not the obligation to buy(or sell) a particular asset at a
specific price at any time during the life of the contract. In contrast with a
futures contract, the buyer is given an obligation to purchase a specific asset,
and the seller to sell and deliver that asset at a specific future date, unless the
holder’s position is closed before the expiration.
Example: A buyer of a T-bond futures contract must either accept

delivery or sell an offsetting futures contract before contract expiration. futures
contract before contract expiration. On the other hand, a buyer of a T-bond
“call” option can either exercise his right and obtain a long position in T-bond
futures or, alternatively, choose not to exercise the option and simply let it
expire. The basic differences between futures and options contracts are
outlined in Table 6.4.
Table 6.4: Basic Differences between Futures Contracts and Options on Futures
Alternative Position Trader’s Rights Trader’s Obligations Margins Required
Futures contract buyer Accept commodity or Yes
asset at contract price
Futures contract seller Deliver commodity or Yes
asset at contract price
Put option buyer Sell futures contract at No
strike price
Put option seller Buy futures contract at Yes
strike price
Call option buyer Buy futures contract at No
strike price
Call option seller Sell futures contract at Yes
strike price
Source: https://books.google.co.in/books?id=UccQAAAAQBAJ&pg=PA76&dq=difference+between+futures+and+
options+contracts+with+example&hl=en&sa=X&ei=he0HVZaGDMqTuASVu4KwAQ&ved=0CCYQ6AEwAg#v=on
epage&q=difference%20between%20futures%20and%20options%20contracts%20with%20example&f=false
To reiterate, an option is a contractual agreement to either purchase or sell a

futures contract at a preestablished price and within a specified time period. As
we know that, there are two types of options: “puts” and “calls.” A call option
gives a buyer the right (but not the obligation) to purchase a futures contract at
a specified strike price and during a specified period of time (before the expiry
date). A put option gives a buyer of the option the right (but not the obligation)
to sell a futures contract at a specified price and during a specified period of
time. The seller (writer) of an option receives a premium, which is the amount
paid by the buyer of the option in return for the right to control a futures
contract. The premium is the price of the option, and thus it fluctuates with the
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supply and demand for the option itself. The holder can exercise an option at Notes
any time during the life of the option.
A few examples will help illustrate these basic concepts. Consider Table 6.5,
where representative futures options prices are reported for options written on
wheat and gold futures contracts. The top panel of Table 6.5 reports wheat
option prices. On the day in question, the purchaser of a call option in wheat
would have numerous different strike prices to choose from, ranging from
$2.60 to $3.10 per bushel. If the option buyer chooses $2.80 as the appropriate
strike price, then he would pay 6.75 per bushel for the right to go long one July
wheat futures contract at a strike price of $2.80 per bushel. He may exercise
this right any time before the month of July? The total premium he pays to the
seller of the option is $337.50 (6.75 per bushel x 5,000 bushels), and this is
paid immediately at the time the option is purchased. If the price of wheat falls
and he chooses not to exercise the option, then his total loss is limited to
$337.50. However, if the price of wheat rises and he exercises his option, he
will acquire a “long” futures position at the option strike price of $2.80. At the
same time, the exchange clearinghouse will assign a “short” futures position to
a trader who has previously sold an identical “call” option, with the same
underlying futures contract and the same strike price.
Table 6.5: Wheat and Gold Futures Options
Source: https://books.google.co.in/books?id=UccQAAAAQBAJ&pg=PA76&dq=difference+between+futures+and+
options+contracts+with+example&hl=en&sa=X&ei=he0HVZaGDMqTuASVu4KwAQ&ved=0CCYQ6AEwAg#v=on
epage&q=difference%20between%20futures%20and%20options%20contracts%20with%20example&f=false
Turning to the gold example in Table 6.5, consider the buyer of a put option. If
the purchaser chooses a strike price of $300 per ounce and an August expiry
date, the premium paid to the option seller is $2.30 per ounce, or $230 for one
put option. The holder of this option has the right to acquire a short position in
August gold futures at a price of $300. If the price of gold falls before the
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Notes month of August and the option is exercised, the holder obtains a short futures
position from the exchange clearinghouse. He must then liquidate his futures
position in order to capture the full profit available to him at the time.
Alternatively, if the price falls, he may choose to sell his option for a profit
before the expiry month. He will profit from selling the option because its
premium will rise when the price of gold falls.
Apart from commissions, an investor can enter into a futures contract with no
upfront cost whereas purchasing an options position does not need the payment
of a premium. As contrast with the absence of upfront costs of futures, the
option premium can be viewed as the fee paid for the privilege of not being
obligated to purchase the underlying in the event of an adverse shift in prices.
The buyer of an option may lose the maximum premium.
Another main difference between options and futures is the size of the
underlying position. In case of futures contract, the underlying position is much
larger and the obligation to purchase or sell this specific amount at a given
price makes futures more risky for the inexperienced investor. The final key
difference between these two financial instruments is the way the gains are
obtained by the parties. The gain on a option can be recovered in the following
three ways : to exercise the option when it is deep in the money, going to the
market and to take the reverse position, or wait until expiry and to collect the
difference between the asset price and the strike price. As compared to the
gains generated on futures positions that are automatically ‘marked to market’
daily, stating the change in the value of the positions that pertains to the futures
accounts of the parties at the end of every trading day-but a futures contract
holder can recover gains also by going to the market and taking the reverse
position.
Learning Activity
Look up and compare the premium for various exercise prices for
put and call options for any stock/index of your own choice in the
page dealing with options in any newspaper.
1. More advanced spreads, such as diagonal spreads are

combinations of time spreads with different exercise
prices.
2. Options contracts, comprising of index options,
permits the investors to profit from an expected market
move or to minimize the risk of holding the underlying
instrument.
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SUMMARY Notes
 Options payoff is a chart of profits and losses for a specific options strategy
prepared in advance of the strategy execution. The diagram gets plotted of
expected profit or loss as compared to the price of the underlying security.
 Options on securities consists of: Equity Option, Bond option, Futures
Option, Index Option and Commodity Option.
 Currency option is a contract that gives the holder the right, but not the
obligation, to buy or sell currency at a particular exchange rate during a
particular period of time. For this right, broker is paid a premium, which
will differ based on the number of contracts purchased. Currency options
are one of the best ways for corporations or individuals for hedging against
unfavourable movements in exchange rates.
 An options contract where the underlying is a single futures contract is
known as futures option. The futures option givers the buyer the right but
not the obligation for assuming a specific futures position at a particular
price(or the strike price) any time before the option expires. The seller of
the futures option must assume the opposite futures position when the
buyer exercises this right.
 The factors affecting the option pricing are-current stock price; exercise
price; volatility; risk-free interest rates; cash dividends; time to expiration.
 Options pricing models constitute- The Black and Scholes Model and
Binomial Model.
 The basic fundamental difference between options and futures lies in the
obligations they put on their buyers and sellers. The buyer is given by an
option, the right but not the obligation to buy(or sell) a particular asset at a
specific price at any time during the life of the contract.
 In contrast with a futures contract, the buyer is given an obligation to
purchase a specific asset, and the seller to sell and deliver that asset at a
specific future date, unless the holder’s position is closed before the
expiration.
KEYWORDS
Binomial Model: The binomial model breaks down the time to expiration into
potentially a very large number of time intervals, or steps. A tree of stock
prices is initially produced working forward from the present to expiration.
Black Scholes Model: The Black-Scholes model gives theoretical values for
European put and call options on non-dividend paying stocks.
Equity Options: They gives the right, but not the obligation, to buy(call) or
sell(put) a quantity of stock (1 contract = 100 shares of stock), at a set price
(strike price), within a specified period of time (prior to the expiration date).
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Notes Iron Butterfly: Contains four options with a combination of puts and calls. It is
equivalent to a regular butterfly spread which contains either puts or calls at
three strike prices.
Option Payoff: The payoffs from European options depend on the underlying
stock price at expiration.
Option Spread: Buy an option and sell another option on the same stock. For a
price/vertical spread choose same expiry month, but different exercise prices.
1. How does the payoff of buyer of a call and put option is calculated?
2. What do you mean by Straddle combination?
3. What do you understand by option spreads?
4. State the strangle combination of option payoff.
5. Define equity options.
6. Define bond options.
7. What are futures options?
8. State atleast four factors affecting option pricing.
9. Discuss the advantages and limitations of Black Scholes Model.
10. What do you mean by Option Stock Indices?
1. What are the potential risks and returns in
(a) Having a long/short position in a spread.
(b) Having a long/short position in a straddle.
(c) Having a long/short position in a strangle.
(d) Having a long/short position in a butterfly.
2. Differentiate between currency option and futures option.
3. Explain Option pricing models with suitable example. How does the
Binomial model is associated with Black Scholes Model?
4. Differentiate between futures and options contract.
5. “Options on securities consist of equity option, bond option, futures option,
index option and commodity option”. Explain each one in detail.
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FURTHER READINGS Notes

John Wiley & Sons.
Hull, C, John and Basu, Sankarshan (2010), Options, Futures
and Other Derivatives, 7th edition, Pearson Education India.
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Notes
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Lesson 7 - Swaps
Notes
UNIT IV
LESSON 7 - SWAPS
CONTENTS
Learning Objectives
Learning Outcomes
Overview
7.1 Definition of Swap
7.1.1 Swap Market Terminology
7.1.2 Types of Swaps
7.2 Interest Rate Swap
7.2.1 Characteristics of Interest Rate Swaps
7.2.2 Advantages of IRS
7.2.3 Types of Interest Rate Swaps
7.2.4 How Swaps Work?
7.3 Currency Swap
7.3.1 Rationale for Existence of Currency Swaps
7.3.2 Forms of Currency Swaps
7.4 Role of Financial Intermediary
7.5 Warehousing
Summary
Keywords
Further Readings
LEARNING OBJECTIVES
 Define swap
 Describe the various types of swaps
 Explain the Interest rate swap and Currency swap
 Discuss the role of financial intermediary
 Understand Warehousing
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understanding of:
 the concept of using a derivative that is SWAP for hedging and risk
management by MNCs.
 the fact that most swaps are traded Over The Counter (OTC), ‘tailor-made’
for the counterparties.
 the datum that a currency swap is a contract to exchange interest payments
in one currency for those denominated in another currency.
OVERVIEW
In the previous lesson you had studied about Option payoff, Options on
Securities, Stock Indices, Currencies option and Futures Option, Options
pricing models and the difference between future and Option contracts.
Swap is a complex derivative as the swap market did not publicly exist until
1981, when currency swaps were first introduced, although its origins can be
traced back to the 1970s. Rising interest rates volatility necessitated a flexible
means by which companies with floating interest rate exposures could hedge
such risks. The result of which was the introduction of US interest rate swaps
in 1982. The swap markets helped the companies lower their funding costs.
They did so by enabling companies to source capital in whatever market or
currency it was found to be cheapest, and then to convert the resulting liability
into whatever form made most sense.
Swaps are essentially a derivative instrument used for hedging and risk
management by MNCs. There are various kinds of swaps but interest rate
swaps and currency swaps are the most commonly used swaps. The present
chapter deals with these two kinds of swaps in detail.
The interest rate and currency swap markets allow firms that have limited
access to specific currencies and interest rate structures to gain access at
relatively low costs and helps these firms to manage their currency and interest
rate risks very effectively. Also, in contrast with futures and exchange traded
options, swap agreements are extremely flexible in amount, maturity and other
contract terms. Swaps have now integrated with all sorts of other more
traditional financial arrangements and have attained a certain maturity. In fact,
financial managers must now recognise that they are a powerful tool and have
had a major impact on the treasury function permitting firms to tap new capital
market and to take advantage of innovative products without increasing the
risk.
In this lesson, you will learn about the SWAP, Interest rate SWAP, Currency
SWAP, and the role of financial intermediary and finally, understand about
Warehousing.
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Lesson 7 - Swaps
7.1 DEFINITION OF SWAP Notes

A swap can be defined as “the exchange of one stream of future cash flows
with another stream of cash flows with different characteristics.”
If firms in separate countries have comparative advantages on interest rates,
then a swap could benefit both firms.
Example: One firm may have a lower fixed interest rate, while another
has access to a lower floating interest rate. These firms could swap to take
advantage of the lower rates.
A swap is an agreement between two or more people/parties to exchange sets
of cash flows over a period in future. Broadly, Swaps can be divided into two
types viz., (a) Currency Swaps, (b) Interest Rate Swaps.
Currency Swaps: The currency swaps are agreements whereby currencies are
exchanged at specified exchange rates and specified intervals. The basic
purpose of swaps is to lock in the rate.
Interest Rate Swaps: An interest rate swap is an agreement whereby one party
exchanges one set of interest rate payments for another. The most common
arrangement is an exchange of fixed interest rate payment for another rate over
a time period. The interest rates are calculated on notional values of principals.
Swaps are agreements on the lines of I’ll pay for you, if you’ll pay for me;
interest rate swaps involve the exchange of the difference in the payment
streams of two different assets or liabilities calculated on the basis of a notional
principal sum. Typically, it is the difference between fixed and floating-rate
interest streams. They are used to manage interest rate risk. Agents who hold
fixed interest rate assets and floating interest rate liabilities will be exposed to
losses if interest rates rise, because the cost of borrowing will rise while the
return on assets will not. Hence, swapping either the fixed asset rate into
floating, or floating liability rate into fixed will reduce risk. The principle
involved here is referred to as ‘matching’ because it creates assets and
liabilities that will move up or down together. Let us explain them in detail,
one by one.
In finance, a swap is a derivative in which two counterparties agree

to exchange one stream of cash flows against another stream. These streams
are called the legs of the swap.
The cash flows are calculated over a notional principal amount, which is
usually not exchanged between counterparties. Consequently, swaps can be
used to create unfunded exposures to an underlying asset, since counterparties
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Notes can earn the profit or loss from movements in price without having to post the
notional amount in cash or collateral.
Most swaps are traded Over The Counter (OTC), ‘tailor-made’ for the
counterparties. Some types of swaps are also exchanged on futures markets, for
instance Chicago Mercantile Exchange Holdings Inc., the largest US futures
market, the Chicago Board Options Exchange and Frankfurt-based Eurex AG.
7.1.1 Swap Market Terminology
Trade Date: It is the date on which swap is entered into. This is the date when
both the parties have agreed for a swap.
Effective Date: Effective date is the date when the initial fixed and floating
payments begin. Effective date is also called value date. If the effective date
falls two days after the trade date, then it is called spot date. The maturity of a
swap contract is computed from the effective date.
Reset Date: The applicable LIBOR for each period is to be determined before
the date of payment. It is usually determined before the commencement of the
applicable period. Generally for the first payment, the LIBOR rate applicable
will be set at the trade date if the value date is two days after the trade date.
The first reset date will generally be 2 days before the 1st payment date, the
second reset date will be 2 days before the 2nd payment date and so on.
Maturity Date: The date on which the interest accrual stops.
Assignment Broker: Market maker in swaps.
LIBOR: London Inter Bank Offered Rate, which is a rate decided on daily
basis based on a sample of lending rates offered by leading banks in London.
The 6-month LIBOR is mostly used for swaps implying that this is the rate
payable for borrowing US dollars for six months in London.
7.1.2 Types of Swaps
 Swaps can be classified into two types on the basis of floating and fixed
rate:
 Fixed to Floating: Here the customer receives cash flows at a fixed
rate of interest and simultaneously pays cash flows at a floating rate of
interest or vice versa. The cash flows are calculated on a Notional
Principal amount. The floating rate of interest is usually determined by
reference to a transparent benchmark.
 Floating to Floating: In this kind of a swap, both the counter-parties
exchange interest amounts based on two different floating reference
rates, through the life of the swap.
Example: Examples of Floating rate benchmarks could be:

Overnight money rate or MIBOR, Term money rate, Government
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Lesson 7 - Swaps
Securities yield to maturity, Treasury Bills yield to maturity. However, Notes

not all of these are currently available in India.
 Based on quantitative importance: The five generic types of swaps in
order of their quantitative importance are:
 Interest Rate Swaps,
 Currency swaps,
 Credit swaps,
 Commodity swaps, and
 Equity swaps.
We will discuss the important ones in details now.
7.2 INTEREST RATE SWAP

An interest rate swap is a contractual agreement entered into between two
counterparties under which each agrees to make periodic payment to the other
for an agreed period of time based upon a national amount of principal (IRS).
The two parties that agree to exchange the cash flows are called counterparties
of the swap. The principal amount is notional because there is no need to
exchange actual amounts of principal in a single currency transaction: there is
no foreign exchange component to be taken account of. Equally, however, a
notional amount of principal is required in order to compute the actual cash
amounts that will be periodically exchanged.
It is important to note two points:
 There is no exchange of principal amount either initially or on maturity, as
the notional principal amount is the same
 On each interest payment date, only the net amount will be paid/received
by the counterparties.
000has shown that people seem to be particularly good at detecting

“cheaters”—those who do not live up to their obligations in reciprocal
altruism—and that these individuals are judged extremely negatively.
Such contracts generally involve the exchange of fixed-to-floating or floating-

to-floating rates of interest. Accordingly, on each payment date, that occurs
during the swap period, a cash payment based on the differential between fixed
and floating rates, is made out by one party involved in the contract to another.
Generally, the two parties in an interest rate swap are trading a fixed-rate and
variable-interest rate.
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Notes
Example One company may have a bond that pays the London
Interbank Offered Rate (LIBOR), while the other party holds a bond that
provides a fixed payment of 5%. If the LIBOR is expected to stay around 3%,
then the contract would likely explain that the party paying the varying interest
rate will pay LIBOR plus 2%. That way both parties can expect to receive
similar payments. The primary investment is never traded, but the parties will
agree on a base value (perhaps $1 million) to use to calculate the cash flows
that they’ll exchange.
7.2.1 Characteristics of Interest Rate Swaps
 Effectively converts a floating rate borrowing to fixed rate or vice-versa.
 Structured as a contract separate from the underlying funding.
 Principal repayment obligations are not exchanged i.e. the principal amount
is only notional.
 Can be applied to either new or existing borrowings.
 They are off-balance sheet instrument.
 On each interest payment date only the net interest differential is
paid/received by counterparties on each interest payment date.
 The frequency of payment reflects the tenor of the floating rate index.
 Involves exchange of interest obligations between two parties at regular
intervals over the life of IRS.
Under the commonest from of interest rate swap, a series of payments
calculated by applying a fixed rate of interest to a notional principal amount is
exchanged for a stream of payments similarly calculated but using a floating
rate of interest. This is a fixed-for-floating interest rate swap. Alternatively,
both series of cash flows to be exchanged could be calculated using floating
rates of interest but floating rates that are based upon different underlying
indices.
Example: Examples might be Libor and commercial paper or Treasury

bills and Libor and this and this form of interest rate swap is known as a basis
or money market swap.
Interest rate swaps are a type of derivatives in which two parties swap the type
of interest payments they pay on their outstanding debt. Introduced in the early
1980s, interest rate swaps were engineered to help corporations and
governments protect themselves from the highly volatile interest rates offered
at that time. Swaps allowed these entities to lock-in rates, thereby offering
them a degree of certainty.
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Lesson 7 - Swaps
7.2.2 Advantages of IRS Notes

 To obtain lower cost funding.
 To hedge interest rate exposure.
 To obtain higher yielding investment assets.
 To create types of investment assets not otherwise obtainable.
 To implement overall asset or liability management strategies.
 To take speculative positions in relation to future movements in interest
rates.
 They are used to hedge interest rate risks as well as to take on interest rate
risks.
 They are a versatile financial tool used in global financial markets. IRS
provides flexibility in asset and liability management and allows banks and
companies to convert assets and liabilities from one interest rate basis to
another.
 IRS can be used as a cost – cutting device, while leaving the underlying
source of funds unaffected. Treasurers can use the interest rate swap market
to manage existing liabilities as well as swap off a new issue.
 Help counterparties to take advantage of current or expected future market
conditions.
 Corporations employ interest rate swaps to dynamically change their
financing structure from floating rate exposure to fixed, and vice versa.
 Swaps can also more precisely match financing risks with operational risks.
 Swaps can be used to lengthen or shorten the average maturity of a
portfolio or liability structure.
Example: An example of a swap issuer is a government with

outstanding variable rate debt. To increase the certainty of its interest payments
for a three, a five, or even a ten-year period, the government may decide to
“swap” its variable rate obligations in exchange for another entity’s
outstanding fixed rate debt. With this exchange, the government’s counterparty
may be seeking to exchange its debt structure to floating rate debt because it
believes that interest rates will drop, or because it wants to restructure its debt
profile. These two parties then agree to swap interest payments.
7.2.3 Types of Interest Rate Swaps
The different types of Interest Rate Swaps are:
 Basis Swap: A swap in which a stream of floating interest rates are
exchanged for another stream of floating interest rates, is known as basis
swap. Such type of swap is possible when
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Notes  Both the floating interest rate streams are based on the same structure,
but different instruments,
 The two interest rate streams are calculated using same index, but with
different tenor e.g. counter party 'A' pays 1month LIBOR and counter
party 'B' pays 3 month LIBOR.
 The two interest rate streams are calculated using same index and same
tenor but one of the rates has margin e.g. counter party pays 3 month
LIBOR+2% and counter party 'B' pays 3 month LIBOR.
 Forward Swaps: forward swaps are those swaps in which the
commencement date is set at a future date. Thus, it is possible to lock the
swap rates and use them later as and when needed. Forward swaps are also
known as deferred swaps (different from deferred rare swaps) as the start
date of the swap is delayed.
 Putable Swaps: A putable swap gives the seller of the swap (the floating
rate payer) the chance to terminate the swap at any time before its maturity.
If the interest rates rise, the floating rate payer will terminate the
putable swap.
 Rate Capped Swaps: An interest rate swap, which incorporates the cap
feature, is called a rate capped swap. If a floating rate Payer anticipates a
rise in interest rates then he can purchase a cap at a free payable up front to
the fixed rate payer so that the floating payable cannot exceed the capped
rate.
 Deferred Rate Swaps: A differed rate swap allows the fixed-rate payer to
enter into a swap at any time up to a specified future date. In the swap the
fixed rate payer can defer the payment until a time when the rates are lower
so that he ends up paying less than what would have been paid, at the rate
on the commencement date.
 Callable Swaps: A callable swap gives the holder, i.e. the fixed-rate payer,
the right to terminate the swap at any time before its maturity.
Example: Interest Rate Swap

Fixed Floating
AAA Bank 10.00% Libor
BBB Co. Ltd 12.00% Libor + 1%
Differential 2% 1%
 Extendible Swaps: In an extendible swap, the fixed rate payer gets the right
to extend the swap maturity date.
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Lesson 7 - Swaps
Table 7.1: Net Borrowing Costs (After Swap) Notes

AAA Bank BBB Co. Ltd.
Debt –10% –Libor
–1%
Swap +10.50% –10.50%
–Libor +Libor
Table 7.2: Borrowing Costs
All in Cost Libor -0.5% 11.50%

Cost without Swap Libor 12.00%
Saving 0.5% 0.5%
An interest rate swap simply arbitrages each borrower’s relative strength in two
different markets. To illustrate, refer to data in the table given above. Bank-
AAA which enjoys very good credit rating, lends at floating rates, borrows at
fixed rate, and is at risk if floating rates fall.
Another company – BBB Company enters into a fixed price contract, has
higher funding costs, whether fixed or floating and has risk of losses if funded
on a floating rate basis. Their relative borrowing costs are shown in the table.
Before entering into the interest rate swap, both borrowers borrow debt in their
respective markets– AAA Bank in the fixed rate and BBB Company in the
floating market, for which they remain responsible throughout the lifetime of
the debt. AAA Bank then contracts to pay Libor to BBB Company in return for
10.50 per cent.
AAA Bank can use the 10.50 per cent income stream to service its 10 per cent
liability creating Libor minus 50 basis points. BBB Company uses the Libor
payments to service its Libor plus 100 basis points debt, which when added to
10.50 per cent, results in a final cost of funds of 11.50 per cent. This is
significantly less than what it would be able to achieve by entering the fixed
market directly which is 12 per cent. Both the counterparties reap a benefit of
50 basis points. The table above shows the details.
Most interest rate swaps take place through an intermediary, or investment
bank that is prepared to take on the risk of each leg of the transaction. The
investment bank can then take the swap onto its own bank, and offset it with
counterparty when the opportunity arises.
7.2.4 How Swaps Work?
Upon determining that an interest rate swap would be a prudent financial
decision, an entity employs a swap dealer to arrange the terms of the swap. The
party with the outstanding floating rate debt seeks the lowest possible fixed
rate. Other factors, such as the financial strength of the dealer and the
counterparty, also are considered at this time. The counterparty’s floating rate
usually is determined using an index.
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Notes Once these parties agree to the terms arranged by the swap dealer, they must
enter into an International Swap Dealers Association (ISDA) Master
Agreement and Certification.
This certification assures that the entity has the legal authority to enter into the
swap. The length of the swap is also determined at this time and is usually one
to ten years. After agreement upon the terms, the parties are ready to enter into
an interest rate swap. Interest payments are determined on a monthly, semi-
annual, or annual basis.
The net difference between the two interest payments is paid by the party
whose payments exceed the other’s. This difference is the only amount
exchanged; principal and interest payments are not exchanged. The original
issuer of the variable rate debt usually still has to pay the remarketing and
liquidity fees associated with that debt.
The risks associated with interest rate swaps are:
 The counterparty to the contract may default. Many entities attempt to
mitigate this risk by swapping only with counterparties whose financial
position is rated AA or higher.
 Another risk with swaps is basis point risk, exposing the swapper to
unexpected, additional costs. Basis point risk occurs when the index used
for the swap contract does not correspond to the actual interest rate on the
variable rate debt. This risk can be eliminated by having the counterparty
pay the same variable rate as the rate on the bonds.
 Finally, an issuer must factor in the cost of swapper fees. These fees are
paid to the dealer and they can erode a sizeable portion of the savings
created by a swap.
If the swap turns unfavourable, a swapper must pay an unwind

fee, or assignment fee, to terminate the agreement. Each of these fees can
be excessive, normally equalling the cost to the counterparty of funding an
equally satisfactory arrangement.
The two most common and most basic types of swaps: the plain vanilla interest
rate and currency swaps.
Plain Vanilla Interest Rate Swap
The most common and simplest swap is a "plain vanilla" interest rate swap. In
this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest
on a notional principal on specific dates for a specified period of time.
Concurrently, Party B agrees to make payments based on a floating interest
rate to Party A on that same notional principal on the same specified dates for
the same specified time period. In a plain vanilla swap, the two cash flows are
paid in the same currency. The specified payment dates are called settlement
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Lesson 7 - Swaps
dates, and the time between are called settlement periods. Because swaps are Notes
customized contracts, interest payments may be made annually, quarterly,
monthly, or at any other interval determined by the parties.
For example, on Dec. 31, 2006, Company A and Company B enter into a five-
year swap with the following terms:
Company A pays Company B an amount equal to 6% per annum on a notional
principal of $20 million.
Company B pays Company A an amount equal to one-year LIBOR + 1% per
annum on a notional principal of $20 million.
LIBOR, or London Interbank Offer Rate, is the interest rate offered by London
banks on deposits made by other banks in the eurodollar markets. The market
for interest rate swaps frequently (but not always) uses LIBOR as the base for
the floating rate. For simplicity, let's assume the two parties exchange
payments annually on December 31, beginning in 2007 and concluding in
2011.
At the end of 2007, Company A will pay Company B $20,000,000 * 6% =
$1,200,000. On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore,
Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000.
In a plain vanilla interest rate swap, the floating rate is usually determined at
the beginning of the settlement period. Normally, swap contracts allow for
payments to be netted against each other to avoid unnecessary payments. Here,
Company B pays $66,000, and Company A pays nothing. At no point does the
principal change hands, which is why it is referred to as a "notional" amount.
Figure 7.1 shows the cash flows between the parties, which occur annually (in
this example).
Source: http://www.investopedia.com/articles/optioninvestor/07/swaps.asp
Figure 7.1: Cash Flows for a Plain Vanilla Interest Rate Swap
Plain Vanilla Foreign Currency Swap

The plain vanilla currency swap involves exchanging principal and fixed
interest payments on a loan in one currency for principal and fixed interest
payments on a similar loan in another currency. Unlike an interest rate swap,
the parties to a currency swap will exchange principal amounts at the
beginning and end of the swap. The two specified principal amounts are set so
as to be approximately equal to one another, given the exchange rate at the
time the swap is initiated.
For example, Company C, a U.S. firm, and Company D, a European firm, enter
into a five-year currency swap for $50 million. Let's assume the exchange rate
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Notes at the time is $1.25 per euro (e.g. the dollar is worth 0.80 euro). First, the firms
will exchange principals. So, Company C pays $50 million, and Company D
pays 40 million euros. This satisfies each company's need for funds
denominated in another currency (which is the reason for the swap).
Figure 7.2: Cash Flows for a Plain Vanilla Currency Swap, Step 1.
Then, at intervals specified in the swap agreement, the parties will exchange
interest payments on their respective principal amounts. To keep things simple,
let's say they make these payments annually, beginning one year from the
exchange of principal. Because Company C has borrowed euros, it must pay
interest in euros based on a euro interest rate. Likewise, Company D, which
borrowed dollars, will pay interest in dollars, based on a dollar interest rate.
For this example, let's say the agreed-upon dollar-denominated interest rate is
8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year,
Company C pays 40,000,000 euros * 3.50% = 1,400,000 euros to Company D.
Company D will pay Company C $50,000,000 * 8.25% = $4,125,000.
As with interest rate swaps, the parties will actually net the payments against
each other at the then-prevailing exchange rate. If, at the one-year mark, the
exchange rate is $1.40 per euro, then Company C's payment equals $1,960,000,
and Company D's payment would be $4,125,000. In practice, Company D
would pay the net difference of $2,165,000 ($4,125,000 - $1,960,000) to
Company C.
Figure 7.3: Cash Flows for a Plain Vanilla Currency Swap, Step 2
Finally, at the end of the swap (usually also the date of the final interest
payment), the parties re-exchange the original principal amounts. These
principal payments are unaffected by exchange rates at the time.
Figure 7.4: Cash Flows for a Plain Vanilla Currency Swap, Step 3
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Lesson 7 - Swaps
Notes
Learning Activity
Write a short note on ‘Plain Vanilla Interest rate Swaps’, focusing
on its features and how it function in derivatives market.
7.3 CURRENCY SWAP

A currency swap is a contract to exchange interest payments in one currency
for those denominated in another currency. The currency swap developed from
back-to-back loans and parallel loans and also functions virtually in the same
manner. At present, the currency swap market, although older than the interest
rate market, is smaller and less sophisticated.
A standard currency swap entails the exchange of debt denominated in one
currency for debt denominated in another currency.
Example: Assume that a US multinational company wants to issue a

yen denominated bond so that it can make payments with yen inflows
generated by a Japanese subsidiary. Also, suppose there exists a Japanese
multinational that wants to issue dollar denominated debt. The US
multinational could issue dollar debt while the Japanese multinational issues
yen debt. The US MNC would then provide yen payment, both principal and
interest to Japanese MNC in exchange for dollar payment. The swap of
currencies allows the two MNCs to make payments to their respective debt
holders without having to repatriate foreign exchange.
Thus, both the multinationals have reduced their exposures through the swap
transactions.
Figure 7.5: A Currency Swap
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Notes
Example: The World Bank-IBM Currency Swap
This deal is supposed to have launched the swap market. One of the party, viz.,
World Bank had intentions to diversify its sources of funding in other
currencies besides the dollar. This was thought of because no market had
sufficient funds to support a large borrowing as envisaged by the World Bank
and the IBM. The Bank had three objectives in mind before thinking of
entering into a Swap Transaction:
 The cost of borrowing via a swap should not be greater than primary
guidelines.
 The counterparty must be of top creditworthiness.
 No currency exposure must be created.
The bank found a worthy partner in IBM which had substantial bond issues in
Sfr and DM on which a potential gain had been made because of strengthening
of the dollar against these two currencies. IBM had intentions of converting its
bond issues into dollars for realising those expected gains.
The steps in the Swap process are as given below:
 On August 11, 1981, the Bank launched a bond issue in the US market of
$210 mn, maturity of 4.6 years. Net of commissions and expenses at
2.15%, it realised $205,485,000. The bond issue was settled on August 25,
which became the effective date of the swap.
 The swap transaction: IBM called for annul interest payments of SFr
12.375 million and DM 30 million as per liabilities on respective bounds.
Bullet payment of SFR 200 million and DM 300 million were receptively
to be bid after 5 years. The cost of capital for SFr being 8% and for DM
being 11%. The following table gives the cash flows and their NPVs.
Table 7.3: Cash Flows and their NPVs
Exchange Date SFr(flows) SFr discount DM flows DM discount

factor factor
30/3/82 12.375 0.995 30.00 0.939
30/3/83 12.375 0.884 30.00 0.846
30/3/84 12.375 0.818 30.00 0.818
30/3/85 12.375 0.758 30.00 0.758
30/3/86 212.375 0.702 30.00 0.702
The present values of these flows (as of August 25, 1981) are SFr 191,367,478
and DM 301,315,273 respectively. On August 11, 1981, World Bank brought
forward these amounts of SFr and DM against the dollar for delivery on
August 25th. The rates as obtained were SFr/$2.18 and DM/$ 2.56. At these
rates, the SFr and DM amounts translated into $87, 783,247 and $117,753
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Lesson 7 - Swaps
respectively for the total of $205, 485,000. To realise this net amount, the face Notes
value of the dollar issue had to be $210 million issued at par.
IBM accepted dollar funding @16%. Bullet repayment of the principal rate
$210 million was envisaged after 5 years. The chart is as follows:
Table 7.4: Dollar Cash Flows with Respect to their Dates
Date Dollar Cash flow

30/3/82 20,066,667
30/3/83 33,600,000
30/3/84 33,600,000
30/3/85 33,600,000
30/3/86 243,600,000
The gains:
 Gain to World Bank was a lower cost of funding than via direct borrowing.
 IBM gained in two ways viz. exchange gain and capital gain due to
changes in DM and SFr rates.
7.3.1 Rationale for Existence of Currency Swaps
The most important reason for firms using currency swaps has been cost
reductions and hedging. In addition, swaps have also been used to create assets
designed to raise investor’s rate of return. Market imperfections have spawned
differences in comparative borrowing costs supplying much of the momentum
for growth in swap financing. Domestic borrowers usually have comparative
advantage over foreign borrowers, though prestigious foreign borrowers have
been known to have comparative borrowing advantages in domestic markets.
Also, because bank’s assessments of borrowers’ creditworthiness have often
differed from those of bond investor, comparative borrowing advantages
between banking and bond markets have stimulated the use of swaps to take
advantages of them. In many cases these market discrepancies have helped the
borrowing cost to reduce by more than 50 basis points. However, the gains
from arbitrage on the base of comparative borrowing cost have tended to
decrease as borrowers have responded to the opportunities. Yet, the volume of
swap financing has continued to increase and shows every indication of further
expansion. This makes it clear that there is much more to the swaps than just
comparative borrowing costs.
Swaps also result in cost savings which may arise as by-product of hedging
with swaps or from what has been called “tax and regulatory arbitrage’. In
addition, swaps have sometimes lowered borrowing costs by developing new
markets or allowing borrowers’ access to markets that were previously closed
to them.
Thus, various reasons why firms use currency swaps are – first, currency swap
may be used to hedge against foreign exchange risk. Hedging can lower a
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Notes firm’s borrowing costs because it reduces uncertainty of cash flows and the
probability of unfavouravble changes in the value of assets and liabilities,
thereby making firms more creditworthy. Second, because it increases the total
amount that a firm can borrow, it facilitates economies of scale, which can
reduce operating costs. Third, a firm may be able to use their surplus funds
more effectively in blocked currencies. Fourth, swaps may be used as a way of
circumventing exchange control regulations. Fifth, currency swaps can be used
as a means of exploiting arbitrage opportunities. Finally, currency swaps play
an important role in integrating the world’s capital markets by overcoming
barriers to international capital movements.
7.3.2 Forms of Currency Swaps
The various forms of currency swaps are:
 Cross-currency Fixed-to-fixed swap: The motivation for this type of swap
is that each of the two counterparties has access to cheap funds in different
countries. Each counterparty can raise funds in the country in which they
have advantage and enter into a swap whereby the payments are
transformed into the currency that they prefer.
 Cross-currency Floating-to-fixed swap: Often a non-US dollar based bank
has medium-term floating assets denominated in dollars. The bank needs to
fund its medium-term floating dollar assets with medium-term floating
dollar liabilities. However, it can only raise funds cheaply on a fixed rate
basis in its domestic currency. A swap is a way to solve this problem.
Example: Counterparty A is domiciled in the United States, and

counterparty B is domiciled in Switzerland. In this case, counterparty A is
in a position to borrow cheaply in US dollar on a floating rate basis and
counterparty B is in a position to borrow cheaply on a fixed rate basis in
Swiss francs. Each counterparty can use its comparatively strong
borrowing capacity to reduce the overall cost of funds by entering into a
currency swap.
Counterparty A can borrow floating rate funds in the US dollar money
market at LIBOR plus a margin. Counterparty B can borrow fixed rate
funds cheaply in Swiss francs by way of a bond issue. During the swap,
counterparty B can pay floating rate dollars to Counterparty A to service
the dollar loan. Counterparty A can pay fixed rate Swiss francs to
counterparty B to service the Swiss francs loan.
 Cross-currency Floating-floating (basis) swaps: This type of currency
swap is used as an alternative to the foreign exchange market. It does not
tend to be widely used because of capital adequacy requirements, but it is
certainly worth knowing how to use it. Its main advantage is that the
counterparties can obtain a term commitment which would roll over an
effective forward foreign exchange contract according to an agreed period.
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Lesson 7 - Swaps
 Basis swaps: Basis swaps involve an exchange of floating rate payments Notes
calculated on different basis. The structure of a basis swap is the same as
the straight interest rate swap, with the exception that floating interest
calculated on one basis is exchanged for floating interest calculated on a
different basis.
Example: Examples of basis swaps include LIBOR-LIBOR (3

months against 6 months, etc.), Prime-LIBOR and CP-LIBOR.
 Amortizing swaps: Amortizing swaps are very popular for lease based
transaction where the principal reduces annually or even more frequently.
Example: Company A has borrowed $9 million to buy a building.

They have agreed with their bankers to pay back the loan, principal plus
interest at 8.50% fixed, over 3 years. Company A thinks that interest rates
are going to fall over the period and thus would prefer to pay a floating rate
rather than fixed rate. Company A can enter into a swap with the bank in
which the notional principal decreases on each of the amortization dates.
 Roller-coaster swaps: A variation on the amortizing swap is the roller-
coaster swap where the principal involved increases and decreases over the
life of the swap.
 LIBOR adjustments and Off-market coupons: An off-market coupon or
non-par value swap is one which has a fixed rate above or below the
currency market rate. In this case, an up-front payment is made which is
equal to the present value of the annuity based on the difference between
the off-market coupon swap rate and the current market rate, multiplied by
the notional principal amount.
 LIBOR-in-arrears swaps: In a generic swap, LIBOR is normally set 6
months and 2 days before a payment date; however, it is possible to
structure a swap so that LIBOR is fixed 2 days before the payment date.
This structure may be advantageous when the yield curve is positively
sloped and the implied forward rates are higher than the physical yield
curve, but at the same time, the swap user expects that short-term rates will
remain stable or decrease.
 Participation swaps: The participation swap is a new hybrid product,
which incorporates the advantages of the swap and cap/floor products.
Under this arrangement, an interest rate swap is transacted to cover a
portion of the notional principal and an interest rate cap is transacted to
cover the remainder of the notional principal. The fixed rate on the swap
and the strike price on the cap are identical. The term and periodicity of the
cap and swap are also identically matched. There is no up-front premium
payable.
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Notes  Zero-coupon swaps: Like a zero-coupon bond, the player in a zero-coupon

swap will make only one fixed payment at maturity. The ultimate fixed
payment is a single forward rate based on the compounding of the
immediate cash flows at the swap rate. This structure is most commonly
used in conjunction with zero-coupon bond issues, so the issuer’s net cash
flow is almost identical to what it would have been if it had issued a low
cost coupon floating rate instrument.
 Commodity swaps: Innovations in the swap market have enabled users to
link the transactions to various floating indices. Commodity swaps have
proven to be such an innovation. Commodity swaps work the same way as
interest rate swaps except the floating index is based on commodity, most
commonly gold, oil or wheat. It is a useful hedging tool for manufacturers
which require a certain commodity for the production of their goods, yet
are exposed to an increase in the price of the commodity.
7.4 ROLE OF FINANCIAL INTERMEDIARY

Primary dealers, Banks and financial institutions are allowed to enter into Rupee
IRS for the purposes of hedging their exposure as well as for market making.
However, corporate customers are allowed to enter into Rupee IRS only for the
purposes of hedging the interest rate risk on an underlying asset/liability. In the
case of non-Rupee IRS all participants are allowed to enter into these
transactions only for the purposes of hedging an underlying exposure.
Usually, two non-financial companies do not come in context with each other
directly for arranging a swap in the way as shown in the figures 7.6 and 7.7.
Each one of them transact with a financial intermediary such as a bank of other
financial institution. “Plain vanilla” fixed or floating swaps on U.S interest
rates are normally structured for the financial institution to earn about 3 basis
points on a pair of offsetting transactions.
5.2% 5%
Company Company
A B
LIBOR LIBOR + 0.8%

Source: http://www.ucema.edu.ar/u/jrs06/Derivados_Financieros_2011/Capitulos_Adicionales/CHAPTER_5.pdf
Figure 7.6: Companies A and B each uses the Swap to Transform a Liability
5%
4.7% Company Company
A B
LIBOR -0.25% LIBOR

Source:http://www.ucema.edu.ar/u/jrs06/Derivados_Financieros_2011/Capitulos_Adicionales/CHAPTER_5.pdf
Figure 7.7: Companies A and B each uses the Swap to Transform an Asset
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Lesson 7 - Swaps
Figure 7.8 depicts the role of the financial institution’s role in case of situation Notes
existing in Figure 7.6. The financial institution comes into two offsetting swap
transactions with companies A and B. Assuming that neither A nor B defaults,
the financial institution is sure of making a profit of 3 basis points per year on
the principal. Figure 7.9 shows the role of the financial institution in the
circumstance as shown in figure 7.7.
4.985% 5.015%
5.2% Company Financial Company
A Institution B
+0.8%
LIBOR LIBOR LIBOR +0.8%
Figure 7.8: Interest Rate Swap from Figure 7.2, when Financial Intermediary is used
Company A 4.985% Financial Institution 5.015% Company 4.7 %

B
LIBOR -
0.25% LIBOR LIBOR
Figure 7.9: Interest Rate Swap from Figure 7.3, when Financial Institution is used
It is to be noted that in every case, the financial institution consists of two
separate contracts. When one companies defaults, the financial institution still
has to abide by its agreements with the other company. The 3-basis-point
spread earned by the financial institution is partly to remunerate it for the
default risk it is bearing.
7.5 WAREHOUSING
Warehousing Swaps can be described as arranging a swap contract with one
counterparty without having arranged an offsetting swap with another
counterparty.
In practice, it is contrary that two companies will contact a financial institution
appropriately at the same time and wish to take opposite positions in exactly
the same swap. Due to this reason, many of the large financial institutions are
prepared for warehousing interest rate swaps. This consists of entering into a
swap with one counterparty, and then hedging the interest rate risk until a
counterparty wishes to take an opposite position is found.
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Notes
Learning Activity
Review the annual report of an MNC of your choice. Did the MNC
enter into a swap deal in the recent past? Explain how the MNC
benefited from the swap deal. Also perform a forecasted scenario
analysis to show how the MNCs would fare in the coming years.
Currency Swap Pact Between IFC and SBI
T he World Bank’s private lending arm, International Finance

Corporation entered into a currency swap agreement with State Bank
of India as part of efforts to increase its business in the country
further from $400 million since FY 2000.
According to the agreement, IFC would provide loans to Indian companies
in local currency without their being exposed to foreign exchange risk. The
facility is expected to be particularly useful in IFC’s efforts to extend local
currency financing for the infrastructure as well as for the general
manufacturing sector.
This offering would complement IFC’s other rupee financing products,
which include partial guarantees and structural finance products. With
annual business volume of about $400 million, India has emerged as the
largest recipe of IFC financing in the financial year ended 2001. IFC’s
initiatives in local currency financing are expected to sustain further growth
in the size and diversity of its business in India.
Questions:
1. Discuss the Swap agreement between IFC and SBI.
2. How the Swap agreement would impact the two corporations. Discuss.
1. Swaps can be used to hedge certain risks such as

interest rate risk, or to speculate on changes in the
underlying.
2. Interest rate swaps are used by a wide range of
commercial banks, investment banks, insurance
companies, mortgage companies, investment vehicles
and trusts, government agencies.
SUMMARY
 Swaps can be divided into two types viz., (a) Currency Swaps, (b) Interest
Rate Swaps.
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Lesson 7 - Swaps
 Swaps can broadly be classified into two types: Fixed to floating and Notes
floating to floating. The five generic types of swaps in order of their
quantitative importance are: Interest Rate Swaps, currency swaps, credit
swaps, commodity swaps and equity swaps.
 The two parties that agree to exchange the cash flows are called
counterparties of the swap. The principal amount is notional because there
is no need to exchange actual amounts of principal in a single currency
transaction: there is no foreign exchange component to be taken account of.
Equally, however, a notional amount of principal is required in order to
compute the actual cash amounts that will be periodically exchanged.
 The types of interest rate swaps are basis swap, forward swap, putable
swap, rate capped swaps, deferred rate swaps, callable swaps and
extendible swaps.
 Upon determining that an interest rate swap would be a prudent financial
decision, an entity employs a swap dealer to arrange the terms of the swap.
The party with the outstanding floating rate debt seeks the lowest possible
fixed rate. Other factors, such as the financial strength of the dealer and the
counterparty, also are considered at this time. The counterparty’s floating
rate usually is determined using an index.
 The currency swap developed from back-to-back loans and parallel loans
and also functions virtually in the same manner. At present, the currency
swap market, although older than the interest rate market, is smaller and
less sophisticated.
 The various forms of currency swaps are – Cross-currency fixed to fixed
swap; Cross-currency Floating-to-fixed swap; Cross-currency Floating-
floating(basis) swaps; basis swaps; amortizing swaps; roller-caster swaps;
LIBOR-in-arrears swaps; participation swaps; zero-coupon swaps and
commodity swaps.
 Primary dealers, Banks and financial institutions are allowed to enter into
Rupee IRS for the purposes of hedging their exposure as well as for market
making. However, corporate customers are allowed to enter into Rupee IRS
only for the purposes of hedging the interest rate risk on an underlying
asset/liability. In the case of non-Rupee IRS all participants are allowed to
enter into these transactions only for the purposes of hedging an underlying
exposure.
 In practice, it is contrary that two companies will contact a financial
institution appropriately at the same time and wish to take opposite
positions in exactly the same swap. Due to this reason, many of the large
financial institutions are prepared for warehousing interest rate swaps. This
consists of entering into a swap with one counterparty, and then hedging
the interest rate risk until counterparty wishes to take an opposite position
is found.
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Notes KEYWORDS
Callable Swaps: A callable swap gives the holder, i.e. the fixed-rate payer, the
right to terminate the swap at any time before its maturity.
Currency Swaps: The currency swaps are agreements whereby currencies are
exchanged at specified exchange rates and specified intervals. The basic
purpose of swaps is to lock in the rate.
Forward Swaps: Forward swaps are those swaps in which the commencement
date is set at a future date.
Interest Rate Swaps: An interest rate swap is an agreement whereby one party
exchanges one set of interest rate payments for another.
London Inter-Bank Offered Rate: This is a rate decided on daily basis based
on a sample of lending rates offered by leading banks in London.
Swaps: A swap can be defined as the exchange of one stream of future cash
flows with another stream of cash flows with different characteristics.
1. What is a swap?
2. Discuss the various types of Swaps.
3. Define Interest rate Swaps.
4. What are the characteristics and advantages of Interest rate Swaps?
5. How do Swaps work?
6. What are Currency Swaps? Give an example of Currency Swap.
7. Explain at least four forms of currency swaps.
8. What is a LIBOR rate?
9. What do you mean by Commodity Swap?
10. What are basis swaps?
1. “Swaps are risk-management instruments; yet they give rise to certain risk
themselves”. Elucidate with examples.
2. How do companies benefit from Interest Rate swaps and currency swaps?
Give examples to illustrate your answer.
3. ‘Swap remains a good bet to protect interest rate position in these times of
rising yields. Some gains by the side are also likely.’ Comment
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Lesson 7 - Swaps
4. Explain the role of intermediaries in Swap transactions. Why there arises a Notes
need to warehouse interest rate swaps?
5. Companies A and B has offered the following rates per annum on a $20
million five-year loan:
Fixed rate Floating rate
Company A 13.0% LIBOR +0.3%
Company B 14.5% LIBOR +0.5%
Company A requires a floating-rate loan: Company B requires a fixed-rate

loan. Design a swap that will net a bank, acting as intermediary, 0.2 % per
annum and that will appear equally attractive to both companies.
FURTHER READINGS
Chance, Don and Brooks, Roberts (2012), Introduction to

Derivatives and Risk Management, 9th edition, Cengage Learning.
John Wiley & Sons.
Verma, Rama, Jayanth (2008), Derivatives and Risk Management,
Tata McGraw Hill Education.
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Notes
LESSON 8 - VALUATION OF SWAPS
CONTENTS
Learning Objectives
Learning Outcomes
Overview
8.1 Valuation of Interest Rate Swaps and Currency Swaps
8.1.1 Valuation of Interest Rate Swap
8.1.2 Valuation of Currency Swap
8.2 Bonds and Floating Rate Notes
8.2.1 Bonds
8.2.2 Floating Rate Notes –FRNs
8.3 Credit Risk
Summary
Keywords
Further Readings
LEARNING OBJECTIVES
 Understand the Valuation of Interest rate SWAPs and Currency SWAPs
 Describe what are Bonds and FRNs
 Explain what is a Credit Risk
LEARNING OUTCOMES
understanding of:
 the concept of swaps as a powerful tool propelling global capital market
integration.
 the datum that in case of currency swaps, the valuation can be determined
by considering the swap as a portfolio of two bonds.
 the fact that the intermediation of currency swaps by global bankers play a
crucial role in the globalization of the world’s financial marketplace.
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Lesson 8 - Valuation of Swaps
OVERVIEW Notes
In the previous lesson you had studied about the definition of SWAP, Interest
rate SWAP, Currency SWAP, the role of financial intermediary and the
meaning of Warehousing.
Swaps have now integrated with all sorts of other more traditional financial
arrangements. Therefore, not only do the treasury staffs of companies have to
be well versed in swaps, but the bank officers who call on those people also
have to understand how swaps can be used to help companies accomplish their
financial objectives.
Two categories of swaps have denominated the swap revolution: currency
swaps and interest rate swaps. In a currency swap, the counter parties initially
exchange a principal amount in one currency for the same amount converted to
another currency at the prevailing spot rate. Interest payments are then made in
the respective currencies at interest payment dates and the principal amounts
are re-exchanged at maturity. In an interest-rate swap, the counter parties agree
to exchange interest payments based on a notional principal; no actual
exchange of principal takes place.
The market for both currency and interest rate swaps has grown substantially
during the last two decades. For instance, although the first interest rate swap
appeared in 1982, the total amount of interest rate swap outstandings increased
from $ 683 billion at year end 1987 to $309,588 billion in Dec 2007 to $356,
772 billion in June 2008.
Swaps, together with futures, options and other financial derivatives that rose
to prominence during the last two decades, have attained a certain maturity.
Individually and together, they allow yield curve and currency risks and
liquidity and geographic market considerations, all to be managed separately –
and also independently of underlying cash market states.
Thus, swaps are a powerful tool propelling global capital market integration.
However, the realisation of total swap potential will require resolution by
governments and judicial authorities of tax and legal issues, plus revamping of
management and accounting practices concerning risk exposure.
In this lesson, you will learn about the Valuation of Interest rate SWAPs and
Currency SWAPs, Bonds and FRNs, Credit Risk.
8.1 VALUATION OF INTEREST RATE SWAPS AND

CURRENCY SWAPS
The price of the swap is the difference between the values of two cash flows.
Swaps can be priced by determining the values of each stream of cash flows.
The value of each stream of cash flow is nothing but the present value of cash
flow in the stream. If the cash flow is in different currencies, the present values
are converted into a single currency at the prevailing exchange rate.
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Notes
Swaps can be valued on the similar ways as bonds as they

constitute a series of cash flows at various points of time.
The cash inflows are first discounted at an appropriate rate to find the present
value. This process is continued for cash outflows too. The difference between
the present value of inflows and outflows is simply the value of swap.
Normally, the prevailing LIBOR rate (in India, we use PLR rate) is used for
discounting the cash flows of floating rate and market quoted rate is used for
fixed rate.
 There are two approaches of swap valuation that are as follows:
 Swap may be considered as long term forward contract.
 Swap may be considered as portfolio of two bonds.
8.1.1 Valuation of Interest Rate Swap

Let us assume that at maturity the fixed rate party and the floating rate party
provide each other equal amount of cash, and then the value of swap is nothing
but the value of fixed coupon bond minus the floating rate note.
Symbolically,
Pi = Vb – Vf .... (1)
Where P denotes the price or value of the swap; Vb denotes the value of fixed
coupon bond; and V denotes the value of floating rate note.
At times when the market rate varies, the value of both the fixed and floating
rate side will be different. It is to be noted that the cash flows on the fixed leg
do not change but discount factor changes. On the floating side, both cash
flows and discounting factor change.
Example 1: A financial institution structures a 2-year interest rate swap

at a 6-month treasury bill rate for a quote of 7 per cent(bid) on 1 March on a
notional amount of ` 10 million. The financial institution will pay the firm 7
per cent p.a. on the notional amount every six months and receive from the
firm the applicable 6-month treasury bill rate.
The firm pays or receives interest from the financial institution on the basis of
the market treasury bill rates on exercise dates. Since the swap was initiated in
March in year 1, the 6 month T-bill rate prevalent in March in year-1 will be
the floating rate for the next exercise date. Thus, the 2-year interest rate swap
will involve a comparison of the respective floating rates with the fixed rate to
determine the net cash inflow(outflow) to the firm. Whenever the floating rates
are lower than the fixed rate, the firm receives cash flows from the financial
institution and when the floating rates are higher than the fixed rate, the net
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differential cash flows are paid by the firm to the financial institution. The Notes
related cash flows for the swap duration for the firm are given in Table 8.1
Table 8.1: Cash Flows from Swap Structure
Interest Payment Fixed Rate 6-Month T- Floating Fixed Cash Net Cash
Date Bill Rate Cash Flow(`) Flow(`) Flow for the
Firm (`)
March, year 1 7% 6.61%
September, year 1 7% 6.77% 330,500 350,000 19,500
March, year 2 7% 7.98% 330,500 350,000 11,500
September, year 2 7% 7.33% 399,000 350,000 (49,000)
March, year 3 7% 7.45% 366,500 350,000 (16,500)
The March, year 1 treasury bill rate is applied for computing the floating rate
cash flow for September, year 1. The difference in interest rates (0.39 per cent)
on the notional amount of ` 10 million for six months is ` 19,500 (0.39%
*10,000,000*(1/2)). This amount will be a receipt for the firm from the
financial institution since payment rates are lower than the fixed rates set by
the financial institution. September, year 1 treasury bill rates are applicable to
determine the floating rate payment of the firm for March, year 2. Here also the
firm receives a cash flow of ` 11,500 since the differential interest rate is
positive for the firm (0.23 percent). The notional amount for subsequent cash
flows also remains the same at ` 10 million since this amount is a non-
amortized notional obligation between the counterparties.
The March, year 2 treasury bill rates(7.98 percent) are higher than the swap
rate of the financial institution and hence, the firm will make a payment for
` 49,000 (0.98% *10,000,000*(1/2)) in September, year 2.
Again the September, year 2 rates are higher at 7.33 percent requiring the firm
to make a cash outflow of ` 16,500(0.33%*10,000,000*(1/2)) for the six
months in March, year 3, when the 2-year swap contract comes to an end. The
respective cash flows over the swap duration for the financial institution and
the firm are given in Figure 8.1.
Source: https://books.google.co.in/books
Figure 8.1: Swap Contract Cash Flows
ANNA UNIVERSITY 215

Notes
Example 2:Companies A & B have been offered the following rates per
annum on a $20 million five-year plan.
Fixed Rate Floating Rate
Company A 5% LIBOR+0.5%
Company B 6.5% LIBOR+1.0%
Company A requires a floating rate loan; Company B requires a fixed rate

loan. Design a swap that will net a bank; acting as intermediary, 40 basis points
per annum and that will appear equally attractive to both companies.
Solution: Company ‘A’ requires floating rate loan. Where as Company ‘B’
requires fixed rate loan.
But in reality;
Company A has an advantage in fixed rate as well as in floating rate.
But in fixed rate advantage = (6.5 – 5)% = 1.5%
In floating rate advantage = (LIBOR + 1 – LIBOR-0.5)%=0.5%
So, Company A has comparative advantage in fixed rate.
For this, “A” searches for a counter party, who has a comparative advantage in
floating rate, that is only possible through an intermediary (banks) than only
swap deal occurs.
Before the deal, Company “A” paid floating rate interest LIBOR+0.5%
But after the deal, paid by company LIBOR+0.2%
So, total gain =>LIBOR+0.5% – LIBOR – 0.2%=0.3%
Before the deal Company B paid fixed rate interest 6.5%
But after the deal, interest paid by company 6.2%
So, total gain =>6.5% – 6.2%=0.3%
For the bank, gain in fixed rate=>(6.2 – 5)%=1.2%
Gain in floating rate=>LIBOR+0.2% – LIBOR – 1%=(–)0.8%
Total Gain of Bank=1.2% – 0.8%=0.4%
216 ANNA UNIVERSITY

Notes
Example 3: Nestle rolls over a $25 million loan priced at LIBOR3 on a
three-month basis. The company feels that interest rates are rising and that
rates will be higher at the next roll-over date in three months time. Suppose the
current LIBOR3 is 5.4375%.
(a) Explain how Nestle can use an FRA at 6% from credit Suisse to reduce its
interest rate risk on this loan.
(b) In three months time interest rates have risen to 6.25%. How much will
Nestle receive/pay on its FRA? What will be Nestlé’s hedged interest expense
for the upcoming three-month period?
(c) After three months, interest rates have fallen to 5.25%. How much will
Nestle receive/pay on its FRA? What will be Nestlé’s hedge interest expense
for the next three-month period?
Solution: (a) Nestle can borrow at FRA 6% from Credit Suisse and give it
FRA at LIBOR to reduce its Interest rate risk. In this Credit Suisse is offering
the FRA to Nestle.
(b) In the upcoming 3 months, the rate for LIBOR has increased to 6.25%
which means that Nestle has to make a net payment of 0.25% to the bank.
The payment will be $0.015625mn (3 month period)
(c) After the 3 month period if the net rates have fallen to 5.25%. This means
that the bank will have to pay Nestle a net payment at 0.75%
The payment will be $0.046875 mn (3 month period)
Example 4: A financial institution has entered into an interest rate swap

with company X. Under the terms of the swap, it receives 10% per annum and
pays six-month LIBOR on a principal of $10 million for five years. Payments
are made every six months. Suppose that company X defaults on the sixth
payment date when the interest rate is 8% per annum for all maturities. What is
the loss to the financial institution? Assume that six month LIBOR was 9% per
annum halfway through year 3.
Solution: The Bank pays LIBOR and receives 10%.
After the 5th payment the company defaults on payments to the bank.
In this case the loss would be:
Total No. of payments = 10
No. of payments left = 5
Difference in Interest rates that the company would pay = 2%
The amount based on that = 5 × 2 × 10/(2 × 100) mn= $0.5 mn
If the LIBOR was 9% midway through year 3,
ANNA UNIVERSITY 217

Notes Then this means that for the last 5 payments the difference on interest rates
becomes 1%
The loss to the bank based on that = 5 × 1 × 10/(2 × 100) = $ 0.25 mn
Example 5: Under the terms of an interest rate swap, a financial

institution has agreed to pay 10% per annum and to receive three-month
LIBOR in return on a notional principal of $100 million with payments being
exchanged every three months. The swap has a remaining life of 14 months.
The average of the bid and offer fixed rates currently being swapped for three-
month LIBOR is 14% per annum for all maturities. The three-month LIBOR
rate one month ago was 12.5% per annum. All rates are compounded quarterly.
What is the value of the swap?
Solution: Remaining Life of 14 months would lead to = 5 interest payments.
The rate for payment after 2 months = 12.5%
The rate for the payment for all subsequent payments = 14%
The value for the payments is:
Period LIBOR Difference Rate Amount Payable
2 months 12.5 2.5 0.83 mn
5 months 14 4 1.33 mn
8 months 14 4 1.33 mn
11 months 14 4 1.33 mn
14 months 14 4 1.33 m
Total value of the swap = $ 6.17 mn

8.1.2 Valuation of Currency Swap
In case of currency swaps, the valuation can be determined by considering the
swap as a portfolio of two bonds. So, the price of swap will be the difference
between the current value of both the bonds, one denominated in the foreign
currency and another in the local currency.
Symbolically,
Pc = Vf – Vl .... (2) Where Pc denotes the price or value of the currency
swap; Vf denotes the value of foreign currency bond; and Vl denotes the value
of local currency bond.
Example 6: Let us consider a flat rate of interest in India and the USA.
The US rate is 3% per annum and Indian rate is 8% per annum, both the rates
being compounded continuously. The ICICI Bank has entered into a currency
swap where it receives 7.5 % per annum in Indian currency and 4 % per annum
in US dollars. The principal amounts in both the currencies are ` 5 lakhs and
218 ANNA UNIVERSITY

US $ 75 lakhs. The swap period is for two years and current exchange rate is 1 Notes
US$ = ` 45.00.
The price of the currency swap is as given below:
P =V –V
V = 0.375e + 5.375 e = $ 0.3461 + $ 4.5802 = $ 4.9263 = ` 221.6835
V = 3e + 78e = ` 2.9113 + ` 73.4576 = ` 76.3689
Therefore, P = ` 221.6835 – ` 76.3689 = ` 145.3146
If ICICI Bank were to pay US$ and receive Indian Rupees, the value of the
currency swap would have been ` 145.3146.
Example 7: Company A, a British manufacturer, wishes to borrow US

dollars at a fixed rate of interest. Company B, a US multinational, wishes to
borrow sterling at a fixed rate of interest. They have been quoted the following
rates per annum (adjusted for differential tax effects).
Sterling US dollars
Company A 11.0 % 7.0%
Company B 10.6 % 6.2%
Design a swap that will net a bank, acting as intermediary, 10 basis points per
annum and that will produce equally gain per annum for each of the two
companies.
Solution: Company “A” wishes to borrow US dollars
Company “B” wishes to borrow Sterling
But Company B has competitive advantage in both (Sterling & US dollars).
In Sterling advantage is = (11.0 – 10.6) % = 0.4%
In US dollars advantage is = (7.0 – 6.2) % = 0.8%
So, Company B has competitive advantage in US$, but he wants to borrow
Sterling.
Therefore B wants a counter party who has competitive advantage in sterling,
but really wants US dollars. So he gets Company A, both go for swap deal with
the help of a financial institution.
ANNA UNIVERSITY 219

Notes For Company A:

Before the deal Company A gives 7% US $
But after the swap deal he gives 6.85% US $
So Gain for A=>(7 – 6.85)%=0.15% US $
For Company B:
Before the deal, company B gives 10.6% sterling
But after swap deal he gives 10.45% sterling
So Gain for B = (10.6 – 10.45) % = 0.15% sterling
For Financial Institution:
In US dollar gain = (6.85 – 6.2)%=0.65%
In sterling gain = (10.45 – 11.0)% = (–) 0.55% sterling
Net Gain = (0.65 – 0.55)% = 0.10%
In practice, many currency swaps are arranged with a global bank as the
counterparty. Banks make intermediation profits by charging a fee and/or
spread for dealer services. The intermediated approach reduces the default risk
and lowers the search costs that would be present if two corporations, generally
of different nationalities, tried to structure a currency swap directly between
them. The intermediation of currency swaps by global bankers has played a
crucial role in the globalization of the world’s financial marketplace.
Example 8: A currency swap has a remaining life of 14 months. It

involves exchanging interest at 14% on Pounds 20 million for interest at 12%
on $40 million once a year. The term structure of interest rates in both the
United Kingdom and the United States is currently flat, and if the swap were
negotiated today the interest rates exchanged would be 9% in dollars and 12%
in sterling. All interest rates are quoted with annual compounding. The
current exchange rate is 1Pound =2 Dollars. What is the value of the swap to
the party paying sterling? What is the value of the swap to the party paying
dollars?
Solution: Payment conducted = annually
The period of swap left = 14 months
No. of payments due = 2
The amount of payment left to be paid:
In dollars = 12 × 2 × 40/100 = $ 9.6 mn
In Pounds = 14 × 2 × 20/100 = 5.6 mn Pounds
220 ANNA UNIVERSITY

If the current rates were used then : Notes

In dollars = 9 × 2 × 40/100 = $ 7.2 mn
In pounds = 12 × 2 × 20/100 = $ 4.8 mn
For the party paying Sterling:
Amount received currently = 5.6 – 9.6/2 = Loss 0.8 mn Pounds
At new rates = 4.8 – 7.2 = Loss 1.2 mn pounds
Total Value of Swap = 0.4 mn Pounds
For the party paying in Dollars:
Amount Received currently = 1.6 mn $
Amount to be received at current rates = 2.4 mn $
Total value of swap = 0.8 mn $
Example 9: A financial institution has entered into a 10-year currency

swap with Company Y. Under the terms of the swap. It receives interest at
3% per annum in Euros and pays interest at 9% per annum in U.S dollars.
Interest payments are exchanged once a year. The principal amounts are 8
million dollars and 10 million Euros. Suppose that company Y declares
bankruptcy at the end of the year 6, when the exchange rate is $0.80 or Euros.
What is the cost to the financial institution? Assume that, at the end of year 6,
the interest rate is 3% per annum in Euros and 8% per annum in U.S dollars for
all maturities. All interest rates are quoted with annual compounding.
Solution: Interest rate on Euros = 3%
Interest rate on Dollars= 9%
Amount in Dollars = 8 mn
Amount in Euros = 10 mn
Year of declared Bankruptcy = Year 6
No. of years left for payment after the declaration = 5
Exchange rate = $0.8/Euro
The amount to be received by the institution for the remaining period = 3 × 5 ×
10/100 = 1.5 mn Euros
Converting into $ at $0.8/Euro = $1.2 mn
The amount to be given by the institution for the remaining period = 9 × 5 ×
8/100= $33.6 mn
The cost to the bank is = - $ 2.4 mn
If the interest rate for Dollars = 8%
ANNA UNIVERSITY 221

Notes Then,
The amount to be given by the institution for the remaining period = 8 × 5 ×
8/100= $3.2 mn
The cost to the bank is = – $ 2.0 mn
Learning Activity
Write a note analyzing the relationship of (a) Swap Value to Bond
prices and (b) Swap Value to Forward Rate Agreements.
8.2 BONDS AND FLOATING RATE NOTES

Bonds and FRNs (Floating Rate Notes) are means of debt investment.
8.2.1 Bonds
Bonds are a means of debt investment where an investor credits the money to
an entity (corporate or governmental) that borrows the funds for a specified
period of time at a fixed interest rate. Bonds are used by companies,
municipalities, states and U.S. and foreign governments for financing a variety
of projects and activities.
The indebted entity (issuer) issues a bond that defines the interest rate (coupon)
that will be paid and when the loaned funds (bond principal) are to be returned
(maturity date). Interest on bonds is normally paid every six months (semi-
annually). The prime divisions of bonds are corporate bonds, municipal bonds,
and U.S. Treasury bonds, notes and bills, which are collectively called as
“Treasuries."
Two features of a bond - credit quality and duration - are the principal
indicators of a bond's interest rate. Bond maturities range from a 90-day
Treasury bill to a 30-year government bond. Corporate and municipals are
frequently in the three to 10-year range.
8.2.2 Floating Rate Notes –FRNs
Floating Rate Notes is a debt instrument with a variable interest rate. It can also
be called a “floater” or “FRN”, a floating rate note’s interest rate is linked with
a benchmark such as the U.S Treasury bill rate, LIBOR, the fed funds or the
prime rate. Floaters are primarily issued by financial institutions and
governments and they mostly have a two-to-five-year term to maturity.
Floating rate notes (FRNs) make up an important component of the

U.S investment-grade bond market, and they tend to become more
prosperous when interest rates are anticipated to increase.
222 ANNA UNIVERSITY

In contrast with fixed-rate debt instruments, floaters safeguard investors Notes

against a rise in interest rates. Because there is an inverse relationship between
interest rates and bond prices, a fixed-rate note’s market price will decline if
interest rates increase. FRNs deliver lower yields as compared to fixed notes of
the same maturity. They also have uncertain coupon payments, though if the
note has a cap or a floor, the investor will have the knowledge of the maximum
or minimum interest rate the note might pay.
The interest rate of an FRN can alter as often or as regularly as the issuer
selects, from once a day to once a year. The “reset period” informs the investor
how often the rates modify. The issuer may pay interest monthly, quarterly,
semiannually or annually. FRNs get issued with or without a call option.
Commercial banks, state and local governments, corporations and money
market funds buy these notes, which provide a variety of terms to maturity and
may be callable or non-callable.
Example 10: IBM International can borrow in the United States at 6

percent and in France at 9 percent. MicroSun International can borrow in
France at 8 percent and in the United States at 10 percent.
(a) Assume IBM and MicroSun borrow four-year, non-amortizing debt in the
foreign currency. Calculate for IBM and MicroSun showing percentages
for interest payments and principal. Assume annual interest payments.
(b) Suppose the two companies arrange a parallel loan in which IBM charges
MicroSun 9.5 percent on dollars and MicroSun charges IBM 8.5 percent
interest on Euro. Draw time lines illustrating the parallel loans.
(c) What are IBM’s net borrowing costs in Euro?
(d) What are MicroSun’s net borrowing costs in dollars?
Solution:
Company Rate in US Rate in France
IBM 6% 9%
MicroSun 10% 8%
(a) Since the companies have to borrow in foreign currency, IBM borrows in
France and MicroSun borrows in US.
Assuming IBM borrows 100,000 Euro.
Interest Payment (Euro) Principal Payment (Euro)
Payment after 1st Yr 9,000
Payment after 2nd Yr 9,000
Payment after 3rd Yr 9,000
Payment after 4th Yr 9,000 100,000
ANNA UNIVERSITY 223

Notes Total Payment: 136,000 Euro

Assuming MicroSun borrows 10,000$
Interest Payment (Euro) Principal Payment (Euro)
Payment after 1st Yr 1,000
Payment after 2nd Yr 1,000
Payment after 3rd Yr 1,000
Total Payment: 14,000$

(b) Incase of the companies arranging a parallel loan with each other
Company Rate given Rate received
IBM 9.5% ($) 8.5% (Euro)
MicroSun 8.5% (Euro) 9.5% ($)
Assuming IBM borrows 10,000$ and gives to MicroSun

Assuming MicroSun borrows 100,000 Euro and gives to IBM
Payment made by IBM Payment by MicroSun
to MicroSun (Euro) to IBM ($)
Payment after 1st Yr 8,500 950
Payment after 2nd 8,500 950
Yr
Payment after 3rd Yr 8,500 950
(c) IBM’s Net Borrowing Costs in Euro : 34,000Euro

(d) MicroSun’s Net Borrowing Costs in Dollars : 3,800 $
Example 11: Consider the following indication pricing Schedule for

currency coupon swaps of yen and pounds sterling:
Currency Coupon swap Indication Pricing Schedule (Yen/Pound)
Maturity Midrate
2 years 5.90% sa
3 years 6.28% sa
4 years 6.35% sa
5 years 6.48% sa
Deduct 8 bps if the bank is paying a fixed rate.

Add 8 bps if the bank is receiving a fixed rate.
All quotes are against six-month yen LIBOR flat.
Bonds in Japan and the United Kingdom are quoted as a bond equivalent
yield.
224 ANNA UNIVERSITY

(a) Japan International (JI) has three-year debt at a floating rate money market Notes
yield of six-month LIBOR+115 bps. JI wants fixed-rate pound sterling
debt to fund its U.K operations. Describe JI’s yen-for-pound currency
coupon swap.
(b) British International Ltd (BI) has three-year fixed-rate pound debt at a bond
equivalent yield of 7.65 percent. BI wants floating rate yen debt to fund its
expansion into Japan. Describe BI’s pound-for-yen currency coupon swap.
(c) What does the swap bank gain from these transactions?
Solution: a. Japan International will borrow at LIBOR +115 bps
Bank will give Japan International at 6.28% -8 bps
This way the transaction will be
Institution Pays Receives
Japan Int LIBOR +115 bps 6.2%
Bank 6.2% LIBOR + 115 bps
(b) British International will borrow at 7.65%

Bank will give BI at LIBOR
Adjusting for the deductions, the final transaction will be:
British International 7.73% LIBOR
Bank LIBOR 7.73%
(c) The gain for the Bank from the transaction is:
Rate type Pays Receives
Fixed 6.2% 7.73%
Floating LIBOR LIBOR +115 bps
Net Benefit: 268 bps (2.68%)
Example 12: As an Investment Manager of Pettunia International

(Europe) at Citi bank’s capital, you manage Citi’s European exposures to
currency risk. Citi’s business in Poland generates polish zloty (ZI) cash inflows
of about ZI 40 millions per year, or about $10 million at the current exchange
rate of $0.25/ZI, although this amount is expected to fluctuate with Polish
interest rates. Citi’s Policy is to hedge one half of expected cash flows from
operations for up to five years. Banks are unwilling to quote forward exchange
rates beyond one year because of illiquidity in the Zloty forward market. A
ANNA UNIVERSITY 225

Notes Company quotes the following indication pricing schedule for currency coupon
swaps of zlotys and dollars:
Coupon Swap Indication Pricing Schedule (Z1/$)
Maturity Midrate( in ZI)
2 years 7.28% sa
3 years 7.08% sa
4 years 9.08% sa
5 years 8.05% sa
Deduct 60 bps if the bank is paying a fixed rate.

Add 60 bps if the bank is receiving a fixed rate.
All quotes are against six-month dollar LIBOR flat.
(a) In the absence of a zloty forward market, how can you hedge your Zloty
cash inflows?
(b) Suppose Citi has five-year dollar debt at a bond equivalent yield of 8.50
percent. Citi wants floating-rate Zloty debt to fund its polish operations.
Describe Citi’s dollar-for-zloty currency coupon swap.
(c) Zeta Partners (ZP) has five-year debt at a floating-rate money market yield
of six-month ($) LIBOR+235 bps. ZP wants fixed-rate dollar debt to fund
its U.S operations.
(d) What does the swap bank gain from these transactions?
Solution:
(a) Zloty cash flows can be hedged by purchasing coupon swaps for 5 yrs. This
way it can have an assured rate of interest.
(b) Citi will borrow at fixed rate of 8.5%
Bank will provide it at a floating rate of LIBOR
Citi 8.5% + 60 bps LIBOR
Bank LIBOR 8.5% + 60 bps
(c) SP will borrow at LIBOR + 235 bps

Bank will provide SP with at a fixed rate of 8.05% - 60 bps
ZP LIBOR + 235 bps 7.45%
Bank 7.45% LIBOR + 235 bps
(d) The gain for the swap Bank will be the following:
Rate type Pays Receives
Fixed 7.45% 9.1%
Floating LIBOR LIBOR + 235 bps
Net Gain: 4% or 400bps
226 ANNA UNIVERSITY

Notes
Example 13: Company A, a low-rated firm, desires a fixed-rate, long-
term loan. Company A presently has access to floating interest rate funds at a
margin of 2.5% over LIBOR. Its direct borrowing cost is 15% in the fixed-rate
bond market. In contrast, company B, which prefers a floating-rate loan, has
access to fixed-rate funds in the Eurodollar bond market at 12% and floating-
rate funds at LIBOR +1/2%.
(a) How can A and B use a swap to advantage?
(b) Suppose they split the cost savings. How much would A pay for its fixed-
rate funds? How much would B pay for its floating-rate funds?
Solution: The interest rate table for both the companies is as follows:
Company A B Comparative Advantage
Fixed 15% 12% 3%
Floating LIBOR +2.5% LIBOR +1.2% 1.3%
By looking at the rates it is easy to see that company B has an advantage in the
fixed rate market. So B will raise debt in the fixed rate market.
Step 1
Company A will raise money in the floating rate market and give a fixed rate to
company B.
Company B will raise money in the fixed rate market and give floating rate to
Company A.
The advantage in the interest rates of 1.7% will be divided between them both
in a required ratio.
Step 2 — Swap:
Co. A raises at 15%, Co. B raises at: LIBOR + 1.2%
Company A B
Borrowing LIBOR + 2.5% 12%
Co. A pays Co. B 12.5% 12.5%
Co. B pays Co. A LIBOR + 0.35% LIBOR + 0.35%
All in Cost of funding 14.65% LIBOR + 0.85%
Direct Funding 15% LIBOR + 1.2%
Savings .35% .35%
Example 14: Chrysler has decided to make a $100 million investment

in Mexico via a debt-equity swap. Of that $100 million, $20 million will go to
pay off high interest peso loans in Mexico. The remaining $80 million will go
for new capital investment. The government will go for new capital
investment. The government will pay 86 cents on the dollar for debt used to
pay off peso loans and 92 cents on the dollar for debt used to finance new
ANNA UNIVERSITY 227

Notes investment. If Chrysler can buy Mexican debt in the secondary market for 60
cent on the dollar, how much will it cost Chrysler to make its $100 million
investment?
Solution: If Chrysler decides to raise $ 100 mn in the secondary market then it
will cost it: $ 60 mn
Since the Govt. is paying Chrysler for the money, the total amount paid by the
government is:
For Peso loans: $17.20 mn
For New Capital Investment: $ 73.60 mn
Total paid by Government: $90.8 mn
So, the gain to Chrysler = $ 30.8 mn
Example 15: Companies A and B has been offered the following rates
per annum on a $20 million five-year loan:
Company A 13.0% LIBOR +0.3%
Company B 14.5% LIBOR +0.5%
Company A requires a floating-rate loan; company B requires a fixed-rate loan.

Design a swap that will net a bank, acting as intermediary, 0.2% per annum
and that will appear equally attractive to both companies.
Solution:
Co. A 13% LIBOR + 30 bps
Co. B 14.5% LIBOR +50 bps
The comparative advantage is of 150 – 20 = 130 bps

Two companies can enter the swap in the following manner:
A borrows loan at fixed rate of 13%
B Borrows loan at floating rate of LIBOR + 50 bps
With the Financial Intermediary netting 20 basis points, both the companies are
left with the benefit of = (130 – 20)/2 = 55 bps
A will pay LIBOR to Financial Intermediary and in turn get a fixed rate of
13.25 %
Financial Intermediary will pay LIBOR to B which in turn pays 13.45% to
Financial Intermediary.
Hence, by this SWAP, B just need to pay a fixed rate of 13.95 % instead of
14.50% and hence saves 55 bps on the transaction.
228 ANNA UNIVERSITY

Also, A will need to pay LIBOR + 30 – 55 = LIBOR – 25 as rate of interest. Notes

Financial Intermediary will net 20 bps.
The above mentioned SWAP can also be described as follows:
8.3 CREDIT RISK

The principles that govern the management of credit risk of swaps are the same
as other traditional banking business. Nevertheless, the measurement of the
exposure of a swap is more complicated.
The credit risk of a swap is the swap’s current exposure, which is the
replacement cost or the current M-T-M value, if positive, plus its future
replacement cost. This is the so-called “current exposure method”. The current
exposure method is not just an appropriate method for measuring credit risk of
swaps. It is recommended by the Basle Committee and the G-40 for measuring
credit risk of all derivatives.
The current exposure is straightforward. It is just the current M-T-M value of a
swap position if positive. If the M-T-M value is negative, the holder of the
position does not have current credit exposure. This is because credit default
occurs when a counterparty does not fulfill its financial obligation. It will not
default if it has a financial instrument with a positive market value.
Conservative market participants usually assign a zero value for an instrument
whose M-T-M value is negative unless there is a bilateral netting agreement.
The measurement of the future replacement cost or the “potential exposure” of
a swap or a derivative instrument is quite complicated. It usually needs
simulation techniques and mathematical models to derive a meaningful
measurement result. The analysis generally involves modeling the volatility of
the underlying variables and the effect of movements of these variables on the
value of the derivatives. For interest rate swaps, the variable is interest rates.
ANNA UNIVERSITY 229

Notes Because it does not involve exchange and re-exchange of principals, the risk
profile of a typical interest rate swap is shown in the diagram below :
Source: http://www.hkma.gov.hk/media/eng/publication-and-research/reference-materials/banking/ch05.pdf
Figure 8.2: Risk Profile of a Typical Interest Rate Swap

The expected exposure is the mean of all probability-weighted replacement
costs. The maximum potential exposure is an estimate of the “worst case”
exposure at any point in time.
The so-called “hump-back” profile is due to two offsetting effects : diffusion
effect and amortization effect. The diffusion effect says that due to the passage
of time, there is an increase of probability that the value of the underlying
instrument will drift substantially away from its original value. The amortization
effect is the reduction in the number of settlements as time elapses.
For an interest rate swap, its peak exposure for default is when sufficient time
has passed, the counterparty finds itself at an adverse position, and there is
sufficient time remaining for this adverse position to continue. This usually
happens at about the intermediate point during the life of a contract. Because
there is no final exchanges of principals, the risk exposure drops gradually to
zero at maturity after it reaches the maximum.
For cross currency swaps, the risk profile is different because the re-exchange
of principals at the end increases the diffusion effect and reduces the
amortization effect:
Source: http://www.hkma.gov.hk/media/eng/publication-and-research/reference-materials/banking/ch05.pdf
Figure 8.3: Risk Profile of Cross-currency Swaps
230 ANNA UNIVERSITY

How do you aggregate the maximum exposure of these two swaps? It is Notes
incorrect to simply add the two notional amounts together or add the two
maximum exposure amounts together and say that is the maximum exposure.
Why? It is easy to see it if you stagger the two above diagrams together. The
maximum exposure of the interest rate swap happens at about the mid-point of
the transaction while the maximum exposure of the currency swap is still
increasing. The maximum exposure for the currency swap is at the end of the
transaction. At that time, the exposure for the interest rate swap has reduced to
zero. For a portfolio of two swaps, you can still manage to aggregate the risk
manually. If there is a portfolio of hundreds or thousands of swaps, it is
necessary to use simulation technique to aggregate counterparty credit risk.
So far, the only potential current and future exposures are measured in case of
defaults by counterparty. The probability to measure the counterparty default is
generally viewed to be a function of credit ratings and of the maturity of the
transaction. The lower the credit rating and longer the maturity, the higher the
probability of default. The maturity factor is straightforward and does not need any
explanation. Credit analysis for swaps, however, is more a qualitative analysis
than quantitative analysis, and is an art rather than a science. Again, it is no
different from credit analysis for regular loans or for any other banking products.
After a reasonable probability of default factor is derived, the simplest way to
estimate credit loss for a swap is to multiply the expected or maximum
exposure by the specified probability of default factor. Others use more
sophisticated simulation analyses.
Example16: Suppose a financial institution gives 50 bp higher on

floating interest rate (LIBOR) on its deposits and pays floating interest rate to
housing society at a fixed rate of 14%. To hedge against the risk involved due
to non-payment of interest to the depositor, it enters into a swap agreement
with a dealer and makes that it will receive from the dealer G floating rate
(LIBOR) + 100 bp and will pay 14% fixed interest on the same notional
amount. In this process the financial institution gets a profits of (0.5%) on
notional amount. The dealer enters into another swap contract with a bank with
whom it agrees to pay a (LIBOR + 125 bp) and receives 14% interest on
notional principal. In this way, every participant gets profit due to this swap
transaction which can be shown by the following diagram:
Case I
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Notes Case II
If both the cases are merged in a single case

Case III
From the above figure it is clear that the profit to FI ‘A’ is 50 bp (0.50%), to
the bank ‘B’ is (0.25%) and to the swap dealer it is (1.25%).
There are various types of interest rate swaps. Zero coupon to floating swaps,
the fixed rate payer makes a bullet payment at the end and floating rate payer
makes periodic payments. Alternative floating rate type swap include
alternative floating rates e.g. 3-month LIBOR, 1-month CP, T-Bill rate etc.
which are charged to meet the exposure of other party. In a floating to floating
swap, one party pays one floating rate and the other pays another floating.
Forward swaps include exchange of interest rate payments that do not begin
until a predetermined future date in time. In a swaption, the features of swaps
and options are combined together. The buyer of a swaption has the right to
enter into an interest rate agreement by some specified time period and in case
the buyer exercises the option, the writer will become the counterparty. In a
swaption agreement it is clearly written that either the buyer should pay fixed
rate or floating rate. A call swaption provides the party paying fixed payment
the right to terminate the swap to maturity, thereby making the writer fixed
payer and floating receiver. In a put swaption, the writer has the right to
terminate the swap to the party making floating payments, thereby making the
writer of the put swaption as floating rate receiver and fixed rate payer. Equity
swap involves the exchange of interest payment linked to the stock index.
232 ANNA UNIVERSITY

Notes
The credit risk emerges from the likelihood of a default by the
counterparty, when the value of the contract to the financial institution
becomes positive.
Learning Activity
Analyze the role of Credit ratings in managing credit risks in any
financial transaction of a stock-broking company of your choice.
Under what parameters credit risks are being assessed? Discuss in
detail.
1. Bonds are frequently referred to as fixed-income

securities and are one of the three main asset classes,
along with stocks and cash equivalents.
2. Fannie Mae is one of the major FRN issuer. Its FRNs
have varied reference rates, consisting of three-month
T-bills, the prime rate, the fed funds rate, one-month
LIBOR and three-month LIBOR.
SUMMARY
 Swaps can be priced by determining the values of each stream of cash
flows. The value of each stream of cash flow is nothing but the present
value of cash flow in the stream. If the cash flow is in different currencies,
the present values are converted into a single currency at the prevailing
exchange rate.
 An interest rate swap can be valued either as a long position in one bond
alongwith a short position in another bond, or as a portfolio of forward rate
agreements.
 In case of currency swaps, the valuation can be determined by considering
the swap as a portfolio of two bonds. So, the price of swap will be the
difference between the current value of both the bonds, one denominated in
the foreign currency and another in the local currency.
 The indebted entity (issuer) issues a bond that defines the interest rate
(coupon) that will be paid and when the loaned funds (bond principal) are
to be returned (maturity date). Interest on bonds is normally paid every six
months (semi-annually).
 Two features of a bond - credit quality and duration - are the principal
indicators of a bond's interest rate. Bond maturities range from a 90-day
ANNA UNIVERSITY 233

Notes Treasury bill to a 30-year government bond. Corporate and municipals are
frequently in the three to 10-year range.
 In contrast with fixed-rate debt instruments, floating rate notes safeguard
investors against a rise in interest rates. Because there is an inverse
relationship between interest rates and bond prices, a fixed-rate note’s
market price will decline if interest rates increase
 A financial institution faces credit risk from a swap only when the swap
value to the financial institution is positive.
KEYWORDS
Bonds: Bonds are a means of debt investment where an investor credits the
money to an entity (corporate or governmental) that borrows the funds for a
specified period of time at a fixed interest rate.
Counterparty: The other party that enters into a financial transaction. Each
transaction should have counterparty for the conduct of smooth flow of
transaction. More specifically, every buyer of an asset must be linked with a
seller who is willing to sell and vice versa.
Coupon: The interest rate specified on a bond when it is issued. The coupon is
generally paid semiannually. It is also stated as the “coupon rate” or “coupon
percent rate”.
Credit Risk: Credit Risk is the risk of loss due to non-repayment by
counterparty.
Floating Rate Note: Floating Rate Notes is a debt instrument with a variable
interest rate. It is also called a “floater” or “FRN. Floaters are primarily issued
by financial institutions and governments and they mostly have a two-to-five-
year term to maturity.
Pricing of Swap: The price of the swap is the difference between the values of
two cash flows.
1. How interest rate SWAPS are valued?
2. How currency SWAPS are valued?
3. State the valuation of currency SWAP by giving an example.
4. What do you mean by bonds?
5. What are floating rate notes?
6. How do bonds differ from floating rate notes?
7. What is credit risk?
234 ANNA UNIVERSITY

8. How pricing of Swap is ascertained? Discuss. Notes

9. How are bonds different from floating rate notes? Discuss
10. Consider the following indication pricing Schedule for currency coupon
swaps of yen and pounds sterling:
Currency Coupon Swap Indication Pricing Schedule (Yen/Pound)
Maturity Midrate
2 years 5.90% sa
3 years 6.28% sa
4 years 6.35% sa
5 years 6.48% sa
(a) Deduct 8 bps if the bank is paying a fixed rate.

(b) Add 8 bps if the bank is receiving a fixed rate.
(c) All quotes are against six-month yen LIBOR flat.
Bonds in Japan and the United Kingdom are quoted as a bond equivalent
yield.
(a) Japan International (JI) has three-year debt at a floating rate money
market yield of six-month LIBOR+115 bps. JI wants fixed-rate pound
sterling debt to fund its U.K operations. Describe JI’s yen-for-pound
currency coupon swap.
(b) British International Ltd. (BI) has three-year fixed-rate pound debt at a
bond equivalent yield of 7.65 percent. BI wants floating rate yen debt to
fund its expansion into Japan. Describe BI’s pound-for-yen currency
coupon swap.
(c) What does the swap bank gain from these transactions?
1. A financial institution has entered into a 10-year currency swap with
Company Y. Under the terms of the swap, it receives interest at 3% per
annum in Euros and pays interest at 9 % per annum in U.S dollars. Interest
payments are exchanged once a year. The principal amounts are 8 million
dollars and 10 million Euros. Suppose that company Y declares bankruptcy
at the end of the year 6, when the exchange rate is $ 0.80 or Euros. What is
the cost to the financial institution? Assume that, at the end of year 6, the
interest rate is 3% per annum in Euros and 8% per annum in U.S. dollars
for all maturities. All interest rates are quoted with annual compounding.
2. A currency swap has a remaining life of 14 months. It involves exchanging
interest at 14% on Pounds 20 million for interest at 12% on $40 million
once a year. The term structure of interest rates in both the United
Kingdom and the United States is currently flat, and if the swap were
negotiated today the interest rates exchanged would be 9% in dollars and
ANNA UNIVERSITY 235

Notes 12% in sterling. All interest rates are quoted with annual compounding.
The current exchange rate is 1 Pound = 2 Dollars. What is the value of the
swap to the party paying sterling? What is the value of the swap to the
party paying dollars?
3. “A fixed-rate note’s market price will decline if interest rates increase”.
Explain in detail.
4. “A financial institution faces credit risk from a swap only when the swap
value to the financial institution is positive”. Explain.
5. Under what circumstances does credit risk occurs in a Swap transaction.
Discuss in detail.
FURTHER READINGS

John Wiley & Sons.
edition, Excel Books India.
Vij, Madhu (2010), International Financial Management, 3rd
Edition, Excel Books.
236 ANNA UNIVERSITY

Lesson 9 - Derivatives in India
Notes
UNIT V
LESSON 9 - DERIVATIVES IN INDIA
CONTENTS
Learning Objectives
Learning Outcomes
Overview
9.1 Evolution of Derivatives Market in India
9.2 Regulations and Framework Associated with Derivatives in India
9.2.1 Regulations for Derivatives Trading
9.2.2 Framework for Derivatives Trading in India
9.3 Exchange Trading in Derivatives
9.4 Commodity Futures
9.4.1 Specifications of Futures Contract
9.5 Contract Terminology and Specifications for Stock Options and Index
Options in NSE
9.5.1 Stock Options
9.5.2 Index Options
Summary
Keywords
Further Readings
LEARNING OBJECTIVES
 Understand the Evolution of Derivatives Market in India
 Explain about Regulations and Framework associated with Derivatives in
India
 Describe about Exchange Trading in Derivatives
 Understand about Commodity Futures
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Notes  Understand about Contract Terminology and Specifications for Stock

Options and Index Options in NSE.
LEARNING OUTCOMES
understanding of:
 the concept of commodities futures trading, as global phenomenon and its
offer by tremendous potential to market participants for both profit-taking
on small price corrections as well as to hedgers looking at managing price
risk on account of price fluctuations.
 the fact that to provide price discovery and better investment opportunities
the necessity of national-level commodity futures exchanges rises up.
 the datum that at if the contract is not traded for the day, the base price of
the contract for the next trading day shall be the theoretical price of the
options contract arrived at based on Black-Scholes model of calculation of
options premiums.
OVERVIEW
In the previous lesson you had studied about the Valuation of Interest rate
SWAPs and Currency SWAPs, Bonds and FRNs, Credit Risk.
In the last few decades, the word derivatives have started to find a prominent
place in the world of finance. There are a number of exchanges that offer
trading in futures and options. In the Over-the-Counter market, which is a big
segment, instruments like forward contracts, swaps, and many different types
of options are regularly traded. Major participants here are financial
institutions, fund managers, and corporate treasurers. These instruments are
commonly referred as Derivatives.
In this lesson, you will learn about the Evolution of Derivatives Market in
India, Regulations and Framework associated with Derivatives in India,
Exchange Trading in Derivatives, Commodity Futures and Contract
Terminology and Specifications for Stock Options and Index Options in NSE.
9.1 EVOLUTION OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which
withdrew the prohibition on options in securities.
SEBI set up a 24–member committee under the chairmanship of Dr.L.C.Gupta
on November 18, 1996 to develop appropriate regulatory framework for
derivatives trading in India, submitted its report on March 17, 1998. The
committee recommended that the derivatives should be declared as ‘securities’
238 ANNA UNIVERSITY

so that regulatory framework applicable to trading of ‘securities’ could also Notes

govern trading of derivatives.
SEBI also set up a group in June 1998 under the chairmanship of
Prof.J.R.Varma, to recommend measures for risk containment in derivatives
market in India. The report, which was submitted in October 1998, worked out
the operational details of margining system, methodology for charging initial
margins, broker net worth, deposit requirement and real–time monitoring
requirements.
The Securities Contracts Regulation Act (SCRA) was amended in December
1999 to include derivatives within the ambit of ‘securities’ and the act also
made it clear that derivatives shall be legal and valid only if such contracts are
traded on a recognized stock exchange, thus precluding OTC derivatives. The
government also rescinded in March 2000, the three–decade old notification,
which prohibited forward trading in securities.
Derivatives trading commenced in India in June 2000 after SEBI

granted the final approval to this effect in May 2000. SEBI permitted the
derivative segments of two stock exchanges – NSE and BSE, and their
clearing house/corporation to commence trading and settlement in approved
derivatives contracts.
To begin with, SEBI approved trading in index futures contracts based on S&P
CNX Nifty and BSE–30 (Sensex) index. This was followed by approval for
trading in options based on these two indices and options on individual
securities. The trading in index options commenced in June 2001 and the
trading in options on individual securities commenced in July 2001. Futures
contracts on individual stocks were launched in November 2001.
9.2 REGULATIONS AND FRAMEWORK ASSOCIATED

WITH DERIVATIVES IN INDIA
9.2.1 Regulations for Derivatives Trading
All futures transactions in the United States are regulated by the Commodity
Futures Trading Commission (CFTC), an independent agency of the United
States Government. The Commission has the right to hand out fines and other
punishments for an individual or company who breaks any rule. Although by
law the commission regulates all transactions, each exchange can have their
own rule, and under contract can fine companies for different things or extend
the fine that the CFTC hands out. The CFTC publishes weekly reports
containing details of the open interest of market participants for each market-
segment, which has more than 20 participants. These reports are released every
Friday (including data from the previous Tuesday) and contain data on open
ANNA UNIVERSITY 239

Notes interest split by reportable and non-reportable open interest as well as

commercial and non-commercial open interest. This type of report is referred
to as ‘Commitments-Of-Traders’-Report, COT-Report or simply COTR.
In India, following are the major regulations for trading of derivatives:
1. Any exchange fulfilling the eligibility criteria as prescribed in the L.C.
Gupta committee report may apply to SEBI for grant of recognition under
Section 4 of the SC(R)A, 1956 to start trading derivatives. The derivatives
exchange/segment should have a separate governing council and
representation of trading/clearing members shall be limited to a maximum
of 40% of the total members of the governing council.
. The exchange shall regulate the sales practices of its members and
will obtain prior approval of SEBI before start of trading in any derivative
contract.
2. The exchange shall have minimum 50 members.

3. The members of an existing segment of the exchange will not automatically
become the members of derivative segment. The members of the derivative
segment need to fulfill the eligibility conditions as laid down by the L.C.
Gupta committee.
4. The clearing and settlement of derivatives trades shall be through a SEBI
approved clearing corporation/house.
5. Derivative brokers/dealers and clearing members are required to seek
registration from SEBI. This is in addition to their registration as brokers of
existing stock exchanges. The minimum net worth for clearing members of
the derivatives clearing corporation/house shall be ` 300 lakh. The
networth of the member shall be computed as follows:
Capital + Free reserves - non-allowable assets viz.,
(a) Fixed assets; (b) Pledged securities; (c) Member’s card; (d) Non-
allowable securities (unlisted securities); (e) Bad deliveries; (f) Doubtful
debts and advances; (g) Prepaid expenses; (h) Intangible assets; (i) 30%
marketable securities.
6. The minimum contract value shall not be less than ` 2 lakh. Exchanges
should also submit details of the futures contract they propose to introduce.
7. The initial margin requirement, exposure limits linked to capital adequacy
and margin demands related to the risk of loss on the position shall be
prescribed by SEBI/Exchange from time to time.
240 ANNA UNIVERSITY

8. The L.C.Gupta committee report requires strict enforcement of “Know Notes

your customer” rule and requires that every client shall be registered with
the derivatives broker.
The members of the derivatives segment are also required to make

their clients aware of the risks involved in derivatives trading by issuing to
the client the Risk Disclosure Document and obtain a copy of the same duly
signed by the client.
9.2.2 Framework for Derivatives Trading in India

With the amendment in the definition of ''securities'' under SC(R)A (to include
derivative contracts in the definition of securities), derivatives trading takes
place under the provisions of the Securities Contracts (Regulation) Act, 1956
and the Securities and Exchange Board of India Act, 1992.
Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory
framework for derivative trading in India. SEBI has also framed suggestive
bye-law for Derivative Exchanges/Segments and their Clearing
Corporation/House which lays down the provisions for trading and settlement
of derivative contracts. The Rules, Bye-laws & Regulations of the Derivative
Segment of the Exchanges and their Clearing Corporation/House have to be
framed in line with the suggestive Bye-laws. SEBI has also laid the eligibility
conditions for Derivative Exchange/Segment and its Clearing
Corporation/House. The eligibility conditions have been framed to ensure that
Derivative Exchange/Segment & Clearing Corporation/House provide a
transparent trading environment, safety & integrity and provide facilities for
redressal of investor grievances. Some of the important eligibility conditions
are:
1. Derivative trading to take place through an online screen based Trading
System.
2. The Derivatives Exchange/Segment shall have online surveillance
capability to monitor positions, prices, and volumes on a real time basis to
deter market manipulation.
3. The Derivatives Exchange/ Segment should have arrangements for
dissemination of information about trades, quantities and quotes on a real
time basis through atleast two information vending networks, which are
easily accessible to investors across the country.
4. The Derivatives Exchange/Segment should have arbitration and investor
grievances redressal mechanism operative from all the four areas / regions
of the country.
5. The Derivatives Exchange/Segment should have satisfactory system of
monitoring investor complaints and preventing irregularities in trading.
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Notes 6. The Derivative Segment of the Exchange would have a separate Investor
Protection Fund.
7. The Clearing Corporation/House shall perform full novation, i.e. the
Clearing Corporation/House shall interpose itself between both legs of
every trade, becoming the legal counterparty to both or alternatively should
provide an unconditional guarantee for settlement of all trades.
8. The Clearing Corporation/House shall have the capacity to monitor the
overall position of Members across both derivatives market and the
underlying securities market for those Members who are participating in
both.
9. The level of initial margin on Index Futures Contracts shall be related to
the risk of loss on the position. The concept of value-at-risk shall be used in
calculating required level of initial margins. The initial margins should be
large enough to cover the one-day loss that can be encountered on the
position on 99% of the days.
10. The Clearing Corporation/House shall establish facilities for electronic
funds transfer (EFT) for swift movement of margin payments.
11. In the event of a Member defaulting in meeting its liabilities, the Clearing
Corporation/House shall transfer client positions and assets to another
solvent Member or close-out all open positions.
12. The Clearing Corporation/House should have capabilities to segregate
initial margins deposited by Clearing Members for trades on their own
account and on account of his client. The Clearing Corporation/House shall
hold the clients' margin money in trust for the client purposes only and
should not allow its diversion for any other purpose.
13. The Clearing Corporation/House shall have a separate Trade Guarantee
Fund for the trades executed on Derivative Exchange / Segment.
9.3 EXCHANGE TRADING IN DERIVATIVES

For the real success of the commodities markets, it is necessary to have a
common platform of commodity futures exchange where demand and supply
forces can act together in bringing out the best price for any commodity. The
main economic purpose of a futures commodity exchange as a marketplace is
to enable commodity producers/processors to sell their produce in advance to
protect them against possible price fall for their commodities and allow
consumers, traders, processors to buy in advance, to protect against possible
price increase. In this way, they are able to “hedge” their price risk, by locking
a price, which they will receive, and which they will pay respectively.
Commodities futures trading is a global phenomenon and offers tremendous
potential to market participants for both profit-taking on small price corrections
as well as to hedgers looking at managing price risk on account of price
fluctuations.
242 ANNA UNIVERSITY

In India, futures trading is permitted in more than 100 commodities. Most of Notes
the allowable commodities are traded through various exchanges in India. The
Indian economy is directly and indirectly dependent on agricultural produce.
The agricultural commodity market already has a major share and with the
availability of futures trading on national-level, commodity futures exchanges
will provide more liquidity, price discovery and better risk management
strategies. National level commodity exchanges have introduced new streams
of investors for new trading and business opportunities for diversification.
With government control gradually coming to an end, all commodity prices
will be market-determined. It necessitates national-level commodity futures
exchanges to provide price discovery and better investment opportunities In
India, the futures trading in India is being conducted via the four national
commodity exchanges. These exchanges have been approved by the
government of India after a thorough check. These exchanges are-
1. National Commodity and Derivatives Exchange Limited
National Commodity and Derivatives Exchange Limited or NCDEX, as it
is popularly called, was set up as a public limited company in April 2003
and began its operations in December 2003. It is located in Mumbai and is
promoted by institutions like the ICICI Bank Limited, Life Insurance
Corporation of India (LIC), National Bank for Agriculture and Rural
Development (NABARD) and National Stock Exchange of India Limited
(NSE). ICICI, however, later divested its holding in NCDEX. In the list of
important shareholders, banks like Canara Bank, Punjab National Bank
(PNB), institutions like CRISIL Limited, Indian Farmers Fertiliser
Cooperative Limited (IFFCO), Goldman Sachs, Intercontinental Exchange
(ICE) and Shree Renuka Sugars Limited are prominent. NCDEX is a
professionally managed commodity exchange trading in different
commodities. It is an online multi-commodity exchange. Presently, the
exchange offers trading in more than 50 commodities. Out of these, the
major are agriculture commodities, others include base metals, precious
metals, energy, polymers, ferrous metal, and CER. The most widely traded
commodity for NCDEX is Rape/Mustard Seed, Gaur Seed, Soyabean
Seeds, Turmeric and Jeera.
2. Multi Commodity Exchange of India Limited
The Multi Commodity Exchange of India Limited or the MCX is one of the
most vibrant exchanges in the world. It is an exchange established by
Financial Technologies Ltd, an IT company in the field of online trading
solutions. Other prominent shareholders of MCX Include NYSE Euronext,
State Bank of India and its associates (SBI), National Bank for Agriculture
and Rural Development (NABARD), National Stock Exchange of India
Ltd (NSE), SBI Life Insurance Co Ltd, Bank of India (BOI) , Bank of
Baroda (BOB), Union Bank of India, Corporation Bank, Canara Bank,
HDFC Bank, Fid Fund (Mauritius) Ltd. — an affiliate of Fidelity
International, ICICI Ventures, IL&FS, Kotak Group, Citi Group and
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Notes Merrill Lynch. Like NCDEX, it is also a nationwide, online commodity

exchange dealing in multiple commodities. At present, MCX is ranked as
No.1 in silver, No.2 in gold, copper and natural gas and No.3 in crude oil.
MCX began its operation in November 2003, and today has in excess of
2,000 registered members operating through over 100,000 trader work
station throughout India. Unlike the NCDEX, the major volume of MCX is
from the trading in metal and energy futures.
3. National Multi Commodity Exchange of India Limited
The National Multi Commodity Exchange of India Ltd., or the NMCE, was
the first multi-commodity exchange with an online trading capacity to be
established in India. It began its operations in November 2002. This
exchange is promoted by public institutions like Central Warehousing
Corporation (CWC), National Agricultural Cooperative Marketing
Federation of India (NAFED), Gujarat Agro-Industries Corporation
Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB),
National Institute of Agricultural Marketing (NIAM), and Punjab National
Bank (PNB).Recently, Reliance Money Limited (RML), an Anil Dhirubhai
Ambani Group company acquired a stake in NMCE. The Exchange began
with the futures trading in 24 commodities. The commodity base of NMCE
includes cash crops, food grains, plantations, spices, oil seeds, metals and
bullion among others.
4. Indian Commodity Exchange
The Indian Commodity Exchange Limited or the ICEX is the fourth online
exchange for commodities established in India. The ICEX is promoted by
Indiabulls Financial Services Ltd and MMTC Limited. The major
shareholders include Indian Potash Ltd., KRIBHCO and IDFC. The
commodities traded at ICEX include agricultural commodities, metals and
energy.
Besides the four national level exchanges listed above, there are more than
20 listed regional commodity futures trading exchanges. Ever since the
lifting of the ban in 2003, the aggregate value of commodity futures trading
has been showing a staggering increase of over 200 per cent per annum. In
keeping with the pace of growth and development in the area of futures
commodity trading, the government introduced the Forward Contracts
(Regulation) Amendment Bill, in the Lok Sabha session of March 2006. It
was eventually passed as an ordinance in February 2008. This seemed to be
a relief measure for the traders and others involved in futures trading of
commodities. In modern systems, commodity futures trading has become
much more convenient because of the online facilities available to
investors, which makes trading much easier.
Commodity trading has been prevalent from a considerable time in the
history. However, the major trading has been under the derivative segment.
Derivatives are contracts that derive their origin and value from the price
244 ANNA UNIVERSITY

movements in different assets traded in the market. The market of Notes

immediate delivery is known as spot, whereas the market for a later
delivery is called as derivative.
9.4 COMMODITY FUTURES

An agreement to buy or sell a specified amount of a commodity at a
predetermined price and date. Buyers use these to avoid the risks linked with
the price fluctuations of the product or raw material, while sellers try to lock in
a price for their products. Like in all financial markets, others use such
contracts to gamble on price movements.
Just like the price of bananas at the grocery store, the prices of commodities
change on a weekly or even daily basis. If the price goes up, the buyer of the
futures contract makes money, because he gets the product at the lower,
agreed-upon price and can now sell it at the today's higher market price. If the
price goes down, the futures seller makes money, because he can buy the
commodity at the todays' lower market price, and sell it to the futures buyer at
the higher, agreed-upon price.
If the commodities traders had to actually deliver the product,

very few people would do it. Rather then they can meet the contract
specifications by delivering the proof that the product is at the warehouse,
by paying the cash difference, or by providing another contract at the
market price.
It is to be noted that there is a high amount of leverage generally included in

holding futures contracts.
Example: For an initial margin of $5,000, an investor can enter into a

futures contract for 1,000 barrels of oil valued at $50,000. Given this large
amount of leverage, even a very small move in the price of a commodity could
result in large gains or losses compared to the initial margin. Unlike options,
futures are the obligation of the purchase or sale of the underlying asset.
Simply not closing an existing position could lead to an inexperienced investor
taking delivery of a large quantity of an unwanted commodity.
9.4.1 Specifications of Futures Contract
The commodity futures trading happens based on certain pre-specified
parameters. These parameters are announced by the exchange when a new
contract is launched. They detail the exact nature of the agreement between the
two parties.
 Nature and quality of the asset: In the case of commodities, there is a
widespread difference in the terms of the quality of the asset. The important
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Notes thing is that the prices also depend on the delivered quantity. The exchange
in this type of situation has to specify the parameters of quality that will be
acceptable for delivery. Also, since in case of commodities it is difficult to
give a specific quality standard, it is a common practice for exchanges to
provide a range for quality with appropriate discounts and premiums for
variation in quality.
 Contract Size: It signifies the quantity deliverable in each contract. The
exchange specifies the volume each contract will be made up of.
Example: In India, one contract of gold is made of 1 Kg, one

contract of silver is of 30 Kg., and one contract of chana is of 10 MT etc.
However, in case of agricultural commodities since the weight may change
due to weather conditions and other uncontrollable reasons, the exchanges
allow a band for quantity as well.
Example: A band of 250 Kg will be offered for refined soyabean

oil delivery. However, it will attract an appropriate premium or discount.
 Delivery location : It signifies the place where the seller is obliged to give
the delivery to the buyer. Normally it is the place where maximum trade of
the commodity takes place.
Example: The delivery location for chana in India is Delhi, for

soyabean it is Indore etc. It must also be noted that it is not uncommon for
exchanges to specify multiple delivery centres with appropriate adjustment
for transportation cost.
 Delivery time: Each contract has a time period when the physical delivery
has to be exchanged by the buyers and sellers. This time depends on the
nature of trade of the commodity in the physical market. Like for
commodities like gur, it is just one day from the expiry, in case of
agricultural commodities, it is more.
 Price limits : Exchanges normally allow a certain percentage of fluctuation
to happen. Based on the historical volatility of the asset in the physical
market, the percentage of fluctuation allowed is fixed. This is the permitted
fluctuation as compared to the last trading day that a commodity contract
can experience.
Learning Activity
Access the annual reports of two competitive firms in an industry
having similar asset sizes. Compare their involvement in
derivatives to reduce their risk. Are net positions and profits from
derivative trades consistent across these firms?
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9.5 CONTRACT TERMINOLOGY AND SPECIFICATIONS Notes

FOR STOCK OPTIONS AND INDEX OPTIONS IN NSE
9.5.1 Stock Options
A benefit, sold by one party to another, that offers the buyer the right, but not
the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within
a specified period or on a specific date. American options can be exercised
anytime between the date of purchase and the expiration date. European
options may only be redeemed at the expiration date. Most exchange-traded
stock options are American.
Contract Terminology and Specifications for Stock Options
 The current stock Price So.
 The strike price, K
 The time to expiration, T
 The volatility of the stock price 
 The risk-free interest rate, r
 The dividends expected during the life of the option
The current stock Price So. and the strike price, K
If a call option is exercised at some future time, the payoff will be the amount
by which the stock outweighs the strike price. Call options therefore become
more valuable as the stock price increases and less valuable as the strike price
increases. For a put option, the payoff on exercise is the amount by which the
strike price outweighs the stock price. Put options however, behave in the
reverse way from the call options; they become less valuable as the stock price
increases and more valuable as the strike price increases. Figure 9.1 (a-d)
exhibit the way in which put and call prices are based on the stock price and
strike price.
Table 9.1: Summary of the effect on the price of a stock option of increasing
one variable while keeping all others fixed.
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Notes The time to expiration, T

Considering the effect of the expiration date. Both put and call American
options become more precious( or atleast do not decrease in value) as the time
to expiration increases. Consider two American options that varies only as far
as the expiration date is concerned. The owner of the long-life option has all
the exercise opportunities open to the owner of the short-life option- and more.
The long-life option most however always be worth at least as much as the
short-life option.
Although European put and call options often become more precious as the
time to expiration increases (e.g Figure 9.1 (e,f)), this is not always the
instance. Considering two European call options on a stock; one with an
expiration date in 1 month, the other with an expiration date in 2 months. Lets
for an instance, that a very large dividend is estimated in 6 weeks. The
dividend will led to decline in stock price, so that the short-life option could be
worth more than the long-life option.
The volatility of the stock price, 
The volatility of a stock price is a measure of how uncertain we are about the
movements of future stock price. As volatility increases, the chance that the
stock will do very well or very poorly increases. For the owner of a stock, these
two results tend to offset each other. However, this is not so for the owner of a
call or put.
The values of both calls and puts therefore increase as volatility increases
(Figure 9.1 (a,b)).
The risk-free interest rate, r
The risk free interest rate influences the price of an option in a less-clear cut
way. As interest rates in the economy increase, the estimated return
necessitated by investors from the stock tends to increase.
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Notes
Figure 9.1 Effect of changes in stock price, strike price, and expiration date on option
prices when S0 = 50, K=50, r=5%,  =30% and T=1.
Additionally, the present value of any future cash flow obtained by the holder
of the option decreases. The combined influence of these two impacts is to
increase the value of call options and decrease the value of put options (Figure
9.2 (c,d)).
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Notes
Figure 9.2: Effect of changes in volatility and risk-free interest rate on

option prices when S0 = 50, K=50, r=5%,  =30% and T=1.
It becomes necessary to lay emphasis in assuming that interest rates change
while other other variables stay the same. In general, we assume that in Table 9
that interest rates change while the stock price remains the same. In practice,
when interest rates rise(fall), stock prices tend to fall(rise). The net effect of an
interest rate increase and the accompanying stock price decrease can be to
decrease the value of a call option and increase the value of a put option.
Similarly, the net effect of an interest rate decrease and the accompanying
stock price increase can be to increase the value of a call option and decrease
the value of a put option.
The dividends expected during the life of the option
Dividends have the influence of reduction in the stock price on the ex-dividend
date. This is not a good news for the value of call options and good news for
the value of put options. The value of a call option is however, negatively
linked to the size of an estimated future dividend, and the value of a put option
is positively linked to the size of an estimated future dividend.
9.5.2 Index Options
A financial derivative that gives the holder the right, but not the obligation, to
buy or sell a basket of stocks, such as the S&P 500, at an agreed-upon price
and before a certain date. An index option is similar to other options contracts,
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the difference being the underlying instruments are indexes. Options contracts, Notes
including index options, permits investors to profit from an anticipated market
move or for reducing the risk of holding the underlying instrument.
Index options provide diversification as investors are exposed to a large
number of securities in one trading instrument. The degree of exposure varies
with the particular index option. Popular index options include S&P 500 Index
Options (SPX), Dow Jones Industrial Average Index Options (DJX) and
Nasdaq-100 Index Options (NDX). Index options are typically cash settled.
Contract Terminology and Specifications for Index Options
NSE introduced trading in index options on June 4, 2001. The options
contracts are European style and cash settled and are based on the popular
market benchmark S&P CNX Nifty index.
Contract terminology constitutes:
 Contract Specifications
 Trading Parameters
Contract Specifications
It includes the following:
 Security descriptor: The security descriptor for the S&P CNX Nifty
options contracts is:
 Market type: N
 Instrument Type: OPTIDX
 Underlying: NIFTY
 Expiry date: Date of contract expiry
 Option Type: CE/ PE
 Strike Price: Strike price for the contract
 Instrument type represents the instrument i.e. Options on Index.
 Underlying symbol denotes the underlying index, which is S&P CNX
Nifty
 Expiry date identifies the date of expiry of the contract
 Option type identifies whether it is a call or a put option, CE - Call
European, PE - Put European.
 Underlying Instrument: The underlying index is S&P CNX NIFTY.
 Trading cycle: S&P CNX Nifty options contracts have 3 consecutive
monthly contracts, additionally 3 quarterly months of the cycle March /
June / September / December and 5 following semi-annual months of the
cycle June / December would be available, so that at any point in time there
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Notes would be options contracts with atleast 3 year tenure available. On expiry
of the near month contract, new contracts (monthly/quarterly/ half yearly
contracts as applicable) are introduced at new strike prices for both call and
put options, on the trading day following the expiry of the near month
contract.
 Expiry day: S&P CNX Nifty options contracts expire on the last Thursday
of the expiry month. If the last Thursday is a trading holiday, the contracts
expire on the previous trading day.
 Strike Price Intervals: The number of contracts provided in options on
index is based on the range in previous day’s closing value of the
underlying index and applicable as per the following table:
Index Level Strike Interval Scheme of Strike to be
introduced
Upto 2000 50 4-1-4
>2001 upto 4000 100 6-1-6
>4001 upto 6000 100 6-1-6
>6000 100 7-1-7
The above strike parameters scheme shall be applicable for all Long terms
contracts also.
Trading Parameters
 Contract size: The value of the option contracts on Nifty may not be less
than ` 2 lakhs at the time of introduction. The permitted lot size for futures
contracts & options contracts shall be the same for a given underlying or
such lot size as may be stipulated by the Exchange from time to time.
 Price steps: The price step in respect of S&P CNX Nifty options contracts
is Re.0.05.
 Base Prices: Base price of the options contracts, on introduction of new
contracts, would be the theoretical value of the options contract arrived at
based on Black-Scholes model of calculation of options premiums.
 The options price for a Call, computed as per the following Black Scholes
formula:
C = S * N (d1) - X * e- rt * N (d2)
and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1)
where :
d1 = [ln (S / X) + (r + σ2 / 2) * t] / σ * sqrt(t)
d2 = [ln (S / X) + (r - σ2 / 2) * t] / σ * sqrt(t)
= d1 - σ * sqrt(t)
C = price of a call option
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P = price of a put option Notes

S = price of the underlying asset
X = Strike price of the option
r = rate of interest
t = time to expiration
σ = volatility of the underlying
N represents a standard normal distribution with mean = 0 and standard
deviation = 1
It represents the natural logarithm of a number. Natural logarithms are
based on the constant e (2.71828182845904).
Rate of interest may be the relevant MIBOR rate or such other rate as may
be specified.
The base price of the contracts on subsequent trading days, will be the daily
close price of the options contracts. The closing price shall be calculated as
follows:
 If the contract is traded in the last half an hour, the closing price shall
be the last half an hour weighted average price.
 If the contract is not traded in the last half an hour, but traded during
any time of the day, then the closing price will be the last traded price
(LTP) of the contract.
If the contract is not traded for the day, the base price of the contract for the
next trading day shall be the theoretical price of the options contract arrived
at based on Black-Scholes model of calculation of options premiums.
 Quantity freeze: Orders which may come to the exchange as quantity
freeze shall be such that have a quantity of more than 15000. In respect of
orders which have come under quantity freeze, members would be required
to confirm to the Exchange that there is no inadvertent error in the order
entry and that the order is genuine. On such confirmation, the Exchange
may approve such order. However, in exceptional cases, the Exchange
may, at its discretion, not allow the orders that have come under quantity
freeze for execution for any reason whatsoever including non-availability
of turnover / exposure limit. In all other cases, quantity freeze orders shall
be cancelled by the Exchange.
Order type/Order book/Order attributes
 Regular lot order
 Stop loss order
 Immediate or cancel
 Spread order
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Notes
Learning Activity
Select a mutual fund and obtain the value held by the fund as
assets under management. Select an option index contract to
protect the value of assets under management. Trace the value of
asset under management for three months. Add the hypothetical
option profit(loss) from the contract(s) that you have created for
this fund. Study the impact of index options on fund values.
1. Presently, SEBI has permitted Derivative Trading on

the Derivative Segment of BSE and the F&O Segment
of NSE.
2. The owner of a call benefits from price increases but
has limited downside risk in the event of price
decreases because the most the owner can lose is the
price of the option. Similarly, the owner of a put gains
from price decreases, but has limited downside risk in
the circumstance of price increases.
SUMMARY
 The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws (Amendment) Ordinance, 1995, which
withdrew the prohibition on options in securities.
 SEBI set up a 24–member committee under the chairmanship of Dr.L.C.
Gupta on November 18, 1996 to develop appropriate regulatory framework
for derivatives trading in India, submitted its report on March 17, 1998 .
The committee recommended that the derivatives should be declared as
‘securities’ so that regulatory framework applicable to trading of
‘securities’ could also govern trading of derivatives.
 All futures transactions in the United States are regulated by the
Commodity Futures Trading Commission (CFTC), an independent agency
of the United States Government. The Commission has the right to hand
out fines and other punishments for an individual or company who breaks
any rule. Although by law the commission regulates all transactions, each
exchange can have their own rule, and under contract can fine companies
for different things or extend the fine that the CFTC hands out.
 Dr. L.C Gupta Committee constituted by SEBI had laid down the
regulatory framework for derivative trading in India. SEBI has also framed
suggestive bye-law for Derivative Exchanges/Segments and their Clearing
Corporation/House which lays down the provisions for trading and
settlement of derivative contracts.
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 The major Exchanges in India are-National Commodity and Derivatives Notes

Exchange Limited, Multi Commodity Exchange of India Limited, National
Multi Commodity Exchange of India Limited and Indian Commodity
Exchange.
 The specifications of futures contract includes nature and quality of the
asset, contract size, delivery location, delivery time, price limits.
 The contract terminology and specifications for stock options include :the
current stock Price So.; the strike price, K; the time to expiration, T; the
volatility of the stock price  ; the risk-free interest rate, r and the dividends
expected during the life of the option.
KEYWORDS
Derivatives: Derivatives in general refer to contracts that derive from another-
whose value depends on another contract or asset.
Commodity Futures: An agreement to buy or sell a specified amount of a
commodity at a predetermined price and date.
Contract Size: It signifies the quantity deliverable in each contract. The
exchange specifies the volume each contract will be made up of.
Delivery Location: It signifies the place where the seller is obliged to give the
delivery to the buyer. Normally it is the place where maximum trade of the
commodity takes place.
Stock Options: A benefit, sold by one party to another, that offers the buyer the
right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon
price within a specified period or on a specific date.
Index Options: A financial derivative that gives the holder the right, but not
the obligation, to buy or sell a basket of stocks, such as the S&P 500, at an
agreed-upon price and before a certain date.
1. Briefly describe regulations for derivatives trading in India.
2. Describe the eligibility conditions criteria for derivatives trading in India.
3. What is the role of Multi-commodity exchange of India Limited?
4. What do you mean by stock options?
5. What do you mean by Index Options?
6. “If a call option is exercised at some future time, the payoff will be the
amount by which the stock outweighs the strike price”. Explain.
7. Analyze the time to expiration for stock options.
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Notes 8. Briefly describe the contract specifications for Index options.

9. Specify the trading cycle for index options.
10. What are the trading parameters for Index Options?
1. Explain the evolution of derivatives market in India.
2. “The commodity futures trading happens based on certain pre-specified
parameters.” Explain in detail.
3. A stock price is currently $40. Assume that the expected return from the
stock is 15% and that its volatility is 25%. What is the probability
distribution for the rate of return (with continuous compounding) earned
over a 2-year period?
4. What is the price of a European put option on a non-dividend paying stock
when the stock price is $69, the strike price is $70, the risk-free interest rate
is 5% per annum, the volatility is 35% per annum and the time to maturity
is 6 months?
5. A fund manager enters into a short position in an index call option contract
with a premium of ` 85 for a strike price of ` 6500. Draw the profit (loss)
profile of the option contract.
FURTHER READINGS

John Wiley & Sons.
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Lesson 10 - Stock and Index Futures and Interest Rate Derivatives
LESSON 10 - STOCK AND INDEX FUTURES Notes

AND INTEREST RATE DERIVATIVES
CONTENTS
Learning Objectives
Learning Outcomes
Overview
10.1 Contract Terminology and Specifications for Stock Futures and Index
Futures in NSE
10.1.1 Stock Futures
10.1.2 Contract Terminology for Single-Stock Futures
10.1.3 Index Futures
10.2 Contract Terminology for Interest Rate Derivatives
10.2.1 Interest Rate Derivatives
10.2.2 Examples of Interest Rate Derivatives
10.2.3 Types of Interest Rate Derivatives
10.2.4 Contract Terminology
Summary
Keywords
Further Readings
LEARNING OBJECTIVES
 Understand the Contract Terminology and specifications for stock futures
and Index futures in NSE.
 Understand about the Contract Terminology and specifications for Interest
Rate Derivatives.
LEARNING OUTCOMES
understanding of:
 the concept of the stock portfolio that managers can use index futures for
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Notes increasing their exposure to movements in a particular index, essentially

leveraging their portfolios.
 the fact that futures contracts provide a distinctive way of reporting
volumes through open interest.
 the datum that yield of a debt instrument is the overall rate of return
available on the investment.
OVERVIEW
In the previous lesson you had studied about the Evolution of Derivatives
Market in India, Regulations and Framework associated with Derivatives in
India, Exchange Trading in Derivatives, Commodity Futures and Contract
Terminology and Specifications for Stock Options and Index Options in
NSE.
A futures contract is a forward contract, which is traded on an Exchange. NSE
commenced trading in futures on individual securities or stock futures on
November 9, 2001. The futures contracts are available on 145 securities
stipulated by the Securities & Exchange Board of India (SEBI).
The interest rate derivatives market is the largest derivatives market in the
world. The Bank for International Settlements assesses that the notional
amount outstanding in June 2012 were US$494 trillion for OTC interest rate
contracts, and US$342 trillion for OTC interest rate swaps. As per the
International Swaps and Derivatives Association, 80% of the world's top 500
companies as of April 2003 used interest rate derivatives to control their
cashflows. This compares with 75% for foreign exchange options, 25% for
commodity options and 10% for stock options.
In this lesson, you will learn about the Contract Terminology and
specifications for stock futures and Index futures in NSE, the Contract
Terminology and specifications for Interest Rate Derivatives.
10.1 CONTRACT TERMINOLOGY AND SPECIFICATIONS

FOR STOCK FUTURES AND INDEX FUTURES IN NSE
10.1.1 Stock Futures
Stock Futures are financial contracts where the underlying asset is an
individual stock. Stock Future contract is an agreement to buy or sell a stated
quantity of underlying equity share for a future date at a price agreed upon
between the buyer and seller. The contracts have standardized specifications
like market lot, expiry day, unit of price quotation, tick size and method of
settlement.
The theoretical price of a future contract is sum of the current spot price and
cost of carry. However, the actual price of futures contract very much is
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dependent upon the demand and supply of the underlying stock. Generally, the Notes
futures prices are higher than the spot prices of the underlying stocks.
Futures Price = Spot Price + Cost of Carry
Cost of carry is the interest cost of a similar position in cash market

and carried to maturity of the futures contract less any dividend expected
till the expiry of the contract.
Example: Spot Price of Infosys = 1600, Interest Rate = 7% p.a. Futures

Price of 1 month contract=1600 + 1600*0.07*30/365 = 1600 + 11.51 =
1611.51
Single Stock Futures
Single stock futures (SSFs) are contracts between two investors. The buyer
promises to pay a stipulated price for 100 shares of a single stock at a
predetermined future point. The seller promises to deliver the stock at the
stipulated price on the specified future date.
10.1.2 Contract Terminology for Single-Stock Futures
NSE specifies the characteristics of the futures contract such as the underlying
security, market lot, and the maturity date of the contract. The futures contracts
are available for trading from introduction to the expiry date.
Contract Specifications
 Security descriptor: The security descriptor for the futures contracts is:
 Market type : N
 Instrument Type : FUTSTK
 Underlying : Symbol of underlying security
 Expiry date : Date of contract expiry
 Instrument type represents the instrument i.e. Futures on Index.
 Underlying symbol denotes the underlying security in the Capital
Market (equities) segment of the Exchange
 Expiry date identifies the date of expiry of the contract
 Underlying Instrument: Futures contracts are available on 145 securities
stipulated by the Securities & Exchange Board of India (SEBI). These
securities are traded in the Capital Market segment of the Exchange.
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Notes  Trading Cycle: Futures contracts have a maximum of 3-month trading

cycle - the near month (one), the next month (two) and the far month
(three). New contracts are introduced on the trading day following the
expiry of the near month contracts.
 Expiry Date: Futures contracts expire on the last Thursday of the expiry
month. If the last Thursday is a trading holiday, the contracts expire on the
previous trading day.
Trading Parameters
 Contract Size: The value of the futures contracts on individual securities
may not be less than ` 2 lakhs at the time of introduction for the first time
at any exchange. The permitted lot size for futures contracts & options
contracts shall be the same for a given underlying or such lot size as may
be stipulated by the Exchange from time to time.
 Price Steps: The price step in respect of futures contracts is Re.0.05.
 Base Prices: Base price of futures contracts on the first day of trading (i.e.
on introduction) would be the theoretical futures price.
The base price of the contracts on subsequent trading days would

be the daily settlement price of the futures contracts.
 Price bands: There are no day minimum/maximum price ranges applicable

for futures contracts.
However, in order to prevent erroneous order entry by trading members,
operating ranges are kept at +/-10 %. In respect of orders which have come
under price freeze, members would be required to confirm to the Exchange
that there is no inadvertent error in the order entry and that the order is
genuine. On such confirmation the Exchange may approve such order.
 Quantity freeze: Orders which may come to the exchange as a quantity
freeze shall be based on the notional value of the contract of around ` 5
crores.
Order type/Order book/Order attribute
 Regular lot order
 Stop loss order
 Immediate or cancel
 Spread order
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Notes
Learning Activity
Write a short detail on the difference between Stock futures and
Stock options.
10.1.3 Index Futures

A futures contract on a stock or financial index. For each index there may be a
different multiple for ascertaining the price of the futures contract.
Example: the S&P 500 Index is one of the most widely traded index
futures contracts in the U.S. Stock portfolio managers who wish to hedge risk
over a specified period of time normally use S&P 500 futures to do so. By
shorting these contracts, stock portfolio managers can safeguard themselves
from the downside price risk of the broader market. However, by using this
hedging strategy, if perfectly done, the manager's portfolio will not participate
in any gains on the index; instead, the portfolio will lock in gains equivalent to
the risk-free rate of interest.
Alternatively, stock portfolio managers can use index futures for increasing
their exposure to movements in a particular index, essentially leveraging their
portfolios.
Contract Terminology and Specifications for Stock Index Futures Trading at
NSE
The National Stock Exchange of India launched futures named ‘NIFTY’ on
June 12, 2000. The specifications are as follows:
 Instrument Name: N FUTIDX NIFTY
 The underlying index: S&P CNX NIFTY(NSE 500).
 Contract Size: The quotation of index futures is based as per the
underlying asset which implies that it will quote just like the Nifty in
points. The value of the contract(contract size), a multiplier of 200 is
applied to the index. It means that the value of a contract will be (` 200 *
index value) on that specified date. The multiplier can be thought of as the
market lot for the futures contract. This can be altered from time to time.
 NSE has instituted three contracts for one month, two months and three
months maturities. These contracts of varied maturities may be called near
month(one month), middle month(two months) and far month (three
months ) contracts. The month in which the contract will expire is called
contract month.
Example: contract month of April 2014 contract will be April 2014.
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Notes  Expiry: Each contract would have a definite code for the purpose of
representation on the terminal. All these contracts will expire on a definite
day of the month and currently, they are fixed for the last Thursday of the
month. As soon as the near month contract expires, middle contract will
become near and so on.
 Tick size/price step: Tick size is the minimum difference between two
quotes of identical nature. Since the index futures would be traded in terms
of index points, the tick size is to be stated in points only. The Nifty tick
size is ` 0.05 which will be converted into points.
 Position limits: Currently, both types of contracts as for the purposes of
speculation and hedging are permitted to be traded. However, these are
likely to change from time to time.
 Trading hours: Trading hours are 10.30 a.m to 3.30 p.m
 Margins: NSE fixes the minimum margin requirements and price limits on
daily basis which are likely to change periodically.
 Settlement: Position remaining open at the close of business on the last day
of trading are marked-to-market as per the official opening level of the
NSE-NIFTY on the following day. There is daily settlement also on the
closing of futures contract.
Volumes and Open interest: Futures contracts have a distinctive way of
reporting volumes and it is called open interest. It gives the information about
the number of outstanding/unsettled positions in the market as a whole at a
particular point of time. In the futures market, total long positions would be
equal to the total short positions, hence, only one side of the contracts are
counted for ascertaining the open interest position. Major stock exchanges
across the world publish the open interest position regularly.
Contd…
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Notes
Source: http://www.nseindia.com/products/content/derivatives/equities/contract_specifitns.htm
Figure 10.1: Summarised Contract Specifications for Index Futures at NSE
10.2 CONTRACT TERMINOLOGY FOR INTEREST RATE

DERIVATIVES
10.2.1 Interest Rate Derivatives
A financial instrument based on an underlying financial security whose value is
influenced by changes in interest rates. Interest-rate derivatives are hedges used
by institutional investors such as banks to withstand the changes in market
interest rates. Individual investors are more expected to use interest-rate
derivatives as a speculative tool - they hope to profit from their guesses about
which direction market interest rates will move.
10.2.2 Example of Interest Rate Derivatives
Interest rate cap
An interest rate cap is designed to hedge a company’s maximum exposure to
upward interest rate movements. It forms a maximum total dollar interest
amount the hedger will pay out over the life of the cap. The interest rate cap is
actually a series of individual interest rate caplets, each being an individual
option on the underlying interest rate index. The interest rate cap is paid for
upfront, and then the purchaser realizes the benefit of the cap over the life of
the contract.
Range accrual note
Suppose a manager anticipates that volatility of interest rates will be low. He or
she may benefit extra yield over a regular bond by buying a range accrual note
instead. This note pays interest only if the floating interest rate (i.e.London
Interbank Offered Rate) stays within a pre-determined band. This note
effectively consist of an embedded option which, in this case, the buyer of the
note has sold to the issuer. This option adds to the yield of the note. In this
way, if volatility remains low, the bond yields more than a standard bond.
Bermudan swaption
Suppose a fixed-coupon callable bond was brought to the market by a
company. The issuer however, entered into an interest rate swap for converting
the fixed coupon payments to floating payments (perhaps based on LIBOR).
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Notes Since it is callable however, the issuer may redeem the bond back from
investors at certain dates during the life of the bond. If called, this would still
leave the issuer with the interest rate swap. Therefore, the issuer also enters
into Bermudan swaption when the bond is brought to market with exercise
dates equal to callable dates for the bond. If the bond is called, the swaption is
exercised, effectively canceling the swap leaving no more interest rate
exposure for the issuer.
10.2.3 Types of Interest Rate Derivatives
Vanilla
The primary building blocks for most interest rate derivatives can be termed as
"vanilla" (simple, basic derivative structures, usually most liquid):
 Interest rate swap (fixed-for-floating)
 Interest rate cap or interest rate floor
 Interest rate swaption
 Bond option
 Forward rate agreement
 Interest rate future
 Money market instruments
 Cross currency swap (see Forex swap)
Quasi-vanilla
The next intermediate level is a quasi-vanilla class of (fairly liquid) derivatives,
examples of which are:
 Range accrual swaps/notes/bonds
 In-arrears swap
 Constant maturity swap (CMS) or constant treasury swap (CTS) derivatives
(swaps, caps, floors)
 Interest rate swap based upon two floating interest rates
Exotic derivatives
Building off these structures are the "exotic" interest rate derivatives (least
liquid, traded over the counter), such as:
 Power reverse dual currency note (PRDC or Turbo)
 Target redemption note (TARN)
 CMS steepener
 Snowball
264 ANNA UNIVERSITY

 Inverse floater Notes

 Strips of Collateralized mortgage obligation
 Ratchet caps and floors
 Bermudan swaptions
 Cross currency swaptions
Most of the exotic interest rate derivatives are structured as swaps or notes, and
can be categorized as having two payment legs: a funding leg and an exotic
coupon leg.
A funding leg normally comprises of series of fixed coupons or floating
coupons (LIBOR) plus fixed spread.
An exotic coupon leg basically comprises of a functional dependence on the
past and current underlying indices (LIBOR, CMS rate, FX rate) and
sometimes on its own past levels, as in Snowballs and TARNs. The payer of
the exotic coupon leg usually has a right to cancel the deal on any of the
coupon payment dates, resulting in the so-called Bermudan exercise feature.
There may also be some range-accrual and knock-out features inherent in the
exotic coupon definition.
10.2.4 Contract Terminology for Interest Rate Derivatives
The contract terminology for Interest Rate Derivatives constitutes the
following:
 Product Description
 Contract Specification
 Trading Parameters
 Clearing and Settlement
 Risk Containment
 Zero Coupon Yield Curve
Product Description
Interest Rate Futures Contracts are contracts based on the list of underlying as
may be described by the Exchange and approved by SEBI from time to time.
To start with, interest rate futures contracts on the following underlyings shall
be available for trading on the F&O Segment of the Exchange:
 Notional T – Bills
 Notional 10 year bonds (coupon bearing and non-coupon bearing)
The list of securities on which Futures Contracts would be available and their
symbols for trading are as under:
ANNA UNIVERSITY 265

Notes Table 10.1 : List of securities on which Futures Contracts would be available and their
symbols for trading
S.No Symbol Description
1. NSETB91D Futures contract on Notional 91 day T bill
2. NSE10Y06 Futures contract on Notional 10 year coupon bearing bond
3. NSE10YZC Futures contract on Notional 10 year zero coupon bond.
NSE states the characteristics of the futures contract such as the underlying
security, market lot and the maturity date of the contract.
Contract Specification
 Security descriptor: The security descriptor for the interest rate future
contracts is:
 Market type: N
 Instrument Type: FUTINT
 Underlying: Notional T- bills and Notional 10 year bond (coupon
bearing and non-coupon bearing)
 Expiry Date: Last Thursday of the Expiry month.
Instrument type represents the instrument i.e. Interest Rate Future Contract.
Underlying symbol denotes the underlying.
Expiry date identifies the date of expiry of the contract
 Underlying Instrument: Interest rate futures contracts are available on
Notional T- bills , Notional 10 year zero coupon bond and Notional 10 year
coupon bearing bond stipulated by the Securities & Exchange Board of
India (SEBI).
 Trading cycle: The interest rate future contract shall be for a period of
maturity of one year with three months continuous contracts for the first
three months and fixed quarterly contracts for the entire year. New
contracts will be introduced on the trading day following the expiry of the
near month contract.
The schedule of contracts for the next one year will be as follows:
Jun-03 Jul-03 Aug-03 Sep-03 Oct-03 Nov-03 Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04
Jul-03 Aug-03 Sep-03 Oct-03 Nov-03 Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04
Aug-03 Sep-03 Oct-03 Nov-03 Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04 Jul-04
Sep-03 Dec-03 Dec-03 Dec-03 Mar-04 Mar-04 Mar-04 Jun-04 Jun-04 Jun-04 Sep-04 Sep-04
Dec-03 Mar-04 Mar-04 Mar-04 Jun-04 Jun-04 Jun-04 Sep-04 Sep-04 Sep-04 Dec-04 Dec-04
Mar-04 Jun-04 Jun-04 Jun-04 Sep-04 Sep-04 Sep-04 Dec-04 Dec-04 Dec-04 Mar-05 Mar-05
Source: http://www.nseindia.com/content/fo/fo_interestrate.htm#2
266 ANNA UNIVERSITY

 Expiry day: Interest rate future contracts shall expire on the last Thursday Notes
of the expiry month. If the last thursday is a trading holiday, the contracts
shall expire on the previous trading day.
Further, where the last Thursday falls on the annual or half-yearly closing
dates of the bank, the expiry and last trading day in view of these
derivatives contracts would be pre-poned to the previous trading day.
 Product Characteristics:
Source: http://www.nseindia.com/content/fo/fo_interestrate.htm#2
Figure 10.2 Product Characteristics
Trading Parameters
 Contract size: The permitted lot size for the interest rate futures contracts
shall be 2000. The minimum value of a interest rate futures contract would
be ` 2 lakhs at the time of introduction.
 Price steps: The price steps in view of all interest rate future contracts
admitted to dealings on the Exchange is Re.0.01.
The Futures contracts having face value of ` 100 on notional ten year
coupon bearing bond and notional ten year zero coupon bond would be
subject to price quotation and Futures contracts having face value of ` 100
on notional 91 days treasury bill would be based on ` 100 minus (-) yield.
 Base Price & operating ranges: Base price of the Interest rate future
contracts on introduction of new contracts shall be theoretical futures price
computed based on previous days’ closing price of the notional underlying
security. The base price of the contracts on subsequent trading days will be
the closing price of the futures contracts. However, on such of those days
ANNA UNIVERSITY 267

Notes when the contracts were not traded, the base price will be the daily
settlement price of futures contracts.
There will be no day minimum/maximum price ranges applicable for the
futures contracts. However, in order to prevent / take care of erroneous
order entry, the operating ranges for interest rate future contracts shall be
kept at +/- 2% of the base price. In respect of orders which have come
under price freeze, the members would be necessitated to confirm to the
Exchange that the order is genuine. On such confirmation, the Exchange at
its discretion may approve such order. If such a confirmation is not given
by any member, such order shall not be processed and as such shall lapse.
 Quantity freeze: Orders which may come to the Exchange as a quantity
freeze shall be 2500 contracts amounting to 50,00,000 which works out on
the day of introduction to approximately ` 50 crores.
In respect of such orders which have come under quantity freeze,

the member shall be required to confirm to the Exchange that the order is
genuine. On such confirmation, the Exchange at its discretion may approve
such order subject to availability of turnover/exposure limits, etc. If such a
confirmation is not given by any member, such order shall not be processed
and as such shall lapse.
Order type/Order book/Order attribute

 Regular lot order
 Stop loss order
 Immediate or cancel
 Good till day
 Good till cancelled*
 Good till date
 Spread order
 2L and 3L orders
* Good till cancelled (GTC) orders shall be cancelled at the end of the period of 7 calendar days from the date of
entering an order.
Clearing and Settlement

 Settlement Procedure and Settlement Price: Daily Mark to Market
Settlement and Final settlement for Interest Rate Futures Contract
 Daily Mark to Market settlement and Final Mark to Market settlement
in respect of admitted deals in Interest Rate Futures Contracts shall be
268 ANNA UNIVERSITY

cash settled by debiting/ crediting of the clearing accounts of Clearing Notes

Members with the respective Clearing Bank.
 All positions (brought forward, created during the day, closed out
during the day) of a F&O Clearing Member in Futures Contracts, at the
close of trading hours on a day, shall be marked to market at the Daily
Settlement Price (for Daily Mark to Market Settlement) and settled.
 All positions (brought forward, created during the day, closed out
during the day) of a F&O Clearing Member in Futures Contracts, at the
close of trading hours on the last trading day, shall be marked to market
at Final Settlement Price (for Final Settlement) and settled.
 Daily Settlement Price shall be the closing price of the relevant Futures
contract for the Trading day.
 Final settlement price for an Interest rate Futures Contract shall be
based on the value of the notional bond determined using the zero
coupon yield curve computed by National Stock Exchange or by any
other agency as may be nominated in this regard.
 Open positions in a Futures contract shall cease to exist after its
expiration day.
 Daily Settlement Price: Daily settlement price for an Interest Rate Futures
Contract shall be the closing price of such Interest Rate Futures Contract on
the trading day. The closing price for an interest rate futures contract shall
be calculated on the basis of the last half an hour weighted average price of
such interest rate futures contract.
In absence of trading in the last half an hour, the theoretical price

would be taken or such other price as may be decided by the relevant
authority from time to time.
Theoretical daily settlement price for unexpired futures contracts, shall be the
futures prices computed using the (price of the notional bond) spot prices
arrived at from the applicable ZCYC Curve. The ZCYC shall be computed by
the Exchange or by any other agency as may be nominated in this regard from
the prices of Government securities traded on the Exchange or reported on the
Negotiated Dealing System of RBI or both taking trades of same day
settlement(i.e. t = 0).
In respect of zero coupon notional bond, the price of the bond shall be the
present value of the principal payment discounted using discrete discounting
for the specified period at the respective zero coupon yield. In respect of the
notional T-bill, the settlement price shall be 100 minus the annualized yield for
the specified period computed using the zero coupon yield curve. In respect of
coupon bearing notional bond, the present value shall be obtained as the sum of
ANNA UNIVERSITY 269

Notes present value of the principal payment discounted at the relevant zero coupon
yield and the present values of the coupons obtained by discounting each
notional coupon payment at the relevant zero coupon yield for that maturity.
For this purpose the notional coupon payment date shall be half yearly and
commencing from the date of expiry of the relevant futures contract.
For computation of futures prices from the price of the notional bond (spot
prices) thus arrived, the rate of interest may be the relevant MIBOR rate or
such other rate as may be specified from time to time.
Final Settlement Price for mark to market settlement of interest rate futures
contracts
Final settlement price for an Interest rate Futures Contract on zero coupon
notional bond and coupon bearing bond shall be based on the price of the
notional bond determined using the zero coupon yield curve computed as
explained above. In respect of notional T-bill it shall be 100 minus the
annualised yield for the specified period computed using the zero coupon yield
curve.
Settlement value in respect of notional T-bill
Since the T-bills are priced at 100 minus the relevant annualised yield, the
settlement value shall be arrived at using the relevant multiplier factor.
Currently it shall be 91/365
Settlement Schedule
Table 10.2 Settlement Schedule
Product Settlement Schedule
Interest Rate Futures Daily Mark-to-Market Pay-in : T+1 working day on or after
Contract Settlement 11.30 a.m.
Payout : T+1 working day on or after
12.00 p.m.
(T is trading day)
Interest Rate Futures Final Settlement Pay-in : T+1 working day on or after
Contract 11.30 a.m.
Payout : T+1 working day on or after
12.00 p.m.
(T is expiration day)
Source: http://www.nseindia.com/content/fo/fo_futintclgsett.htm
Risk Containment Margins

It constitutes the following:
 Initial Margins
 Computation of Initial Margin
 Exposure Limits (2nd line of defense)
 Trading Member wise/ Custodial Participant wise Position Limit
270 ANNA UNIVERSITY

Initial Margins Notes

Initial margin shall be payable on all open positions of Clearing Members, upto
client level, at any point of time, and shall be payable upfront by Clearing
Members in accordance with the margin computation mechanism and/ or
system as may be adopted by Clearing Corporation from time to time.
Presently, the initial margins would be based on the zero coupon yield curve
computed at the end of the day as explained above with trades of same day
settlement (t =0). However, in case of large deviation between the yields
generated using only t = 0 trades and all trades, initial margins revised
accordingly may be computed and collected by the Clearing corporation from
the members at its discretion.
Initial Margin shall include SPAN margins and such other additional margins,
that may be specified by Clearing Corporation from time to time.
Computation of Initial Margin
Clearing Corporation will adopt SPAN (Standard Portfolio Analysis of Risk)
system or any other system for the purpose of real time initial margin
computation.
Initial margin requirements shall be based on 99% value at risk over a one day
time horizon. Provided, however, in the case of futures contracts, where it may
not be possible to collect mark to market settlement value, before the
commencement of trading on the next day, the initial margin may be computed
over a two day time horizon, applying the appropriate statistical formula.
The methodology for computation of Value at Risk percentage will be as per
the recommendations of SEBI from time to time.
Initial margin requirement for a member:
 For client positions - shall be netted at the level of individual client and
grossed across all clients, at the Trading/ Clearing Member level, without
any setoffs between clients.
 For proprietary positions - shall be netted at Trading/ Clearing Member
level without any set offs between client and proprietary positions.
For this purpose, various parameters shall be as specified hereunder or such
other parameters as may be specified by the relevant authority from time to
time:
Price Scan Range
In the case of Notional Bond Futures, the price scan range shall be 3.5
Standard Deviation (3.5 sigma) and in no case the initial margin shall be less
than 2% of the notional value of the Futures Contracts, which shall be scaled
up by look ahead period as may be specified from time to time. For Notional
T-Bill Futures, the price scan range shall be 3.5 Standard Deviation (3.5 sigma)
and in no case the initial margin shall be less than 0.2% of the notional value of
ANNA UNIVERSITY 271

Notes the futures contract, which shall be scaled up by look ahead period as may be
specified from time to time.
Calendar Spread Charge
The margin on calendar spread shall be calculated at a flat rate of 0.125% per
month of spread on the far month contract subject to a minimum margin of
0.25% and a maximum margin of 0.75% on the far side of the spread with legs
upto 1 year apart.
A Calendar spread positions will be treated as non-spread (naked) positions in
the far month contract, 3 trading days prior to expiration of the near month
contract.
Exposure Limits (2nd line of defense)
Clearing Members shall be subject to Exposure limits in addition to initial
margins. Exposure Limit shall be 100 times the liquid net worth i.e. 1% of the
notional value of the gross open positions in Notional 10 year bond futures
(both coupon bearing and zero coupon) and shall be 1000 times the liquid net
worth i.e. 0.1% of the gross open positions in notional 91 day T-Bill futures.
Exposure limit for calendar spreads: the Calendar spread shall be regarded as
an open position of one third of the mark to market value of the far month
contract. As the near month contract approaches expiry, the spread shall be
treated as a naked position in the far month contract three days prior to the
expiry of the near month contract
Trading Member wise/ Custodial Participant wise Position Limit
Each Trading Member/ Custodial Participant shall ensure that his clients do not
exceed the specified position limit. The position limits shall be at the client
level and for near month contracts and shall be 15% of the open interest or
` 100 crores, whichever is higher.
For futures contracts open interest shall be equivalent to the open positions in
that futures contract multiplied by its last available closing price.
Zero Coupon Yield Curve
The yield curve is a curve showing several yields or interest rates across
different contract lengths (2 month, 2 year, 20 year, etc...) for identical debt
contract. The curve shows the relation between the (level of) interest rate (or
cost of borrowing) and the time to maturity, known as the "term", of the debt
for a given borrower in a given currency.
Example: the U.S. dollar interest rates paid on U.S. Treasury securities
for various maturities are closely observed by many traders, and are commonly
plotted on a graph such as the one on the right which is informally called "the
272 ANNA UNIVERSITY

yield curve". More formal mathematical interpretations of this relation are Notes
usually called the term structure of interest rates.
The shape of the yield curve specifies the cumulative priorities of all lenders in
respect to a particular borrower (such as the US Treasury or the Treasury of
Japan). Usually, lenders are concerned about a potential default (or rising rates
of inflation), so they provide higher interest rates on long-term loans as
compared to offering on shorter-term loans. Occasionally, when lenders are
seeking long-term debt contracts more aggressively instead of short-term debt
contracts, the yield curve "inverts", with interest rates (yields) being lower for
the longer periods of repayment so that lenders can attract long-term
borrowing.
The yield of a debt instrument is the overall rate of return available on the
investment. In general the percentage per year that can be earned is based upon
the length of time that the money is invested.
Example: a bank may offer a "savings rate" higher than the normal
checking account rate if the customer is prepared to leave money untouched for
five years. Investing for a period of time t gives a yield Y(t).
This function Y is called the yield curve, and it is often, but not always, an
increasing function of t. Yield curves are used by fixed income analysts, who
analyze bonds and related securities, to understand conditions in financial
markets and to seek trading opportunities. Economists use the curves to
understand economic conditions.
The yield curve function Y is actually only known with certainty for a few
specific maturity dates, while the other maturities are calculated by
interpolation.
Figure 10.3: Zero Coupon Yield Curve as at 9th February 2005 for USD
ANNA UNIVERSITY 273

Notes Zero coupon yields and prices for 91 day and 10 year zero coupon bond
The N-S parameters obtained from the ZCYC estimation can now be used to
compute the spot rate of any term greater than zero and combining all the spot
rates for various terms we can get a zero coupon yield curve (or spot yield
curve). Hence we use the equation specified in the write up of N-S Parameters
to compute the relevant spot interest rate for 91 days and 10 years. The
equation mentioned above requires the time to be converted into years and the
convention used to compute years from number of days is to divide the
relevant number of days by 365. The equation (formula in the excel sheet)
takes care of the same.
Once the relevant spot interest rate relevant to the specific term is found out,
we can calculate the Present Value of the Zero Coupon Bond or T-Bills by
using a formula applicable to the relevant compounding requirement. In the
excel sheet provided here we use discrete discounting formula. It assumes a
redemption value of ` 100/- and accordingly the PV = 100/(1+r)t where PV is
Present value, r is relevant spot interest rate and t is relevant time to maturity.
For semiannual we need to divide "r" by 2 and multiply the time "t" by 2.
N-S Parameters
Nelson-Siegel’s functional form is a method through which the spot interest
rates can be estimated using an equation. The N-S functional form gives a
single equation with four unknowns and the ZCYC estimation process
computes the values of these unknown parameters. The equation used in the N-
S functional form is give by
where ‘m’ denotes related maturity for the cash flows in a bond and b=[ß0, ß1,
ß2 and tau] are parameters to be estimated.Here ß0 is the level parameter and
commonly interpreted as long term (long term in mathematical sense –
approaching infinity) rate, ß1 is slope parameter, ß2 is curvature parameter and
tau is scale parameter while (ß0 + ß1) gives the short term rate. Alternatively it
can also be said that ß0 is the contribution of long term component, ß1 is the
contribution of short term component, ß2 indicates the contribution of medium
term component, tau is the decay factor and ß2 & tau determine the shape of
the curve.
r (m, b)  0  (1  2)[1  exp( m / )] /(m / )  2 exp( m / )
The N – S parameter values [ß0, ß1, ß2 and tau] are computed daily using the
traded bonds. The excel file contains the historical data of N-S parameters.
N – S parameters for the day
Table 10.3: N – S parameters for the Day
Date Beta 0 Beta 1 Beta 2 Tau
04-Feb-2011(for trades upto 3:00 16.9903 -9.4000 -8.8502 14.9879 Archives
p.m)
03-Feb-2011(for all trades) 12.5551 -4.7496 -3.7377 15.5000
274 ANNA UNIVERSITY

Notes
Learning Activity
Compare the stock index futures traded on NSE and BSE. In what
respects do they differ?
1. The new contracts are introduced for a three month

duration. This way, at any point in time, there will be 3
contracts available for trading in the market (for each
security) i.e., one near month, one mid month and one
far month duration respectively.
2. Quantity freeze is calculated for each underlying on
the last trading day of each calendar month and is
applicable through the next calendar month.
SUMMARY
 The contracts have standardized specifications like market lot, expiry day,
unit of price quotation, tick size and method of settlement.
 The theoretical price of a future contract is sum of the current spot price
and cost of carry. However, the actual price of futures contract very much
is dependent upon the demand and supply of the underlying stock.
Generally, the futures prices are higher than the spot prices of the
underlying stocks.
 NSE specifies the characteristics of the futures contract such as the
underlying security, market lot, and the maturity date of the contract. The
futures contracts are available for trading from introduction to the expiry
date.
 The examples of interest rate derivatives include-Interest rate Cap, Range
accrual note, Bermudan Swaption.
 Types of Interest rate derivatives are-Vanilla, Quasi-vanilla and exotic
derivatives.
 The contract terminology for Interest Rate Derivatives constitutes: the
product description, Contract Specification, Trading Parameters, Clearing
and Settlement, Risk Containment and Zero Coupon Yield Curve
 The N-S parameters obtained from the Zero Coupon Yield Curve
estimation can now be used to compute the spot rate of any term greater
than zero and combining all the spot rates for various terms we can get a
zero coupon yield curve (or spot yield curve).
ANNA UNIVERSITY 275

Notes KEYWORDS
Stock Futures: Stock Futures are financial contracts where the underlying
asset is an individual stock. Stock Future contract is an agreement to buy or sell
a stated quantity of underlying equity share for a future date at a price agreed
upon between the buyer and seller.
Single-Stock Futures: Single stock futures (SSFs) are contracts between two
investors. The buyer promises to pay a stipulated price for 100 shares of a
single stock at a predetermined future point. The seller promises to deliver the
stock at the stipulated price on the specified future date.
Interest Rate Derivatives: A financial instrument based on an underlying
financial security whose value is influenced by changes in interest rates.
Interest Rate Cap: An interest rate cap is designed to hedge a company’s
maximum exposure to upward interest rate movements. It forms a maximum
total dollar interest amount the hedger will pay out over the life of the cap.
Exotic Coupon Leg: An exotic coupon leg basically comprises of a functional
dependence on the past and current underlying indices (LIBOR, CMS rate, FX
rate) and sometimes on its own past levels, as in Snowballs and TARNs.
Zero Coupon Yield Curve: The yield curve is a curve showing several yields
or interest rates across different contract lengths (2 month, 2 year, 20 year,
etc...) for identical debt contract
1. What do you mean by stock futures?
2. What do you mean by single-stock futures?
3. What are the contract specifications for single-stock futures?
4. Discuss the trading parameters for single stock futures.
5. What is an index future?
6. Discuss the Contract Terminology and Specifications for Stock Index
Futures Trading at NSE.
7. What do you mean by Interest Rate Derivatives?
8. Give examples of Interest rate derivatives.
9. Explain the types of interest rate derivatives.
10. Explain briefly the contract terminology for interest rate derivatives.
276 ANNA UNIVERSITY

Long Answer Questions Notes

1. Determine the value of weighted index for three stocks with following
prices and capitalization. The current index divisor is 0.10.
Stock Share Outstanding Price base period Current price
HUL 1000 50 70
SBI 800 100 90
HDFC 500 80 90
2. In December 2008, a short-position holder delivers one expiring 10-year

treasury note futures contract. The settlement price of the contract is 115-
17. The trader chooses 4.25% bond of August 2013 for trade settlement on
29 December 2008 with a conversion factor of 0.9040. For 10-year note
futures(or Bond or 5-year Note futures), the settlement price is multiplied
by the contract size of $1,000 per contract price point. For 2-year note
futures, the settlement price is multiplied by the contract size of $2,000 per
contract price point. Calculate the principal amount of the futures invoice
price?
3. Suppose a return equally-weighted index contains the three stocks and have
a previous day value of 270. Compute the index’s value today.
Stock Previous day’s price Current price
HUL 70 77
SBI 90 108
HDFC 90 95
4. An investor enters into one long July futures contracts on orange juice.
Each contract is for the delivery of 1,500 litres. The current futures price is
` 35 per litre, the initial margin is ` 10,000 per contract, and the
maintenance margin is ` 8,000. What price change would lead to a margin
call? Under what circumstances could ` 2,000 be withdrawn from the
margin account?
5. Explain in detail risk containment margins.
FURTHER READINGS

John Wiley & Sons.
ANNA UNIVERSITY 277

Notes Kulkarni, Bharat (2011), Commodity Markets & Derivatives, 1st

278 ANNA UNIVERSITY

Model Question Paper
Model Question Paper

Reg. No.:
M.B.A. DEGREE EXAMINATION

Fourth Semester – Financial Services Management
DBA 5035 – FINANCIAL DERIVATIVES MANAGEMENT
Time: Three hours Maximum: 100 marks
Answer ALL questions.
PART A – (10 × 2 = 20 marks)

1. What do you mean by Forward Contracts?
2. List the various types of traders.
3. Explain the term ‘future contract’.
4. Write a short note on Currency Futures.
5. What do you mean by intrinsic value?
6. Mention the various options pricing models.
7. Define swap.
8. Write short notes on FRNs.
9. Mention the important contract terminologies relating to Stock Options.
10. What do you mean by Commodity Futures?
PART B — (5 × 13 = 65 MARKS)
11. (a) Explain the various types of derivatives. Differentiate between cash and futures market.
Or
(b) Explain the functions of OTC derivatives market.
12. (a) Describe the characteristics and settlement procedure of futures contract.
Or
(b) Explain the relationship between futures prices, forward prices and spot prices.
13. (a) Explain the features of various option contracts with example.
Or
(b) Explain the differences between future and option contracts.
ANNA UNIVERSITY 279

14. (a) How the valuation of Interest Rate SWAP, Currency SWAP and FRN are made? Explain them.
Or
(b) Explain the different types of SWAP contracts.
15. (a) Discuss the evolution of Derivatives Market in India.
Or
(b) Discuss the regulatory framework for derivatives market in India.
PART B — (1 × 15 = 15 MARKS)
16. (a) Explain the risks in financial derivatives and suggest some measures to minimise them.
Or
(b) Explain the performance of exchange trading in derivatives.
280 ANNA UNIVERSITY

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CENTRE FOR DISTANCE EDUCATION

Notes LEARNING OUTCOMES

Example: A measure of distance in kilometers could be derived from a

1.1 DERIVATIVES – MEANING AND DEFINITION Notes

A derivative by itself does not constitute ownership; instead it is a

The Underlying Securities for Derivatives are:

Example: In the option contract, the potential loss and potential

 Derivatives are also termed as deferred delivery or deferred payment Notes

Example: A fund manager who is prohibited from taking particular

Name of Futures Market Major Contracts Traded

Year Financial Instruments

1.2 TYPES OF DERIVATIVES

Forwards Futures Options Swaps

Figure 1.1: Types of Derivative

1.2.1 Forwards Contract

Notes There are two major types of forward commitments:

1.2.2 Futures Contract Notes

Two Types of Options Notes

Example: Example of Call Option

Example: Example of Put Option

necessity for an intermediary to cancel both the parties. By arranging Notes

Example: U.S. short-term rates vs. U.K. short-term rates.

Example: A firm having liabilities denominated in Japanese yen

Example: Take for an example that a corporation needs to borrow $10

Example: Take for an example, a commodity swap consisting of a

Features of Equity Swaps Notes

Example: Parties may agree to make periodic payments or a single

Example: Take for an example that illustrates one of the potential

Example: Let us look at another example to illustrate these points. Say

Notes 1.3 DIFFERENCES BETWEEN CASH AND FUTURE

Taking a leveraged position proves to be risky, you can even lose

1.3.1 Cash Market

Notes  Speculating with futures contracts is basically a paper investment. The

Example: You expect a ` 100 stock to go up by ` 10. One way is to

Kolb, W. Robert and Overdahl, A. James (2009), Financial

 Understand the OTC and exchange traded securities Notes

2.1 TYPES OF TRADERS

Example: Suppose Mr. A is currently possessing 50 shares of SBI

Apart from equity markets, hedging is common in the foreign

Example: Let us assume that a company specializes in manufacturing

Unlike investing in business along with its risks, speculators have

Example: If margin money required is 10%, the speculator can take 10

Example: If a speculator believes XYZ Company stock is overpriced,

Example: Let's take an example: let's assume part of your investment

Arbitrage is the process of simultaneous purchase of securities or

Example: On exchange A IBN is trading at $25 and on exchange B

Notes 2.2 OTC AND EXCHANGE TRADED SECURITIES

Example: In the case of a swap involving two bonds, the benefits in

rate of interest, or the currency exchange rate, to be paid or received on an Notes

Example: Let us assume that Company A enters into an FRA with

Example: Exotic Derivatives that fall into the options category

Example: It is because the option writer will need to provide the

Example: Let's say IBM stock is currently trading at $100 per

2.2.1 Development of Derivative Markets in India Notes

In some of the most widely reported mishaps in the derivatives

 Safeguard for clients' moneys: Moneys and securities deposited by

2.3 TYPES OF SETTLEMENT

Notes publicly (exchange) traded securities, however, payment of money today is