FM 402 - Financial Derivatives

PALIVELA PG COLLEGE (MBA) I-CET- CODE: SSSK
FM 402: FINANCIAL DERIVATIVES

Objective: to enlighten the students with the Concepts and Practical applications of
derivatives in the Security markets
Unit – I : Introduction to Financial Derivatives – Meaning and Need – Growth of
Financial Derivatives in India – Derivative Markets – Participants – Functions – Types
of Derivatives – Forwards – Futures – Options – Swaps – The Regulatory Framework
of Derivatives Trading in India.
Unit – II : Features of Futures – Differences Between Forwards and Futures –
Financial Futures – Trading – Currency Future – Interest Rate Futures – Pricing of
Future Contracts – Value At Risk (VAR) – Hedging Strategies – Hedging with Stock
Index Futures – Types of Members and Margining System in India – Futures Trading
on BSE & NSE.
Unit – III : Options Market – Meaning & Need – Options Vs futures – Types of
Options Contracts – Call Options – Put Options – Trading Strategies Involving
Options – Basic Option Positions – Margins – Options on stock Indices – Option
Markets in India on NSE and BSE.
Unit – IV : Option Pricing – Intrinsic Value and Time Value - Pricing at Expiration –
Factors Affecting Options pricing – Put-Call Parity Pricing Relationship – Pricing
Models – Introduction to Binominal Option Pricing Model – Black Scholes Option
Pricing Model.
Unit – V: Swaps – Meaning – Overview – The Structure of Swaps – Interest Rate
Swaps – Currency Swaps – Commodity Swaps – Swap Variant – Swap Dealer Role –
Equity Swaps – Economic Functions of Swap Transactions – FRAs and Swaps.
75 Prepared By : K NAGA BHUSHANARAO Asst. Professor

Unit – I: Introduction to Financial Derivatives – Meaning and Need – Growth of

Financial Derivatives in India – Derivative Markets – Participants – Functions – Types
of Derivatives – Forwards – Futures – Options – Swaps – The Regulatory Framework
of Derivatives Trading in India.
1Q. Define the Financial Derivatives?

2Q. Growth of Financial Derivatives in India?
3Q. Explain the type of Financial Derivatives?
4Q. Explain the Regulatory Framework of Derivatives Trading in India?
5Q. short Questions: Participants, derivative Markets, Undelaying assets
1Q: What Is a Derivative?

A derivative is a contract between two or more parties whose value is based on an
agreed-upon underlying financial asset (like a security) or set of assets (like an
index). Common underlying instruments include bonds, commodities, currencies,
interest rates, market indexes, and stocks.
Definition of Financial Derivatives Section 2(ac) of Securities Contract Regulation Act

(SCRA) 1956 defines Derivative as:
a)“a security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or any other form of security;
b) “a contract which derives its value from the prices, or index of prices, of
underlying securities”.
5QA:Underlying Asset in a Derivatives

Contract:
As defined above, the value of a derivative

instrument depends upon the underlying asset. The
underlying asset may assume many forms:
i. Commodities including grain, coffee beans, orange juice;

ii. Precious metals like gold and silver;

iii. Foreign exchange rates or currencies;

iv. Bonds of different types, including medium to long term negotiable debt
securities issued by governments, companies, etc.
v. Shares and share warrants of companies traded on recognized stock
exchanges and Stock Index vi. Short term securities such as T-bills; and
vi. Over- the Counter (OTC) money market products such as loans or
deposits.
5QA: Participants in Derivatives Market :
1. Hedgers: They use derivatives markets to reduce or eliminate the risk associated
with price of an asset. Majority of the participants in derivatives market belongs to
this category.
2. Speculators: They transact futures and options contracts to get extra leverage
in betting on future movements in the price of an asset. They can increase both the
potential gains and potential losses by usage of derivatives in a speculative venture.
3. Arbitrageurs: Their behavior is guided by the desire to take advantage of a

discrepancy between prices of more or less the same assets or competing assets in
different markets. If, for example, they see the futures price of an asset getting out
of line with the cash price, they will take offsetting positions in the two markets to
lock in a profit.
3QA: Classification of
Derivatives: Broadly derivatives
can be classified in to two
categories as shown in Fig.1:
Commodity derivatives and
financial derivatives. In case of
commodity derivatives, underlying
asset can be commodities like
wheat, gold, silver etc., whereas in case of financial derivatives underlying assets are
stocks, currencies, bonds and other interest rates bearing securities etc. Since, the

scope of this case study is limited to only financial derivatives so we will confine our
discussion to financial derivatives only.
1. Forward Contract
A forward contract is an agreement between two parties to buy or sell an

asset at a specified point of time in the future. In case of a forward contract the
price which is paid/ received by the parties is decided at the time of entering into
contract. It is the simplest form of derivative contract mostly entered by individuals
in day today’s life.
2. Futures Contract:
Futures is a standardized forward contact to buy (long) or sell (short) the
underlying asset at a specified price at a specified future date through a specified
exchange. Futures contracts are traded on exchanges that work as a buyer or seller
for the counterparty. Exchange sets the standardized terms in term of Quality,
quantity, Price quotation, Date and Delivery place (in case of commodity).
the important types of financial futures contract: -
1. Stock Future or equity futures,

2. Stock Index futures,
3. Currency futures, and
4. Interest Rate bearing securities like Bonds, T- Bill Futures
3. Options Contract
In case of futures contact, both parties are under obligation to perform their
respective obligations out of a contract. But an options contract, as the name
suggests, is in some sense, an optional contract. An option is the right, but not the
obligation, to buy or sell something at a stated date at a stated price.
A “call option” gives one the right to buy; a “put option” gives one the right to
sell. Options are the standardized financial contract that allows the buyer (holder) of
the option, i.e. the right at the cost of option premium, not the obligation, to buy
(call options) or sell (put options) a specified asset at a set price on or before a
specified date through exchanges.

4. Swaps Contract
A swap can be defined as a barter or exchange. It is a contract whereby parties
agree to exchange obligations that each of them have under their respective
underlying contracts or we can say, a swap is an agreement between two or more
parties to exchange stream of cash flows over a period of time in the future. The
parties that agree to the swap are known as counter parties. The two commonly
used swaps are:
i) Interest rate swaps which entail swapping only the interest related cash
flows between the parties
ii) Currency swaps: These entail swapping both principal and interest
between the parties, with the cash flows in one direction being in a
different currency than the cash flows in the opposite direction.

4QA: THE REGULATORY FRAMEWORK OF DERIVATIVES TRADING IN

INDIA:
The definition of ''securities'' under SC(R)A (to include derivative contracts in

the definition of securities), derivatives trading takes place under the provisions of
the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange
Board of India Act, 1992.
1. Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory
framework for derivative trading in India.
2. SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments
and their Clearing Corporation/House which lays down the provisions for trading
and settlement of derivative contracts.
3. The Rules, Bye-laws & Regulations of the Derivative Segment of the
Exchanges and their Clearing Corporation/House have to be framed in line with
the suggestive Bye-laws.
4. SEBI has also laid the eligibility conditions for Derivative Exchange/Segment
and its Clearing Corporation/House. The eligibility conditions have been framed
to ensure that Derivative Exchange/Segment & Clearing Corporation/House
provide a transparent trading environment, safety & integrity and provide
facilities for redressal of investor grievances.

Some of the important

eligibility conditions are: -
i) Derivative trading to take

place through an online
screen based Trading
System.
ii) The Derivatives
Exchange/Segment shall
have online observation capability to monitor positions, prices, and volumes
on a real time basis to deter market manipulation.
iii) The Derivatives Exchange/ Segment should have arrangements for
dissemination of information about trades, quantities and quotes on a real
time basis through at least two information vending networks, which are
easily accessible to investors across the country.
iv) The Derivatives Exchange/Segment should have arbitration and investor

grievances redressal [ పరిహారానికి]mechanism operative from all the four areas
[
/ regions of the country.
v) The Derivatives Exchange/Segment should have satisfactory system of

monitoring investor complaints and preventing irregularities in trading.
vi) The Derivative Segment of the Exchange would have a separate Investor
Protection Fund.
vii) The Clearing Corporation/House shall perform full Negotiation, i.e. the
Clearing Corporation/House shall interpose itself between both legs of every
trade, becoming the legal counterparty to both or alternatively should provide
an unconditional guarantee for settlement of all trades.
viii) The Clearing Corporation/House shall have the capacity to monitor the
overall position of Members across both derivatives market and the underlying
securities market for those Members who are participating in both.

ix) The level of initial margin on Index Futures Contracts shall be related to the
risk of loss on the position. The concept of value-at-risk shall be used in
calculating required level of initial margins. The initial margins should be large
enough to cover the one-day loss that can be encountered on the position on
99% of the days.
x) The Clearing Corporation/House shall establish facilities for electronic funds
transfer (EFT) for swift movement of margin payments.
xi) In the event of a Member defaulting in meeting its liabilities, the Clearing
Corporation/House shall transfer client positions and assets to another solvent
Member or close-out all open positions.
xii) The Clearing Corporation/House should have capabilities to segregate initial
margins deposited by Clearing Members for trades on their own account
and on account of his client. The Clearing Corporation/House shall hold the
clients' margin money in trust for the client purposes only and should not
allow its diversion for any other purpose.
xiii) The Clearing Corporation/House shall have a separate Trade Guarantee
Fund for the trades executed on Derivative Exchange / Segment.
Presently, SEBI has permitted Derivative Trading on the Derivative Segment
of BSE and the F&O Segment of NSE.
5QA: Growth of Financial Derivatives in India:
Derivatives markets in India have been in existence in one form or the other
for a long time. the Bombay Cotton Trade Association started futures trading way
back in 1875. In 1952, the Government of India banned cash settlement and options
trading. Derivatives trading shifted to informal forwards markets. In recent years,
government policy has shifted in favour of an increased
role of market-based pricing and less suspicious derivatives trading.
Milestones in the development of Indian derivative market
1. November 18, 1996 L.C. Gupta Committee set up to draft a policy framework
for introducing derivatives

2. May 11, 1998 L.C. Gupta committee submits its report on the policy
framework
3. May 25, 2000 SEBI allows exchanges to trade in index futures
4. June 12, 2000 Trading on Nifty futures commences on the NSE Milestones in
the development of Indian derivative market
5. June 4, 2001 Trading for Nifty options commences on the NSE
6. July 2, 2001 Trading on Stock options commences on the NSE
7. November 9, 2001 Trading on Stock futures commences on the NSE
8. August 29, 2008 Currency derivatives trading commences on the NSE
Milestones in the development of Indian derivative market
9. August 31, 2009 Interest rate derivatives trading commences on the NSE
10. February 2010 Launch of Currency Futures on additional currency pairs
11. October 28, 2010 Introduction of European style Stock Options
12. October 29, 2010 Introduction of Currency Options
6QA: Derivative Markets - Functions:

Some of the applications of financial derivatives can be enumerated as follows:
1. Management of risk: This is most important function of derivatives. Risk
management is not about the elimination of risk rather it is about the management
of risk. Financial derivatives provide a powerful tool for limiting risks that individuals
and organizations face in the ordinary conduct of their businesses. It requires a
thorough understanding of the basic principles that regulate the pricing of financial
derivatives. Effective use of derivatives can save cost, and it can increase returns for
the organizations.
2. Efficiency in trading: Financial derivatives allow for free trading of risk

components and that leads to improving market efficiency. Traders can use a
position in one or more financial derivatives as a substitute for a position in the
underlying instruments. In many instances, traders find financial derivatives to be a
more attractive instrument than the underlying security. This is mainly because of
the greater amount of liquidity in the market offered by derivatives as well as the

lower transaction costs associated with trading a financial derivative as compared to

the costs of trading the underlying instrument in cash market.
3. Speculation: This is not the only use, and probably not the most important use,
of financial derivatives. Financial derivatives are considered to be risky. If not used
properly, these can lead to financial destruction in an organization like what
happened in Barings Plc. However, these instruments act as a powerful instrument
for knowledgeable traders to expose themselves to calculated and well understood
risks in search of a reward, that is, profit.
4. Price discover: Another important application of derivatives is the price
discovery which means revealing information about future cash market prices
through the futures market. Derivatives markets provide a mechanism by which
diverse and scattered opinions of future are collected into one readily discernible
number which provides a consensus of knowledgeable thinking.
5. Price stabilization function: Derivative market helps to keep a stabilizing
influence on spot prices by reducing the short-term fluctuations. In other words,
derivative reduces both peak and depths and leads to price stabilization effect in
the cash market for underlying asset.
***********
Unit – II : Features of Futures – Differences Between Forwards and

Futures – Financial Futures – Trading – Currency Future – Interest Rate
Futures – Pricing of Future Contracts – Value At Risk (VAR) – Hedging
Strategies – Hedging with Stock Index Futures – Types of Members and
Margining System in India – Futures Trading on BSE & NSE.
1Q: Discuss the future market trading mechanism in India?***

2Q: Explain difference b/w Forwards and Futures contract? (Short)
3Q: Explain Pricing of Future Contracts?
4Q: Explain hedging strategies of future contracts?
5Q: Explain Margining System in India for future contracts?****
6Q: Value At Risk (VAR) (short)
7Q: Explain the Financial futures? ******

Definition: Futures is a standardized forward contact to buy (long) or sell

(short) the underlying asset at a specified price at a specified future date through a
specified exchange. Futures contracts are traded on exchanges that work as a buyer
or seller for the counterparty. Exchange sets the standardized terms in term of
Quality, quantity, Price quotation, Date and Delivery place (in case of commodity).
Specification Future Contract:

1. Contract Size: Information about the quantity of the commodity in one futures
contract.
2. Pricing Unit: This is the price unit used for the given futures contract.
3. Tick Size – Minimum Fluctuation: This is the minimum price movement of
the futures contract on the given market.
4. Contract Months Symbols: futures contracts have 5 expiration months –
March (H), May (K), July (N), September (U), and December (Z). For traders,
whose only interest is speculation on the increase or decrease in market prices, it
is the most important information regarding a futures contract. Before we start to
deal with expiration months in a more detail,
5. Trading Hours (business hours/session):This is also a very important
information which says us on which days and times the corn market opens and
closes.
6. Settlement Procedure (contract settlement procedures): there will be no
physical delivery of the commodities and the related financial settlement. The
main and primary objective of traders are speculations on an increase or a
decrease in the futures contract´s price.
7. Exchange Rule (rules of exchange) :This is not an important information in
terms of practical trading.
8. Daily Price Limit: Daily limit price movements can be a double-edged sword. a
daily limit movement is a price range within which the market price can oscillate
during trading hours. This means that the market price cannot increase or
decrease beyond the daily limits
9. Last Trade Date: Remember that you should never hold a commodity contract
on the last day of its trading.

10. Last Delivery Date: Again, as traders you are not much interested in this
information because you do not produce or buy commodities.
11. Product Ticker Symbol (ticker):This is a very important information. Here
you can see the asset´s symbol used in trading.
The features of a futures contract may be specified as follows:
1. These are traded on an organised exchange like IMM, LIFFE, NSE, BSE, CBOT
etc.
2. These involve standardized contract terms viz. the underlying asset, the time of
maturity and the manner of maturity etc.
3. These are associated with a clearing house to ensure smooth functioning of the
market.
4. There are margin requirements and daily settlement to act as further safeguard.
5. These provide for supervision and monitoring of contract by a regulatory
authority.
6. Almost ninety percent future contracts are settled via cash settlement instead of
actual delivery of underlying asset.
Differences between Forwards and Futures:
Forward Contract Futures Contract
Definition A forward contract is an agreement A futures contract is a standardized

between two parties to buy or sell contract, traded on a futures
an asset (which can be of any kind) exchange, to buy or sell a certain
at a pre-agreed future point in time underlying instrument at a certain
at a specified price. date in the future, at a specified price.
Structure & Customized to customer needs. Standardized. Initial margin payment

Purpose Usually no initial payment required. required. Usually used for speculation.
Usually used for hedging.
Transaction Negotiated directly by the buyer and Quoted and traded on the Exchange
method seller
Market Not regulated Government regulated market (the

regulation Commodity Futures Trading
Commission or CFTC is the governing
body)

Forward Contract Futures Contract
Institutional The contracting parties Clearing House

guarantee
Risk High counterparty risk Low counterparty risk
Guarantees No guarantee of settlement until the Both parties must deposit an initial
date of maturity only the forward guarantee (margin). The value of the
price, based on the spot price of the operation is marked to market rates
underlying asset is paid with daily settlement of profits and
losses.
Contract Forward contracts generally mature Future contracts may not necessarily
Maturity by delivering the commodity. mature by delivery of commodity.
Expiry date Depending on the transaction Standardized
Method of Opposite contract with same or Opposite contract on the exchange.

pre- different counterparty. Counterparty
termination risk remains while terminating with
different counterparty.
Contract Depending on the transaction and Standardized

size the requirements of the contracting
parties.
Market Primary & Secondary Primary
Financial Futures – Trading – Currency Future – Interest Rate Futures:

Financial Futures:
A financial future contract is an agreement between two parties to buy or sell

a specified quantity of financial asset at a specified price and at a specified time and
place. Traded on an exchange which sets certain standardized norms for trading in
the future contract.
Financial futures, various particular financial instruments like equity shares,
debentures, bond, treasury, securities, currencies, etc traded.
Types of Financial Future Contracts
1. Stock Index Futures
2. Foreign Currency Futures

3. Interest Rate Futures
1. Stock Index Futures

Stock index future is first type of financial future contacts that indicate
the promise to sell or buy the standardize units of certain index price at
a particular future date. At expiration of the contract, there is no actual
delivery mechanism. All matters are settled in the shape of cash.
2. Currency Futures:
Currency futures are a exchange-traded futures contract that specify
the price in one currency at which another currency can be bought or
sold at a future date. Currency futures contracts are legally binding and
counterparties that are still holding the contracts on the expiration
date must deliver the currency amount at the specified price on the
specified delivery date. Currency futures can be used to hedge other
trades or currency risks, or to speculate on price movements in
currencies.
3. Interest Rate Futures
An interest rate future is a futures contract with an underlying
instrument that pays interest. An interest rate future is a contract
between the buyer and seller agreeing to the future delivery of any
interest-bearing asset. The interest rate future allows the buyer and
seller to lock in the price of the interest-bearing asset for a future date.
Basic Mechanism of a Futures Contract:
A futures contract calls for the delivery of the specified quantity at the
specified rate on specified date. Or, before the maturity date it can be squarred off.
In India, the financial derivatives (futures) are compulsorily squarred off on the
maturity date.
However, in case of commodities futures, delivery is made, if required, by the
transfer of warehouse receipt. An investor can buy (a long position) or sell (a short
position) a futures contract. The profit or payoff position of a futures contract
depends on the differences between the specified price (of the futures contract) and
the actual market price prevailing on the maturity date.

This can be summarized as follows:

For Long investor: Profit = Spot price at Maturity – Futures Price
Loss = Futures Price – Spot Price at Maturity
For Short investor:
Profit = Futures price – Spot Price at Maturity
Loss = Spot Price at Maturity – Futures Price
A futures contact is zero sum game. Profit to one party is the loss of the
other party. Simple reason being that every long position is represented by a short
position in the market. The pay off positions of the long investor and short investor
in futures are shown in Figure
Futures Trading and Role of Clearing House:

Futures are traded at computerized on-line stock exchanges and there is no oneto-one
contact between the buyers and sellers of futures. In case of default by either party,
the counter-guarantee is provided by the exchange. In this scenario, the role of the stock
exchange clearing house becomes imperative.

the position of the clearing house is only neutral and provides a link between
the buyers and sellers. Clearing house makes it possible for buyers and sellers to
easily square off their positions and to make the net position zero. The zero net
position of a party means that neither the original position nor the squaring off is to
be fulfilled.
As the clearing house is obligated to perform to both parties, it protects its
interest by imposing margins on the parties.
Initial Margin and Mark to Market:
In the discussion on payoff positions in futures, it has been shown that the ultimate
profit or loss position of a party to a futures contract depends on the spot price of the
underlying asset on the maturity date. As the parties are betting on the future spot price
of the asset, their expectations may not come true and they may suffer loss.
Convergence Property:
As futures contracts mature and are compulsorily settled on the specified maturity
date, the futures price and the spot price of the underlying asset on that date must converge.
This may be called the convergence property.
Open Interest: Open interest is a technical term used to refer to the number of contracts
outstanding. In order to find out the open interest, the long and short are not added, rather
the total long or short contracts are defined as open interest.
What Is Value at Risk (VaR)?
Value at risk (VaR) is a statistic that measures and quantifies the level of financial
risk within a firm, portfolio or position over a specific time frame. This metric is most
commonly used by investment and commercial banks to determine the extent and occurrence
ratio of potential losses in their institutional portfolios.
Pricing of Future Contracts:

A futures contract is a standardized contract, traded on a futures exchange, to buy
or sell a certain underlying instrument at a certain date in the future, at a specified
price.
The specified price for which the underlying asset is agreed to be buy/sell in
the future is referred to as the future price.

Terms & Meaning:

Spot Price: The spot price is the current price in the marketplace at which a
given asset. It can be bought or sold for immediate delivery.
Basis: it is deference b/w the cash price and futures price of an assets.
BASIS = CASH PRICES – FUTURES PRICE
Convergence?
Convergence is the movement of the price of a futures contract toward the spot
price of the underlying cash commodity as the delivery date approaches.
Spread?
A futures spread is an arbitrage technique in which a trader takes two positions on a
commodity to capitalize on a discrepancy in price. In a futures spread, the trader
completes a unit trade, with both a long and short position.
Arbitrage
It arises when an asset is selling for different prices in different markets. It is the
process of seeking riskless profit without investment by taking advantage of
differences in prices in different markets.
Open Interest?
Open interest is the total number of outstanding derivative contracts, such
as options or futures that have not been settled for an asset. The total open interest
does not count, and total every buy and sell contract.
Future Pricing Models:

They are 2 models:
1. Cost of Carry Model
2. The Expectancy Model
Cost of Carry models:
Cost of carry refers to costs associated with the carrying value of an investment.
These costs can include financial costs, such as the interest costs on bonds, interest
expenses on margin accounts, interest on loans used to make an investment, and
any storage costs involved in holding a physical asset.

The model also assumes for simplicity sake, that the contract is held till
maturity, so that a fair price can be arrived at.
In short, the price of a futures contract (FP) will be equal to the spot price
(SP) plus the net cost incurred in carrying the asset till the maturity date of the
futures contract.
FP = SP + (Carry Cost – Carry Return)
Carry Cost refers to the cost of holding the asset till the futures contract
matures. This could include storage cost, interest paid to acquire and hold the asset,
financing costs etc. Carry Return refers to any income derived from the asset while
holding it like dividends, bonuses etc. While calculating the futures price of an index,
the Carry Return refers to the average returns given by the index during the holding
period in the cash market. A net of these two is called the net cost of carry.
The bottom line of this pricing model is that keeping a position open in the
cash market can have benefits or costs. The price of a futures contract basically
reflects these costs or benefits to charge or reward you accordingly.
Suppose the spot price of scrip X is Rs 1,600 and the prevailing

interest rate is 7 per cent per annum. Futures price of one-month contract
would therefore be:
1,600 + 1,600*0.07*30/365 = Rs 1,600 + Rs 11.51 = 1,611.51

Here, Rs 11.51(1611.51-1600) is the cost of carry.
The Expectancy Model of futures pricing:
The Expectancy Model of futures pricing states that the futures price of an
asset is basically what the spot price of the asset is expected to be in the future.
 This means, if the overall market sentiment leans towards a higher price
for an asset in the future, the futures price of the asset will be positive.
 In the exact same way, a rise in bearish sentiments in the market would
lead to a fall in the futures price of the asset.
 Unlike the Cost of Carry model, this model believes that there is no
relationship between the present spot price of the asset and its

futures price. What matters is only what the future spot price of the asset is
expected to be.
 This is also why many stock market participants look to the trends in futures
prices to anticipate the price fluctuation in the cash segment.
Basic Strategies Using Futures:
While the use of short and long hedges can reduce (or eliminate in some cases - as
below) both downside and upside risk. The reduction of upside risk is certainly a
limitation of using futures to hedge.
Short Hedges: A short hedge is one where a short position is taken on a futures
contract. It is typically appropriate for a hedger to use when an asset is expected to
be sold in the future. Alternatively, it can be used by a speculator who anticipates
that the price of a contract will decrease.
Long Hedges: A long hedge is one where a long position is taken on a futures
contract. It is typically appropriate for a hedger to use when an asset is expected to
be bought in the future. Alternatively, it can be used by a speculator who anticipates
that the price of a contract will increase.
Cross-Hedging: In the case when an asset is looking to be hedged and there is

not an exact replication in the futures/options market, cross hedging can be
employed.
Hedge Ratio: - The ratio of the size of a position in a hedging instrument to the
size of the position being hedged.
 When an asset to be hedged is exactly the same as the asset

underlying the futures contract, the hedge ratio is equal to 1.0
 The existence of basis risk often prevents this from happening
 It is not always optimal to cross hedge (not is it usually possible) to

hedge such that the hedge ratio equals 1.0
The optimal hedge ratio (h∗) can be computed as:

Hedging with Stock Index Futures:
Index Futures for Hedging

Portfolio managers will often buy equity index futures as a hedge against potential
losses. If the manager has positions in a large number of stocks, index futures can
help hedge the risk of declining stock prices by selling equity index futures.
Stocks Prices Decline : Since many stocks tend to move in the same general
direction, the portfolio manager could sell or short an index futures contract in case
stocks prices decline.
market downturn: In the event of a market downturn, the stocks within the
portfolio would fall in value, but the sold index futures contracts would gain in value
offsetting the losses from the stocks.
The fund manager could hedge all of the downside risks of the portfolio, or only
partially offset it. The downside of hedging is that hedging can reduce profits if the
hedge isn't required. For example, if in the above scenario, the portfolio manager
shorts the index futures and the market rises, the index futures would decline in
value. The losses from the hedge would offset gains in the portfolio as the stock
market rises.
Speculation on Index Futures

Speculation is an advanced trading strategy that is not suited for many investors.
However, experienced traders will use index futures to speculate on the direction of
an index. Instead of buying individual stocks or assets, a trader can bet on the
direction of a group of assets by buying or selling index futures.

Types of Margining System in India:
In order to buy or sell commodities

on the exchange, the user must deposit
specific amount of money with the
broker. This money is called the margin.
Without margins place, the parties cannot

enter into any contract. For most future
contracts, the margin requirement in the
range of 4%-15%. There are 6 types of
margins applicable to futures trading in commodities are:
1. Initial margin: The ‘initial margin’ is the amount that is required to be

placed by the trader when they intend to enter a contract. This amount is
meant to compensate for a potential loss that may occur in that day.
2. Exposure & Mark-to-Market Margin: he exchange also requires the
traders to pay mark-to-market margin which are positions restated at the
‘daily settlement prices’ (DSP). After every trading session, the margin
account of each user is adjusted to reflect the trader’s gain or loss
3. Additional margin: Additional margin’ is called forth on occasional situations
where there has been unexpected volatility in the market
4. Pre-expiry margin: This ‘pre-expiry’ margin is charged by the exchange on
a cumulative basis over 3-5 days near the contract expiry to ensure better
convergence of the futures and spot market prices by having only interested
parties remain in the market while the speculators roll over their positions to
subsequent months
5. Delivery Margin: When a trader wants to settle the contract by taking
delivery of the commodity, this margin is charged.
6. Special Margin: Special margin is usually imposed by an exchange on
certain commodities as a surveillance measure during times when there is
more than 20% price movement in the same direction from a pre-determined
base (underlying spot price).

7. Margin for Calendar Spread positions: a ‘margin for calendar spread’ is

charged for such positions. Such benefits are given subject to the positive
correlation in the prices of the contract months and the far month contracts’
liquidity.
Type of member in Indian Future markets: [ 3 MARKS Question]
Investors:
Investors in the futures market are those that view the futures market as
an alternative to the cash market (i.e. the underlying market). An investor may
also use long-term instruments and short futures contracts to invest short-term, or
use short-term financial instruments and long futures contracts to invest long term.
Arbitrageurs:
Arbitrageurs endeavor to profit from price differentials (mispricing) that may

exist in different markets on similar securities. Arbitrageurs play a significant role in
the futures market by ensuring that futures prices do not stray too far from fair
value prices and by adding to the liquidity of the market.
Hedgers

Hedgers are those participants that have exposures in cash markets and wish to
reduce risk by taking the opposite positions in the futures markets. Most investors,
such as retirement funds, life offices and banks hedge their portfolios from time to
time in the financial futures market. The equivalents in the commodity futures
markets are the producers (e.g. farmers) and consumers (e.g. millers of flour) of
commodities. Hedgers transfer risk to speculators and speculators willingly seek risk
positions (accept the risk being shed).
Speculators
Speculators are those participants that endeavor to gain from price movements in
the futures market. Given the small outlay (i.e. the margin) in comparison with cash
markets (where the full price is paid), speculators are attracted to futures markets
because they are able to "gear up".
Futures/Option/ Financial Derivative Contract Trading on BSE & NSE:

Introduction
BSE Markets:
BSE created history on June 9, 2000 by launching the first Exchange-traded Index
Derivative Contract in India i.e. futures on the capital market benchmark index - the
BSE Sensex. In sequence of product innovation, BSE commenced trading in Index
Options on Sensex on June 1, 2001, Stock Options were introduced on 31 stocks on
July 9, 2001 and Single Stock Futures were launched on November 9, 2002.
NSE MARKETS:
The derivatives trading on National Stock Exchange (NSE) has

commenced with S&P CNX Nifty Index futures on June 12, 2000.
Single stock futures were launched on November 9, 2001.
Trading Mechanism: Now we will be dealing on the trading platforms or the

software used for trading. In order to induce more transparency and efficiency in the
trading system, NSE and BSE introduced nationwide online fully automated “Screen

Based Trading System”. The trading platform used by BSE is called BOLT-Bombay
Online Trading.
Recently BSE has launched new software for trading called BEST (BSE Electronic
Smart Trader). It can be downloaded directly from Android play store and an
investor can enjoy zero transaction charges for 6 months on cross currency
derivatives.
Now we will be moving into the trading Process:
Flowchart of Trading:

Trading Cycle Process:
***END OF 2ND UNIT***

Unit – III : Options Market – Meaning & Need – Options Vs futures – Types
of Options Contracts – Call Options – Put Options – Trading Strategies
Involving Options – Basic Option Positions – Margins – Options on stock
Indices – Option Markets in India on NSE and BSE.
Options Contract
In case of futures contact, both parties are under obligation to perform their
respective obligations out of a contract. But an options contract, as the name
suggests, is in some sense, an optional contract. An option is the right, but not the
obligation, to buy or sell something at a stated date at a stated price.
A “call option” gives one the right to buy; a “put option” gives one the right to sell.
Options are the standardized financial contract that allows the buyer (holder) of the
option, i.e. the right at the cost of option premium, not the obligation, to buy (call
options) or sell (put options) a specified asset at a set price on or before a specified
date through exchanges.
OPTION TERMINOLOGY:
 Call Option
A right to BUY the underlying asset at predetermined price within specified
interval of time is called a CALL option.

 Put Option
A right to SELL the underlying asset at predetermined price within a
specified interval of time is called a PUT option.
 Buyer or Holder
The person who obtains the right to buy or sell but has no obligation to
perform is called the owner/holder of the option. One who buys an option has
to pay a premium to obtain the right.
 Writer or Seller
One who confers the right and undertakes the obligation to the holder is
called seller/writer of an option.
 Premium
While conferring a right to the holder, who is under no obligation to perform,
the writer is entitled to charge a fee upfront. This upfront amount is called the
premium. This is paid by the holder to the writer and is also called the price
of the option.
 Strike Price
The predetermined price at the time of buying/writing of an option at which it
can be exercised is called the strike price. It is the price at which the holder of
an option buys/ sells the asset.
 Strike Date/Maturity Date
The right to exercise the option is valid for a limited period of time. The latest
time when the option can be exercised is called the time to maturity. It is also
referred to as expiry/maturity date.
 OPTION In-the-Money, Out-the-Money and At-The- Money: [**3
Marks]
The underlying futures price/stock price is greater than the strike or exercise
price, the call option will be IN-THE-MONEY.
If the future price is lesser than the strike price as known as OUT-THE-MONEY
If the Option price is equal to the strike price as known as AT-THE-MONEY.
Payoff profile of option
Type of option Call Option Put option

In-The-Money Future Option Price>Strike Future Option Price<Strike
out-The-Money Future Option Price<Strike Future Option Price>Strike
At-The-Money Future Option Price=Strike Future Option Price=Strike
Types of Options:
1. Calls
2. Puts
3. American Style

4. European Style
5. Exchange Traded Options
6. Over The Counter Options
EXPLAIN
1. Call Option
A right to BUY the underlying asset at predetermined price within specified
interval of time is called a CALL option.
2. Put Option
A right to SELL the underlying asset at predetermined price within a
specified interval of time is called a PUT option.
3. American Style
The term “American style” in relation to options has nothing to do with where
contracts are bought or sold, but rather to the terms of the contracts. Options
contracts come with an expiration date, at which point the owner has the right to
buy the underlying security (if a call) or sell it (if a put). With American style options,
the owner of the contract also has the right to exercise at any time prior to the
expiration date.
4. European Style
The owners of European style options contracts are not afforded the same flexibility
as with American style contracts. If you own a European style contract then you
have the right to buy or sell the underlying asset on which the contract is based only
on the expiration date and not before.
5. Exchange Traded Options
Also known as listed options, this is the most common form of options. The term
“Exchanged Traded” is used to describe any options contract that is listed on a
public trading exchange.
6. Over The Counter Options
“Over The Counter” (OTC) options are only traded in the OTC markets, making them
less accessible to the general public. They tend to be customized contracts with
more complicated terms than most Exchange Traded contracts

Futures Vs Options:
Basis of
Futures Options
Comparison
Agreement binding the A contract allowing the investors

counterparties to buy and sell a the right to buy or sell an
Meaning financial instrument at a instrument at a pre-decided price.
predetermined price and a specific It is to be executed on or before
date in the future. the date of expiry.
Restricted to the amount of

Level of Risk High
premium paid.
Full obligation to execute the

Buyer’s Obligation There is no obligation
contract
If the buyer chooses then the

Seller’s Obligation Complete obligation
seller will have to abide by it.
Paid in the form of premium

Payment in No advance payment to be made
which is a small percentage of
Advance except commission
the entire amount.
Extent of Gain/Loss No Restriction Unlimited Profits but limited loss
On the pre-decided date as per Any point of time before the date
Date of Execution
contract of expiry.
Time Value of
Not Considered Relied heavily upon
Money
Trading Strategies Involving Options:

There are different trading strategies:
 Take a position in the option and the underlying
 Take a position in 2 or more options of the same type (A spread)
 Combination: Take a position in a mixture of calls & puts (A combination)
Positions in an Option & the Underlying:
a) Writing a covered call (long stock and short call): the portfolio consists of a
long position in a stock plus short position in call option. This is known as writing a
covered call options.

b) Short a stock and long call (reverse of writing a covered call): it protects
the investor from the possibility of a sharp decrease in stock price.
Positions in an Option & the Underlying:
c) Protective put i.e. long stock and long put: it involves buying a put option on a
stock and the stock itself.
d) Short put and short stock (reverse of protective put): a short position in a put
option is combined with a short position in the stock
Profit
Profit
X S S
T T
(b
Profit Profit
X
ST X S
(c d T
The trading strategies are classified in three types:

1. Spread strategy
2. Straddle strategy
3. Strangle strategy

1. Spread strategy: to involves combining two or more options of the same type
at different strike prices or expiration dates. Spread strategy are classified into
three types
Call
Bullish
Put
Vertical
Call
Breaish
Spread Put
Options Call
Horizontal
Put
Diagonal

A. VERTICAL SPREADS: they are two types

I. Vertical Bull Spread:
It is very popular spreads. The investor purchase a call option on a stock
with certain strike price and selling a call option on the same stock with a
higher strike price
Profit
a. Bullish Call Option spreads:
Buy call with lower strike and sell
call with higher strike price S
K T
1
K
b. Bullish Put Option spreads:
Buy put with higher strike and sell Profit
2
put with lower strike
price
K K S
1 2 T
II. Vertical Bearish Spread: The investor

purchases an option with higher strike price and sell the option with a relatively
low strike price and expiration date is the same
a. Bearish Call Option spreads:Buy call
Profit
with higher strike and sell call with lower strike
price K K S
1 2 T
b. Bearish Put Option spreads: Buy put Profit

with higher strike and sell put with lower strike
price
K K S
1 2 T

III. Butterfly spread: this is a particular position in options with three different
strike prices. It can be done by using puts and
calls, and both options.
Profit
Butterfly Spread Using Calls: The Investors
a call with a low strike price and high strike
K K K S
price along with selling two call with a strike 1 2 3 T
price.
Butterfly Spread Using Puts:

The Investors a put with a low strike price and
Profit
high strike price along with selling two puts
within an intermediate strike price.
K K K S
1 2 3 T
B. Horizontal Spreads or time OR calendar Spreads:

The horizontal spread refers to a family of spreads involving options of
the same underlying stock, same strike prices, but different expiration month. They
can be created with either all calls or all puts. Also known as calendar spread or
time spread.
Profit
K Pro
fit
The horizontal Call Spreads The horizontal put spreads

C. Diagonal spreads : A diagonal spread is an options strategy established by

simultaneously entering into a long and short position in two options of the same
type (two call options or two put options) but with different strike prices and
different expiration dates.
COMBINATIONS:
A combination is an option trading strategy that involves the purchase and/or
sale of both call and put options on the same underlying asset. The main strategy
in this respect is as straddles, strangles, strips and straps.
I. Straddlestrategy:
 A straddle is the simultaneous purchase (or sale) of two identical options, one
a call and the other a put.
 To "buy a straddle" is to purchase
a call and a put with the same
exercise price and expiration date.
 To "sell a straddle" is the
opposite: the trader sells a call
and a put with the same exercise
price and expiration date.
II. Strangle strategy :A strangle is similar to a straddle, except that the call and
the put have different exercise prices. Usually, both the call and the put are out-
of-the-money.
 To "buy a strangle" is to purchase
a call and a put with the same
expiration date, but different
exercise prices. Usually the call
strike price is higher than the put
strike price
 To "sell a strangle" is to write a call
and a put with the same expiration
date, but different exercise prices.
III. Strip
The strip is a modified, more bearish version of the common straddle. Construction
is similar to the straddle except that the ratio of puts to calls purchased is 2 to 1.

IV. Strap
The strap is a more bullish variant of the straddle. Twice the number of call options
are purchased to modify the straddle into a strap.
Options on stock Indices
Definition: All the options that have an index as underlying are known as
Index Options. The two most basic and popular index options are Call Option and
Put Option. Further, they may be American Options or European Options.
Basics of an Index Option

 Index call and put options are simple and popular tools used by investors,
traders and speculators to profit on the general direction of an underlying
index while putting very little capital at risk.
 The profit potential for long index call options is unlimited, while the risk is limited
to the premium amount paid for the option, regardless of the index level at expiration.
 For long index put options, the risk is also limited to the premium paid, and the
potential profit is capped at the index level, less the premium paid, as the index can
never go below zero.
 Beyond potentially profiting from general index level movements, index
options can be used to diversify a portfolio when an investor is unwilling to
invest directly in the index's underlying stocks.
 Index options can also be used in multiple ways to hedge specific risks in a
portfolio.
 American-style index options can be exercised at any time before the
expiration date, while European-style index options can only be
exercised on the expiration date.

Specification of Options on stock indices (Repeat)
Call Option
A right to BUY the underlying asset at predetermined price within specified interval
of time is called a CALL option.
Put Option
A right to SELL the underlying asset at predetermined price within a specified
interval of time is called a PUT option.
Buyer or Holder
The person who obtains the right to buy or sell but has no obligation to perform is
called the owner/holder of the option. One who buys an option has to pay a
premium to obtain the right.
Writer or Seller
One who confers the right and undertakes the obligation to the holder is called
seller/writer of an option.
Premium
While conferring a right to the holder, who is under no obligation to perform, the
writer is entitled to charge a fee upfront. This upfront amount is called the premium.
This
is paid by the holder to the writer and is also called the price of the option.
Strike Price
The predetermined price at the time of buying/writing of an option at which it can
be exercised is called the strike price. It is the price at which the holder of an option
buys/ sells the asset.
Strike Date/Maturity Date
The right to exercise the option is valid for a limited period of time. The latest time
when the option can be exercised is called the time to maturity. It is also referred to
as expiry/maturity date.
Option Markets in India on NSE and BSE:
December, 1995, the NSE applied to the SEBI for permission to undertake
trading in stock index futures. Later SEBI appointed the Dr. L.C. Gupta Committee,
which conducted a survey amongst market participants and observed an
overwhelming interest in stock index futures, followed by other derivatives products.

The LCGC recommended derivatives trading in the stock exchanges in a phased

manner. It is in this context SEBI permitted both NSE and BSE in the year 2000 to
commence trading in stock index futures.
Following are some benefits of derivatives:
1. India’s financial market system will strongly benefit from smoothly

functioning index derivatives markets.
2. Internationally, the launch of derivatives has been associated with substantial
improvements in market quality on the underlying equity market.
Liquidity and market efficiency on India’s equity market will improve once the
derivatives commence trading.
3. Many risks in the financial markets can be eliminated by diversification.
Index derivatives are special in so far as they can be used by the investors to
protect themselves from the one risk in the equity market that cannot be
diversified away, i.e., a fall in the market index. Once the investors use index
derivatives, they will stiffer less when fluctuations in the market index take
place.
4. Foreign investors coming into India would be more comfortable if the
hedging vehicles routinely used by them worldwide are available to them.
5. The launch of derivatives is a logical next step in the development of
human capital in India. Skills in the financial sector have grown
tremendously in the last few years. Thanks to the structural changes in the
market, the economy is now ripe for derivatives as the next area for addition
of Skills.

Unit – IV : Option Pricing – Intrinsic Value and Time Value

- Pricing at Expiration – Factors Affecting Options pricing – Put-
Call Parity Pricing Relationship – Pricing Models – Introduction
to Binominal Option Pricing Model – Black Scholes Option
Pricing Model.
1Q: Explain Binominal Option pricing Model? ****
2Q: Explain factors affecting option pricing? **
3Q: Case study Problem: Black Scholes Option Pricing Model.
Binominal Option Pricing Model.
4Q: Shorts: 1) Intrinsic Value 2) Time Value 3)Put-Call Parity
PRICING OFOPTIONS:
Factors affecting the Option premium:
Options are used as risk management tools and the valuation or pricing of the
instruments is a careful balance of market factors. There are four major factors
affecting the Option premium:
 Price of Underlying
 Time to Expiry
 Exercise Price Time to Maturity
 Volatility of the Underlying
And two less important factors:

 Short – Term Interest Rates
 Dividends
A. The Intrinsic Value of an Option [3MARKS]
The intrinsic value of an option is defined as the amount by which an option is

in-the immediate exercise value of the option when the underlying position is
marked-to-market.
For a call option:

Intrinsic Value = Spot Price – Strike Price
For a put option:
Intrinsic Value = Strike Price – Spot Price
The intrinsic value of an option must be positive or zero. It cannot be
negative. For a call option, the strike price must be less than the price of the
underlying asset for the call to have an intrinsic value greater than 0. For a put
option, the strike price must be greater than the underlying asset price for it to have
intrinsic value.
Comparing two CALLS with the

same underlying asset, the higher the
exercise price of a call, the lower its
premium.
PUT OPTION
Comparing two PUTS with the same

underlying asset, the higher the exercise price
of a PUTS, the Higher its premium.
B. Price of Underlying
The premium is affected by the Price Movements in the underlying
instrument. For Call options the right to buy the underlying at a fixed strike price –
as the underlying price raises so does its premium. As the underlying price falls, so
does the cost of the option premium. For put options – the right to sell the
underlying at a fixed strike price as the underlying price rises, the premium falls; as
the underlying price decreases the premium cost raises.
C. The Time Value of an Option: [3MARKS***]
The time value of an option is an additional amount an investor is willing to pay over
the current intrinsic value. Investors are willing to pay this because an option could increase
in value before its expiration date.
Time Value =Option Premium - Intrinsic Value

PUT AND CALL American options become more
valuable as the time to
expiration increases.
EUROPEAN PUT AND CALL options do not
necessarily become more valuable as the time to expiration
increases.
D. Volatility:
This is the tendency of the underlying security‘s market price to
fluctuate either up or down. It reflects a price change‘s magnitude; it does not
imply a bias towards price movement in one direction or the other.
Higher volatility = Higher premium
Lower volatility = Lower premium
PUT
F. INTEREST RATES :
They have the least influence on options and equate approximately to the cost of carry
of a futures contract. All other factors being equal as interest rates rise, premium costs fall
and vice versa.
The higher the "risk less interest rate", the higher the call premium.
The higher the "risk less interest rate", the lower the put premium.

G. Dividends:
Dividends have the effect of reducing the stock price on the ex-dividend date. The
value of a call option is negatively related to the size of any anticipated dividend and the
value of a put option is positively related to the size of any anticipated dividend.
Pricing Models –
There are various option pricing models which traders use to arrive at the
right value of the option. Some of the most popular models have been enumerated
below.
Introduction to Binominal Option Pricing Model
The binomial options pricing model provides a Generalizable numerical
method for the valuation of options. The binomial model was first proposed by Cox,
Ross and Rubinstein (1979). Essentially, the model uses a "discrete-time" model
of the varying price over time of the underlying financial instrument. Option
valuations then via application of the risk neutrality assumption over the life of the
option, as the price of the underlying instrument evolves.
Under the binomial model, we consider that the price of the underlying asset
will either go up or down in the period. Given the possible prices of the underlying
asset and the strike price of an option, we can calculate the payoff of the option
under these scenarios, then discount these payoffs and find the value of that option
as of today.
They are two type of binomial trees:
1. One-Step Binomial tree: the stock price follows a binomial model and
we are interested in finding the price of a European option that expires at
the of the one period.
2. Two or Multiple step binomial tree: In this model can be used to price
and option wherein the life of the option may be divided into any number
of periods or steps

The assumptions:
1. There are no market frictions. It means there are no transaction costs, no
bid/ask spreads, no margin requirement, no taxes etc.
2. Market participants entail no counterparty risk.
3. Markets are competitive.
4. There are no arbitrage opportunities.
5. There is no interest rate uncertainty.
Formula :
Single step binomial model: f =e - r T [pf u +(1-p)f d ]
where: -
erT- d
p= ---------------
u- d
where:
S0= Current Stock price fu= payoff from Option (move up)
S0u= current stock price move up fd=payoff from Option (move down)
S0d= current stock price move down u = stock price Move up
f= Option price d= stock price Move down
r= risk free interest rate (e)= Natural logs value of ex
T= time of expired P= up state probability

PROBLE: A stock price is currently Rs.20. and it is known that at the end of
3 Moths it will be either 10% increase or Decrease. we further assume
that we are considering in valuing a European call option to buy the stock
for Rs.21 in three months. Risk free interest rate is 12%. find the current
value of the option.
Solution:
After 3 Months, if stock S0u=Rs. 22

price move up 10% fu= Rs.1 ( 22-21)
Curren Value of [u=1.1 (110/100)
Stock (S0)=Rs.20
f=0.633 S0d=Rs. 18
After 3 Months, if stock
price move Down 10%
fd= Rs.0 ( 18-21)
u=0.9 (90/100)
f =e-rT[pfu+(1-p)fd]
where: -
erT- d
p=---------------
u- d
Where:-
fu=1, fd=0, u=1.1, d=0, r=12% or 0.12 , T= 3 months =>3/12years

e0.12x3/12 - 0.9
p=----------------------
1.1 -- 0.9
e0.03- 0.9 1.03045- 0.9

p=---------------------- = ---------------------- =0.65225

1.1 - 0.9 0.2
f= e -0.12x3 /12 [0.65225x1 + (1-0.65225)x0)

=0.633
PROBLE: A stock price is currently Rs.20. and it is known that at the end of
3 Moths it will be either 10% increase or Decrease. we further assume
that we are considering in valuing a European call option to buy the stock
for Rs.21 in three months. Risk free interest rate is 12%. The stock price
each of two time steps may go up by 10% or down by 10%. find the
current value of the option.
Solution:
S0uu=Rs. 24.2
D fuu= Rs.3.2 ( 24.2-21)
S0u=Rs. 22 [uu=1.1 (110/100)
fu=2.0257 B
[u=1.1 (110/100)
Curren Value of
Stock (S0)=Rs.20 A
f=1.2823 S0u=Rs. 22 19.8
S0ud=Rs.
E fuf=udRs.1 ( 22-21)
= Rs.0 ( 19.8-21)
[u=1.1 (110/100)
[ud=1.1 (110/100)
S0d=Rs. 18
fd= Rs.0 C
u=0.9 (90/100) S0dd=Rs. 16.2
F fdd= Rs.0 ( 16.2-21)
[dd=1.1 (110/100)
f =e-rT[pfu+(1-p)fd]
where: -
erT- d
p=---------------
u- d
Node :B
fuu=3.2, fdu=0, u=1.1, d=0, r=12% or 0.12 , T= 3 months =>3/12years
e0.12x3/12 - 0.9
p=----------------------
1.1 -- 0.9
e0.03 - 0.9 1.03045 - 0.9

p=---------------------- = ---------------------- =0.65225
1.1 - 0.9 0.2
f= e -0.12x3 /12 [0.65225x3.2+ (1-0.65225)x0)

=2.0257
Node : C
fud=0, fdd=0, u=1.1, d=0, r=12% or 0.12 , T= 3 months =>3/12years
e0.12x3/12 - 0.9
p=----------------------
1.1 - 0.9
e0.03- 0.9 1.03045- 0.9

p=---------------------- = ---------------------- =0.65225
1.2 - 0.9 0.2
f=
e -0.12 x3/12 [0.65225x0+ (1-0.65225)x0)
=0
Node : A
fu=2.0257, fd=0, u=1.1, d=0, r=12% or 0.12 , T= 3 months =>3/12years
e0.12x3/12 - 0.9
p=----------------------
1.2 -- 0.9
e0.03 - 0.9 1.03045 - 0.9

p=---------------------- = ------------------------ =0.65225
1.2 - 0.9 0.2
f= e -0.12x3 /12 [0.65225x2.0257+ (1-0.65225)x0)

=1.2823
Black Scholes Option Pricing Model:

The Black–Scholes models a model of the evolving price of financial
instruments, in particular stocks. It is a mathematical formula for the theoretical
value of European put and call stock options derived from the assumptions of the
model. The formula was derived by Fischer Black and Myron Scholes and
published in 1973. They built on earlier research by Edward Thorpe, Paul
Samuelson, and Robert C. Merton. The fundamental insight of Black and Scholes
is that the option is implicitly priced if the stock is traded.
Merton and Scholes received the 1997 Nobel Prize in Economics for this
and related work; Black was ineligible, having died in 1995.
The key assumptions of the Black–Scholes model are:

 The price of the underlying instrument Stfollows a geometric Brownian
motion with constant drift μ and volatility σ:
 It is possible to short sell the underlying stock.
 There are no arbitrage opportunities.
 Trading in the stock is continuous.
 There are no transaction costs or taxes.
 All securities are perfectly divisible (e.g. it is possible to buy 1/100th of a
share).

 A constant risk-free interest rate exists and is the same for all maturity dates.
The formula
The above lead to the following formula for the price of a call option with
exercise price K on a stock currently trading at price S, i.e., the right to buy a
share of the stock at price Kafter Tyears. The
constant interest rate is r, and the constant stock volatility is σ (Sigma).

VALUE OF CALL OPTION:
C=S.N(d1)-K e –r T
N(d2)
In(S/K)+r T
d1=----------------------------+0.5σ √T
σ √T
d2= d1 -σ √T
The price of a put option may be computed from this by put-call parity and
simplifies to:
VALUE OF PUT OPTION:
P=K e –r T
N(-d2)-S.N(-d1)
In(S/K)+r T
d1=----------------------------+0.5σ √T
σ √T
d2= d1 -σ √T
Instruments paying continuous dividends:

The dividend payment paid over the time period is then modelled as
for some constant the dividend yield
Under this formulation the arbitrage-free price implied by the Black–Scholes model
can be shown to be:
FIND OUT THE Dividend
D0=D e-rT
S*= S- D0
where : D0–present dividend value
D- pay the dividend
S*- adjusted present value of share
In(S*/F)+r T
d1=----------------------------+0.5σ √T
σ √T
d2= d1 - σ √T
Advantage:
 The main advantage of the Black-Scholes model is speed.
 It lets you calculate a very large number of option prices in a very short time.
 High accuracy is not critical for American option pricing using' Black-Scholes
is a good option.
 You can experiment with the Black-Scholes model using on-line options
pricingcalculator.
Limitation:

Dividends are ignored in the basic Black-Scholes formula, but there
are a number of widely used adaptations to the original formula, which enable it to
handle both discrete and continuous dividends accurately.
Problems: from the following data, calculate the price of the call option
and the put option by using Black-Scholes option pricing model.
i. Current stock price = Rs.160 per square
ii. Volatility of the share =20%
iii. Risk free interest rate =8%p.a
iv. Exercise Price =Rs.150
v. These are q call option and put option on the share expiring in
6months.
N(d1)= N(-0.3517) =0.3632

N(d2)= N(-0.85881)= 0.1977
N(d1)= N(0.3517) =0.6338
N(d2)= N(0.85881)= 0.8023
Solution:
VALUE OF CALL OPTION:
C=S.N(d1)-K e –r T
N(d2)
In(S/K)+r T
d1=----------------+0.5σ √T
σ √T
d2= d1 -σ √T
Where : S = 160 K=150, r=8% or 0.8, T =6 months or 6/12(0.5)
,σ=20% or 0.20
In(160/150)+(0.8)(0.5)
d1=------------------------------- +0.5(0.20 x√0.5)

0.20 x√0.5
0.06485 +0.4
d1= ------------------------+0.0707
0.1414212
d1= -0.3517
d2= d1 -σ √T
d2= -0.3517- (0.20x√0.5)

= -0.3517-0.50711
= -0.85881
N(d1)= N(-0.3517) =0.3632
N(d2)= N(-0.85881)= 0.1977
C= S. N(d1)-K e-r T N. (d2)
C= 160 x 0.3632 – 150 e –0.8x6/12 x0.1977

= 58.112-(-32.24)
=90.352
Call value is =90.352
VALUE OF PUT OPTION IS:
P=K e –r T
N(-d2)-S.N(-d1)
N(d1)= N(-0.3517) =0.3632
N(d2)= N(-0.85881)= 0.1977
P= 150e –0.8x6/12x0.1977-160 x 0.3632

=-32.244-58.112
=-90.356
Put-Call Parity Pricing Relationship:

Put-call parity is a principle that defines the relationship between the price of
European put options and European call options of the same class, that is, with the
same underlying asset, strike price, and expiration date.
The put/call parity concept was introduced by economist Hans R. Stoll in his
Dec. 1969 paper "The Relationship Between Put and Call Option Prices," published
in The Journal of Finance.
The equation expressing put-call parity is:

C + K(1+r)-T = P + S
where:
C = price of the European call option
K = the present value of the strike price
r = the risk-free rate
T = expiration date
P = price of the European put
S = spot price or the current market value of the underlying asset
 Put/call parity says the price of a call option implies a certain fair price for the
corresponding put option with the same strike price and expiration (and vice
versa).
 When the prices of put and call options diverge, an opportunity for arbitrage
exists, enabling some traders to earn a risk free rate.
Important of Put-Call Parity:
1. The put-call parity theory is important to understand because this
relationship must hold in theory.
2. With European put and calls, if this relationship does not hold, then
that leaves an opportunity for arbitrage.
3. Rearranging this formula, we can solve for any of the components of
the equation.

4. This allows us to create a synthetic call or put option. If a portfolio of
the synthetic option costs less than the actual option, based on put-call
parity, a trader could employ an arbitrage strategy to profit.
Put-Call Parity – European Call Option Example

Let us now consider a question involving the put-call parity. Suppose a
European call option on a barrel of crude oil with a strike price of $50 and a maturity
of one-month, trades for $5. What is the price of the put premium with identical
strike price and time until expiration, if the one-month risk-free rate is 2% and the
spot price of the underlying asset is $52?
Here we can see the calculation that would be used to find the put premium:
C + K(1+r)-T = P + S
C- P =S –K(1+r)-T
Where : C= 5 K=50 r=2% T=1 P= ? S=52
5-P=52-50(1+0.02)-0.08
5-P= 52-48.9984
P=5 -3
P=2
Unit – V: Swaps – Meaning – Overview – The Structure of Swaps –

Interest Rate Swaps – Currency Swaps – Commodity Swaps – Swap
Variant – Swap Dealer Role – Equity Swaps – Economic Functions of Swap
Transactions – FRAs and Swaps.
Q1: Explain about swap? And explain types of swaps?
Q2: explain equity swap? *******
Q3: explain Interest rate swaps?
Q4: explain currency swaps?
Q5: explain about swap Dealer role?***
Swaps Contract

A swap can be defined as a barter or exchange. It is a contract whereby parties
agree to exchangeobligations that each of them have under their respective
underlying contracts or we can say, a swap isan agreement between two or more
parties to exchange stream of cash flows over a period of time inthe future. The
parties that agree to the swap are known as counter parties.
 In finance, a swap is a derivative contract in which one party exchanges or
swaps the values or cash flows of one asset for another.
 Of the two cash flows, one value is fixed and one is variable and based on an
index price, interest rate or currency exchange rate.
 Swaps are customized contracts traded in the over-the-counter (OTC) market
privately, versus options and futures traded on a public exchange.
 The plain vanilla interest rate and currency swaps are the two most common
and basic types of swaps.
Feature of swaps:
I. Counter parties: all swaps involve the exchange of a series of periodical
payments between at least two parties.
II. Facilitators: swap agreements are arranged mostly through an
intermediary which is usually a large international finical institution or
banks having network of its operation in major countries.
III. Cash flows: in the swap deal two different payment streams in terms of
cash flows are estimated to have identical present values at the outset
when discounted at the respective cost of funds in the relevant primary
markets.
IV. Documentations: swap transactions may be set up with great speed
since their documentations and formalities are generally much less in
comparable to loan deals.
V. Transaction costs: it has been also observed that transaction costs are
relatively low in swap transactions in comparison to loan agreements.
VI. Benefit to parties: swap deals are needed as long as it is profitable to
transform them.

VII. Termination: since swap is an agreement between two parties. It
cannot be terminated at one’s instance. The termination will be accepted
counter parties.
VIII. Default risk: most of the swap deals are mutual agreement. The
problems of potential default by either of the counter party exist, hence
making them more risky products in comparison to future and options.
Swaps are not exchange-traded instruments. Instead, swaps are customized
contracts that are traded in the over-the-counter (OTC) market between private
parties.Because swaps occur on the OTC market, there is always the risk of
a counterparty defaulting on the swap.
Types of swaps:
The generic types of swaps, in order of their quantitative importance, are:

1. interest rate swaps,
2. currency swaps,
3. equity swaps. There are also many other types of swaps.
Interest rate swaps:
An interest rate swap is a type of a derivative contract through which two
counterparties agree to exchange one stream of future interest payments for
another, based on a specified principal amount. In most cases, interest rate swaps
include the exchange of a fixed interest rate for a floating rate.
Similar to other types of swaps, interest rate swaps are not traded on public
exchanges – only over-the-counter (OTC).
2. Currency Swap: Where cash flows in one currency are exchanged for cash flows
in another currency. A currency swap is contractually similar to an interest rate
swap.
3. An equity swap: contract is a derivative contract between two parties that

involves the exchange of one stream (leg) of equity-based cash flows linked to the
performance of a stock or an equity index with another stream (leg) of fixed-income
cash flows.
Uses of Swap:
1. To create either synthetic fixed or floating rate liabilities or assets,
2. To hedge against adverse movements,
3. As an asset liability management tool,
4. To reduce the funding cost by exploiting the comparative advantage that each
counterparty has in the fixed/floating rate markets, and for trading.
5. In the Indian market Banks are allowed to run a book on swaps which have an
Indian Rupee leg. Banks can offer swaps, which do not have an Indian Rupee leg, to
their customers but have to cover these with an overseas bank on a back-to-back
basis.

Q2: Explain the Interest rate swaps?
Interest rate swaps:
An interest rate swap is a type of a derivative contract through which two
counterparties agree to exchange one stream of future interest payments for
another, based on a specified principal amount. In most cases, interest rate swaps
include the exchange of a fixed interest rate for a floating rate.
Similar to other types of swaps, interest rate swaps are not traded on public
exchanges – only over-the-counter (OTC).
Example of such swaps in the Indian market are:

Overnight Index Swaps (OIS) – Fixed v/s NSE Overnight MIBOR Index
Feature of interest rate swaps:
1. Notionalprincipal: in the nearest rate swap agreement, the interest
amount whether fixed or floating is calculated on a specified amount
borrowed or lent. The notional amount not exchange the both parties.
2. Fixed rate: This is the rate which is used to calculate the size of the
fixed payment.
3. Floating rate: this rates may be defined as one of the market
indexes like LIBOR, SIBOR, MIBBOR.
4. Swap quotation: A Dealers can quote a swap into two different

ways. First way is the all in quote. Swaps rate is the interest rate paid
on the fixed interest rate leg of the swap also called swap price.
5. Trade date, effective date, rest date and payment date: all the
above stated dates are important term in the swap deal .

Types of Interest Rate Swaps:
1. A Plain Vanilla Swap:
This is the simplest form of Interest rate swaps where a fixed rate is exchanged for
a floating rate or vice versa on a given notional principal at pre-agreed intervals

during the life of the contract.
2. A Basis Swap:
In a floating to floating swap, it is possible to exchange the floating rates based on
different benchmark rates. For example, we may agree to exchange 3m Mibor for 91
days T Bills rate. Such a swap is called a Basis Swap.
3. An Amortising swap:
As the name suggests, swaps that provide for reduction in notional principal amount
corresponding to the amortisation of a loan, are called amortising swaps.
4. Step-up Swap:
This is the opposite of an amortising swap. In this variety the notional principal
increases as per a pre- agreed schedule.
5. Extendable Swap:
When one of the counter parties has the right to extend the maturity of the swap
beyond its original life, the swap is said to be an extendable swap.
6. Delayed Start Swaps/Deferred Swaps/ Forward Swaps:
When it is agreed between the counter parties that the swap will come into effect on
a future date, it is termed as a delayed start swap or deferred swap or a forward

swap.
7. Differential Swaps:
Interest rate swaps which are structured in such a way that one leg of the swap
provides for payment of interest at a rate pertaining to a currency other than the
currency of the underlying principal amount. The other leg provides for payment of
interest at the rate and currency of the underlying principal.
Features of RBI Guidelines on IRS (Interest Rate Swaps):
1. Scheduled commercial banks (excluding Regional Rural Banks), Primary
Dealers and all India Financial Institutions are free to undertake IRS as a product for
their own balance sheet management for market making.
2. They may also offer these products to corporates for hedging their own balance
sheet exposures.
3. Participants should ensure adequate infrastructure and risk management

systems before venturing into market making activities.
4. The Bench Mark rate should necessarily evolve on its own in the market and
require market acceptance.
5. The parties are free to use any domestic money or debt market rate as
benchmark rate provided the methodology of computing the rate is objective,

transparent and mutually acceptable.
6. There is no restriction on the minimum or maximum size of notional principal
amounts. Size norms are to emerge in the market with the development of the
market.
7. There is no restriction on the tenor as well.
8. Banks, Financial Institutions and Primary Dealers are required to maintain

capital for FRAs and IRS.

9. Transactions for hedging and market making purposes should be recorded
separately. Positions on account of market making activities should be marked to
market at least at fortnightly intervals. Transactions entered into for hedging

purposes should be accounted for on accrual basis.
10. Participants could consider using ISDA standard documentation with suitable
modifications for transactions in FRAs and IRS.
11. Participants are required to report their operations in FRAs and IRS on a
fortnightly basis to Monetary Policy Department of RBI.
12. Capital adequacy for banks and financial institutions for undertaking FRAs and
IRS transactions shall be calculated.
Q3: Explain Currency Swap:
Where cash flows in one currency are exchanged for cash flows in another currency.
A currency swap is contractually similar to an interest rate swap.
The main difference between Interest rate swap and Currency swap
i. Each interest rate is in a different currency,
ii. The notional amount is now replaced by two principal amounts – one in each
currency, and
iii. These principal amounts are typically exchanged at the start of the swap and
then re-exchanged at maturity.
iv. The major difference between a generic interest rate swap (IRS) and a generic
currency swap is that the latter includes not only the exchange of interest rate
payments but also the exchange of principal amounts both initially and on
termination. Since the payments made by both parties are in different currencies,
the payments need not be acquired.
The different kinds of currency swaps are as follows:

i. Principal + Interest Swap – Covers both Principal and Coupon flows,

ii. Principal Only Swap (POS) – Covers only Principal amount, and
iii. Coupon (Interest) Only Swap – Covers only Coupon flows.
Feature of currency swaps:
1. Notional principal: in the nearest rate swap agreement, the interest
amount whether fixed or floating is calculated on a specified amount
borrowed or lent. The notional amount not exchange the both parties.
2. Fixed rate: This is the rate which is used to calculate the size of the
fixed payment.
3. Floating rate: this rates may be defined as one of the market
indexes like LIBOR, SIBOR, MIBBOR.
4. Swap quotation: A Dealers can quote a swap into two different
ways. First way is the all in quote. Swaps rate is the interest rate paid
on the fixed interest rate leg of the swap also called swap price.
5. Trade date, effective date, rest date and payment date: all the
above stated dates are important term in the swap deal .
Basis Swaps:
Where cash flows on both the legs of the swap are referenced to different floating
rates A Basis swap could be an Interest Rate Swap or a currency swap where both
legs are based on a floating rate.
A basis swap involves a regular exchange of cash flows, both of which are based on
floating interest rates. Most swaps are based on payment of a fixed rate against a

floating rate, say, LIBOR. In the basis swap both legs are calculated on floating
rates.
For example:
1. 6 months USD LIBOR against 3 months USD LIBOR.
2. 6 month JPY LIBOR against 6 month USD LIBOR.
3. 6 month MIFOR against 6 Month USD LIBOR.
A Basis Swap is most commonly used when:

1. Liabilities are tied to one floating rate index and,
2. Financial assets are tied to another floating index, and
3. This mismatch can be hedged via a basis swap.
Q3: Explain an equity swap:
An equity swap contract is a derivative contract between two parties that
involves the exchange of one stream (leg) of equity-based cash flows linked to the
performance of a stock or an equity index with another stream (leg) of fixed-income

cash flows.
The standardization of an equity swaps:
1. In equity swap contracts, the cash flows are based on a predetermined

notional amount. However, unlike currency swaps, equity swaps do not
imply the exchange of principal amounts. The exchange of cash flows
occurs on fixed dates.
2. Equity swap contracts offer a great degree of flexibility;
3. They can be customized to suit the needs of the parties participating in
the swap contract. Essentially, equity swaps provide synthetic exposure to
equities.
Advantages of Equity Swap Contracts

Equity swap contracts provide numerous benefits to the counterparties
involved, including:
1. Avoid transaction costs : One of the most common applications of equity

swap contracts is for the avoidance of transaction costs associated with equity
trades. Also, in many jurisdictions, equity swaps provide tax benefits to the
participating parties.
2. Hedge against negative returns: Equity swap contracts can be used in

hedging risk exposures. The derivatives are frequently used to hedge against
negative returns on a stock without forgoing the possession rights on it.
3. Access more securities: Equity swap contracts may allow investing in securities
that otherwise would be unavailable to an investor. By replicating the returns from a
stock through an equity swap, the investor can overcome certain legal restrictions
without breaking the law.
Uses of equity swaps:
Similar to other types of swap contracts, equity swaps are primarily used by
financial institutions, including investment banks, hedge funds, and lending
institutions or large corporations.
Following are advantages of equity swaps:
 Equity Index – Equity swaps can be used to gain exposure to stock or

an equity index without actually owning the stock forex. If an investor who
has an investment in bonds can enter into an equity swap to take temporary
advantage of market movement without liquidating his bond portfolio and
investing the bond proceeds in the equities or index fund.
 Avoiding Transaction Costs – An investor can avoid transaction costs of
equities’ trade by entering into an equity swap and gaining exposure to stocks
or equity index.

 Hedging Instrument – They can be used to hedge equity risk exposures.
They can be used to forgo short-term negative returns of stocks without
forging possession of the stocks. During the period of negative stock return,
an investor can forgo the negative returns and also earn a positive return
from the other leg of the swap (LIBOR, fixed rate of return or some other
reference rate).
 Access to a Wider Range of Securities – Equity swaps can allow investors
exposure to a wider range of securities than that is generally unavailable to
an investor
Disadvantages of Equity Swaps:
Following are disadvantages of equity swaps:
I. Like most of the other OTC derivatives instruments, equity swaps are largely
unregulated.
II. Equity swaps, like any other derivatives contract, have termination/expiration
dates. Thus, they don’t provide open-ended exposure to equities.
III. Equity swaps are also exposed to credit risk which doesn’t exist if an investor
invests directly into stocks or equity index. There is always a risk that the
counterparty may default on its payment obligation.
Example: (Application of equity swaps) -
Consider two parties – Party A and Party B. The two parties enter into an
equity swap. Party A agrees to pay Party B (LIBOR + 1%) on USD 1
million notional principal and in exchange Party B will pay Party A returns
on S&P index on USD 1 million notional principal. the cash flows will be
exchanged every 180 days.

Solutions:
 Assume a LIBOR rate of 5% per annum in the above example and

appreciation of S&P index by 10% at the end of 180 days from the
commencement of the swap contract.
 At the end of 180 days, Party A will pay USD 1,000,000 * (0.05 + 0.01) * 180
/ 360 = USD 30,000 to Party B. Party B would pay Party A return of 10% on
the S&P index i.e. 10% * USD 1,000,000 = USD 100,000.
 The two payments will be netted off and in net Party B would pay USD
100,000 – USD 30,000 = USD 70,000 to Party A. It should be noted that the
notional principal is not exchanged in the above example and is only used to
calculate cash flows at the exchange dates.
 Stock returns experience negative returns very frequently and in case of
negative equity returns, the equity return payer receives the negative equity
return instead of paying the return to its counter-party.
In the above example, if the returns of stocks were negative say -2% for the
reference period, then Party B would receive USD 30,000 from Party A (LIBOR + 1%
on notional) and in addition would receive 2% * USD 1,000,000 = USD 20,000 for
the negative equity returns. This would make a total payment of USD 50,000 from
Party A to Party B after 180 days from the start of an equity swap contract.
What is a Swap Dealer?
A swap dealer is an individual or entity that deals in swaps, makes markets in

swaps or enters into swaps with counterparties. Swap dealer, as a term, was

formally defined in the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010, a piece of legislation born in the aftermath of the 2008-
2009 financial crisis.
 Defines a “swap dealer” as any person that: –

a. Holds itself out as a dealer in swaps;
b. Makes a market in swaps;
c. Regularly enters into swaps with counterparties in the ordinary course of
its business for its own account;
d. Engages in any activity causing the person to be commonly known in the
trade as a dealer or market maker in swaps.
Exclusions from Swap Dealer Activity:
Inter-Affiliate Transactions: Transactions between common majority-owned

affiliates do not give rise to swap dealer status.
Loan Origination: To be excluded, swaps in connection with loan origination must

be effected within 90 to 180 days before or after loan origination
Floor Traders: The CFTC (but not the SEC) provided an exception from swap
dealer status for a registered floor trader that limits its swap dealing to cleared
exchange/SEF-traded transactions,
Problems of Interest rate swaps:
Firm A needs fixed-rate funds which are available to it at the rate of

10.50% to be computed ½ yearly but it has cases to cheaper floating rat
fund available to it at LIBOR+0.3%. FIRMA B needs floating rate funds
available to it at 6 months LIBOR flat, but has access to cheaper fixed rate
funds available to it at the rate of 9.50 %.
Solution :
Basic information:
1. Firm A needs fixed-rate funds which are available to it at the rate of 10.50%.
2. It to be computed ½ yearly(6months).
3. FIRM A has cases to cheaper floating rat fund available to it at LIBOR+0.3%.
4. FIRMA B needs floating rate funds a available to it at 6 months LIBOR flat
5. FIRMA B access to cheaper fixed rate funds available to it at the rate of
9.50%.
Step 1 : sport transaction :
1. Firm A has access to floating rate loan market

2. It will borrow from floating rate loan market
3. Firm B has access to fixed rate loan market
4. It will borrow from fixed rate loan market.
Fixed rate loan market

Firm A
Floating rate loan market
Firm B
STEP 2: Both Firm have Interest rate swap and approach a swap dealer.
1. A &B have borrowed according to their needs.

2. They approach a swap dealer.
3. A needs fixed rate loan and B nee ds floating rate loan.
4. A have pay to the lender LIBOR+0.3% AND B have pay to the lender 9.50%
5. For Example: it is, say 9.75% in exchange, the swap dealer pay firm A the
interest at 6 month LIBOR. Firm A pays LIBOR+0.3% to the lender on its
floating rate borrowing.
6. For Example: it is, say 9.65% here firm B gets interest from the swap dealer at
9.65 % and pay interest to the fixed rate lend at 9.50%.

9.75% 9.65%
SWAP DEALER
Firm A Firm B
LIBOR LIBOR
Floating rate loan Market Fixed rate loan Market

LIBOR+0.3% 9.50%
Step 3: at the maturity the two firms repay the loan

Cost of borrowing:
Firm A:
Cost of Floating rate loan : LIBOR + 0.3%
Less(-): Floating interest rate received : LIBOR
------------------------------
NET cost differential : 0.3%
Converting the cost differential from
money-market yield to bond – equivalent
yield( for One Year) : 0.3% x 365/360 = 0.304%
ADD : swap Coupon(it says) : 9.75%
Total cost of borrowing : 10.054% (0.304%+9.75%)
Firm B:
Cost of FIXED rate loan : 9.50%
LESS: Fixed rate received : 9.65%
------------------------------
NET cost differential : -0.15%
Converting the cost differential from
money-market yield to bond – equivalent
yield : -0.15% x 365/360 = -0.148%
Total cost of borrowing : LIBOR -0.148%
GAIN TO SWAP DEALER:

Interest rate received : 9.75%
Interest rate paid : 9.65%
Net Gain : 0.10%
**End **
Problem of currency swap:

Firm A can borrow euro at a fixed rate of 8% or it can borrow US dollar at
a floating rate of one-year LIBOR. Firm B can borrow at a fixed rate of
9.2% and can borrow US dollar at one-year LIBOR. If Firm B needs fixed-
rate Euro, it will approach the swap dealer provided Firm A needs floating
rate US dollar.
Solution:
Basic information:
1. Firm A can borrow Euro at a fixed rate of 8%.
2. Firm A can Borrow US dollar at a floating rate of One-Year LIBOR.
3. Firm B can borrow at a fixed rate of 9.2%
4. Firm B can borrow US dollar at One-year LIBOR.
5. Firm B Want Fixed Rate Euro.
6. Firm A Want Floating rate US dollar.
7. The swap agreement deal by Swap Dealer.
step 1:-
1. Firm A can borrow Euro at a fixed rate of 8%.

2. Firm B can borrow US dollar at One-year LIBOR
Step 2:
The exchange the borrowed currencies with the help of the swap dealer. After
exchange
1. Firm A will possess US Dollar.
2. Firm B Will Possess Euro.
EURO
FIRM A FIRM B
US DOLLAR
Enter with Swap Dealer :
EURO EURO
FIRM A Swap FIRM
Dealer B
US DOLLAR US DOLLAR
Step 3: how to interest flow:

1. Firm A will pay LIBOR on US dollar through the Swap Dealer and swap dealer
will pay Firm B
2. Firm B will pay Fixed rate of inters on Euro through the Swap Dealer and
swap dealer will pay Firm A
3. Firm B: Pay the Fixed Rate Between 8% and 9.20% (through Swap dealer)
4. Firm A: Pay the One year LIBOR (through Swap dealer)
Suppose it will be say: The fixed interest rate current market 8.60% and
swap dealer own commission Firm A pay in this case only say 8.40%.
{ }
Euro 8.40% Euro 8.60%

142 Swap FIRM Asst. Professor
Prepared By : K NAGA BHUSHANARAO
FIRM A
Dealer B
US Dollar US Dollar
LIBOR LIBOR
Benefits from the currency swaps:

Cost to firm A:
Cost of Us Dollar debt in absence of Swap : LIBOR
Cost of US dollar debt after swap:
Interest paid – Interest Received : 8.00%+LIBOR -8.40%
---------------------------------
The cost of Firm A used LIBOR -0.40%
Cost to Firm B:
Cost of euro debt without swap : 9.20%
Cost of Euro debt after swap
Interest paid – Interest Received : 8.60+ LIBOR- LIBOR
-------------------------------------
The cost of Firm B used : 0.60%
Firm A Befit is LIBOR -0.40% and Firm B befit is 0.60% in swap agreement.
************ ALL THE BEST YOUR FUTURE *************

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PALIVELA PG COLLEGE (MBA) I-CET- CODE: SSSK

FM 402: FINANCIAL DERIVATIVES

75 Prepared By : K NAGA BHUSHANARAO Asst. Professor

Unit – I: Introduction to Financial Derivatives – Meaning and Need – Growth of

1Q. Define the Financial Derivatives?

1Q: What Is a Derivative?

Definition of Financial Derivatives Section 2(ac) of Securities Contract Regulation Act

5QA:Underlying Asset in a Derivatives

As defined above, the value of a derivative

i. Commodities including grain, coffee beans, orange juice;

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iii. Foreign exchange rates or currencies;

5QA: Participants in Derivatives Market :

3. Arbitrageurs: Their behavior is guided by the desire to take advantage of a

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A forward contract is an agreement between two parties to buy or sell an

1. Stock Future or equity futures,

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4QA: THE REGULATORY FRAMEWORK OF DERIVATIVES TRADING IN

The definition of ''securities'' under SC(R)A (to include derivative contracts in

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Some of the important

i) Derivative trading to take

iv) The Derivatives Exchange/Segment should have arbitration and investor

/ regions of the country.

v) The Derivatives Exchange/Segment should have satisfactory system of

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5QA: Growth of Financial Derivatives in India:

Milestones in the development of Indian derivative market

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6QA: Derivative Markets - Functions:

2. Efficiency in trading: Financial derivatives allow for free trading of risk

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lower transaction costs associated with trading a financial derivative as compared to

Unit – II : Features of Futures – Differences Between Forwards and

1Q: Discuss the future market trading mechanism in India?***

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Definition: Futures is a standardized forward contact to buy (long) or sell

Specification Future Contract:

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Differences between Forwards and Futures:

Forward Contract Futures Contract

Definition A forward contract is an agreement A futures contract is a standardized

Structure & Customized to customer needs. Standardized. Initial margin payment

Market Not regulated Government regulated market (the

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Forward Contract Futures Contract

Institutional The contracting parties Clearing House

Risk High counterparty risk Low counterparty risk

Expiry date Depending on the transaction Standardized

Method of Opposite contract with same or Opposite contract on the exchange.

Contract Depending on the transaction and Standardized

Market Primary & Secondary Primary

Financial Futures – Trading – Currency Future – Interest Rate Futures:

A financial future contract is an agreement between two parties to buy or sell

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3. Interest Rate Futures

1. Stock Index Futures

1,600 + 1,6000.0730/365 = Rs 1,600 + Rs 11.51 = 1,611.51

END OF 2ND UNIT