Derivative & IRRM

Derivatives & Interest Rate Risk Management
A. Basics of Derivatives
B. Forward and Futures Contract
QUESTION 1:
RTP N 12
Suppose that there is a future contract on a share presently trading at Rs. 1000. The life of future
contract is 90 days and during this time the company will pay dividends of Rs. 7.50 in 30 days, Rs.
8.50 in 60 days and Rs. 9.00 in 90 days
Assuming that the Compounded Continuously Risk-Free Rate of Interest (CCRRI) is 12% p.a. You
are required to find out:
a) Fair Value of the contract if no arbitrage opportunity exists.
b) Value of cost of carry
[ Given e-0.01 = 0.9905, e-0.02 = 0.9802, e-0.03 = 0.97045 and e0.03 = 1.03045]
Solution:
Logical Solution:
a) Calculation of fair value of contract, if no Arbitrage opportunity exists
FP = (S0 – PV(I)) x ert
= (1000 – 24.49)  e0.1290/360
= 975.51  1.03045
= 1005.21
Calculation of Income
Dividend Day PV (I)
7.50 30 7.50/e0.1230/360 = 7.43
8.50 60 8.50/e0.1260/360 = 8.33
9 90 9/e0.1290/360 = 8.73
24.49
b) Value of cost of carry = Forward – Spot
= 1005.21 – 1000
= 5.21
Solution by ICAI:
a) Fair Value of Future Contract = ₹ 1000 e0.12X90/360 – Dividend Proceeds
= ₹ 1000 × 1.03045 – ₹ 24.49
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= ₹ 1005.96
b) Since Value of Future Contract = Spot Price + Cost to Carry
₹ 1005.96 = ₹ 1000 + Cost to Carry
Cost to Carry = ₹ 5.96
QUESTION 2:
M 12 | RTP M 12
On 31-8-2011, the value of stock index was ₹2,200. The risk-free rate of return has been 8% per
annum. The dividend yield on this Stock Index is as under:
Month Dividend paid p.a.
January 3%
February 4%
March 3%
April 3%
May 4%
June 3%
July 3%
August 4%
September 3%
October 3%
November 4%
December 3%
Assuming that interest is continuously compounded daily, find out the future price of contract
deliverable on 31-12-2011. Given: e0.01583 = 1.01593
Solution:
The date given is as on 31/8/2011 therefore the relevant months are September, October,
November and December
FP = S0  e(r-y) × t
= 2200  e(0.08 – 0.0325) × 4/12
= 2200  1.01593 = 2235.05
Calculation of average dividend yield

3+3+4 +3
Dividend yield = = 3.25%
4
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QUESTION 3:
RTP N 09 | RTP M 11
The following information about copper scrap is given:

Spot Price : $ 10,000
Future Price : $ 10,800 for a one-year contract
Interest rate : 12%
PV (storage cost) : $ 500 per year
What is the PV (convenience yield) of copper scrap?
Solution:
The formula to be used is the when the question is silent
FP = (S0 + PV(S) – PV(CY))  (1 + r × n)
12
10800 = (10000 + 500 – PV(CY))  (1 + 0.12 × )
12
10800 = (10500 – PV(CY))  1.12
PV(CY) = 857.14
Conclusion: PV of convenience yield is $857.14
QUESTION 4:
N 11 | N 08 | RTP
The 6-months forward price of a security is ₹ 208.18. The borrowing rate is 8% per annum payable
with monthly rests. What should be the spot price?
Solution:
FP = S0  (1+r)n
6
0.08 12×12
208.18 = S0  (1+ )
12
208.18 = S0  1.0407
200.04 = S0
S0 = 200.04
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QUESTION 5:
N 19
A future contract is available on R Ltd that pays an annual dividend of ₹4 and whose stock is
currently priced at 125. Each future contract calls for delivery of 1,000 shares to stock in one year,
daily marking to market. The corporate treasury bill rate is 8%.
Required:
a. Given the above information, what should the price of one future contract be?
b. If the company stock price decreases by 6%, what will be the price of one futures contract?
c. As a result of the company stock price decrease, will an investor that has a long position in
one futures contract of R Ltd. realizes a gain or loss. What will be the amount of his gain or
loss?
(Ignore margin and taxation, if any)
Solution:
(i) Price of one future contract: = ([S0  (1 + r × n)] – I)  Contract size
= ([125  (1 + .08 × 12/12)] – 4)  1000
= 1,31,000
(ii) New Share price: = 125 – 6% = 117.5
New price of one future contract = [117.5  (1 + .08 × 12/12) – 4]  1000
= 1,22,900
(iii) Loss on long position = 1,22,900 – 1,31,000
= 8,100
QUESTION 6:
RTP N 20
Mr. SG sold five 4-Month Nifty Futures on 1st February 2020 for ₹ 9,00,000.
At the time of closing of trading on the last Thursday of May 2020 (expiry),
Index turned out to be 2100. The contract multiplier is 75.
Based on the above information calculate:
a. The price of one Future Contract on 1st February 2020.
b. Approximate Nifty Sensex on 1st February 2020 if the Price of Future Contract on same date
was theoretically correct. On the same day Risk Free Rate of Interest and Dividend Yield on
Index was 9% and 6% p.a. respectively.
c. The maximum Contango/ Backwardation.
d. The pay-off of the transaction.
Note: Carry out calculation on month basis.
Solution:
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a. Price of one future contract on 1st Feb, 2020

900000
=
5
= ₹ 180000
b. Calculation of Nifty Index Spot Price:
FP = SP  [1 + (r - y) × n] x 75
180000 = SP  [1+(0.09 – 0.06) × 4/12] × 75
178218 = SP × 75
2376.23 = SP
c. Maximum contango/Backwardation
spot = 2376.23
future = 2400 (180000/75
S<F
2376.23 < 2400  market is in contango
Max. contango = Basis
=S–F
= 2376.23 – 2400 = - 23.77
d. Pay-off of the transaction
Inflow 9,00,000
Outflow -7,87,500 (5  2100  75)
Gain 1,12,500
Note: Remember 75 multiplies in second past of the question
QUESTION 7:
RTP M 15
Mr. X, is a Senior Portfolio Manager at ABC Asset Management Company. He expects to purchase
a portfolio of shares in 90 days. However, he is worried about the expected price increase in
shares in coming day and to hedge against this potential price increase he decides to take a
position on a 90-day forward contract on the Index. The index is currently trading at 2290.
Assuming that the continuously compounded dividend yield is 1.75% and risk free rate of interest
is 4.16%, you are required to determine:
a. Calculate the justified forward price on this contract.
b. Suppose after 28 days of the purchase of the contract the index value stands at 2450 then
determine gain/ loss on the above long position.
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c. If at expiration of 90 days the Index Value is 2470 then what will be gain on long position.
Note: Take 365 days in a year and value of e0.005942 = 1.005960, e0.001849 = 1.001851.
Solution:
(a) FP = S0  e(r - y) × t
= 2290  e(0.0416 - 0.0175) × 90/365
= 2290  1.005960
= 2303.65
Justified forward price is ₹2303.65
(b) Logical Solution:
FFP = S0  e(r - y) × t
Index forward price after 28th days = 2450  e(0.0416 - 0.0175) × 62/365
= 2450  e0.004094
= 2450  1.00410
= 2460.05
Calculation of e0.00409
x1 x2 x3
Ex =1+ + +
1! 2! 3!
0.00409 0.004092 0.004093
= 1+ + + 3×2×1
1 2×1
= 1.00410
Gain on long position = 2460.05 – 2303.65
= 156.39
Solution by ICAI:
Gain/loss on Long Position after 28 days = 2450 – 2290  e28/365(0.0416 – 0.0175)
= 2450 – 2290  e^0.001849
= 2450 – 2290  1.001851
= 155.76
th
(c) Gain on long position at 90 day = 2470 – 2303.65
= ₹166.35
QUESTION 8:
N 09 | M 04 | MTP N 14 | RTP
The following data relate to Anand Ltd.'s share price:

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Current price per share ₹ 1,800

6 months future's price/share ₹ 1,950
Assuming it is possible to borrow money in the market for transactions in securities at 12% per
annum, you are required:
a. to calculate the theoretical minimum price of a 6-months forward purchase; and
b. to explain arbitrate opportunity.
Solution:
Calculation of FFP = S0 × (1 + r × n)
= 1800 × (1 + 0.12 × 6/12)
= 1908
Calculation of arbitrage profit:
Since AFP (₹ 1950) > FFP (₹ 1908)
 Futures are overvalued.
 Cash and Carry arbitrage will be followed
Particulars Today At the end of 6m
Action Amount Action Amount
Future Sell – Settle 1950
Spot Buy (1800)
Borrowing Borrow 1800 Repay (1908) *
Profit 0 42
* 1800 x (1+ 0.12 × 6/12) = 1908
QUESTION 9:
M 09 | RTP
The share of X Ltd. is currently selling for ₹ 300. Risk free interest rate is 0.8% per month. A three
months futures contract is selling for ₹ 312. Develop an arbitrage strategy and show what your
risk-less profit will be 3 months hence assuming that X Ltd. will not pay any dividend in the next
three months.
What will be the strategy if actual futures price is ₹ 290?
Solution:
S0 = ₹300
Calculation of Fair Future Price:
FFP = S0  (1 + r)n
= 300  (1+ 0.008)3
= 307.26
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If Actual Future Price (AFP) is ₹312:

Since AFP (₹312) > FFP (307.26)
 Futures are overvalued.
 Cash and Carry arbitrage will be followed
Future Sell – Settle 312
Spot Buy (300)
Borrowing Borrow 300 Repay (307.26) *
Profit 0 4.74
* 300 x (1+ 0.008)3 = 307.26
If Actual Future Price (AFP) is ₹290:

AFP (₹290) < FFP (₹307.26)
 Futures are undervalued
 Reverse cash and carry arbitrage will be followed
Future Buy – Settle (290)
Spot Sell 300
Investment Invest (300) Redeem 307.26
Profit 0 17.26
QUESTION 10:
N 19
The NSE-50 Index futures are traded with rupee value being ₹100 per index point. On 15th
September, the index closed at 1195, and December futures (last trading day December 15) were
trading at 1225. The historical dividend yield on the index has been 3% per annum and the
borrowing rate was 9.5% per annum.
a. Determine whether on September 15, the December futures were underpriced or
overpriced?
b. What arbitrage transaction is possible to gain out this mispricing?
c. Calculate the gains and losses if the index on 15th December closes at (a) 1260 (b) 1175.
Assume 365 days in a year for your calculations.
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Solution:
i) FP = S0  [1+ (r - y) × n]
= 119500  [1 + (0.095 – 0.03) × 91/365]
= 1,21,437
Since AFP (₹ 1225  100) > FFP (₹ 121437)
ii) Since futures is overpriced

 we will conduct cash and carry arbitrage by Selling futures, Buying spot and Borrowing.
iii) Calculation of Gain loss

On 15th Sept On 15th Dec
Particulars
Action Amount Action 126000 117500
Future Sell – Settle (3500) 5000
Spot Buy (119500) Sell 1,26,000 1,17,500
Borrow Borrow 119500 Repay (1,22,330)* (1,22,330)*
Dividend Received 893.79# 893.79#
Profit 0 1063.79 1063.79
* S0  1 + r  n = 119500  [1 + 0.095  91/365] =122330
# 119500  3%  91 / 365 =893.79
QUESTION 11:
J 21
Mr. A is holding 1000 shares of face value of ₹ 100 each of M/s. ABC Ltd. He wants to hold these
shares for long term and have no intention to sell.
On 1st January 2020, M/S. XYZ Ltd. has made short sales of M/s. ABC Ltd.'s shares and approached
Mr. A to lend his shares under Stock Lending Scheme with following terms:
(i) Shares to be borrowed for 3 months from 01-01-2020 to 31-03-2020,
(ii) Lending Charges/Fees of 1% to be paid every month on the closing price of the stock quoted
in Stock Exchange and
(iii) Bank Guarantee will be provided as collateral for the value as on 01-01-2020.
Other Information:
a) Cost of Bank Guarantee is 8% per annum,
b) On 29-02-2020 M/s. ABC Ltd., declared dividend of 25%,
c) Closing price of M/S. ABC Ltd.'s share quoted in Stock Exchange on various dates are as
follows:
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Share Price
Date
Scenario — 1 Bullish Scenario — 2 Bearish
01-01-2020 1000 1000
31-01-2020 1020 980
29-02-2020 1040 960
31-03-2020 1050 940
You are required to find out:
a. Earnings of Mr. A through Stock Lending Scheme in both the scenarios.
b. Total Earnings of Mr. A during 01-01-2020 to 31-03-2020 in both the scenarios.
c. What is the Profit or loss to M/S. XYZ by shorting the shares using through Stock Lending
Scheme in both the scenarios?
Solution:
(a) Earnings of Mr. A through Stock Lending Scheme:
Scenario A Scenario B
Particulars
Price Lending fees Price Lending fees
31/1/2020 1020 (102010001%) = 980 9800
10200
29/2/2020 1040 10400 960 9600
31/3/2020 1050 10500 940 9400
31100 28800
(b) Total Earnings of Mr. A during 01-01-2020 to 31-03-2020:
Particulars Scenario 1 Scenario 2
Dividend Received (₹100  1000 shares  25%) = 25000 25000
Lending Charges 31100 28800
Total Earnings 56100 53800
(c) Profit or loss to M/S. XYZ
Scenario 1 Scenario 2
P/(L) on short sales (1000 – 1050) x 1000 = (50000) (1000 – 940) x 1000 = 60000
Lending charges (31100) (28800)
Bank Guarantee (20000)* (20000)
(1,01,100) 11,800
*₹1000  1000 shares  8%  3/12
Assumption: M/s XYZ Ltd. has borrowed all the1000 shares from Mr. A
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QUESTION 12:
N 08 | RTP
Calculate the price of 3 months PQR futures, if PQR (FV ₹ 10) quotes ₹ 220 on NSE and the three
months future price quotes at ₹ 230 and the one month borrowing rate is given as 15 percent and
the expected annual dividend is 25 percent per annum payable before expiry. Also examine
arbitrage opportunities. What if 3 months PQR Futures quotes at ₹210.
Solution:
Calculation of Fair Future Price
FFP = S0  (1+r)n – I
3
FFP = 220   1 + 0.15  - 2.50

 12 
FFP = 225.85
When AFP (₹230) > FFP (225.85), we will follow cash and carry arbitrage
Today At the end of 3M
Particulars
Futures Sell – Settle 230
Spot Buy 220 - -
Borrowings Borrow (220) Repay (228.35)*
Dividend Received 2.5
Profit 0 4.15
3
  0.15 
* 220  1 +  
  12 
If 3M FP quotes at ₹210 then, AFP (₹210) < FFP (₹225.85) we will follow reverse cash and carry
arbitrage

Particulars
Futures Buy – Settle (210)
Spot Sell 220
Investments Invest (220) Redeem 228.35*
Dividends Pay (2.5)
Profit 0 15.85
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QUESTION 13:
RTP N 13
Suppose current price of an index is ₹ 13,800 and yield on index is 4.8% (p.a.). A 6- month future
contract on index is trading at ₹ 14,340.
Assuming that Risk Free Rate of Interest is 12%, show how Mr. X (an arbitrageur) can earn an
abnormal rate of return irrespective of outcome after 6 months. You can assume that after 6
months index closes at ₹ 10,200 and ₹ 15,600 and 50% of stock included in index shall pay divided
in next 6 months.
Also calculate implied risk-free rate
Solution:
The fair price of the index future contract can be calculated as follows:
FP = 13,800 × [1 + (0.12 × 6/12)] – (13,800 × 4.8% × 50%)
= ₹ 14,296.80
Since presently 6-month index future is trading at ₹ 14,340, hence it is overpriced.
Therefore, Mr. X should follow cash and carry arbitrage:
1) He should take long position in a portfolio replicating index.
2) He should take short position in index futures.
He can earn an abnormal return as follows:
Step 1: Take position as per point 1 & 2 above today:
Total amount invested: 13,800
Step 2: Square off above portfolio after 6m and inflow will be:
If price turns out to be:
10,200 15,600
Profit on sale of long spot index 10,200 15,600
Profit on short futures position 4,140.0 - 1,260.0
#
Dividend Received 331.2 331.2
Total Profit 14,671.2 14,671.2
#
(13,800 × 4.8% × 50%) = 331.2
Profit on investment 12
Step 3: Implied risk-free rate =  100
Amount of Investment 6
14,671.2 - 13,800 12
=   100
13,800 6
= 12.63%
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Since the above implied risk-free rate (12.63%) is more than given risk free rate (12%), Mr. A has
earned an abnormal return
QUESTION 14:
M 23 | RTP N 20 | M 19
Mr. V is a commodity trader and specialized himself in trading of rice. He has 24,000 Kg. of rice
which he is planning to sell after 3 months from now. The following details are available as on
date:
Spot price 1 Kg. 70
3 month’s future is trading at 1 Kg. 68
Expected Lower price after 3 months 1 Kg. 64
Contract size 500 Kg/contract
You are required to advise to Mr. V:
1. Interpret the position of trader in the cash market.
2. How to mitigate the risk of fall in price.
3. How to use the futures market.
4. What will be the effective realized price for his sales if, after 3 months, spot price is ₹ 69/ Kg.
and the 3 months future contract price is:
a. ₹ 72/Kg
b. ₹ 67/Kg
Solution:
(a) Rice trader is having long position in cash market
(b) The risk of fall in price can be mitigated by hedging this position by taking a position in
derivatives market.
(c) Since, Mr. V has a long position in the cash market, therefore he should take a short
position in future market to mitigate the risk
24,000 kgs
(d) No. of contracts to short = = 48 contracts
500 kgs
Calculation of effective price realized:
Particulars If price = ₹ 72/Kg If price = ₹ 72/Kg
Sale proceeds from spot market ₹ 16,56,000 ₹ 16,56,000
(69  24,000) (69  24,000)
Gain/Loss or short future’s (₹ 96,000) ₹ 24,000
position ((68 - 72)  48  500) ((67 - 68)  48  500)
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Total realization / inflow quantity 15,60,000 16,80,000

÷ Quantity 24,000 24,000
Effective realized price per kg ₹ 73/kg ₹ 70/kg
QUESTION 15:
M 21 | M 17 | N 13 | RTP
A trader is having in its portfolio shares worth ₹85 lakhs at current price and cash ₹15 lakhs. The
beta of share portfolio is 1.6. After 3 months the price of shares dropped by 3.2%. Determine:
(i) Current portfolio beta
(ii) Portfolio beta after 3 months if the trader on current date goes for long position on ₹100 lakhs
Nifty futures.
Solution:
βx × MVx + βY × MVY
(i) Current portfolio Beta =[ ]
Total Value of Portfolio
85 lakhs  1.6 + 15 0
=
100
= 1.36 times
(ii) Calculation of portfolio Beta after 3m
Value of index after 3m:
 in portfolio return
P =
 in market return (index)
- 3.2
1.6 =
Δ in market return (index)
 in market return (index) = - 2% i.e., market fell by 2%
Value of Nifty Futures after 3 months = 100 – 2% = 98
Loss on long nifty futures = 100 – 98 = 2 lacs i.e., mark to
market
Portfolio value after 3m:

Value
Share 85 - 3.2% = 82.28
Cash 15 - 2 = 13.00
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= 95.28
100 - 95.28
% Change in portfolio value = = 4.72%
100
Portfolio Beta after 3m = 4.72%/2% = 2.36 times
QUESTION 16:
N 11 | M 19 | RTP
A Portfolio Manager (PM) has the following four stocks in his portfolio:
Security No. of Shares Market Price per share (₹) Beta
VSL 10,000 50 0.9
CSL 5,000 20 1
SML 8,000 25 1.5
APL 2,000 200 1.2
Compute the following:
a. Portfolio beta.
b. If the PM seeks to reduce the beta to 0.8, how much risk free investment should he bring
in?
c. If the PM seeks to increase the beta to 1.2, how much risk free investment should he bring
in?
Solution:
(a) Computation of portfolio beta
Security Market Value Weight  W
VSL 5,00,000 0.417 0.9 0.3753
CSL 1,00,000 0.083 1 0.083
SML 2,00,000 0.167 1.5 0.2505
APL 4,00,000 0.333 1.2 0.3996
12,00,000  = 1.108
(b) RA  WRA + RFA  WRFA = T
1.108 WRA + 0  WRFA = 0.8
WRA = 0.722  72.20%
WRFA = 27.80%
 WRA i.e., 72.20% is equal to ₹ 12,00,000
1200000
∴ WRF i.e., 27.80% =  0.2780 = 4,62,050
0.7220
PM should long risk-free security of ₹4,62,050
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(c) RA  WRA + RFA  WRFA = T

1.108  WRA + 0  WRFA = 1.20
WRA = 1.0830
WRFA = -0.083
 1.0830 -----------> 1200000
∴ - 0.083 -----------> 91966.76
PM should short risk-free security of ₹91966.76
QUESTION 17:
RTP N 14
Mr. A has a portfolio of ₹ 5 crore consisting of equity shares of X Ltd. and Y Ltd. with beta of 1.15.
Other information is as follows:
Spot Value of Index Future: 21000
Multiplier: 150
You are requested to reduce beta of portfolio to 0.85 and increase beta to 1.45 by using:
(a) Change in composition through Risk Free securities
(b) Index futures
Solution:
(a) Change in composition through risk free security
(i) Decrease beta to 0.85
RA  WRA + RFA  WRFA = T
1.15  WRA + 0  WRF = 0.85
WRA = 0.7391
WRF = 0.2609
If, 100% -----------> 5 Cr.
Then, WRA i.e., 0.7391 ----------> 5 Cr.  0.7391 = ₹3.6955 cr.
And, WRF i.e., 0.2609 ----------> 5 Cr.  0.2609 = ₹1.3045 cr.
Hence, to reduce Beta of portfolio to 0.85 Mr. A should sell risky Assets (X Ltd. & Y
Ltd.) of ₹1.3045 Cr. & buy Risk free securities for ₹1.3045 cr.
(ii) Increase beta to 1.45

1.15  WRA + 0 = 1.45
WRA = 1.2609
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WRFA = - 0.2609
If, 100% -----------> 5 Cr.
Then, WRA i.e., 1.2609 ----------> 5 Cr.  1.2609 = ₹6.3045 cr.
And, WRF i.e., - 0.2609 --------> 5 Cr.  - 0.2609 = - ₹1.3045 cr.
Hence, to increase Beta to 1.45, Mr. A should continue to held portfolio equity
shares of ₹5 cr. and short sell risk free securities of ₹1.3045 Cr. and invest the sale
proceeds in the equity shares of X and Y. Hence total investment in the equity
portfolio would become ₹6.3045 cr.
(b) Index Futures

(i) Decrease beta to 0.85
T − P
No. of Index Futures Contracts = VP 
Fm
5 Cr. × (0.85 - 1.15)
=
21000 × 150
-0.30
= 5,00,00,000 
3150000
= - 4.76
 5 contracts short
To reduce the beta to 0.85, Mr A should short 5 contracts
(ii) Increase beta to 1.45

T − P
No. of Index Future Contracts = VP 
Fm
1.45 - 1.15
= 50000000 
21000 × 150
= + 4.76
 5 contracts long
To increase beta to 1.45, Mr. A should long 5 contracts.
QUESTION 18:
RTP M 09
You have the following five stocks in your portfolio:
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Security No. of shares Price/share Beta

A 10,000 50 1.2
B 5,000 20 2
C 8,000 25 0.7
D 1,000 100 1
E 500 200 1.3
a. Compute portfolio beta
b. How much additional investment is required in Risk free investment to have beta to 0.8?
c. How much additional investment is required in Security B to increase beta to 1.4?
d. If the Nifty future is 2700 points and future have a contract multiplier of 50, how many future
contracts to be hedged to obtain the position as in (iii) above?
Solution:
(i) Portfolio Beta:
Security MV W Beta BxW
A 5,00,000 0.5 1.2 0.60
B 1,00,000 0.1 2 0.20
C 2,00,000 0.2 0.7 0.14
D 1,00,000 0.1 1 0.10
E 1,00,000 0.1 1.3 0.13
10,00,000 1.17
(ii) Risk free investment to have beta to 0.8
1.17  WRA + 0  WRFA = 0.80
WRA = 68.38%
If, WRA i.e., 68.38% ----------> 10,00,000
Then, WRFA i.e., 31.62% ----------> 4,62,416
Additional Investment in risk free Security is ₹4,62,416 long
(iii) Additional Security B to increase beta to 1.4
1.17  WEP + 2  WAB = 1.40 WEP = Weight of Existing Portfolio
1.17  WEP + 2  (1 – WEP) = 1.40 WAB = Weight of Additional Security B
WEP = 72.29%
If, WEP i.e., 72.29% ----------> 10,00,000
Then, WB i.e., 27.71% ----------> 3,83,330
Additional Investment in Security B is ₹3,83,330 long
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Adish Jain CA CFA
(iv) Logical Solution:

No. of futures contract to be hedged
 T − P
= VP 
FM
1.40 - 1.17
= 10,00,000 
2700 × 50
= 1.70
 2 contracts long
To obtain the position as in (iii) above, 2 futures contracts should be hedged
Solution by ICAI:
Rupee Value of one Future contract = Index Value x multiplier
= 2700 x 50 = 135000
No of Future Contracts = (RA x additional investment) / Rupee Value of Future contract
= 1.17 x 383,334/ 135000
= 3 (rounded)
QUESTION 19:
N 21 | RTP M 17
On 1st July 2021 Mr. P has made the following investment:

Name of Company No. of Equity Share Beta Value Purchase Price per Equity Share
ML Ltd 1000 1.25 ₹ 700
He wants to hold the investment till end of September 2021 with an expectation of huge dividends
to be announced in the AGM.
On the date of investment, September Nifty Futures are quoting at 17500 and tradeable with lot
size of 50 for each contract.
You are the Investment advisor to Mr. P:
1. Please advise Mr. P how to hedge his market exposure using the available data.
2. Calculate the profit or loss of Mr. P during the expiry of September 2021 futures in following
situation:
a. Nifty Future rise by 10%
b. ML Ltd. falls by 5%
3. Is it possible stock as well as nifty to raise or fall at the same percentage? Please state the
reason.
343
Adish Jain CA CFA
Solution:
1. To hedge his market exposure Mr. P should take short position in the Nifty Futures.
 T − P
No. of Contract of Nifty Future = VP 
FM
(0 - 1.25)
= 700 × 1000 ×
17500 × 50
= 1 contract short
2. Profit or loss of Mr. P during the expiry of September 2021 Futures:

a. If Nifty rises by 10%
Them security rise by: 10% x 1.25 = 12.5%
₹
Loss on Nifty Futures (17,500 x 50 x 1 x 10%) (87,500)
Gain on Stock of ML Ltd. (₹ 7,00,000 x 12.5%) 87,500
Net Gain/ (Loss) 0
b. If ML Ltd. falls by 5%
Then market fall by: 5%/1.25 = 4%
₹
Gain on Nifty Futures (17,500 x 50 x 1 x 4%) 35,000
Loss on Stock of ML Ltd. (5% x ₹ 7,00,000) (35,000)
Net Gain/ (Loss) 0
3. Normally it is not possible that Nifty to rise or fall by same percentage because of systematic
risk i.e., Beta may not be the same as of market.
QUESTION 20:
M 11 | RTP
A Mutual Fund is holding the following assets in ₹Crores:

Investments in diversified equity shares 90.00
Cash and Bank Balances 10.00
The Beta of the equity share portfolio is 1.1. The index future is selling at 4300 level. The Fund
Manager apprehends that the index will fall at the most by 10%. How many index futures he
should short for perfect hedging? One index future consists of 50 units.
Substantiate your answer assuming the Fund Manager's apprehension will materialize.
Solution:
Calculation of no. of future contracts to short
344
Adish Jain CA CFA
 T − P
= VP 
FM
0 − 1.1
= 90,00,00,000 
4300 50
= – 4604.6
 4605 short contracts
Justification of the answer
Loss on equity shares: [90 cr.  (10%  1.1)] = (9.9 Cr)
Gain on index futures: [4,605  50 units  (10%  4,300)] 9.9 Cr.
0.00
QUESTION 21:
J 21 | N 21 | N 13 | M 05 | RTP
Ram buys 10,000 shares of X Ltd. at a price of ₹22 per share whose beta value is 1.5 and sells
5,000 shares of A Ltd. at a price of ₹40 per share having a beta value of 2. He obtains a complete
hedge by Nifty futures at ₹1,000 each. He closes out his position at the closing price of the next
day when the share of X Ltd. dropped by 2%, share of A Ltd. appreciated by 3% and Nifty futures
dropped by 1.5%.
What is the overall profit/loss to Ram?
Is it possible stock as well as nifty to rise of fall at the same percentage? Please state the reason.
Solution:
MV of X 2,20,000
MV of A -2,00,000
Value of portfolio 20,000
1.5  2,20 ,000 + 2  (− 2,00 ,000 )

Beta of the portfolio = = - 3.5
2,20 ,000 − 2,00 ,000
 T − P
No. of contracts to hedge: = VP 
FM
20,000 × [0 - (-3.5)]
= = + 70 contracts long
1,000
Particulars Position Value % Gain/(loss)
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Adish Jain CA CFA
X Long 2,20,000 -2% (4,400)

A Short 2,00,000 +3% (6,000)
Future Long 70,000 -1.5% (1,050)
(11,450)
It is possible for stock as well as nifty to raise of fall at the same percentage. When beta of
the stock is equal to 1, it moves same as market.
QUESTION 22:
RTP M 15
Mr. Careless was employed with ABC Portfolio Consultants. The work profile of Mr. Careless
involves advising the clients about taking position in Future Market to obtain hedge in the position
they are holding. Mr. ZZZ, their regular client purchased 100,000 shares of X Inc. at a price of $22
and sold 50,000 shares of A plc for $40 each having beta 2. Mr. Careless advised Mr. ZZZ to take
long position in Index Future trading at $1,000 each contract. Though Mr. Careless noted the
name of A plc along with its beta value during discussion with Mr. ZZZ but forgot to record the
beta value of X Inc.
On next day Mr. ZZZ closed out his position when:
• Share price of X Inc. dropped by 2%
• Share price of A plc appreciated by 3%
• Index Future dropped by 1.5%
Mr. ZZZ, informed Mr. Careless that he has made a loss of $114,500 due to the position taken.
Since record of Mr. Careless was incomplete he approached you to help him to find the number
of contract of Future contract he advised Mr. ZZZ to be long to obtain a complete hedge and beta
value of X Inc.
You are required to find these values.
Solution:
Calculation of loss on Index Futures Position:
Particulars Position Value % Gain/(loss)
Total Loss (1,14,500)
Loss on X Long (1 Lac  22) = 22,00,000 -2% (44,000)
Loss on A Short (0.5 Lac  40) = (20,00,000) +3% (60,000)
Loss on Index Futures (10,500)
Value of Index Futures long position: = 10,500 / 1.5% = 7,00,000

Valuer of the portfolio to be hedged: = 22,00,000 (Long) – 20,00,000 (Short)
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Adish Jain CA CFA
= 2,00,000
Calculation of P using hedging formula:
Value of Index Futures Position = VP  (T - P)
7,00,000 = 2,00,000  (0 - P)
– 3.5 = P
Calculation of x using formula of Weighted Average Beta of the portfolio:
2200000 x + (− 2000000 2)
– 3.5 =
200000
x = 1.50
QUESTION 23:
M21 | N 20 | N 07 | RTP
BSE 5000
Value of portfolio ₹10,10,000
Risk free interest rate 9% p.a.
Dividend yield on Index 6% p.a.
Beta of portfolio 1.5
We assume that a future contract on the BSE index with four months maturity is used to hedge
the value of portfolio over next three months. One future contract is for delivery of 50 times the
index.
Based on the above information calculate:
i. Price of future contract.
ii. The gain on short futures position if index turns out to be 4,500 in three months.
Solution:
(i) Price of Index future = S0  [1+ (r – y)  n]
 4
= 5,000  1 + (0.09 − 0.06 ) 
 12 
= 5,050
Price of future contract = 5050  50 multiplier = 2,52,500
T − P
(ii) No. of contracts to short = VP 
FM
= 10,10,000  0 − 1.50
5050 50
= - 6 i.e., 6 contracts short
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Adish Jain CA CFA
1
Price of index futures of the end of 3m = 4500 * [1 + (0.09 – 0.06)  ] = 4511.25
12
Gain on short futures position = 6 contract  50 times  (5050-4511.25)
= ₹ 1,61,625
QUESTION 24:
N 21
A future contract. on BSE Index with 4 months maturity is used to hedge the value of the portfolio
over. the next 3 months. One future contract for delivery is 50 times of the index.
The following information is available:
Value of the portfolio 1,16,00,000
BSE Sensex on 1st January 2022 58,580
(Anticipated on 1st September 2021)
BSE Sensex on 1st January 2022 56641.25
(Anticipated on 1st December 2021)
Dividend Yield of Index 6% p.a.
181 days’ treasury bill offer a rate of interest 9% p.a.
Beta of the portfolio 1.5
You are required to calculate
a. The present value of the Sensex as on 1st September 2021
b. Turned out value of the Sensex as on 1 December 2021
c. The number of contracts to hedge the portfolio.
Solution:
a. Present value of the Sensex as on 1st September 2021:
FFP = S × [1 + (r-y) × n]
58,580 = S × [1 + (0.09 - 0.06) × 4/12]
S = 58,000
b. Turned out value of the Sensex as on 1 December 2021:
56,641.25 = S × [1 + (0.09 - 0.06) × 1/12]
S = 56,500
c. Number of contracts to hedge the portfolio:
T − P
= VP 
FM
1,16,00,000 × (0 - 1.5)
= = - 5.95
58,580 × 50
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Adish Jain CA CFA
~ 6 contracts short
QUESTION 25:
N 22 | N 16 | M 21 RTP
The Following data relate to A Ltd.’s Portfolio:

Shares No. of shares (lakh) Price per share Beta
X Ltd 6 ₹1000 1.5
Y Ltd 8 ₹1500 1.3
Z Ltd 4 ₹500 1.7
The CEO is of opinion that the portfolio is carrying a very high risk as compared to the market risk
and hence interested to reduce the portfolio’s systematic risk to 0.95. Treasury Manager has
suggested two below mentioned alternative strategies:
(i) Dispose off a part of his existing portfolio to acquire risk free securities, or
(ii) Take appropriate position on Nifty Futures, currently trading at 8250 and each Nifty points
multiplier is ₹ 210.
You are required to:
a. Interpret the opinion of CEO, whether it is correct or not.
b. Calculate the existing systematic risk of the portfolio,
c. Advise the value of risk-free securities to be acquired,
d. Advise the number of shares of each company to be disposed off,
e. Advise the position to be taken in Nifty Futures and determine the number of Nifty contracts
to be bought/sold; and
f. Calculate the new systematic risk of portfolio if the company has taken position in Nifty
Futures and there is 2% rise in Nifty
Or
The value of portfolio beta for 2% rise in Nifty
Note: Make calculations in ₹ lakh and upto 2 decimal points.
Solution:
(a) Yes, the apprehension of CEO is correct as the current portfolio is more riskier than market
as the beta (Systematic Risk) of market portfolio is as computed as follows:
(in Lakhs)
Shares No. of shares Market Price Market Value W  W
X Ltd. 6.00 1,000.00 6,000.00 0.30 1.50 0.45
Y Ltd. 8.00 1,500.00 12,000.00 0.60 1.30 0.78
Z Ltd. 4.00 500.00 2,000.00 0.10 1.70 0.17
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Adish Jain CA CFA
20,000.00 1.00 1.40

(b) Since the Beta of existing portfolio is 1.40, the systematic risk of the current portfolio is
1.40.
(c) Required Beta 0.95
Let the proportion of risk-free securities for target beta 0.95 = WRF
0.95 = 0  WRF + 1.40 (1 – WRF)
WRF = 0.3214 i.e. 32.14%
Shares to be disposed-off to reduce beta = 20000 lakhs  32.14% = ₹6,428 lakh and Risk
Free securities to be acquired for the same amount.
(d) Number of shares of each company to be disposed off
Shares Weight Amount of disposal Market Price No. of Shares (Lakh)
X Ltd. 0.30 1928.4 1000.00 1.9284
Y Ltd. 0.60 3856.8 1500.00 2.5712
Z Ltd. 0.10 642.8 500.00 1.2856
6428.0
(e) Since, the company is in long position in cash market it shall take short position in Future
Market.
T − P
Number of Nifty Contract to be sold: = VP 
FM
20,000 lakh × (0.95 - 1.40)
= = - 519 contracts
8,250 × 210
(f) If there is 2% rises in Nifty there will be 2.80% (2%  1.40) rise for portfolio of shares
₹Lakh
Current Value of Portfolio of Shares 20,000
Value of Portfolio after rise (20,000 + 2.8%) 20,560
Loss on futures (8,250  0.020  ₹210  519) 179.83
Net value of the portfolio after rise of Nifty 20,380.17
% Change in value of portfolio (20,380.17 – 20,000)/ 20,000 1.90%
% Rise in the value of Nifty 2%
New Systematic Risk (Beta) (1.9%/2%) 0.95
QUESTION 26:
M 13 | RTP
350
Adish Jain CA CFA
On January 1, 2013 an investor has a portfolio of 5 shares as given below:

Security Price No. of Shares Beta
A 349.3 5,000 1.15
B 480.5 7,000 0.4
C 593.52 8,000 0.9
D 734.7 10,000 0.95
E 824.85 2,000 0.85
The cost of capital to the investor is 10.5% per annum.
You are required to calculate:
a. The beta of his portfolio.
b. The theoretical value of the NIFTY futures for February 2013.
c. The number of contracts of NIFTY the investor needs to sell to get a full hedge until February
for his portfolio if the current value of NIFTY is 5900 and NIFTY futures have a minimum
trade lot requirement of 200 units. Assume that the futures are trading at their fair value.
d. The number of future contracts the investor should trade if he desires to reduce the beta of
his portfolios to 0.6.
No. of days in a year be treated as 365.
Given: In (1.105) = 0.0998 and e0.015858 = 1.01598
Solution:
(a) Beta of the portfolio
Security Market Value Weights Beta BW
A 17,46,500 0.0926 1.15 0.106
B 33,63,500 0.1784 0.40 0.071
C 47,48,160 0.2578 0.90 0.227
D 73,47,000 0.3897 0.95 0.370
E 16,49,700 0.0875 0.85 0.074
1,88,54,860 0.849
(b) Theoretical value of Nifty futures for February 2013
FP = S0  ert
= 5900  e0.10558/365
= 5900  e0.0167
= 5900  1.0168
= 5999.12
(c) Number of contracts to sell for full hedge:
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Adish Jain CA CFA
T − P
No. of contracts: = VP 
FM
0 - 0.849
= 18,854,860 
5999.12 200
= - 13.34 contracts
(d) Number of contracts if portfolio beta is to be reduced to 0.6
= 18,854,860  0.60- 0.849
5999.12 200
= 3.91 contracts
QUESTION 27:
N 23 | N 15
On April 1, 2015, an investor has a portfolio consisting of eight securities as shown below:
Security Market Price No. of Shares Value
A 29.4 400 0.59
B 318.7 800 1.32
C 660.2 150 0.87
D 5.2 300 0.35
E 281.9 400 1.16
F 275.4 750 1.24
G 514.6 300 1.05
H 170.5 900 0.76
The cost of capital for the investor is 20% p.a. continuously compounded. The investor fears a fall
in the prices of the shares in the near future. Accordingly, he approaches you for the advice to
protect the interest of his portfolio.
You can make use of the following information:
a) The current NIFTY value is 8500.
b) NIFTY futures can be traded in units of 25 only.
c) Futures for May are currently quoted at 8700 and Futures for June are being quoted at 8850.
1. the beta of his portfolio.
2. the theoretical value of the futures contract for contracts expiring in May and June.
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Adish Jain CA CFA
3. the number of NIFTY contracts that he would have to sell if he desires to hedge until June in
each of the following cases:
a. His total portfolio
b. 50% of his portfolio
c. 120% of his portfolio
Given (e0.03 =1.03045, e0.04 = 1.04081, e0.05 =1.05127)
Solution:
(i) Beta of the portfolio:
Security MV Weights Beta W
A 11,760 0.0118 0.59 0.007
B 2,54,960 0.2564 1.32 0.338
C 99,030 0.0996 0.87 0.087
D 1,560 0.0016 0.35 0.001
E 1,12,760 0.1134 1.16 0.132
F 2,06,550 0.2077 1.24 0.258
G 1,54,380 0.1552 1.05 0.163
H 1,53,450 0.1543 0.76 0.117
Total 9,94,450 1.103
Portfolio Beta: 1.103
ii) Theoretical value of May’s futures contract
=S0  ert
= 8,500  e0.202/12
= 8,500  e0.0333
= 8,500  1.0338688
= 8788
Calculation of e0.0333 using interpolation:
e0.03 ––– 1.03045
e0.0333 ––– ?
e0.04 ––– 1.04081
0.0333 - 0.03 x - 1.03045

= 1.04081 - 1.03045
0.04 - 0.03
x = 1.0338688
Theoretical value of June’s futures contract
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Adish Jain CA CFA
= S0  e-t
= 8,500  e0.20  3/12
= 8,500  e0.05
= 8,500  1.05127 =
= 8935.795
(iii) No. of NIFTY Contracts required to sell to hedge:
(a) Total Portfolio
T − P
= VP 
FM
0-1.103
= 9,94,450  100% 
8850×25
= - 4.95 i.e., 5 contracts short
(b) 50% of the Portfolio
0-1.103
= 9,94,450  50% 
8850×25
(c) 120% of the Portfolio
0-1.103
= 9,94,450  120% 
8850×25
QUESTION 28:
N 10 | RTP
Sensex futures are traded at a multiple of 50. Consider the following quotations of Sensex futures
in the 10 trading days during February, 2009:
Day High Low Closing
04/02/2009 3306.4 3290.0 3296.5
05/02/2009 3298.0 3262.5 3294.4
06/02/2009 3256.2 3227.0 3230.4
07/02/2009 3233.0 3201.5 3212.3
10/02/2009 3281.5 3256.0 3267.5
11/02/2009 3283.5 3260.0 3263.8
12/02/2009 3315.0 3286.3 3292.0
14/02/2009 3315.0 3257.1 3309.3
17/02/2009 3278.0 3249.5 3257.8
18/02/2009 3118.0 3091.4 3102.6
354
Adish Jain CA CFA
Abhishek bought one Sensex futures contract on February, 04. The average daily absolute change
in the value of contract is ₹10,000 and standard deviation of these changes is ₹2,000. The
maintenance margin is 75% of initial margin.
You are required to determine the daily balances in the margin account and payment on margin
calls, if any.
Solution:
Initial margin =  + 3σ
= 10,000 + 3  2,000 = 16,000
Maintenance margin = 75%  16,000 = 12,000
Calculation of daily margin balance & margin calls:
Day Settlement Mark to Market Margin Call Closing Balance
Price Gain/(loss)
4/2/2009 3296.5 - - 1,6000
5/2/2009 3294.4 (105) - 15,895
6/2/2009 3230.4 (3200) - 12,695
7/2/2009 3212.3 (905) 4210 16,000
10/2/2009 3267.5 2760 - 18,760
11/2/2009 3263.8 (185) - 18,575
12/2/2009 3292.0 1410 - 19,985
14/2/2009 3309.3 865 - 20,850
17/2/2009 3257.8 (2575) - 18,275
18/2/2009 3120.6 (7760) 5485 16,000
QUESTION 29:
N 21 | N 20
The price of March Nifty Futures Contract on a particular day was 9170. The minimum trading lot
on Nifty Futures is 50. The initial margin is 8% of contract value and the maintenance margin is
6%. The index closed at the following levels on next five days:
Day Settlement Price (₹)
1 9380
2 9520
3 9100
4 8960
5 9140
1. Mark to market cash flows and daily closing balances on account of
355
Adish Jain CA CFA
▪ An investor who has taken a long position at 9170

▪ An investor who has taken a short position at 9170
2. Net profit/loss on each of the contracts
Solution:
1. Calculation of mark to market cash flows and daily closing balances:
Value of future contract = ₹9,170  50 Nifty futures
= ₹4,58,500
Initial Margin: 4,58,500  8% = ₹36,680
Maintenance margin: 6%  4,58,500 = ₹27,510
• An investor who has taken a long position at 9170
Closing
Mark to market
Day Settlement price Margin call margin
gain/(loss)
balance
0 9,170 – – 36,680
1 9,380 10,500 – 47,180
2 9,520 7,000 – 54,180
3 9,100 -21,000 – 33,180
4 8,960 -7,000 10,500 36,680
5 9,140 9,000 – 45,680
• An investor has taken a short position at 9190
Closing
Mark to market
Day Settlement price Margin call margin
gain/(loss)
balance
0 9,170 – – 36,680
1 9,380 -10,500 10,500 36,680
2 9,520 -7,000 – 29,680
3 9,100 21,000 – 50,680
4 8,960 7,000 – 57,680
5 9,140 -9,000 – 48,680
2. Net profit/loss on each of the contracts:
On long Position = (9,140 – 9,170)  50
= 1,500 Loss
On Short Position = (9,170 – 9,140)  50
= 1,500 Profit
356
Adish Jain CA CFA
QUESTION 30:
MTP N 20 | M 12 | RTP
A company is long on 10 MT of copper @ ₹ 534 per kg (spot) and intends to remain so for the
ensuing quarter. The variance of change in its spot and future prices are 16% and 36%
respectively, having correlation coefficient of 0.75. The contract size of one contract is 1,000 kgs.
Required:
a. Calculate the Optimal Hedge Ratio for perfect hedging in Future Market.
b. Advice the position to be taken in Future Market for perfect hedging.
c. Determine the number and the amount of the copper futures to achieve a perfect hedge.
Solution:
(a) Standard Deviation of Spot Price (σS) = Variance
= 16 = 4
Standard Deviation of Futures Price (σF) = 36 = 6
σs
Optimal Hedge Ratio = Correlation(S,F) 
σf
= 0.75 4
6
= 0.50
(b) Since, company has long position in spot market
 they should take short position in future’s market
(c) Amount of copper (VP) = 534  1000  10 = ₹53,40,000
Amount of copper futures = VP  (HRT – HRP]
= 53,40,000  (-0.5)
= -26,70,000 short
-26,70,000
No. of contracts = = -5
534 × 1000
= 5 contracts short
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Adish Jain CA CFA
C. Options
QUESTION 31:
M 18 | M 16 | M 10 | M 06 | RTP
Fresh Bakery Ltd.' s share price has suddenly started moving both upward and downward on a
rumour that the company is going to have a collaboration agreement with a multinational
company in bakery business. If the rumour turns to be true, then the stock price will go up but if
the rumour turns to be false, then the market price of the share will crash. To protect from this
an investor has purchased the following call and put option:
(i) One 3 months call with a striking price of ₹ 52 for ₹ 2 premium per share.
(ii) One 3 months put with a striking price of ₹ 50 for ₹ 1 premium per share.
Assuming a lot size of 50 shares, determine the followings:
1. The investor's position, if the collaboration agreement pushes the share price to ₹ 53 in 3
months.
2. The investor's ending position, if the collaboration agreement fails and the price crashes to ₹
46 in 3 month’s time.
Solution:
(1) If share price becomes ₹53, call will be exercised and put will lapse
(loss)/profit on call = [(53 – 52) – 2]  50
= – 50
(loss)/profit on put = – 1  50
= – 50
Total Loss = ₹100
(2) If share price becomes ₹46, call will lapse and put will exercise
(loss)/profit on call = – 2  50
= - 100
(loss)/profit on put = [(50 - 46) - 1]  50
= 150
Total Profit = ₹50
QUESTION 32:
N 20 | M 19 | N 11 | N 09 | N 08 | RTP
Mr. X established the following spread on the Delta Corporation’s stock :

(i) Purchased one 3-month call option with a premium of ₹ 30 and an exercise price of ₹ 550.
358
Adish Jain CA CFA
(ii) Purchased one 3-month put option with a premium of ₹ 5 and an exercise price of ₹ 450.
Delta Corporation’s stock is currently selling at ₹ 500. Determine profit or loss, if the price of Delta
Corporation’s:
(i) remains at ₹500 after 3 months.
(ii) falls at ₹350 after 3 months.
(iii) rises to ₹600.
Assume the size of option is 100 shares of Delta Corporation
Solution:
i) Call option (lapse) – 30
Put option (lapse) – 5
– 35
 100 shares
Total Loss –3500
ii) Call option (lapse) – 30

Put option (exercise) 95 [(450 – 350) – 5]
65
 100 shares
Total Profit 6500
iii) Call option (exercise) 20 [(600 – 550) – 20]

Put option (lapse) –5
15
 100 shares
Total Profit 1500
QUESTION 33:
RTP N 18
Ram holding shares of Reliance Industries Ltd. which is currently selling at ₹ 1000. He is expecting
that this price will further fall due to lower than expected level of profits to be announced after
one month. As on following option contract are available in Reliance Share.
Strike Price (₹) Option Premium (₹)
1030 Call 40
1010 Call 35
359
Adish Jain CA CFA
1000 Call 30
990 Put 35
970 Put 20
950 Put 8
930 Put 5
Ram is interested in selling his stock holding as he cannot afford to lose more than 5% of its value.
RECOMMEND a hedging strategy with option and show how his position will be protected.
Solution:
Since ram is holding a long position, therefore he should take a put option.
Since, he cannot afford to lose more than 5% of the value, he will take put option with exercise
price
= 1000 – 5% = ₹950
Payoff of Mr. Ram after 1 month:
Particulars 900 1050
1 share 900 1050
1 put option (X = 950) 50 –
950 1050
Less: Premium 8 8
Net Proceed 942 942
Comment: In both the cases it can be observed that total inflow to Ram is not less than ₹942 as
Put Option will compensate for loss below spot price of ₹ 950. However, to buy this put option
Mr. Ram will have to pay premium of ₹8.
QUESTION 34:
N 18 | M 09 | RTP
The equity share of VCC Ltd. is quoted at ₹210. A 3-month call option is available at a premium of
₹6 per share and a 3-month put option is available at a premium of ₹5 per share. Ascertain the
net payoffs to the option holder of a call option and a put option.
a) the strike price in both cases in ₹220; and
b) the share price on the exercise day is ₹200,210,220,230,240.
Also indicate the price range at which the call and the put options may be gainfully exercised.
Solution:
Payoffs to option holder of a Call option:
Share price Exercise Price Premium Net-pay off
360
Adish Jain CA CFA
200 220 6 -6
210 220 6 -6
220 220 6 -6
230 220 6 4
240 220 6 14
0
Payoffs to option holder of a Put option:

Exercise Price Share price Premium Net-pay off
220 200 5 15
220 210 5 5
220 220 5 -5
220 230 5 -5
220 240 5 -5
5
Price Range
Call option can be gainfully exercise for price higher than: 220 + 6 = ₹226
Put option can be gain fully exercised for price lower than: 220 – 5 = ₹215
QUESTION 35:
MTP M 16
A call option has been entered into by Arnav for delivery of share of X Ltd. at Rs. 460. The expected
future prices at the time of expiry of contract are as follows:
Price (Rs.) Prob.
470 0.20
450 0.25
480 0.35
490 0.05
500 0.15
Determine the premium at which Arnav will break even.
Solution:
Price Pay off (S1 – E) Prob.
470 10 0.20 2
361
Adish Jain CA CFA
450 0 0.25 0
480 20 0.35 7
490 30 0.05 1.5
500 40 0.15 6
Vc =16.5
QUESTION 36:
M 22 | N 18 | N 12 | N 10
You as an investor had purchased a 4-month call option on the equity shares of X Ltd. of ₹10, of
which the current market price is ₹132 and the exercise price ₹150. You expect the price to range
between ₹120 to ₹190. The expected share price of X Ltd. and related probability is given below:
Expected Price (₹) 120 140 160 180 190
Probability .05 .20 .50 .10 .15
Compute the following:
a. Expected Share price at the end of 4 months.
b. Value of Call Option at the end of 4 months, if the exercise price prevails.
c. In case the option is held to its maturity, what will be the expected value of the call option?
d. Find out the price of share quoted at the stock exchange to get the value of the call option as
computed in (c) above?
Solution:
a. Expected share price at the end of 4M
Expected price Prob
120 0.05 6
140 0.20 28
160 0.50 80
180 0.10 18
190 0.15 28.5
160.5
b. Value of call option at the end of 4M, if exercise price prevails, since the exercise price
prevails that is ₹150, therefore the value of call option will be 150-150 = 0
c. Exercise price = ₹150
Expected value of call option:
Expected Price Pay off Prob Pay off  Prob
362
Adish Jain CA CFA
120 0 0.05 0
140 0 0.20 0
160 10 0.50 5
180 30 0.10 3
190 40 0.15 6
14
d. To get the value of option as 14 on maturity, the share price should be: 150 + 14 = 164
QUESTION 37:
N 23 | M 11 | RTP
The following information is available pertaining to shares of Omni Limited:

Current Market Price ₹ 420
Strike Price ₹ 450
Maximum Price in 3m time ₹ 525
Minimum Price in in 3m time ₹ 378
Continuously Compounded Rate of Return (p.a.) (%) 8%
ert 1.0202
a. Calculate the 3 months call option by using Binomial Method and Risk Neutral Method. Are
the calculated values under both the models are same?
b. What will be the value as per binomial model if given option is a put option?
c. State also clearly the basis of Valuation of options under these models.
Solution:
a. Binomial Tree:
At month 0 At month 3 Call payoff Put Payoff
S0 = 420 p = 0.3434 Su = 525 75 0
Exercise price = 450 (1-p) = 0.6566 Sd = 378 0 72
Calculation R = ert = e0.08  3/12 = e0.02 = 1.0202

Value of option using Binomial Model
525
U = = 1.25
420
37
D = = 0.9
420
363
Adish Jain CA CFA
1.0202 - 0.9
P = = 34.34%
1.25 - 0.9
1 – P = 1 – 34.34% = 65.66%
75 × 0.3434 + 0 × 0.6566
VC = = ₹ 25.25
1.0202
Value of option using Risk Neutral Model
525 × P + 378 × (1-P)
P = = 420
1.0202
= 4.34%
1 – P = 65.66%
75 × 0.3434 + 0 × 0.6566
VC = = ₹ 25.25
1.0202
Value of option under both the model is same.
0 × 0.3434 + 72 × 0.6566
b. VP = = ₹ 46.34
1.0202
Value of put option is ₹ 46.34
c. Refer N 23 Suggested Answers
QUESTION 38:
M 12 | RTP
Sumana wanted to buy shares of ElL which has a range of ₹411 to ₹592 a month later. The present
price per share is ₹421. Her broker informs her that the price of this share can soar up to ₹522
within a month or so, so that she should buy a one-month CALL of ElL. In order to be prudent in
buying the call, the share price should be more than or at least ₹522 the assurance of which could
not be given by her broker.
Though she understands the uncertainty of the market, she wants to know the probability of
attaining the share price ₹592 so that buying of a one-month CALL of EIL at the execution price of
₹522 is justified. Advise her. Take the risk free interest to be 3.60% and e0.036 =1.037.
Solution:
Binomial Tree:
At month 0 At month 3
364
Adish Jain CA CFA
Su = 592
S0 = 420
Sd = 411
Calculation of probability (p) of share price attaining ₹ 592:
R = ert = e0.036 = 1.037
592
u= = 1.406
421
411
d= = 0.976
421
R-d 1.037-0.9762
p = =
u-d 1.406-0.976
= 0.0607 = 0.1419 or 14.19%
0.43
QUESTION 39:
N 17
A call option on gold with exercise price ₹ 26,000 per ten gram and three months to expire is being
traded at a premium of ₹ 1,010 per ten grams. It is expected that in three months time the spot
price might change to ₹ 27,300 or 24,700 per ten grams. At present this option is at-the-money
and the rate of interest with simple compounding is 12% per annum. Is the current premium for
the option justified? Evaluate the option and comments.
Solution:
Binomial Tree:
At month 0 At month 3 Call payoff
S0 = 26,000 p = 0.80 Su = 27,300 1300
E = 26,000 (1-p) = 0.20 Sd = 24,700 0
Calculation of probabilities (p) of Su & Sd:
R = 1+ (r  n)
3
R = 1 + 0.12 
12
= 1.03
27,300
u= = 1.05
26,000
24,700
d= = 0.95
26,000
R-d 1.03-0.95
p = = = 0.8 or 80%
u-d 1.5-0.95
365
Adish Jain CA CFA
(1-p) = 1 – 0.8 = 0.2 or 20%

1,300 0.80 + 0  0.20
Value of call option = = 1,010
1.03
Since fair premium = current premium that is ₹1,010 therefore event premium of option is
justified
QUESTION 40:
N 15 | RTP
Mr. Dayal is interested in purchasing equity shares of ABC Ltd. which are currently selling at ₹600
each. He expects that price of share may go upto ₹780 or may go down to ₹480 in three months.
The chances of occurring such variations are 60% and 40% respectively. A call option on the shares
of ABC Ltd. can be exercised at the end of three months with a strike price of ₹630.
a) What combination of share and option should Mr. Dayal select if he wants a perfect hedge?
b) Explain how Mr. Dayal will be able to maintain identical position regardless of the share price
(not a part of original question).
c) What should be the value of option today (the risk free rate is 10% p.a.)?
d) What is the expected rate of return on the option?
Solution:
(a) Binomial Tree:
At month 0 At month 3 Call payoff
S0 = 600 p = 0.45 Su = 780 150
E = 630 (1-p) = 0.55 Sd = 480 0
Calculation of delta of call option:
 in pay off
ΔC =
 in price
150 − 0
= = 0.50 times
780 − 480
If he wants a perfect hedge, then Mr. Dayal should buy 0.50 shares and sell 1 call option.
(b) Calculation of probabilities (p) of Su & Sd:
R = 1+ (r  n)
3
= 1 + 0.10  = 1.025
12
480
d= = 0.80
600
366
Adish Jain CA CFA
780
u= = 1.30
600
R − d 1.025− 0.80 0.225
p = = = = 0.45
U − d 1.30 − 0.80 0.50
(1 - p) = 1 – 0.45 = 0.55
150 0.45 + 0  0.55

Value of call option = = 65.85
1.025
Explanation of identical position:

Today At the end of 3m
Particulars
0.50 shares Buy (300) Sell 390 240
1 call option Sell 65.85 Settle (150) (0)
(234.15) 240 240
(c) Value of call option = 65.85 [as in part (b) above]
(d) Expected value of option after 3m = 150  0.60 + 0  0.40 = 90

90 - 65.85
Expected rate of return = × 100
65.85
= 36.67
QUESTION 41:
N 19
AB Ltd.'s equity shares are presently selling at a price of 500 each. An investor is interested in
purchasing AB Ltd.'s shares. The investor expects that there is a 70% chance that the price will go
up to 650 or a 30% chance that it will go down to 450, three months from now. There is a call
option on the shares of the firm that can be exercised only at the end of three months at an
exercise price of 550.
Calculate the following:
(i) If the investor wants a perfect hedge, what combination of the share and option should he
select?
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Adish Jain CA CFA
(ii) Explain how the investor will be able to maintain identical position regardless of the share
price.
(iii) If the risk-free rate of return is 5% for the three months period, what is the value of the option
at the beginning of the period?
(iv) What is the expected return on the option?
Solution:
(i) Binomial Tree:
At year 0 At year 1 Call payoff
S0 = 500 p = 0.375 Su = 650 100
E = 550 (1-p) = 0.625 Sd = 450 0
 in pay off
Delta of call option =
 in price
= 00 − 0 = 100 = 0.5 times

650 − 450 200
If the investor wants a perfect hedge, he should sell 1 call option and Buy 0.5 shares
(ii) Calculation of probabilities (p) of Su & Sd:
R = (1 + r × n)
= 1 + 0.5 = 1.05
d = 450 = 0.90
500
U = 650 = 1.30
500
p = R − d = 1.05 − 0.90 = 0.1125 = 0.375
U − d 1.30 − 0.90 0.40
Value of Call option = 100 0.375 + 0  0.625 = 35.71
1.05
Explanation of identical position:
Particulars
0.50 shares Buy -250.00 Sell 325 225
Cal option Sell 35.71 Settle -100 0
214.29 225 225
(iii) Value of call option = 35.71 [as in part (b) above]
(iv) Expected value of option after 3m = 100  0.70 + 0  0.30 = 70
368
Adish Jain CA CFA
70 - 35.71
Expected returns = = 96%
35.71
QUESTION 42:
N 20
A two year tree for a share of stock in ABC Ltd.,

Now 1 year later 2 years later
116.64
N2: 108
102.60
N1: 100
102.60
N3: 95
90.25
Consider a two years American call option on the stock of ABC Ltd., with a strike price of ₹ 98. The
current price of the stock is 100. Risk free return is 5 per cent per annum with a continuous
compounding and e0.05 = 1.05127.
Assume two time periods of one year each.
Using the Binomial Model, calculate:
a. The probability of price moving up and down;
b. Expected pay offs at each node i.e., N1, N2 and N3
(Round off upto 2 decimal points).
Solution:
a. Probability
Binomial Tree
At year 0 At year 1 At year 2
Suu = 116.64 | Cuu = 18.64
Su = 108
S0 = 100 Sud = 102.60 | Cud = 4.60
E = 98 Sdu = 102.60 | Cdu = 4.60
Sd = 95
Sdd = 90.25 | Cdd = 0.00
369
Adish Jain CA CFA
R = ert
= e0.05  12/12 = e0.05 = 1.05127
108
u = = 1.08
100
95
d = = 0.95
100
p = R − d = 1.05127− 0.95
U− d 1.08 − 0.95
= 0.10127 = = 0.7790
0.13
1 – P = 0.2210
Expected Pay offs: = Max [Intrinsic Value, Discounted Value]
18.64  0.7790+ 4.60 0.2210
At N2 = Max [ (108 – 98), ( )] = 14.78
1.05127
4.60 0.7790+ 0  0.2210
At N3 = Max [ (0), ( )] = 3.41
1.05127
14.78 0.7790+ 3.41 0.2210
At N1 = Max [ (100 – 98), ( )] = 11.67
1.05127
QUESTION 43:
RTP N 09 | SM
Following is a two sub-periods tree of 6-months each for the share of CAB Ltd.:
Now S1 One period
36.3
33
29.7
30
29.7
27
24.3
370
Adish Jain CA CFA
Using the binomial model, calculate the current fair value of a regular call option on CAB Stock
with the following characteristics: X = ₹ 28, Risk Free Rate = 5 percent p.a. You should also indicate
the composition of the implied riskless hedge portfolio at the valuation date.
Solution:
R = 1+ r  n
6
= 1 + 0.05  = 1.025
12
33
u= = 1.1
30
27
d= = 0.90
30
R-d 1.025 - 0.90
p= = .625
u-d 1.1-0.90
Payoffs at different nodes:
Suu = Max [0, 36.30 – 28] = 8.30
Sud = Max [0, 29.70 – 28] = 1.70
Sdu = Max [0, 29.70 – 28] = 1.70
Sdd = Max [0, 24.30 – 28] = 0
Value of call option
At Su = 8.3  0.625+ 1.7  0.375 = 5.68
1.025
At Sd = 1.7  0.625+ 0  0.375 = 1.036  1.04
1.025
At S0 = 5.68 0.625+ 1.04  0.375 = 3.84
1.025
Current FV of regular call = 3.84
Riskless Hedge Portfolio
At month 0 At month 6 Pay off
S0 = 30 Su = 33 Cu = 5
X = 28 Sd = 27 Cd = 0
5−0
C = = 5/6 or 0.833 shares
33 − 27
For riskless hedge portfolio, we will buy 0.833 shares of CAB Ltd for selling every 1 Call option.
371
Adish Jain CA CFA
QUESTION 44:
M 09 | RTP
Consider a two year at the money American call option with a strike price of Rs. 50 on a stock.
Assume that there are two time periods of one year and in each year the stock price can move up
or down by equal percentage of 20%. The risk free interest rate is 6%. Using binominal option
model, calculate the probability of price moving up and down. Also draw a two step binomial tree
showing prices and payoffs at each node.
Solution:
Binomial Tree
At year 0 At year 1 At year 2
Suu = 72 | Cuu = 22
Su = 60
S0 = 50 Sud = 48 | Cud = 0
E = 50 Sdu = 48 | Cdu = 0
Sd = 40
Sdd = 32 | Cdd = 0
12
R = 1 + 0.06  = 1.06
12
60
U = = 1.02
50
40
d = = 0.80
50
p = R − d = 1.06 − 0.80 = 0.65
U− d 1.20 − 0.80
1-P = 0.35
Calculation of payoffs at different nodes = Max [Intrinsic Value, Discounted Value]
22 × 0.65 + 0 × 0.35
At Su = Max [(60 – 50), ( )] = 13.49
1.06
0 × 0.65 + 0 × 0.35
At Sd = Max [(0), ( )] = 0
1.06
13.49 × 0.65 + 0 × 0.35
At S0 = Max [(50 – 50), ( )] = 8.27
1.06
Value of option: ₹ 8.27
372
Adish Jain CA CFA
QUESTION 45:
RTP M 11
The following table provides the prices of options on equity shares of X Ltd. The risk free interest
is 9%. You as a financial planner are required to spot any mispricing in the quotations of option
premium and stock price? Suppose, if you find any such mispricing then how you can take
advantage of this pricing position.
Shares Maturity Exercise Price (₹) Share Price (₹) Call Price (₹) Put Price (₹)
X Ltd 6 months 100 160 56 4
Solution:
According to Put Call Parity Theorem:
VC + PV(X) = VP + Spot
Calculating PV(X) i.e., fair value of risk-free security (having FV equal to strike price) using this
theorem:
56 + PV(X) = 4 + 160
PV(X) = 108
100
Actual price of RF security (PV of exercise price) = = 95.67
1.045
Strategy: Sell Share, Sell Put & Buy call option and invest the proceeds into a RF security
Action Amount Action P = 170 P = 80
Call Buy (56) Settle 70 0
Put Sell 4 Settle 0 (20)
Share Sell 160 Buy (170) (80)
Investment Invest (108) Redeem 112.97* 112.97*
Profit 0 12.97 12.97
*108  e0.045 = 108  1.046
QUESTION 46:
SM
a. The shares of TIC Ltd. are currently priced at ₹ 415 and call option exercisable in three months’
time has an exercise rate of ₹ 400. Risk free interest rate is 5% p.a. and standard deviation
(volatility) of share price is 22%. Based on the assumption that TIC Ltd. is not going to declare
any dividend over the next three months, is the option worth buying for ₹ 25?
b. Calculate value of aforesaid call option based on Block Scholes valuation model if the current
price is considered as ₹ 380.
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Adish Jain CA CFA
c. What would be the worth of put option if current price is considered ₹ 380.
d. If TIC Ltd. share price at present is taken as ₹ 408 and a dividend of ₹ 10 is expected to be paid
in the two months time, then, calculate value of the call option.
Given:
Log Natural Cumulative area till -∞
1.0375 0.03681 0.5033 0.6928
0.9500 -0.05129 0.3933 0.6529
0.9952 -0.00480 -0.2976 0.3830
x
e -0.4076 0.3418
0.0125 1.012578 0.1250 0.5498
0.0083 1.008368 0.0150 0.5060
Solution:
a. Value of call option, if spot price is ₹ 415
Calculation of N(d1):
 S0    
2
Ln  +  r + t
E  2 
d1 =
 t
(0.22)2 
3 / 12
 415  
Ln  + 0.05 +
 400   2 
=
0.22 3 / 12
= 0.03681+ 0.01855 = 0.5033

0.11
N(d1) : Area of 0.5033 = 0.6928
d2 = d1 -  t
= 0.5033 – 0.22 3 / 12 = 0.3933
N(d2): Area of 0.3933 = 0.6529
E
Value of call option = S0  N(d1) −  N(d2)
ert
400
= 415  0.6928 - 0.053 / 12
 0.6529
e
400
= 287.512 –  0.6529
e 0.0125
374
Adish Jain CA CFA
400
= 287.512 -  0.6529
1.012578
= 29.60
The fair price of call option is 29.60. If the option is ₹25 then it is worth buying the option
as it is undervalued.
b. Value of call option, if spot price is ₹ 380
(0.22)2 
3 / 12
 380  
Ln  + 0.05 +
 400   2 
d1 =
0.22 3 / 12
Ln(0.95) + 0.01855
=
0.11
− 0.05129+ 0.01855
= = – 0.2976
0.11
N(d1): Area of –0.2976 = 0.3830
d2 = d1 -  t
= –0.2976 – 0.22 3 / 12 = – 0.4076
N(d2): Area of – 0.4076 = 0.3418
400
Value of call option: = 380  0.3830 -  0.3418
e 0.053 /12
= 145.54 – 135.022
= 10.518  10.52
(c) If the given option is a put option:
E
Using call parity theorem: Vs + VP = Vc +
eH
400
380 + Vp = 10.518 + 0.05 3 / 12
e
380 + Vp = 405.549
Vp = 25.55
(d) Calculation of Value of call option
Calculation of Ex-dividend spot price (S0*)
375
Adish Jain CA CFA
10
PV of Dividend = 0.052 / 12
e
10
= = 9.92
1.008368
S 0* = 408 - 9.92 = 398.08
 398.08   0.05 + (0.22) 
2 3 / 12
Ln +
 400   2 

d1 =
0.22 3 / 12
Ln(0.9952) + 0.01855
=
0.11
− 0.00480+ 0.01855
= = 0.125
0.11
N(d1) : Area of 0.125 = 0.5418
d2 = d1 -  t
0.125 – 0.22 3 / 12 = 0.015
N(d2) : Area of 0.015 = 0.5060
400
Value of call option = 398.08 × 0.5498 -  0.5060
e0.053 / 12
= 218.864 – 199.886
= 18.978
QUESTION 47:
RTP N 09 | N 06 | N 08 | RTP M 10
From the following data for certain stock, find the value of a call option:
Price of stock now ₹80
Exercise price ₹75
Standard deviation of continuously compounded annual return 0.4
Maturity period 6 months
Annual interest rate 12%
Given: Number of S.D. from Mean, (z) Area of the left or right (one tail)
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Adish Jain CA CFA
0.25 0.4013
0.3 0.3821
0.55 0.2912
0.6 0.2743
0.12x0.5
Given: e = 1.062 | In (1.0667) = 0.0646
Solution:
 S0    
2
Ln  +  r + t
E  2 
Calculation of D1 =
 t
 80   (0.4 )2 
Ln  +  0.12 + 6 / 12
 75   2 
=
0.4 6 / 12
= Ln(1.067) + 0.1
0.2828
0.0646+ 0.1
=
0.2828
= 0.5820
Calculation of tail area for d1:
0.55 ––––––> 0.2912
0.60 ––––––> 0.2743
0.5820 ––––––> ??
Using Interpolation:
0.5820− 0.55 x − 0.2912
=
0.60 − 0.55 0.2743− 0.2912
0.032 x − 0.2912
=
0.05 − 0.0169
0.64-0.0169 = x – 0.2912
X = 0.2803
N(d1) = 1 – 0.2803 = 0.7197
Calculation of D2 = D1 -  t
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Adish Jain CA CFA
= 0.5820 – 0.40  6 / 12 = 0.2992

Calculation of tail area for D2
0.25 ––––––> 0.4013
0.30 ––––––> 0.3821
0.2992 ––––––> ??
Using Interpolation:
0.2992− 0.25 x − 0.4013
=
0.30 − 0.25 0.3821− 0.4013
0.0492 x − 0.4013
=
0.05 − 0.0192
X = 0.3824
1 – 0.3824 = 0.6176
E
Value of call Option = S0  N(d1) −  N(d2)
ert
75
= 80  0.7197 – 0.126 / 12
 0.6176
e
= 57.576 - 75  0.6176 = 13.96
1.062
378
Adish Jain CA CFA
D. FORWARD RATE AGREEMENT (FRA)

QUESTION 48:
RTP
TM Fincorp has bought a 6 x 9 ₹100 crore Forward Rate Agreement (FRA) at 5.25%. On fixing date
reference rate i.e., MIBOR turns out be as follows:
Period Rate (%)
3 months 5.5
6 months 5.7
9 months 5.85
You are required to determine:
a. Profit/Loss to TM Fincorp. in terms of basis points.
b. The settlement amount.
(Assume 360 days in a year)
Solution:
a) Profit to TM Fincorp = (0.055 – 0.0525) x 100
= 25 Basis points (bps)
NP  (RR − FR ) 3 / 12
b) Settlement Amount =
1 + RR  3 / 12
= 100  (0.055 − 0.0525 ) 3 / 12 x 100 Cr.
1 + 0.055  3 / 12
= 6,16,523
QUESTION 49:
MTP M 14 V 2
The treasurer of a company expects to receive a cash inflow of $15,000,000 in 90 days. The
treasurer expects short-term interest rates to fall during the next 90 days. In order to hedge
against this risk, the treasurer decides to use an FRA that expires in 90 days and is based on 90-
day LIBOR. The FRA is quoted at 1.5%. At expiration, LIBOR is 1.25%. Assume that the notional
principal on the contract is $15,000,000.
a. Indicate whether the treasurer should take a long or short position to hedge interest rate risk.
b. Using the appropriate terminology identify the type of FRA used here.
c. Calculate the gain or loss to the company as a consequence of entering the FRA.
Solution:
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Adish Jain CA CFA
(i) To hedge the interest rate risk, treasure should take a short position in FRA
(ii) Appropriate terminology = FRA 90  180 or FRA 3  6
15,000,000 × (0.015 - 0.0125) × 90/360
(iii) Gain or loss on FRA =
1+ 0.0125 × 90/360
= $ 9345.79
QUESTION 50:
N 19 | M 13 | RTP
M/s. Parker & Co. is contemplating to borrow an amount of ₹60 crores for a period of 3 months
in the coming 6 month's time from now. The current rate of interest is 9% p.a., but it may go up
in 6 month’s time. The company wants to hedge itself against the likely increase in interest rate.
The Company's Bankers quoted an FRA (Forward Rate Agreement) at 9.30% p.a.
What will be final settlement amount, if the actual rate of interest after 6 months happens to be
(i) 9.60% p.a. and (ii) 8.80% p.a.?
Solution:
NP  (RR − PR) n
(i)
1 + RR  n
60  (0.096 − 0.093 )  3 / 12
1 + 0.096  3 / 12
0.045
= 0.04394 Cr. ~ 439453.125 Cr.
1.024
60 × (0.088 - 0.093) × 3/12

(ii)
1 + 0.096 × 3/12
0.075
− = – 0.07338 Cr.
1.022
= – 733855.1859 Cr.
QUESTION 51:
M 10 | RTP
The following market data is available:

Spot USD/JPY 116.00
Deposit rates p.a. USD JPY
3 months 4.50% 0.25%
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Adish Jain CA CFA
6 months 5.00% 0.25%

Forward Rate Agreement (FRA) for Yen is Nil.
a. What should be 3 months FRA rate at 3 months forward?
b. The 6 & 12 months LIBORS are 5% & 6.5% respectively. A bank is quoting 6/12 USD FRA at
6.50 – 6.75%. Is any arbitrage opportunity available? Calculate profit in such case.
Solution:
(i) Calculation of Fair FR 3  6
 6  3  3
 1 + S 6   =  1 + S 3   1 + Fair FR  
 12   12  12 
 6  3  3
 1 + 0.05   =  1 + 0.045   1 + Fair FR  
 12   12  12 
 3
1.025 = (1.01125)  1 + Fair FR  
 12 
5.44% = Fair FR
(ii) Calculation of Fair FR 6  12

 12   6  6
 1 + S12   =  1 + S 6     1 + Fair FR  
 12   12   12 
 12   6  6
 1 + 0.065   =  1 + 0.05   1 + Fair FR  
 12   12  12 
 6
1.065 = 1.025  1 + Fair FR  
 12 
Fair FR = 7.80%
Arbitrage:
Since, Actual FR [6.50% - 6.75%] < Fair FR (7.80%)
Therefore, Its undervalued
Hence, Arbitrage process will be: Borrow in Path-A and Invest in Path-B
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Adish Jain CA CFA
Step 1: Borrow $ 1,000 @ 5% for 6 months & Buy 6  12 FRA @ 6.75%. Therefore,
outflow at the end of 12M:
 6  6
$ 1000   1 + 0.05     1 + 0.0675   = 1059.59
 12   12 
Step 2: Invest $ 1000 @ 6.5% for 1 year. Therefore, Inflow at the end of 1 year:
 12 
$1000   1 + 0.065   = $1065
 12 
Step 3: Arbitrage profit = inflow – outflow
= 1065 – 1059.59 = $ 5.41
382
Adish Jain CA CFA
E. INTEREST RATE OPTIONS: CAP, FLOOR & COLLAR

QUESTION 52:
RTP M 13
Suppose that a 1-year cap has a cap rate of 8% and a notional amount of ₹ 100 crore. The
frequency of settlement is quarterly and the reference rate is 3-month MIBOR. Assume that 3-
month MIBOR for the next four quarters is as shown below.
Quarters 3-months MIBOR (%)
1 8.7
2 8.0
3 7.8
4 8.2
You are required to compute payoff for each quarter.
Solution:
Calculation of pay-off of each Quarter:
Quarters Cap 3m MIBOR Diff Settlement Amount
1 8% 8.7% 0.7% 0.175 Cr.
(100  0.7%  3/12)
2 8% 8% 0% 0
(100  0%  3/12
3 8% 7.8% - 0
4 8% 8.2% 0.2% 0.05 Cr.
(100  0.2%  3/12
0.225 Cr.
QUESTION 53:
RTP M 13
Suppose that a 1-year floor has a rate of 4% and a notional amount of Rs.200 crore. The frequency
of settlement is quarterly and the reference rate is 3- month MIBOR. Assume that 3-month MIBOR
for the next four quarters is as shown below.
Quarters 3-months MIBOR (%)
1. 4.7
2. 4.4
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Adish Jain CA CFA
3. 3.8
4. 3.4
You are required to compute payoff each quarter.
Solution:
Calculation of pay-off of each Quarter:
Quarters Floor 3m MIBOR Diff Settlement Amount
1 4% 4.7% -
2 4% 4.4% -
3 4% 3.8% 0.2% 0.10 Cr.
(200  0.2%  3/12)
4 4% 3.4% 0.6% 0.30 Cr.
(200  0.6% 3/12)
0.40 Cr.
QUESTION 54:
N 17
A textile manufacturer has taken floating interest rate loan of Rs. 40,00,000 on 1 st April, 2012. The
rate of interest at the inception of loan is 8.5%p.a. interest is to be paid every year on 31 st March,
and the duration of loan is four years. In the month of October 2012, the Central bank of the
country releases following projections about the interest rates likely to prevail in future.
(i) on 31st March, 2013, at 8.75%; on 31st March, 2014 at 10%; on 31st March, 2015 at 10.5%
and on 31st March, 2016 at 7.75%. Show how this borrowing can hedge the risk arising out
of expected rise in the rate of interest when he wants to peg his interest cost 8.50% p.a.
(ii) Assume that the premium negotiated by both the parties is 0.75% to be paid on 1st October,
2012 and the actual rate of interest on the respective due dates happens to be as; on 31 st
March, 2013 at 10.2%; on 31st March, 2014 at 11.5%; on 31st March, 2015 at 9.25%; on 31st
March, 2016 at 8.25%. Show how the settlement will be executed on the respective interest
due dates.
Solution:
(i) The Textile manufacturer can hedge the interest rate risk by buying a CAP option will
following specification:
• Exercise Rate = 8.5%
• National principle = ₹40,00,000
• Cap option start date = 1/4/2012
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Adish Jain CA CFA
• Cap option end date = 31/3/2016

• Int. Pay off settlement date = 31st March every year
• Ref. Rate = Rate applicable to loan
• Premium = 0.75% to be paid on 1st Oct, 2021
Whenever the interest rate will rise above 8.5%, cap option will be exercise and pay off
from the option will compensate the rising interest cost.
(ii) Settlement Amount [pay off = Notional Principle  (RR- E) × n]

Date Calculation Settlement Amount
31/3/2013 40,00,000(10.2 – 8.50)  12/12 68,000
31/3/2014 40,00,000(0.0115 – 0.085)  12/12 1,20,000
31/3/2015 40,00,000(0.0925 – 0.085)  12/12 30,000
31/3/2016 Option not exercised 0
The textile manufacturer will have to pay premium @ 0.75% of ₹ 30,000 (i.e., 40,00,000 
0.75%) on Oct. 1, 2012
QUESTION 55:
M 22 | RTP
MPD Ltd. issues a ₹ 50 million Floating Rate Loan on July 1, 2018 with resetting of coupon rate
every 6 Months equal to LIBOR + 50 bps.
MPD is interested in an Interest rate Collar Strategy of selling a Floor and buying a cap. MPD buys
the 3 years cap and sell 3 years Floor as per the following details on July 1, 2018:
Principal Amount ₹ 50 million
Strike Rate 5% for Floor & 8% for Cap
Reference Rate 6 months LIBOR
Premium NIL, since premium paid for cap = premium received for Floor
The Reset dates & Interest rates p.a., on that dates are:
Reset Date LIBOR (%)
31/12/2018 7.00
30/06/2019 8.00
31/12/2019 6.00
30/06/2020 4.75
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Adish Jain CA CFA
31/12/2020 4.25
30/06/2021 5.25
Using the above data, you are required to determine:
a. Effective Interest paid out at each six reset dates, (Round off to the nearest rupee)
b. Average overall effective rate of interest p.a. (round off to 2 decimals)
Solution:
Self-note: Solution of this question has been updated by ICAI in May-22 suggested to make it
logical.
a. Effective interest paid out at each reset date
Date of No. of Interest Payoff Paid/(recd.) Effective
Reset Date Libor
Payment days (L + 0.5%) Cap Floor Interest
31-12-2018 30-06-2019 181 7 18,59,589 18,59,589
30-06-2019 31-12-2019 184 8 21,42,466 21,42,466
31-12-2019 30-06-2020 182 6 16,16,120 16,16,120
30-06-2020 31-12-2020 184 4.75 13,19,672 62,842 13,82,514
31-12-2020 30-06-2021 181 4.25 11,77,740 1,85,959 13,63,699
30-06-2021 31-12-2021 184 5.25 14,49,315 14,49,315
1096 98,13,703
b. Average overall effective rate of interest p.a.
98,13,703 365
=   100
500,00,000 1096
= 6.54% p.a.
QUESTION 56:
RTP
Two companies ABC Ltd. and XYZ Ltd. approach the DEF Bank for FRA (Forward Rate Agreement).
They want to borrow a sum of ₹100crores after 2 years for a period of 1 year. Bank has calculated
Yield Curve of both companies as follows:
Year XYZ Ltd. ABC Ltd.*
1 3.86 4.12
2 4.2 5.48
3 4.48 5.78
*The difference in yield curve is due to the lower credit rating of ABC Ltd. compared to XYZ Ltd.
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Adish Jain CA CFA
a. You are required to calculate the rate of interest DEF Bank would quote under 2V3 FRA, using
the company’s yield information as quoted above.
b. Suppose bank offers Interest Rate Guarantee for a premium of 0.1% of the amount of loan,
you are required to calculate the interest payable by XYZ Ltd. if interest rate in 2 years turns
out to be
1. 4.50%
2. 5.50%
Solution:
(i) Rate of interest under FRA 2  3
For XYZ Ltd.: (1+ 0.0448)3 = (1 + 0.042)2 (1+ fair FR)1
1.1405 = (1.085) (1 + Fair FR)1
Fair FR = 5.04%
Bank will quote 5.04% for a 2V3 FRA.
For ABC Ltd.: (1+ 0.0578)3 = (1 + 0.0548)2 (1+ Fair FR)1
1.01445 = (1.009133) (1 + Fair FR)1
Fair FR = 6.38%
Bank will quote 6.38% for a 2V3 FRA.
(ii)
4.50% 5.50%
Interest ₹ 100 crores X 4.50% ₹ 4.50 crores
₹ 100 crores X 5.04% ₹ 5.04 crores
Premium ₹ 100 crores X 0.1% ₹ 0.10 crores ₹ 0.10 crores
4.60 crores 5.14 crores
QUESTION 57:
M 13 | RTP
XYZ Limited borrows £ 15 Million of six months LIBOR + 10.00% for a period of 24 months. The
company anticipates a rise in LIBOR, hence it proposes to buy a Cap Option from its Bankers at
the strike rate of 8.00%. The lump sum premium is 1.00% for the entire reset periods and the
fixed rate of interest is 7.00% per annum. The actual position of LIBOR during the forthcoming
reset period is as under:
Reset Period LIBOR
1 9.00%
2 9.50%
3 10.00%
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Adish Jain CA CFA
You are required to show how far interest rate risk is hedged through Cap Option.
For calculation, work out figures at each stage up to four decimal points and amount nearest to
£. It should be part of working notes.
Solution:
Lump Sum premium =1,50,00,00,000  0.1% = 150,000
Calculation of equated 6 monthly premiums:
1,50,000 = Equated 6 monthly premiums  PVAF (3.5%, 4 periods)
1,50,000 = Equated 6M premium  3.6731
40837.6709 = Equated 6M premium
Calculation of amount of interest rate risk hedged:
Reset Period LIBOR Pay of Premium Net Payoff
1 9% 75000 40,837 34,163
1,50,00,000  (9-8%)  6/12
2 9.5% 1,12,500 40,837 71,663
1,50,00,000  (9.5-8)  6/12
3 10.00% 1,50,000 40,837 1,09,163
1,50,00,000  (10-8)  6/12
Self-note: ICAI has made a calculation mistake while solving the question, therefore above answer
will not match with their solution. Since, our method is same as ICAI, alternative answer has not
been included.
388
Adish Jain CA CFA
F. INTEREST RATE FUTURES

QUESTION 58:
RTP
Electraspace is consumer electronics wholesaler. The business of the firm is highly seasonal in
nature. In 6 months of a year, firm has a huge cash deposits and especially near Christmas time
and other 6 months firm cash crunch, leading to borrowing of money to cover up its exposures
for running the business.
It is expected that firm shall borrow a sum of €50 million for the entire period of slack season in
about 3 months.
A Bank has given the following quotations:
Spot 5.50% - 5.75%
3 × 6 FRA 5.59% - 5.82%
3 × 9 FRA 5.64% - 5.94%
3-month €50,000 future contract maturing in a period of 3 months is quoted at 94.15 (5.85%).
You are required to determine:
a) How a FRA, shall be useful if the actual interest rate after 3 months turnout to be:
(i) 4.5% (ii) 6.5%
b) How 3 months Future contract shall be useful for company if interest rate turns out as
mentioned in part (a) above.
Solution:
a) FRA shall be useful as:
If Interest Rate 4.5% 6.5%
turns out to be
Int. On Borrowings (11,25,000) (16,25,000)
(50,000,0004.5%  6/12) (50,000,000  6.5%  6/12)
Gain/(Loss) on FRA (360,000) 140,000
[50,000,000  (4.5 – 5.94%)  (50,000,000  (6.5% – 5.94%)
6/12] 6/12)
Net Interest Cost (14,85,000) (14,85,000)
14,85,000 12
Net Interest Cost (%) =   100 = 5.94%
50,000,000 6
b) 3 months future contract shall be useful as:
Amount of Borrowing Duration of Loan
No. of Contracts = ×
Contract Size 3 months
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Adish Jain CA CFA
€ 50,000,000 6
= × = 2000 Contracts
€ 50,000 3
If Interest Rate 4.5% 6.5%
turns out to be
Int. on Borrowings (11,25,000) (16,25,000)
(50,000,000  4.5%  6/12) (50,000,000  6.5%  6/12)
Gain/(Loss) on (337,500) 162500
Futures [50,000,000  (4.5 – 5.85)%  50,000,000  (6.5 – 5.85)% 
6/12] 6/10)
(14,62,500) (14,62,500)
Net Interest Cost (%) = (14 ,62,500 )  12  100 = 5.85%

5,00 ,00 ,000 6
QUESTION 59:
M 21 RTP
Espaces plc is consumer electronics wholesaler. The business of the firm is highly seasonal in
nature. In 6 months of a year, firm has a huge cash deposits and especially near Christmas time
and other 6 months firm cash crunch, leading to borrowing of money to cover up its exposures
for running the business.
It is expected that firm shall borrow a sum of £25 million for the entire period of slack season in
about 3 months.
The banker of the firm has given the following quotations for Forward Rate Agreement (FRA):
Spot 5.50% - 5.75%
3 × 6 FRA 5.59% - 5.82%
3 × 9 FRA 5.64% - 5.94%
3-month £50,000 future contract maturing in a period of 3 months is quoted at 94.15.
You are required to:
a. Advise the position to be taken in Future Market by the firm to hedge its interest rate risk and
demonstrate how 3 months Future contract shall be useful for the firm, if later interest rate
turns out to be (i) 4.5% and (ii) 6.5%
b. Evaluate whether the interest cost to Espace plc shall be less had it adopted the route of FRA
instead of Future Contract.
Note: Ignore the time value of money in settlement amount for future contract.
390
Adish Jain CA CFA
QUESTION 60:
N 23 | M 21 MTP
In March 2020, XYZ Bank sold some 7% Interest Rate Futures underlying Notional 7.50%
Coupon Bonds. The exchange provides following details of eligible securities that can be
delivered:
Security Quoted Price of Bonds Conversion Factor
7.96 GOI 2023 1037.4 1.037
6.55 GOI 2025 926.4 0.906
6.80 GOI 2029 877.5 0.9195
6.85 GOI 2026 972.3 0.9643
8.44 GOI 2027 1146.3 1.1734
8.85 GOI 2028 1201.7 1.2428
Calculate the Invoice price in each of the case & recommend the Security that should be delivered
by the XYZ Bank if Future Settlement Price is 1000.
Solution:
The XYZ Bank shall choose those CTD (Cheapest-to-Deliver) Bonds from the basket of deliverable
Bonds which gives maximum profit computed as follows:
Profit = Future Settlement Price  Conversion Factor - Quoted Spot Price of Deliverable Bond
Accordingly, the profit of each bond shall be computed as follows:
Security (1) Future Conversion Invoice Quoted Price of Profit
Settlement Factor (3) Price Bonds (5) (4) – (5)
Price (2) (4) = 2  3
7.96 GOI 2023 1,000 1.0370 1037.00 1037.40 - 0.40
6.55 GOI 2025 1,000 0.9060 906.00 926.40 - 20.40
6.80 GOI 2029 1,000 0.9195 919.50 877.50 42.00
6.85 GOI 2026 1,000 0.9643 964.30 972.30 - 8.00
8.44 GOI 2027 1,000 1.1734 1173.40 1146.30 27.10
8.85 GOI 2028 1,000 1.2428 1242.80 1201.70 41.10
Since maximum profit to the Bank is in case of 6.80 GOI 2029, same should be opted for.
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Adish Jain CA CFA
G. SWAPS
QUESTION 61:
RTP N 11
Euroloan Bank has a differential advantage in issuing variable-rate loans, but wishes to avoid the
income risk associated with such loan. Currently bank has a portfolio €25,000,000 loans with PLR
+ 150bp, reset monthly PLR is currently 4%.
IB an investment bank has arranged for Euroloan to swap into a fixed interest payment of 6.5%
on notional amount of loan for its variable interest income. If Euroloan agrees to this, what
amount of interest is received and given in the first month? Further, assume that PLR increased
by 200 bp.
Solution:
When PLR is 4%:
1
Interest Received = 2,50,00,000  6.5%  = 1,35,416.67
12
1
Interest Paid = 2,50,00,000  5.5%  = 1,14,583.33
12
Net Interest Received: = 1,35,416.67 – 1,44,583.33 = 20,833.34
When PLR increases by 200bps i.e., become 6%:
Interest Received (Same as above) = 1,35,416.67
1
Interest Paid = 2,50,00,000  7.5%  =1,56,250
12
Net Interest Paid: 1,35,416.67 – 1,56,250 = (20,833.33)
QUESTION 62:
RTP M 11
The following details are related to borrowing requirements of two companies, ABC Ltd & DEF
Ltd:
Company Requirement Fixed Floating
ABC Fixed Rupee Rate 4.5% PLR + 2.0%
DEF Floating Rupee Rate 5.0% PLR + 3.0%
Both Companies are in need of Rs. 2,50,00,000 for a period of 5 years. The interest rates on the
floating rate loans are reset annually.
You are required to exhibit how these two companies can reduce their borrowing cost by adopting
swap assuming that gains resulting from swap shall be share equally among them.
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Adish Jain CA CFA
Solution:
a. Exhibition of swap diagram.
Swap Diagram:
Calculation of Saving in total interest cost

Total Interest cost under Desired position (PLR + 3% + 4.5%) PLR + 7.5%
(-) Total Int. Cost under Actual (PLR + 2% + 5%) (PLR + 7%)
Net savings in int. 0.5%
Distributed as (1:1)
ABC Ltd. (50%) 0.25%
DEF Ltd (50%) 0.25%
Calculation of fixed leg under the swap by assuming floating leg as flat ‘PLR’
From view point of ABC Ltd.
Desired – (Actual + Swap) = Savings
4.5% - (PLR + 2% - PLR + F) = 0.25
4.5 – PLR – 2% + PLR – F = 0.25
F = 2.25%
Swap Arrangement will be as follows:

ABC Ltd. Wants to borrow at fixed rate of 4.5% and DEF Ltd. At floating rate of PLR + 3%.
However, to save the interest cost we will make ABC Borrow at a floating rate of PLR + 2%
and DEF at a fixed rate of5% and make them enter into fixed v/s floating swap as follows:
• ABC will pay fixed rate of 2.25% and received PLR
• DEF will pay PLR and received 2.25%
Accordingly, effective interest cost =
ABC Ltd: = PLR + 2% + 2.25% - PLR
= 4.25%
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Adish Jain CA CFA
DEF Ltd: = 5% + PLR – 2.25

= PLR + 2.75%
QUESTION 63:
N 20 | M 19
IB an Indian firm has its subsidiary in Japan and Zaki a Japanese firm has its subsidiary in India and
face the following interest rates:
Company IB Zaki
INR Floating Rate BPLR + 0.5% BPLR + 2.5%
JPY Fixed Rate 2% 2.25%
Zaki wishes to borrow Rupee Loan at a floating rate and IB wishes to borrow JPY at a fixed rate.
The amount of loan required by both the firms is same at the current exchange rate. A financial
institution may arrange a swap and requires 25 basis points as its commission. Gain, if any, is to
be shared by the firms equally.
You are required to find out:
a. Whether a swap can be arranged which may be beneficial to both the firms?
b. What rate of interest will the firms end up paying?
Solution:
a. Though Company IB has an advantage in both the markets but it has comparative more
advantage in the INR floating-rate market. Company Zaki has a comparative advantage in
the JPY fixed interest rate market.
IB wishes to borrow at fixed rate of 2% Zaki wishes to borrow at a floating rate of Int. BPLR
+ 2.5% However, to arrange a swap we will make IB Borrow at a floating rate of BPLR +
0.5% and Zaki at a fixed rate of 2.25%.
Total Interest Cost under Desired: BPLR + 2.5 + 2 = BPLR + 4.5%

Total Interest Cost under Actual: BPLR + 0.5 + 2.25 = BPLR + 2.75
Gross savings 1.75%
Commission (0.25)
Net Savings 1.50
Since, there is a net savings of 1.5%
Therefore, a beneficial swap can be arranged
b. Total saving in interest 1.50
Distributed in the ratio 1:1 between IB 0.75
Zaki 0.75
394
Adish Jain CA CFA
Calculating effective interest cost

Particulars IB Zaki
Int. Cost under desired position 2% BPLR + 2.5%
(-) saving due to swap (0.75) (0.75)
Effective Interest under swap 1.25 BPLR + 1.75%
QUESTION 64:
M 23
IF an Indian firm has its subsidiary in Singapore and SF a Singapore firm has its subsidiary in India
and face the following interest rates:
Company IF SF
INR Floating Rate BPLR+ 0.5% BPLR + 1.5%
SGD (fixed rate) 3% 3.50%
SF wishes to borrow Rupee loan at a floating rate and IF wishes to borrow SGD at a fixed rate. The
amount of loan required by both the companies is same at the current exchange rate. A Bank
arranges a swap and requires 50 basis points as its commission, which is to be shared equally, IF
requires a minimum gain of 20 basis points and SF requires a minimum gain of 10 basis points for
structuring the deal. The Bank is very keen to structure the deal, even if, it has to forego a part of
its commission.
You are required to find out
a. Whether there are any advantages available to IF and SF?
b. Whether a swap can be arranged which may be beneficial to both the firms?
c. What rate of interest will they end up paying? Show detailed working
Solution:
a) Though firm IF has an advantage in both the markets but it has comparative more
advantage in the INR floating-rate market. Firm SF has a comparative advantage in the SGD
fixed interest rate market.
b) Firm IF wants to borrow in the SGD fixed interest rate market and firm SF wants to borrow
in the INR floating-rate market. This gives rise to the swap opportunity and we make the
borrow other way round.
Total interest cost under desired: BPLR + 1.5 + 3 = BPLR + 4.5%
Total interest cost under actual: BPLR + 0.5 + 3.5 = BPLR + 4%
Gross savings 0.5%
Commission (0.2)%*
Net Savings 0.3%
395
Adish Jain CA CFA
Since, there is a net savings of 0.3%, therefore, a swap beneficial to both the firms can be
arranged.
* Maximum commission = Gross savings – minimum gain of IF & SF
= 0.5% - 0.2% - 0.1%
= 0.2%
c) Calculating effective interest cost
Particulars IF SF
Interest Cost under desired position 3% BPLR + 1.5%
(-) saving due to swap (0.2) (0.1)
Effective Interest under swap 2.8% BPLR + 1.4%
QUESTION 65:
N 23 | M 21 | N 18 | N 10 | N 08 | RTP
Suppose a dealer bank quotes for a generic swap "AIC 8%/8.20% vs. 6M LIBOR Flat". Notional
principal amount of swap is ₹ 1 Million, and the same is for a period of three years, reset after
every six months. In this context, answer the following questions:
a. Interpret the dealer bank quote.
b. If a firm is buying a swap, what is the nature of cash flows?
c. If a firm is selling a swap, what is the nature of cash flows?
d. Calculate semi-annual fixed payment for the buyer of swap at the end of every six months.
e. If the six-month period from the effective date of swap to the settlement date comprises of
181 days and that the corresponding LIBOR was 5% on the effective date of swap, then what
will be the first floating rate payment for the buyer?
f. If the settlement is on "Net Basis", how much the buyer of swap has to pay or receive at the
end of first six months?
[Assume 30/360 days basis]
Solution:
Refer Nov 23 suggested answer for the solution
QUESTION 66:
M 10 older
ABC Bank is seeking fixed rate funding. It is able to finance at a cost of six months LIBOR + 1/4%
for ₹200 million for 5 years. The bank is able to swap into a fixed rate at 7.5% versus six month
LIBOR treating six months as exactly half a year.
396
Adish Jain CA CFA
a. What will be the "all in cost" funds to ABC Bank?

b. Another possibility being considered is the issue of a hybrid instrument which pays 7.5% for
first three years and LIBOR – 0.25% for remaining two years.
Given a three-year swap rate of 8%, suggest the method by which the bank should achieve fixed
rate funding.
Solution:
a) Calculation of ‘all in cost’ funds to ABC Bank:
Cost finance (Int on borrowing) L + 0.25%
Int paid under swap 7.5%
(-) Int Received under swap (L)
All in cost (%) 7.75%
6
All in cost (₹) = ₹200 million  7.75% 
12
= ₹7.75 million
b) Calculation of Cost of funds under hybrid instrument:
Two swaps are given: 5 year: 7.5% v/s LIBOR
3 year: 8.0% v/s LIBOR
Years 1-3 4-5
Interest paid on Hybrid Instrument 7.5% L – 0.25%
Interest under 5 year swap:
Received floating (L) (L)
Paid fixed 7.5 7.5
+15 - L 7.25%
Interest under 3 year swap:
Received fixed (8) -
Paid floating L -
7% 7.25%
Conclusion: The bank should a achieve fixed rate finding by issuing hybrid instrument as
the interest cost is lower.
QUESTION 67:
N 10 | M 18 | N 17 | RTP
397
Adish Jain CA CFA
Derivative Bank entered into a plain vanilla swap through on OIS (Overnight Index Swap) on a
principal of ₹10 crores and agreed to receive MIBOR overnight floating rate for a fixed payment
on the principal. The swap was entered into on Monday, 2nd August, 2010 and was to commence
on 3rd August, 2010 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were:
7.75%, 8.15%, 8.12%, 7.95%, 7.98%, 8.15%
If Derivative Bank received ₹317 net on settlement, calculate Fixed rate and interest under both
legs.
Notes: Sunday is Holiday.
Work in rounded rupees and avoid decimal working.
Consider 365 days in a year.
Solution:
Day Int. Rate Interest Closing
Monday - - 10,00,00,000
Tuesday 7.15% 21,233 10,00,21,233
Wednesday 8.15% 22,334 10,00,43,567
Thursday 8.12% 22,256 10,00,65,823
Friday 7.95% 21,795 10,00,87,618
Sat + Sun (2 days) 7.98% 43,764 10,01,31,382
Monday 8.15% 22,358 10,01,53,740
1,53,740
Interest under floating leg (₹): 1,53,740
- Net settlement (317)
Interest under fixed leg (₹): 1,53,423
153423 365
Interest under fixed leg (%): =   100
10 ,00 ,00 ,000 7
= 7.9999 ~ 8%
QUESTION 68:
RTP N 10
TMC Corporation entered into €3.5 million notional principal interest rate swap agreement. As
per the agreement TMC is to pay a fixed rate and to receive a floating rate of LIBOR.
The Payment will be made at the interval of 90 days for one year and it will be based on the
adjustment factor 90/360. The term structure of LIBOR on the date of agreement is as follows:
398
Adish Jain CA CFA
Days Rate (%)

90 7.00
180 7.25
270 7.45
360 7.55
You are required to calculate Fixed Rate on the swap and first net payment on the Swap.
Solution:
Calculation of PVF
Days Rate (%) Periodic rates PVFs
90 7.00 7.0 × 90 1⁄
= 1.75% 1.0175 = 0.9828
360
180 7.25 7.25 × 180 1⁄
= 3.50% 1.0350 = 0.9662
360
270 7.45 7.45 × 270 1⁄
= 5.59% 1.0559 = 0.9471
360
360 7.55 7.55 × 360 1⁄
= 7.55% 1.0755 = 0.9298
360
Total 3.8258
1 - PVFn 360
Swap Fixed Rate =
ƩPVFs
×
n
× 100
1 - 0.9298 360
=
3.8258
×
90
× 100 = 7.34%
QUESTION 69:
M 11 | RTP
A Inc. and B Inc. intend to borrow $200,000 and $200,000 in ¥ respectively for a time horizon of
one year. The prevalent interest rates are as follows:
Company ¥ Loan $ Loan
A Inc 5% 9%
B Inc 8% 10%
The prevalent exchange rate is $1 = ¥120.
They entered in a currency swap under which it is agreed that B Inc will pay A Inc @ 1% over the
¥ Loan interest rate which the later will have to pay as a result of the agreed currency swap
399
Adish Jain CA CFA
whereas A Inc will reimburse interest to B Inc only to the extent of 9%. Keeping the exchange rate
invariant, quantify the opportunity gain or loss component of the ultimate outcome, resulting
from the designed currency swap.
Solution:
Net Interest cost
A B
Int on Borrowing 5% 10%
Int Paid under swap 9% 6%
Int Received under swap (6%) (9%)
Effective Int cost 8% 7%
Gain/Loss due to swap A B

Cost under desired position 9% 8%
(-) Net Interest cost (8%) (7%)
1% 1%
Currency $ Yen
$ 2,00,000 ¥ 2,40,00,000
Loan Amount
(2,00,000 × 120)
$ 2,000 ¥ 2,40,000
Gain
($ 2,00,000 × 1%) (¥ 2,40,00,000 × 1%)
QUESTION 70:
RTP M 18
TMC Holding Ltd. has a portfolio of shares of diversified companies valued at ₹400 crore enters
into a swap arrangement with None Bank on the terms that it will get 1.15% quarterly on notional
principal of ₹400 crore in exchange of return on portfolio which is exactly tracking the Sensex
which is presently 21600.
Calculate the net payment to be received/ paid at the end of each quarter if Sensex turns out to
be 21,860, 21,780, 22,080 and 21,960.
Solution:
Calculation of Sensex returns:
Quarters
400
Adish Jain CA CFA
21,860 − 21,600
1 1.204%
21,600
21,780 − 21,860
2 -0.365%
21,860
22,080 − 21,780
3 1.377%
21,780
21,960 − 22,080
4 - 0.543%
22,080
Net amount to be (paid)/received (in crores):
Quarters Payment of Sensex Received of Int Net Amount
(4.816) 4.60 (0.216)
1
400  1.204% (400  1.15%)
1.46 4.60 6.06
2
[400  (-0.365%)] (400  1.15%
3 (5.508) 4.60 (0.908)
4 2.172 4.60 6.772
401
Adish Jain CA CFA
402
Adish Jain CA CFA

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Derivatives & Interest Rate Risk Management

Calculation of average dividend yield

The following information about copper scrap is given:

a. Price of one future contract on 1st Feb, 2020

The following data relate to Anand Ltd.'s share price:

Current price per share ₹ 1,800

If Actual Future Price (AFP) is ₹312:

If Actual Future Price (AFP) is ₹290:

ii) Since futures is overpriced

iii) Calculation of Gain loss

FFP = 220   1 + 0.15  - 2.50

Today At the end of 3M

Total realization / inflow quantity 15,60,000 16,80,000

Portfolio value after 3m:

(c) RA  WRA + RFA  WRFA = T

(ii) Increase beta to 1.45

(b) Index Futures

(ii) Increase beta to 1.45

You have the following five stocks in your portfolio:

Security No. of shares Price/share Beta

(iv) Logical Solution:

On 1st July 2021 Mr. P has made the following investment:

2. Profit or loss of Mr. P during the expiry of September 2021 Futures:

A Mutual Fund is holding the following assets in ₹Crores:

1.5  2,20 ,000 + 2  (− 2,00 ,000 )

X Long 2,20,000 -2% (4,400)

Value of Index Futures long position: = 10,500 / 1.5% = 7,00,000

The Following data relate to A Ltd.’s Portfolio:

20,000.00 1.00 1.40

On January 1, 2013 an investor has a portfolio of 5 shares as given below:

0.0333 - 0.03 x - 1.03045

▪ An investor who has taken a long position at 9170

Mr. X established the following spread on the Delta Corporation’s stock :

ii) Call option (lapse) – 30

iii) Call option (exercise) 20 [(600 – 550) – 20]

Payoffs to option holder of a Put option:

The following information is available pertaining to shares of Omni Limited:

Calculation R = ert = e0.08  3/12 = e0.02 = 1.0202

(1-p) = 1 – 0.8 = 0.2 or 20%

150 0.45 + 0  0.55

Explanation of identical position:

(c) Value of call option = 65.85 [as in part (b) above]

(d) Expected value of option after 3m = 150  0.60 + 0  0.40 = 90

= 00 − 0 = 100 = 0.5 times

A two year tree for a share of stock in ABC Ltd.,

= 0.03681+ 0.01855 = 0.5033

= 0.5820 – 0.40  6 / 12 = 0.2992

D. FORWARD RATE AGREEMENT (FRA)

60 × (0.088 - 0.093) × 3/12

The following market data is available:

6 months 5.00% 0.25%

(ii) Calculation of Fair FR 6  12

E. INTEREST RATE OPTIONS: CAP, FLOOR & COLLAR

• Cap option end date = 31/3/2016

(ii) Settlement Amount [pay off = Notional Principle  (RR- E) × n]

F. INTEREST RATE FUTURES

Net Interest Cost (%) = (14 ,62,500 )  12  100 = 5.85%

Calculation of Saving in total interest cost

Swap Arrangement will be as follows:

DEF Ltd: = 5% + PLR – 2.25