ACKNOWLEDGEMENT

This project would never have been complete if it had not been for the
support by a magnitude of very exemplary people, each even more
outstanding in their own area of specialization.

First of all, my sincere thanks to my project guide Prof. Mr. S.

Krishnan for his support and encouragement during the entire course of
work.

I would also like to thank our principal Mrs. Shakuntala Singh and our
coordinator Prof. Mr. D. Murdeshwar for their support during the entire
project work. Also I would like to thank my family and friends for their
suggestions and contributions to the fulfillment of the project.

DECLARATION
1
 I Bhushan Orpe student of N.G. Bedekar College of Commerce
studying in T.Y. B.com Banking and Insurance (semester V) hereby
declare that I have completed this project on “FINANCIAL
DERIVATIVES” for the academic year 2009-2010.

The information in this project is true and original to my best

knowledge.

(Bhushan Orpe)

Signature

TABLE OF CONTENT

2
SR. NO. TOPIC PAGE NO.
 DESIGN OF STUDY 1-2
1. INTRODUCTION TO DERIVATIVES 3-21
2. FORWARDS 22-33
3. FUTURES 34-50

4. OPTIONS 51-72
5. SWAPS 73-84
6. DERIVATIVES AND RISK MANAGEMENT 85-90
7. FINDING, SUGGESTIONS,CONCLUSION 91-93

 BIBLIOGRAPHY 94
 ANNEXURE 95

LIST OF FIGURES AND TABLE

3
SR. NO. NAME PAGE
NO.
Table no. Specification of major US grain futures 39
3.1 contract
Table Cash flows in fully hedged 64
no.4.1 position flows at T
Figure 4.1 Interest rate cap 56
Figure 4.2 Interest rate floor 57
Figure 4.3 Interest rate collar 58

4
DESIGN OF STUDY
Objective of Study:

 To study the meaning of derivatives.

 To understand how derivative instruments are valued.
 To study the various pricing models such as Cost-of-carry model,
Binomial model, Black-Scholes model
Scope of Study:

 Chapter 1 contains introduction of derivatives, basic of financial

derivatives, definition, participants in the derivatives market,
history, and development of derivatives in India.
 Chapter 2 has the derivatives instrument “Forward”. It has
definition of forwards, types of forwards, valuation and pricing of
various forwards.
 Chapter 3 contains information about “Futures” like its structure,
type, mechanics, valuation, cost-of-carry model.
 Chapter 4 is about “Option” like call and put options, caps, floors
and collars, The Binomial model, Black-Scholes model.
 Chapter 5 has information on “Swaps” like its definition, types,
valuation, forward swaps and swaptions.
 Chapter 6 is about derivatives and risk management and topics
such as risk identification and qualification, decision to accept or
manage risk, strategy development and implementation.
 Chapter 7, the last chapter has findings, suggestion and conclusion.

5
Limitations of Study:

 The derivative in a nut shell is a very wide topic and could not be
covered completely.
 Various formulae’s for valuation difficult to understand.
 Derivative instruments are complex so very difficult to understand
by common man.
Research Methodology:

 The primary data has been collected by asking question to the

active trader of derivative market.
 The collection of secondary data is done mainly by the use of
various books on derivatives, the list of which has been given in
the bibliography.

6
 CHAPTER 1

INTRODUCTION OF DERIVATIVES

1.1 Introduction

1.2 Basis Of Financial Derivatives

1.3 Definition Of Derivatives

1.4 History Of Derivatives

1.5 Participants In Derivatives Market

1.6 Derivatives In India

1.7 Development Of Derivatives In India

1.8 Factors Contributing To Growth Of Derivatives

7
1.1 INTRODUCTION
Derivatives are one of the most complex instruments. The word
derivative comes from the word ‘to derive’. It indicates that it has no
independent value. A derivative is a contract whose value is derived from
the value of another asset, known as the underlying asset, which could be
a share, a stock market index, an interest rate, a commodity, or a
currency. The underlying is the identification tag for a derivative contract.
When the price of the underlying changes, the value of the derivative also
changes. Without an underlying asset, derivatives do not have any
meaning. For example, the value of a gold futures contract derives from
the value of the underlying asset i.e., gold. The prices in the derivatives
market are driven by the spot or cash market price of the underlying asset,
which is gold in this example.

Derivatives are very similar to insurance. Insurance protects against

specific risks, such as fire, floods, theft and so on. Derivatives on the
other hand, take care of market risks - volatility in interest rates, currency
rates, commodity prices, and share prices. Derivatives offer a sound
mechanism for insuring against various kinds of risks arising in the world
of finance. They offer a range of mechanisms to improve redistribution of
risk, which can be extended to every product existing, from coffee to
cotton and live cattle to debt instruments.

In this era of globalization, the world is a riskier place and exposure to

risk is growing. Risk cannot be avoided or ignored. Man, however is risk
averse. The risk adverse characteristic of human beings has brought about
growth in derivatives. Derivatives help the risk adverse individuals by
offering a mechanism for hedging risks.

Derivative products, several centuries ago, emerged as hedging

devices against fluctuations in commodity prices. Commodity futures and

8
options have had a lively existence for several centuries. Financial
derivatives came into the limelight in the post-1970 period; today they
account for 75 percent of the financial market activity in Europe, North
America, and East Asia. The basic difference between commodity and
financial derivatives lies in the nature of the underlying instrument. In
commodity derivatives, the underlying asset is a commodity; it may be
wheat, cotton, pepper, turmeric, corn, orange, oats, Soya beans, rice,
crude oil, natural gas, gold, silver, and so on. In financial derivatives, the
underlying includes treasuries, bonds, stocks, and stock index, foreign
exchange, and Euro dollar deposits. The market for financial derivatives
has grown tremendously both in terms of variety of instruments and
turnover.

Presently, most major institutional borrowers and investors use

derivatives. Similarly, many act as intermediaries dealing in derivative
transactions. Derivatives are responsible for not only increasing the range
of financial products available but also fostering more precise ways of
understanding, quantifying and managing financial risk.

Derivatives contracts are used to counter the price risks involved in

assets and liabilities. Derivatives do not eliminate risks. They divert risks
from investors who are risk averse to those who are risk neutral. The use
of derivatives instruments is the part of the growing trend among
financial intermediaries like banks to substitute off-balance sheet activity
for traditional lines of business. The exposures to derivatives by banks
have implications not only from the point of capital adequacy, but also
from the point of view of establishing trading norms, business rules and
settlement process. Trading in derivatives differ from that in equities as
most of the derivatives are market to the market.

9
1.2 BASIC OF FINANCIAL DERIVATIVES

Financial derivative assets are assets whose values are determined by

the value of some other assets, called the underlying. There are two
common types of derivative contracts, those patterned on forwards and on
options. Derivatives based on forward have linear payoffs, meaning their
pay offs move one for one with the changes in the underlying price. Such
contracts are generally relatively easy to understand, value and mange.
Derivatives based on options have non linear payoffs, meaning their
payoffs may move proportionally more or less than the underlying price.
Such contracts can be quite difficult to understand, value, and manage.

Options are traded both on organized exchanges and over-the-counter.

The two modes of trading are quite different and lead to important
differences in market conventions. The over-the-counter currency and
interest rate option markets have become much more liquid in recent
years. Many option market participants prefer the over-the-counter
markets because of the ease with which option contracts tailored to a
particular need can be acquired. The exchanges attract market
participants who prefer or required to minimize the credit risk of
derivatives transactions, or who required to transact in markets with
publicly posted process. There are many types of options. A European
option can be exercised only at expiration. An American option can be
exercised at any time between initiation of the contract and expiration. In
a market, the basic options are call and put. A call option is a contract
giving the owner the right, but not the obligation, to purchase, at
expiration, an amount of an asset at a specified price called the strike or
exercise price. A put option is a contract giving the owner the right, but
to the obligation, to sell, at expiration, an amount of an asset at the
exercise price. The amount of the underlying asset is called the notional

10
principal or underlying amount. The price of the option contract is called
the option premium.

The issuer of the option contract is called the writer and is said to have
the short position. The owner the option is said to be long. There are
thus several ways to be long assets: long the spot assets; long a forward
on the asset; long a call on the asset; and, short a put on the asset.

In a forward contract, one party agrees to deliver a specified date in

the future at a specified price. The commodity may be a commodity in
the narrow sense, e.g. fold or wheat, or a financial asset e.g. shares or
foreign exchange. The price of the underlying asset for immediate
delivery is called the cash or spot price.

The party obliged to deliver the commodity is said to have a short

portion and the party obliged to take delivery of the commodity and pay
the forward price for it is said to have a long position. A party with no
obligation offsetting the forward contract is said to have an open position.
A party with an open position is something called a speculator. A party
with an obligation offsetting the forward contract is said to have a
covered portion. A party with a closed position is sometimes called a
hedger.

Derivatives assets, e.g. forwards, can often be constructed from

combinations of underlying assets. Such constructed assets are called
synthetic assets.

Covered parity or cost-of-carry relations are between the prices o

forward and underlying assets. These relations are enforced by arbitrage
and tell us how to determine arbitrage based forward asset prices. One
condition for markets to be termed efficient is absence of arbitrage.

11
 Futures are similar to forwards in except two important and related
respects firs, futures trade on organized commodity exchanges.
Forwards, in contrast, trade over-the-counter, that is, as simple bilateral
transactions, conducted as a rule by telephone, without posted prices.
Second, a forward contract involves only one cash flow, at the maturity of
the contract, while futures contracts generally require interim cash flows
prior to maturity.

The most important consequence of the restriction of the futures

contracts to organized exchanges is the radical reduction of credit risk by
introducing a clearinghouse as the counter party to each contract. The
clearing house composed of exchange members. Becomes the counter
party to each contract and provides a guarantee of performance in
practice, default on exchange traded futures and option is exceedingly
rare. Over-the-counter contracts are between two individual
counterparties and have as much or as little credit risk as those counter
parties.

Clearing houses bring other advantages as well, such as consolidating

payment and delivery obligations of participants with positions in many
different contracts. In order to preserve the advantages, exchanges offer
only a limited number of contract types and maturities. For example,
contracts expire on fixed dates that may or may not coincide precisely
with the needs of participants. While there is much standardization in
over-the-counter markets. It is possible in the principle to enter into
obligations with any maturity date. It is always possible to unwind a
futures position via an offsetting transaction, while over-the-counter
contracts can be offset at a reasonable price only if there is a liquid
market in the offsetting transaction. Settlement of future contracts may
be by net cash amounts or by delivery of the underlying.

12
 In order to guarantee performance while limiting risk to exchange
members, the clearing house requires performance bond from each
counterparty. At the initiation of a contract, both counterparties put up
initial or original margin to cover potential default losses. Both parties
put up margin because at the time a contract is initiated, it is not known
whether the terminal spot price will favour the long or the short. Each
day, at that day’s closing price, on counterparty will have gained and the
other will have lost a precisely offsetting amount. The loser for the day is
obliged to increase his margin account and the gainer is permitted to
reduce his margin account by an amount, called variation margin,
determined by the change on the basis of the change in the futures price.
Both counterparties earn a short term rate of interest on their margin
accounts.

Swap-a plain vanilla interest rate swap is an agreement between two

counterparties to exchange a stream of fixed interest rate payments of a
stream of floating interest rate payments, both streams are denominated in
the same currency and are based on a notional principal amount. The
notional principal is to exchange. The design of a swap has three features
that determine its price: the maturity of the swap, the maturity of the
floating rate, and the frequency of payments.

At initiation, the price of a plain vanilla swap is set so is current value-

the net value of the two interest payments streams, fixed and floating is
zero. The swap can be seen as a portfolio which, from the point of view
of the payer of fixed interest is long a fixed rate bond, both in the amount
of the notional principal. The payer of floating rate interest is long the
floater and shorts the fixed rate bond.

13
 The price of a swap is usually quoted as swap rate that is as the yield
to maturity on a notional par bond, what determines this rate? A floating
rate bond always trades at par at time it is issued, the fixed rate bond,
which represents the payers commitment in the swap must then also trade
at par if the swap is to have an initial value of zero. In other words, the
swap rate is the market adjusted yield to maturity on a par bond.

Swap rates are also often quoted as a spread over the government bond
with a maturity closest to that of the swap. This spread, called the swap
treasury spread, is almost invariably positive, but varies widely in
response to factors such as liquidity and risk appetites in the fixed income
markets.

A forward swap is an agreement between two counter parties to

commence a swap at some future settlement date. As in the case of a
cash swap, the forward swap rate is the market adjusted par rate on a
coupon bond issued at the settlement date. The rate on a forward swap
can be calculated from forward rates or spot rates.

Many of the derivatives instruments do not, in fact, involve the

delivery of a financial instrument in the future. They are contracts for
differences. If it were not for the purposes of avoiding the gambling laws
of various countries, such financial instruments would be more honestly
called bets. Interest rate futures contracts are no less than bets on the
future course of a particular interest rating. The price written into the
contract is compared with the interest rate outcome at the agreed date or
dates in the future and cash is exchanged based on the difference.

14
1.3 DEFINITION OF DERIVATIVES

Derivative is a product whose value is derived from the value of one

or more basic variables, called bases (underlying asset, index, or
reference rate), in a contractual manner. The underlying asset can be
equity, Forex, commodity or any other asset.

According to Securities Contracts (Regulation) Act, 1956 {SC(R) A}, a

derivative is:

“A security derived from a debt instrument, share, loan, whether secured

or unsecured, risk instrument or contract for differences or any other form
of security.”

“A contract which derives its value from the prices, or index of prices, of
underlying securities.”

Derivatives are securities under the Securities Contract (Regulation) Act

and hence the trading of derivatives is governed by the regulatory
framework under the Securities Contract (Regulation) Act.

1.4 HISTORY OF DERIVATIVES

The history of derivatives is quite colorful and surprisingly a lot longer
than most people think. Forward delivery contracts, stating what is to be
delivered for a fixed price at a specified place on a specified date, existed
in ancient Greece and Rome. Roman emperors entered forward contracts
to provide the masses with their supply of Egyptian grain. These contracts
were also undertaken between farmers and merchants to eliminate risk
arising out of uncertain future prices of grains. Thus, forward contracts
have existed for centuries for hedging price risk.

15
 The first organized commodity exchange came into existence in the
early 1700’s in Japan. The first formal commodities exchange, the
Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal
with the problem of ‘credit risk’ and to provide centralized location to
negotiate forward contracts. From ‘forward’ trading in commodities
emerged the commodity ‘futures’. The first type of futures contract was
called ‘to arrive at’. Trading in futures began on the CBOT in the 1860’s.
In 1865, CBOT listed the first ‘exchange traded’ derivatives contract,
known as the futures contracts. Futures trading grew out of the need for
hedging the price risk involved in many commercial operations. The
Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed
in 1919, though it did exist before in 1874 under the names of ‘Chicago
Produce Exchange’ (CPE) and ‘Chicago Egg and Butter Board’ (CEBB).
The first financial futures to emerge were the currency in 1972 in the US.
The first foreign currency futures were traded on May 16, 1972, on
International Monetary Market (IMM), a division of CME. The currency
futures traded on the IMM are the British Pound, the Canadian Dollar, the
Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar,
and the Euro dollar. Currency futures were followed soon by interest rate
futures. Interest rate futures contracts were traded for the first time on the
CBOT on October 20, 1975. Stock index futures and options emerged in
1982. The first stock index futures contracts were traded on Kansas City
Board of Trade on February 24, 1982.

The first of the several networks, which offered a trading link between
two exchanges, was formed between the Singapore International
Monetary Exchange (SIMEX) and the CME on September 7, 1984.

Options are as old as futures. Their history also dates back to ancient
Greece and Rome. Options are very popular with speculators in the tulip

16
craze of seventeenth century Holland. Tulips, the brightly colored
flowers, were a symbol of affluence; owing to a high demand, tulip bulb
prices shot up. Dutch growers and dealers traded in tulip bulb options.
There was so much speculation that people even mortgaged their homes
and businesses. These speculators were wiped out when the tulip craze
collapsed in 1637 as there was no mechanism to guarantee the
performance of the option terms.

The first call and put options were invented by an American financier,
Russell Sage, in 1872. These options were traded over the counter.
Agricultural commodities options were traded in the nineteenth century in
England and the US. Options on shares were available in the US on the
over the counter (OTC) market only until 1973 without much knowledge
of valuation. A group of firms known as Put and Call brokers and Dealers
Association was set up in early 1900’s to provide a mechanism for
bringing buyers and sellers together.

On April 26, 1973, the Chicago Board options Exchange (CBOE) was
set up at CBOT for the purpose of trading stock options. It was in 1973
again that black, Merton, and Scholes invented the famous Black-Scholes
Option Formula. This model helped in assessing the fair price of an
option which led to an increased interest in trading of options. With the
options markets becoming increasingly popular, the American Stock
Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began
trading in options in 1975.

The market for futures and options grew at a rapid pace in the eighties
and nineties. The collapse of the Bretton Woods regime of fixed parties
and the introduction of floating rates for currencies in the international
financial markets paved the way for development of a number of

17
financial derivatives which served as effective risk management tools to
cope with market uncertainties.

The CBOT and the CME are two largest financial exchanges in the
world on which futures contracts are traded. The CBOT now offers 48
futures and option contracts (with the annual volume at more than 211
million in 2001).The CBOE is the largest exchange for trading stock
options. The CBOE trades options on the S&P 100 and the S&P 500
stock indices. The Philadelphia Stock Exchange is the premier exchange
for trading foreign options.

The most traded stock indices include S&P 500, the Dow Jones
Industrial Average, the NASDAQ 100, and the Nikkei 225. The US
indices and the Nikkei 225 trade almost round the clock. The N225 is also
traded on the Chicago Mercantile Exchange.

1.5 PARTICIPANTS IN DERIVATIVES MARKET

1. Trading Participants:

a. Hedgers:

The process of managing the risk or risk management is called as

hedging. Hedgers are those individuals or firms who manage their risk
with the help of derivative products. Hedging does not mean maximizing
of return. The main purpose for hedging is to reduce the volatility of a
portfolio by reducing the risk.

b. Speculators:

Speculators do not have any position on which they enter into futures
and options market i.e., they take the positions in the futures market
without having position in the underlying cash market. They only have a
particular view about future price of a commodity, shares, stock index,
interest rates or currency. They consider various factors like demand and
18
supply, market positions, open interests, economic fundamentals,
international events, etc. to make predictions. They take risk in turn from
high returns. Speculators are essential in all markets – commodities,
equity, interest rates and currency. They help in providing the market the
much desired volume and liquidity.

c. Arbitrageurs:

Arbitrage is the simultaneous purchase and sale of the same

underlying in two different markets in an attempt to make profit from
price discrepancies between the two markets. Arbitrage involves activity
on several different instruments or assets simultaneously to take
advantage of price distortions judged to be only temporary.

Arbitrage occupies a prominent position in the futures world. It is the

mechanism that keeps prices of futures contracts aligned properly with
prices of underlying assets. The objective is simply to make profits
without risk, but the complexity of arbitrage activity is such that it is
reserved to particularly well-informed and experienced professional
traders, equipped with powerful calculating and data processing tools.
Arbitrage may not be as easy and costless as presumed.

2. Intermediary Participants:

a. Brokers:

For any purchase and sale, brokers perform an important function of

bringing buyers and sellers together. As a member in any futures
exchanges, may be any commodity or finance, one need not be a
speculator, arbitrageur or hedger. By virtue of a member of a commodity
or financial futures exchange one get a right to transact with other
members of the same exchange.

19
 All persons hedging their transaction exposures or speculating on price
movement need not be and for that matter cannot be members of futures
or options exchange. A non-member has to deal in futures exchange
through member only. This provides a member the role of a broker. This
activity of a member is price risk free because he is not taking any
position in his account, but his other risk is clients default risk. He cannot
default in his obligation to the clearing house, even if client defaults. So,
this risk premium is also inbuilt in brokerage recharges.

More and more involvement of non-members in hedging and

speculation in futures and options market will increase brokerage
business for member and more volume in turn reduces the brokerage.
Thus more and more participation of traders other than members gives
liquidity and depth to the futures and options market.

1.6 DERIVATIVES IN INDIA

India has started the innovations in financial markets very late. Some
of the recent developments initiated by the regulatory authorities are very
important in this respect. Futures trading have been permitted in certain
commodity exchanges. Bombay Stock Exchange has started futures
trading in cottonseed and cotton under the BOOE and under the East
India Cotton Association. Necessary infrastructure has been created by
the National Stock Exchange (NSE) and the Bombay Stock Exchange
(BSE) for trading in stock index futures and the commencement of
operations in selected scripts. Liberalized exchange rate management
system has been introduced in the year 1992 for regulating the flow of
foreign exchange. A committee headed by S.S.Tarapore was constituted
to go into the merits of full convertibility on capital accounts. RBI has
initiated measures for freeing the interest rate structure. It has also
envisioned Mumbai Inter Bank Offer Rate (MIBOR) on the line of

20
London Inter Bank Offer Rate (LIBOR) as a step towards introducing
Futures trading in Interest Rates and Forex. Badla transactions have been
banned in all 23 stock exchanges from July 2001. NSE has started trading
in index options based on the NIFTY and certain Stocks.

1.7 DEVELOPMENT OF DERIVATIVES MARKETS IN

INDIA
The first step towards introduction of derivatives trading in India was
the promulgation of the Securities Laws (Amendment) Ordinance, 1995,
which withdrew the prohibition on options in securities. The market for
derivatives, however, did not take off, as there was no regulatory
framework to govern trading of derivatives. SEBI set up a 24–member
committee under the Chairmanship of Dr. L. C. Gupta on November 18,
1996 to develop appropriate regulatory framework for derivatives trading
in India. The committee submitted its report on March 17, 1998
prescribing necessary pre–conditions for introduction of derivatives
trading in India. The committee recommended that derivatives should be
declared as ‘securities’ so that regulatory framework applicable to trading
of ‘securities’ could also govern trading of securities. SEBI also set up a
group in June 1998 under the Chairmanship of Prof. J. R. Varma, to
recommend measures for risk containment in derivatives market in India.
The report, which was submitted in October 1998, worked out the
operational details of margining system, methodology for charging initial
margins, broker net worth, deposit requirement and real–time monitoring
requirements. The Securities Contract Regulation Act (SCRA) was
amended in December 1999 to include derivatives within the ambit of
‘securities’ and the regulatory framework were developed for governing
derivatives trading. The act also made it clear that derivatives shall be
legal and valid only if such contracts are traded on a recognized stock

21
exchange, thus precluding OTC derivatives. The government also
rescinded in March 2000, the three decade old notification, which
prohibited forward trading in securities.

Derivatives trading commenced in India in June 2000 after SEBI granted

the final approval to this effect in May 2001. SEBI permitted the
derivative segments of two stock exchanges, NSE and BSE, and their
clearing house/corporation to commence trading and settlement in
approved derivatives contracts. To begin with, SEBI approved trading in
index futures contracts based on S&P CNX Nifty and BSE–30 (Sense)
index. This was followed by approval for trading in options based on
these two indexes and options on individual securities.

The trading in BSE Sensex options commenced on June 4, 2001 and

the trading in options on individual securities commenced in July 2001.
Futures contracts on individual stocks were launched in November 2001.
The derivatives trading on NSE commenced with S&P CNX Nifty Index
futures on June 12, 2000. The trading in index options commenced on
June 4, 2001 and trading in options on individual securities commenced
on July 2, 2001. Single stock futures were launched on November 9,
2001. The index futures and options contract on NSE are based on S&P
CNX Trading and settlement in derivative contracts is done in accordance
with the rules, byelaws, and regulations of the respective exchanges and
their clearing house/corporation duly approved by SEBI and notified in
the official gazette. Foreign Institutional Investors (FII’s) are permitted to
trade in all Exchange traded derivative products.

22
1.8 FACTORS CONTRIBUTING TO GROWTH OF
DERIVATIVES
1. Price Volatility:

A price is what one pays to acquire or use something of value. The

objects having value maybe commodities, local currency or foreign
currencies. The concept of price is clear to almost everybody when we
discuss commodities. There is a price to be paid for the purchase of food
grain, oil, petrol, metal, etc. the price one pays for use of a unit of another
person’s money is called interest rate. And the price one pays in one’s
own currency for a unit of another currency is called as an exchange rate.

Prices are generally determined by market forces. In a market,

consumers have ‘demand’ and producers or suppliers have ‘supply’, and
the collective interaction of demand and supply in the market determines
the price. These factors are constantly interacting in the market causing
changes in the price over a short period of time. Such changes in the price
are known as ‘price volatility’. This has three factors: the speed of price
changes, the frequency of price changes and the magnitude of price
changes.

The changes in demand and supply influencing factors culminate in

market adjustments through price changes. These price changes expose
individuals, producing firms and governments to significant risks. The
breakdown of the BRETTON WOODS agreement brought an end to the
stabilizing role of fixed exchange rates and the gold convertibility of the
dollars. The globalization of the markets and rapid industrialization of
many underdeveloped countries brought a new scale and dimension to the
markets. Nations that were poor suddenly became a major source of
supply of goods. The Mexican crisis in the south east-Asian currency
crisis of 1990’s has also brought the price volatility factor on the surface.
23
The advent of telecommunication and data processing bought information
very quickly to the markets. Information which would have taken months
to impact the market earlier can now be obtained in matter of moments.
Even equity holders are exposed to price risk of corporate share fluctuates
rapidly.

This price volatility risk pushed the use of derivatives like futures and
options increasingly as these instruments can be used as hedge to protect
against adverse price changes in commodity, foreign exchange, equity
shares and bonds.

2. Globalization Of Markets:

Earlier, managers had to deal with domestic economic concerns; what

happened in other part of the world was mostly irrelevant. Now
globalization has increased the size of markets and as greatly enhanced
competition .it has benefited consumers who cannot obtain better quality
goods at a lower cost. It has also exposed the modern business to
significant risks and, in many cases, led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had

affected the competitiveness of our products vis-à-vis depreciated
currencies. Export of certain goods from India declined because of this
crisis. Steel industry in 1998 suffered its worst set back due to cheap
import of steel from south East Asian countries. Suddenly blue chip
companies had turned in to red. The fear of china devaluing its currency
created instability in Indian exports. Thus, it is evident that globalization
of industrial and financial activities necessitates use of derivatives to
guard against future losses. This factor alone has contributed to the
growth of derivatives to a significant extent.

24
 3. Technological Advances:

A significant growth of derivative instruments has been driven by

technological breakthrough. Advances in this area include the
development of high speed processors, network systems and enhanced
method of data entry. Closely related to advances in computer technology
are advances in telecommunications. Improvement in communications
allow for instantaneous worldwide conferencing, Data transmission by
satellite. At the same time there were significant advances in software
programs without which computer and telecommunication advances
would be meaningless. These facilitated the more rapid movement of
information and consequently its instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the

economy as a whole resources are rapidly relocated to more productive
use and better rationed overtime the greater price volatility exposes
producers and consumers to greater price risk. The effect of this risk can
easily destroy a business which is otherwise well managed. Derivatives
can help a firm manage the price risk inherent in a market economy. To
the extent the technological developments increase volatility, derivatives
and risk management products become that much more important.

25
 CHAPTER 2

FORWARDS

2.1 Introduction

2.2 Definition

2.3 Types And Features Of Forward Contracts

2.4 Valuing Forward Contracts

2.4 Pricing And Valuation Of Foreign Currency Forward

Contract

26
2.1 INTRODUCTION
A contract that obligates one counter party to buy and the other to sell
a specific underlying asset at a specific price, amount and date in the
future is known as a forward contract. Forward contracts are the
important type of forward-based derivatives. They are the simplest
derivatives. There is a separate forward market for multitude of
underlying, including the traditional agricultural or physical commodities,
as well as currencies and interest rates. The change in the value of a
forward contract is roughly proportional to the change in the value of its
underlying asset. These contracts create credit exposures. As the value of
the contract is conveyed only at the maturity, the parties are exposed to
the risk of default during the life of the contract.

Forward contracts are customized with the terms and conditions

tailored to fit the particular business, financial or risk management
objectives of the counter parties. Negotiations often take place with
respect to contract size, delivery grade, delivery locations, delivery dates
and credit terms.

2.2 DEFINITION

A forward contract can be defined as an agreement between two

parties, a buyer and a seller, that calls for the delivery of an asset at a
future date with a price agreed today. It is a personalized contract
between parties. The forward market is a general term use to describe the
informal market through which these contracts are entered into.
Standardized forward contracts are known as futures contracts and are
traded on futures exchanges. Often, the buyer of the contract is called
long and seller of the contract is called short.

27
2.3 TYPES AND FEATURES OF FORWARD
CONTRACTS
1. Commodity Forwards:
A commodity forwards contract can be defined as a contract wherein
one party agrees to deliver the underlying commodity to another party a
specified future time. The underlying commodity can be oil, a precious
metal or any other commodity. Producers of commodities take
production decisions based on expectations of price they would receive
when the actual output arrives. Similarly, purchasers of commodities of
inputs or final goods take decisions based on the availability and cost of
commodity at different points of time in a year. To protect against price
volatility and uncertainty in production as well as availability, often
buyers and sellers enter in forward contracts. At the initiation of contract,
the parties also specify the quantity, quality and price of the commodity
they would deliver for sale or acquire for purchase at a predetermined ate
in future. However, commodity forwards are very cumbersome. As there
is no centralized market or exchange where a forward contract is
established, the prices tend to vary and there is uncertainty about the
delivery of underlying commodity. Hence, investors prefer commodity
futures rather than commodity forwards.

2. Currency Forwards Contracts:

Currency forward market’s development over the years can be
attributed to relaxation of government controls over exchange rates of
most of the currencies. Currency forwards contracts are mostly used by
banks and companies to manage foreign exchange risk. For example,
Microsoft its European subsidiary to send it €12 million in period of 3
months. On receiving the Euros form the subsidiary, Microsoft will
convert them into dollars. Thus, Microsoft is essentially long on Euros,

28
as it has to sell Euros. At the same time it is short on dollars as it has to
buy the dollars. In such a situation, a currency forward contract proves
useful because it enables Microsoft to lock-in the exchange rate at which
it can sell Euros and buy dollars in 3 months. This can be done if
Microsoft goes short on forwards. This implies than Microsoft will go
short on euro and long on dollar. This arrangement will offset its
otherwise long-euro, short-dollar position. In other words, Microsoft
requires a forward contract to sell Euros and buy dollars.

3. Equity Forwards:
Equity forward can be defined as a contract calling for the purchase of
an individual stock, a stock portfolio or a stock index on a forward date.

a. Forward Contract On Individual Stocks:

A portfolio can consist of small number of stocks or sometimes stocks
that have been over a number of years. For example, lets us consider a
stock XYZ. The client has heavily invested in this stock and her portfolio
is not diversified. The client informs her portfolio manager of her
requirement of $2 million in cash in a period of 6 months. This amount is
raised by selling 16000 shares at the current price of $125 per share.
Thus, the risk exposure is related to the market value of $2 million of
stock. It is better not to sell the stock any earlier than is required. The
portfolio manager feels that forward contracts to sell the stock XYZ in 6
months will serve the purpose. Hence, the manager contacts a forward
contract dealer and obtains a quote of $128.13 per share. This implies
that the portfolio manager will enter into a contract with the dealer to sell
the stock at $128.13. Let us assume that the shares will be delivered
when the actual sale is made. Further, lets us assume that the client has
some flexibility in the required amount. So the contract is signed for the
sale of 15000 shares at 128.13 per share. This will raise an amount of

29
$1,998,828. However, if the contract expires, the stock could be sold for
any price. The client may either gain or lose on the transaction. Even if
the stock price rises above $128.13 during the 6 months, the client must
and should deliver the stock for $128.13. Conversely, if the price falls,
still the client will get $128.13 per share.

b. Forward Contracts On Stock Portfolio:

To understand the concept of stock portfolios, let us look at pension
funds. Suppose, a pension fund manager knows that he has to sell around
$20 million of stock in 3 months in order to make payments to retirees.
The manger has analyzed the portfolio and identified the precise stocks to
be sold and number of shares of each to be sold. Now, the problem is, the
prices of these stocks in 3 months are not certain. To solve this problem,
the manager can enter into a forward contract to lock-in the sale price.
For this, he can either enter into a forward contract on each stock or can
enter into a forward contract on the overall portfolio. The first option will
prove expensive as each contract would incur administrative expense,
where as in the second option there is only one set of costs. If the
manager chooses the second option then he will provide a list of stock
and number of shares he wishes to sell to the dealer and will obtain quote.
The dealer gives him a quote of $20,200,000. So, in 3 months period, the
manager of the pension fund will sell the stock to the dealer and will
receive $20,200,000 for the stock.

4. Interest Rate Forwards:

An Interest Rate Forward contact is commonly known as a
Forward Rate Agreement or FRA. FRAs are contracts wherein the
underlying instrument is interest payment is made in dollars, Euros or
any other currency at an appropriate rate of that currency. To understand
the mechanics of FRA, let us use dollar LIBOR. Now, let us consider a

30
FRA in 90 days for which the underlying is 180-day LIBOR. Assume
the dealer quotes this instrument at a rate of 5.5 percent and the end user
goes long while the dealer goes short. The end user is essentially long and
it will benefit if the interest rates rise. On the other hand, the dealer is
essentially short the rate and will benefit if the interest rates fall. The
contract covers a given amount of notional principal, which we shall
assume to be $10 million.

According to the forward contract, the parties to the contract at the

time of expiration must identify the rate on new 180-day LIBOR time
deposits. Such rate is known as 180-day LIBOR. This is the underlying
rate on which the contract is based. At the time of expiration in 90 days,
suppose the rate on 180-day LIBOR is 6 percent, then that 6 percent
interest will be paid after 180 days. Hence, the present value of a Euro
dollar time deposit at that point of time will be,

$ 10000000
180
( )
1+ 0.06
360

At the time of expiration the end user will receive the following payment
form the dealer

( 180
$10000000
[ ( 0.06−0.055 )

1+ 0.06 (
180
360 )

360 )
]
In case the underlying interest rate is less than 5.5 percent, then the
payment is calculated on the basis of difference arising between the 5.5
percent interest rate and the underlying interest rate. A significant point to
be noted here is, though the contract expires in 90 days, the rate is on a
180-day LIBOR instrument. Hence, the calculated rate of interest is

31
adjusted by the factor 180/360. The 90 days period of expiration is
considered in calculating the payoff.

In the above equation, by examining the numerator we see that the

contract is paying the difference between the actual rate that is prevailing
in the market on the expiration date of the contract and the agreed-upon
rate, adjusted for the fact that the rate applies to a 180-day instrument,
multiplied by the notional principal. This happens because, when the
Eurodollar rates are quoted in the market, they are based on the
assumption that the rate applies to an instrument that accrues interest at
that rate with the interest paid after a certain number of days (in this case
180 days). Hence, it is essential to adjust the FRA payoff to reflect the
rate which implies that a payment would be made after 180 days based
on a standard Eurodollar deposit. This adjustment is made by just
discounting the payment at the current LIBOR, which is 6 percent,
prorated over 180 days. The same conventions are used in the FRA
markets with other underlying rates.

2.4 VALUING FORWARD CONTRACTS

The value of a forward contract at the time it is first entered into

is zero. At a later stage, it may prove to have a positive or negative
value. It is important for banks and other financial institutions to
value the contract each day. (This is referred to as marking to
market the contract.) Using the notation introduced earlier, we
suppose K is the delivery price for a contract that was negotiated
some time ago, the delivery date is T years from today, and r is the 7-
year risk-free interest rate. The variable Fo is the forward price that
would be applicable if we negotiated the contract today.

32
We also define,

f: Value of forward contract today

It is important to be clear about the meaning of the variables Fo, K,

and f. If today happens to be the day when the contract is first
negotiated, the delivery price (K) is set equal to the forward price (F0)
and the value of the contract (f) is 0. As time passes, K stays the same
(because it is part of the definition of the contract), but F o changes
and f becomes either positive or negative.

A general result, applicable to all long forward contracts (both

those on investment assets and those on consumption assets), is

F = ( F ¿¿ 0−K ) e−rt ¿

To see why equation (5.4) is correct, we use an argument analogous

to the one we used for forward rate agreements. We compare a long
forward contract that has a delivery price of F o with an otherwise
identical long forward contract that has a delivery price of K. The
difference between the two is only in the amount that will be paid for
the underlying asset at time T. Under the first contract, this amount is
Fo; under the second contract, it is K. A cash outflow difference of F o
— K at time T translates to a difference of (Fo — K)e-rT today. The
contract with a delivery price Fo is therefore less valuable than the
contract with delivery price K by an amount (Fo — K)e-rT. The
value of the contract that has a delivery price of F o is by definition zero.
U follows that the value of the contract with a delivery price of K is (Fo
— K)e-rT. This proves equation. Similarly, the value of a short forward
contract with delivery price K is

( K −F 0 ) e−rT

33
 A long forward contract on a non-dividend-paying stock was
entered into some time ago. It currently has 6 months to maturity. The
risk-free rate of interest (with continuous compounding) is 10% per
annum, the stock price is $25, and the delivery price is $24. In this
case, So = 25, r = 0.10, T = 0.5, and K = 24. From equation, the 6-
month forward price, F0, is given by

F0 = 25 e 0.1∗0.5 =$ 26.28

From the above equation the value of the forward contract is

f = (26.28 - 24)e−0.1∗0.5=$ 2.17

Equation shows that we can value a long forward contract on an

asset by making the assumption that the price of the asset at the
maturity of the forward contract equals the forward price F o. To see
this, note that when we make the assumption, a long forward contract
provides a payoff at time T of F o — K. This has a present value of (Fo
- K)e-rT, which is the value of f in equation. Similarly, we can value a
short forward contract on the asset by assuming that the current
forward price of the asset is realized.

f = s0−K e−rT

Similarly, expression for the value of a long forward contract on an

investment asset provides a known income with present values I:

f =S0 – 1−K e−rT

Finally expression for the value of a long forward contract on an

investment asset that provides a known yield at rate q:

f = S0e−qT −K e−rT

Thus, using this equation one can value a forward contract

34
2.5 PRICING AND VALUATION OF FOREIGN
CURRENCY FORWARD CONTRACTS

Foreign currency transactions must be dealt with very carefully.

Exchange rate is quoted in terms of units of domestic currency per unit of
foreign currency. This is also known as direct quote. Let S o denote
exchange rate, r denote foreign interest rate and r denote domestic interest
rate.

Now, let us discuss the following transactions executed today (time

0). The contract expiration date is taken as T.

Take S0/ (l+ rf) T units of domestic currency and convert it into 1/ (1+ r f) T
units of foreign currency. This implies that, if one unit of foreign currency
costs SO, then So /(I + rf )T units of domestic currency would buy 1/(1
+ rf )T units of foreign currency.

Sell a forward contract to deliver one unit of foreign currency at the rate
F(0,T).

Hold the position until time T. That is (1+ r f) T

units of foreign
currency will result in accrued interest at the rate r f and grow to one
units of foreign currency at t given as follows:

T
1
( ) (1 + r ¿ = 1
1+r t
f

Thus, at the time of expiration one unit of foreign currency will be

left, which is then delivered to the holder of long forward contract. The
holder of the long forward contract will pay the amount F(0,T). This
amount is known at the beginning of the transaction as the risk has
been hedged and the exchange rate at the time of expiration is not much
35
relevant. The present value of F(0,T), which is determined by discounting
at the domestic risk-free interest rate must be equal to the initial outlay
of S0/(l+ rf)T. By equating these amounts and solving for F(0,T) we get,

S0
F (0,T) = (( ) )
1+r f T
T
(1+ r)

The term in the brackets indicates the spot exchange rate that is
discounted by the foreign interest rate. This term is again compounded at
the domestic interest rate to the expiration day.

In the international financial markets, the above formula is known as

interest rate parity or sometimes covered interest rate parity. It explains
the equivalence or parity of spot and forward exchange rates after
adjusting the existing differences in the interest rates of two countries.
One of the implications of interest rate parity is that, the forward rate will
exceed the spot rate if the domestic interest rate exceeds the foreign
interest rate. When the exchange rate is quoted directly, in such a case, if
forward rate exceeds the spot rate, the foreign currency is said to be
selling at a premium. Based on this statement we cannot arrive at the
conclusion that a currency selling at a premium is expected to increase
or a currency selling at a discount is expected to decrease. Whether it is
forward premium or discount, they merely implicate the existing
relationship between the interest rates of two countries.

If the forward rate in a market is not equal to the forward rate given by
the interest rate parity, it could result in an arbitrage transaction. This
arbitrage transaction is called covered interest arbitrage. If the forward
rate in the market is greater than the rate given by the interest rate parity,
this implies the forward rate is very high. Whenever the price of an asset
or derivative is too high, it should be sold. Hence, an investor would:

36
• Sell the forward contract at the market rate
• Buy of 1/(1+rf)T units of the foreign currency
• Hold the position, thereby earning interest on the currency

• At the maturity of the forward contract, deliver the currency and

get the payment at Forward rate.

This arbitrage transaction will result in a return which is in excess of

domestic risk free rate without any risk. In case the forward rate is less
than the rate given by the formula, then the investor will do the opposite.
He will sell the foreign currency and buy a forward contract. The
combined actions of more number of investors undertaking the same
transaction will make the forward price in the market in line with the
forward price given by the model.

Now, let us consider the value of a foreign currency forward contract at

some point of time during its life. The formula for foreign currency
forward can be given as,

S0 F (0 , T )
Vt(0,T) = (1+r f )( T−t ) –
( 1+ r)(r−t )

This implies that, the current exchange rate at time t will be

discounted by the foreign interest rate over the remaining life of the
contract and forward price discounted by the domestic interest rate over
the remaining life of the contract is subtracted from it. If we assume
that were using continuous compounding and discounting, the formula
would be given as follows:

Vt(0,T) = St e−r (T−t )−F ( 0 ,T ) e−r(T −t )

37
 CHAPTER 3

FUTURES

3.1 Introduction

3.2 Structure Of Global Futures Markets

3.3 Types Of Contracts and Characteristics

3.4 The Mechanics Of Futures Trading

3.5 Valuation Of Futures Contracts

3.6 The Cost-Of-Carry Model

38
3.1 INTRODUCTION
A future contract is an agreement between two parties to buy or sell an
asset at a certain time the future at the certain price. Futures contracts are
the special types of forward contracts in the sense that are standardized
exchange-traded contracts.

Equities, bonds, hybrid securities and currencies are the commodities

of the investment business. They are traded on organized exchanges in
which a clearing house interposes itself between buyer and seller and
guarantees all transactions, so that the identity of the buyer or the seller is
a matter of indifference to the opposite party. Futures contract protect
those who use these commodities in their business.

Futures trading are to enter into contracts to buy or sell financial

instruments, dealing in commodities or other financial instruments for
forward delivery or settlement on standardized terms. The futures market
facilitates stock holding and shifting of risk. They act as a mechanism for
collection and distribution of information and then perform a forward
pricing function. The futures trading can be performed when there is
variation in the price of the actual commodity and there exists economic
agents with commitments in the actual market. There must be a
possibility to specify a standard grade of the commodity and to measure
deviations from this grade. A futures market is established specifically to
meet purely speculative demands is possible but is not known. Conditions
which are thought of necessary for the establishment of futures trading
are the presence of speculative capital and financial facilities for payment
of margins and contract settlement. In addition, a strong infrastructure is
required, including financial, legal and communication systems

39
3.2 STURCTRE OF GLOBAL FUTURES MARKTES
1. Exchanges:

Development of futures markets can be traced back to the medical

times, when trade fair merchants often entered into contracts for deferred
delivery of goods at a price agreed to advance. In the centuries that
followed, organized spot markets for commodities developed in major
European cities. Consequently, the futures markets were developed to
meet the needs of the farmers and merchants. In 1948, the first modern
futures markets came into existence with the formation of Chicago Board
of Trade and evolved gradually to cater to the needs of investors in
addition to the existing class of farmers and merchants.

2. Chicago Board Of Trade:

The Chicago Board Trade (CBOT) is the oldest and the largest future
exchanges in the world. It is organized as a not-for-profit membership
association. Chicago’s strategic location at the base of lakes close to
fertile agricultural lands contributed to its rapid growth and development
as a grain center. It was established to bring the producers (farmers) and
buyers (merchants) together. It was initially formed to facilitate
standardizing the quantities and qualities of grains. Currently, CBOT
offers futures contracts on many underlying assets, which include corn,
wheat, soybeans, soybean oil, Treasury bonds and Treasury notes.

3. Chicago Mercantile Exchanges:

Chicago Mercantile Exchange’s (CME) is one of the leading futures
exchanges in the world. Constituted in 1874, it was initially known as
Chicago Produce Exchange. It was established to provide a systematic
market for butter, eggs, poultry and other farm products. In 1919, the

40
butter and egg board became Chicago Mercantile Exchange (CME) to
accommodate public participation.

In 1981, CME introduced Eurodollar futures, which gave way to

futures on stock indexes and option products. A post market Global
Electronic Transaction System (GLOBEX) was finalized with Returns in
1988 and live trading started in 1992. In 1998, it introduced GLOBEX
2R, the next generation first global electronic trading system.

In 1999, CME became the first American exchange to construct

concrete plan for demutualization. Currently, CME trades for many
underlying assets, including commodities like pork bellies, live cattle,
live hogs and feeder cattle; contracts on stock indices and currencies are
also traded on the exchange.

4. Trading:
There are two parties involve in a future contract. The seller of the
contract, who agrees to deliver the asset at the specified time in future and
the buyer of the contract, who agrees to pay a fixed price and takes
delivery of the asset. The futures contract is used by a buyer and seller in
order to hedge other positions of the underlying asset. Any price change
in the underlying asset after the futures contract agreement creates gain to
one party at the expense of the other party. In other words, if the price of
the underlying asset increases after the agreement is made, the buyer
stands to gain and the seller incurs loss. Inversely, if the price of asset
decreases, the seller gains and the buyer is at loss.

5. Clearing House:
A clearing house is an institution that clears all the transactions
undertaken by a futures exchange. It can either be a part of the same
exchange or can be a separate entity. It computes the daily settlement

41
amount due to or from each of the members and from other clearing
houses and matches the same.

a. Floor Brokers:
These brokers will execute the orders on others’ account. These people
are normally self-employed individual members of the exchange.

b. Floor Traders:
These traders execute the trades on their own account. Some floor
traders may also execute the orders for the account of others. This
mechanism is known as dual trading and such traders are known as dual
traders.

Some of the floor traders are classified as “scalpers.” A scalper is a

person who stands ready either to buy or sell. Scalpers add to the
liquidity of the market as they are market makers.

3.3 TYPES OF CONTRACTS AND CHARACTERISTICS

1. Commodity Futures:

Commodity futures refer to the contracts made to buy or sell a

commodity at a specific price and on a specific delivery date.
Commodities may be agricultural commodities, metallurgical
commodities, energy commodities and precious metals such as gold,
silver etc. The oldest commodity futures market is the Chicago Board of
Trade (CBOT). It began trading the first futures contract, a standardize
forward agreement, in the year 1865. Initially, commodity futures were
available only for agricultural products. Later on other commodities were
included. Agricultural commodities are further segregated into grains,
soft commodities and meat futures. Commodities such a Red beans,
corn, wheat, soybeans and soybean meal etc form part of grains while

42
cocoa, coffee, dried cocoon, cotton yarn etc form part of soft
commodities. Animal products like live hogs, live cattle, pork bellies,
eggs and poultry products form a part of meat futures.

The following table shows the specifications of the major futures

contracts for grains, soft commodities and meat futures in the US.

Table 3.1: Specification of Major US Grain futures Contracts

'beans Com Soybean Meal Soybean Oil Wheat

Exchange CBOT CBOT CBOT CBOT CBOT

Symbol Open Auction: Open Auction: Open Auction: Open Auction: BO

S C SM
Electronic: ZS Electronic: ZC Electronic: ZM Electronic: ZL

Trading unit 5,000 bu 5,000 bushels 100 tons 60,000 lbs 5,000 bu

Deliverable No.2 Yellow at No.2 yellow at One grade of meal Crude soybean oil No.1 &No. 2

Yellow at 6 At V/j cents protein of 48 - approved grades No.2 Hard Red

cents per bushelperover percent and standards winter, No.1 &
bushel over contract price, No.2 Dark
contract price No.3 yellow at Northern spring,
and No.3 11/2 cents per No.1 Northern
at 6yellow
cents per bushel under Spring at 3 cent/
bushel under contract price bushel premium
contract price* and No.2
Northern.0
Tick size % cent/bu ($ % cent/bushel 10 cents/ton ($ 1/100 cent ($ % cent/bu
($
12.50/contract) 12.50/contract) 10/contract) 0.0001 )/lb ($12.50/contract
($6/contract) )
Contract Sep, Nov, Jan, Dec, Mar, May, Oct, Dec, Jan, Oct, Dec, Jan, Jul, Sept, Dec,
Months Mar, May, July, Jul, Sept May,Mar,
Jul, Aug, Mar, Jul, Aug, Mar, May
Aug Sept Sept
Price quote Cents and Cents/bushel Dollars and cents / Cents/Ib Cents and
quarter- ton quarter—
cents/bu cents/bu
Last Trading The business The business The business day The business day The business
Day day prior to this day prior to the prior to the 15* prior to the 15* day prior to the
15* calendar 15* calendar calendar day of calendar day of 15"1 calendar
day of the day of the contract
themonth contract
themonth day of the
contract month contract month contract month
Last Delivery Second Second Second business Last business day Seventh
day business day business day day following the of the delivery business day
following the following the last trading day of month following the
last trading day trading
lastday of the delivery month trading
lastday of
of the delivery the delivery delivery month
month month

43
 The metallurgical category includes the genuine metals and petro
products. The metals are further grouped into precious and industrial
metals. In general, the precious metals are in relatively short supply and
they retain their value irrespective of the conditions of the economy. On
the other hand, the values of the industrial metals are based on the
demand and supply conditions.

2. Foreign Currency Futures:

A forex futures contract can be defined as an agreement between two
parties in which one of the parties agrees to buy the currency from the
other party at a later date at an exchange rate agreed upon today. Its
working is similar to traditional stock and commodity futures. Forex
Futures were actually the first financial futures contracts. The forex
futures contract calls for delivery of certain number of units of foreign
currency. Prices are always quoted in dollars per unit of that currency.
For example, let us consider British Pound contract. Assume the pound
contract calls for delivery of 65, 000 pounds. If the contract price is
$1.5612, then the actual price is $1.5612(65,000) = $101,478.

There are many advantages in using forex futures for hedging as well
as speculating. The significant feature of forex futures is that they are not
traded on a centralized exchange. They can be used to hedge against
currency fluctuations.

3. Index Futures:
The first index futures contract was introduced in 1982 at the Kansas
City Board of Trade and today, index futures are one of the most popular
types of futures as far as trading is concerned. An index futures contract
is basically an obligation to deliver at settlement, an amount equal to ‘x’
times the difference between the stock index value on the expiration date

44
of the contract and the price at which the contract was originally struck.
The value of ‘x’, which is referred to as the multiple, is predetermined for
each stock market index. Stock index futures are based on complex cash
instruments. The multiple enables to calculate the monetary value of an
index futures contract. For example, if the settlement price of the S&P
500 futures contract is 350, the value of the contract in monetary terms is
350X250=$87,500.

4. Interest Rate Futures:

An interest rate futures contract is an agreement to buy or sell a
standard quantity of underlying asset, at a predetermined future date and
at a price agreed upon between parties. The underlying assets will be
different interest bearing instruments like T-bills, T-notes, T-bonds,
deposits, etc. For example, Treasury Bond Futures Contract is the most
popular long-term interest rate futures contract and the underlying asset
will be a bond.

The main factor behind the growth of interest rate futures are as follows:

 Enormous growth of the market for fixed income securities.

 Increased fluctuation in interest rates worldwide.
In the case of long-term interest rate futures, the most important
contracts are the Treasury bond futures contract, the 10-year Treasury
note futures contract and municipal bond futures contract.

In the US, only short-term interest rate futures like futures on US 90-
day treasury bills and 3 months Eurodollar time deposits are popular.

45
3.4 THE MECHANICS OF FUTURES TRADING

Initially, an individual willing to trade futures contracts must place an

order. For that purpose he needs to open an account with a broker. The
individual is required to make minimum deposit of at least $5,000 and
must sign a disclosure statement agreeing to all the possible risks.

1. Placing An Order:
An investor can place different types of orders. When an investor
places an order the broker makes a phone call to the firm’s desk on the
exchange floor and conveys the order to the firm’s floor broker, who in
turn goes to the pit in which the contract is traded. The pit can be
described as an octagonal or polygonal shaped ring with steps descending
to the center. Bids and make offers are placed through hand signals and
verbal activity. This is known as open outcry system.

Open outcry system is very old tradition. Today, many of the futures
exchanges are fully automated. The bids and offers are submitted
through the computer and trades are executed off the floor.

2. Role Of Clearing House:

Every future exchange has its own independent clearing house which
acts as an intermediary and guarantor to each transaction. Stock holders
of clearing house are its members clearing firms. Each firm maintains a
margin account with the clearing house and must also maintain minimum
amount in the account. All the parties to the futures transactions should
maintain an account with the clearing firm or with the firm that has an
account with the clearing firm.

46
 3. Daily Settlement:
Daily settlement is a significant feature of futures market and is the
major difference between futures and forwards markets. Every futures
contract involves initial margin and maintenance margin. The amount
required to be deposited in the margin account at the time of entering the
contract is called initial margin. Generally, the initial margin is set
between 5% and 15% of the total value of the contract. It covers losses
arising because of price fluctuations. On closure of position or at time of
maturity of contract, the initial margin is released again. The margin
account is readjusted at the end of each trading day to reflect the
investor’s gain or loss on its open position. The amount that is
maintained everyday thereafter is called maintenance margin. At the
close of each day, a committee comprising clearing house officials
determines a settlement price. Usually, settlement price is an average of
the prices of the last few trades of the day. Using the settlement price,
each account is marked to market. Marked to market is a unique feature
of futures contract wherein the positions of both buyers and sellers of the
contracts are adjusted everyday for the change in the market price that
day. In other words, the profits or losses related with the price
movements are either credited or debited from an investor’s account even
if he does not trade.

4. Delivery And Cash Settlement:

All the contracts expire at some or the other time. Every contract has
a delivery month and the delivery procedure differs from one contract to
the other. While some contracts can be delivered on any business day of
the delivery month, others can be delivered only after the contract is
traded for the last day. This last day also varies from contract to contract.
In case of contracts that are cash settled there is no delivery at all.

47
3.5 VALUATION OF FUTURES CONTRACTS

1. Factors Determining Contract Price:

Futures market prices bear economically important relationships to

other significant observable factors. For example, the futures price for
delivery of wheat in three moths must be related to the current spot price
of wheat or current cash price of wheat at a particular physical location.

As the futures contract requires the delivery of some good at a

particular time in future, we can make it sure that the expectations of the
market participant assists to determine the futures prices. Similarly, the
cost of storing the goods underlying the futures contract helps to
determine the relationship between the futures prices and the cash prices.

When a commodity in futures market is delivered at a later date as per

the futures contract, these may be more than one cash price for a
commodity at one point of time.

2. The Basis And Spreads:

We can analyze the relationship between two prices by using basis
and spreads. The basis is the relationship between the cash price of a
product and the futures price of that product. A spread is the difference
between two futures prices.

Basis represents the difference between the cash price and the future
price of a single product.

Basis = Current cash price – Futures price

Here, the cash price is for a specific location, time and quantity of
product. The futures price is for a contract for the same time the cash
price represents. Generally, the basis is calculated as the difference

48
between the cash price and the nearby (closest to expiration) futures
contract.

A spread can be either intracommodity spread or an intercommodity

spread. For the same underlying good, if there are two different prices on
two different expirations dates, the underlying spread is referred as
‘intercommodity’ spread (also known as ‘time spread’). If the spread is
between two futures prices for two different but related commodities,
such as corn oil futures and cottonseed oil futures, it is referred to as
‘intercommodity spread’. If the price difference is between two markets
for the same commodity, it is known as ‘inter-market spread’.

3. Futures Prices And Expected Spot Prices:

While examining the futures prices, the concept of relationship
between futures prices and expected spot prices is very significant. To
understand this concept, let us consider the relationship between spot
prices and expected spot prices. Consider an asset which incurs carrying
costs but does not involve any risk. At time 0, the investor will purchase
the asset with certainty that he will surely cover his opportunity cost and
carrying cost. If not, he would not purchase the asset at all. Thus, at time
0, the spot price is the present value of the total of the spot price at time T
less costs minus benefits.

Thus, FV(CB,O,T) is the future value of the carrying cost and FV,
(C,B,OT)/(Tr)T is the present value of the carrying cost. Hence, on one
hand we can state that the spot price is the future spot price minus the
future value of the carrying cost, all discounted to the present. On the
other hand, we can state that the spot price is the discounted value of the
future spot price minus the present value of the carrying cost.

49
 However, in case the future price is uncertain, some adjustments are
mandatory. As we do not know at time 0 what S T will be, we must make
an expectation which is denoted as E0 (ST). At the same time, we can just
replace the St above with E0 (St). This would not be rational as we would
be paying a price today and expecting compensation only at the risk-free
rate along with coverage of carrying cost. One of the most significant
and intuitive elements of finance is that risky assets require a risk
premium. Risk premium denoted as Ф0 (ST) represents a discount-off of
the expected value that is imbedded in the current price S 0. Here, current
price can be given as

E0 (ST) – FV(C,B,O,T) – Ф0 (ST)

S0 = -------------------------------------------

(1+r)T

We can see that the risk premium lowers the current spot price.
Investors intuitively pay less for risky assets all other things equal.

So far we have not violated rule of no arbitrage, as we have worked

with only spot price only. Hence the futures pricing formula

F0 (T) = S0 (1+r)T + FV (C,B,O,T)

------------------------------------------

(1+r)T

Can still be applied. In case we rewrite the futures pricing formula for
FV(C,B,O,T), substitute the result into the formula for S 0 by solving the
futures price FV(C,B,O,T) we obtain;

50
 f0 (T)=f0(ST) – Ф0 (ST).

According to this equation, the futures price equals the expected future
spot price minus the risk premium.

From the above formula, we conclude that the futures price is not
equal to the expectations of the futures spot price. The futures price will
be biased on the lower side. If the futures price were an unbiased
predictor of the future spot price, f0 (T) = E (ST) one can expect an
average to be able to predict the future spot price, but this is unlikely to
occur. The intuition behind this can be seen easily. Let us start with the
assumption that all units of the asset must be held by some individual.
The person holding the asset is willing to transfer the risk of its future
selling price, he must offer a futures contract for sale. If the futures
contract is offered at a price equal to the expected spot price, then the
buyer of the futures contract takes on the risk expecting to earn a price
equal to the price paid for the futures. Thus, the buyer incurs the risk
without any expected gain in the form of risk premium. Conversely, the
holder of the asset would enjoy a risk-free position with an expected gain
in excess of the risk-free rate. Clearly, the holder of the asset cannot
carry out such a transaction. Hence, he must lower the price to the level
where it will be sufficient to compensate the buyer for the risk he is
taking up. All this process will lead to futures prices equal to the
expected spot price minus the risk premium. The risk premium gets
transferred from the holder of the asset to the buyer of the futures
contract.

51
3.6 THE COST-OF-CARRY PRICING MODEL

1. PRICING OF COMMODITY FUTURES:

Cost-of-carry model is popular and simple model used in pricing of

futures. For the sake of simplicity in understanding, let us assume that
the futures market is perfect. The cost-of-carry or carrying charge is the
total cost incurred in carrying a storable good forward in time. For
example, rice from crop in December can be carried forward or stored
until December next till the next crop or even beyond it.

The significance of carrying costs cannot be ignored because they play

a crucial role in determining pricing relationship between the spot and
futures prices. Moreover, it plays a key role in determining the prices of
various future contracts of different maturities. The following formula
determines the relationship between the cash price and the futures price
of any commodity:

Ft,T = C+Ct * St,T * T-t/365 + Gt,T

Where,

Ct = cash price at time t

St,T= annualized interest rate on borrowings

Gt,T = storage costs

T-t = time period

Ft,T = time futures at time t, which is to be delivered at time period T.

According to cost-carry concept, the future price should be equal to

the spot price of the commodity plus the carrying charges required to
carry the spot commodity forward to deliver.

52
 2. Pricing Of Interest Rate Futures:
Pricing of interest rate futures is very difficult because of its
peculiar characteristics. Theoretically, the fundamental no-arbitrage
equation for bond futures is an applied version of the no-arbitrage
relationships of assets with payouts. Hence, the fair value of an
interest rate futures contract for a bond depends on the forward price of
the underlying asset. This forward price can be determined using
arbitrage. The 'fair' futures price determined by the basic no arbitrage
condition is given by:

F t,T+ Al T (S+AI t ) .(l+R t,T ) −¿C t,T .

The futures 'fair' price at date t is represented by F t,T and future value
of all coupons paid and reinvested between t and T is represented by C t,T
While St represents the spot value of the underlying bond at time t AI t and
AIT respectively represent accrued interest on the underlying bond at time
T.

The above equation can be rewritten as

Ft,T = (S + AIt) * (1 + Rt,T) – AIT .

The cost-of-carry model states that an investor must be indifferent

between buying the bond and carrying it through time or buying the
futures. Hence, to purchase the bond to be delivered, (St + AIt) will be the
total price paid at time t. Purchasing this bond by borrowing the total price
paid for a bond held until time T involves total borrowing costs of (S t +
AIT).The value of all coupons paid and reinvested between t and T is
indicated by Ct.T. This amount is gained by the owner of the bond and is
lost by the futures buyer. The accrued interest (Al t) of the delivered bond
at time T is paid by the futures buyer to the bond owner at delivery.

53
Therefore,

Forward price = Cash price + Financing – Income

As,

Income - Financing = Cost of carry,

We can also write as:

Forward price = Cash price - Cost of carry.

The cost of carry can be either positive or negative based on the

shape of yield curve and the coupon of the underlying bond.

In reality, valuing interest rate futures is very complicated as all the

contracts have a multi-deliverable grade feature. In other words, the
contract facilitates delivery of any bond within a set of maturities and
coupons and thus involves different market values.

54
 CHAPTER 4

OPTIONS

4.1 Introduction

4.2 Call And Put Option

4.3 Underlying Instruments

4.4 Option Trading

4.5 The Binomial Model

4.6 Black-Scholes Model

55
4.1 INTRODUCTION
A derivative transaction that gives the option holder the right but not
the obligation to buy or sell the underlying asset at a price, called the
strike price, during a period or on a specific date in exchange for payment
of a premium is known as ‘option’. Underlying asset refers to any asset
that is traded. The price at which the underlying is traded is called the
‘strike price’.

4.2 CALL OPTIONS AND PUT OPTIONS

There are two types of options i.e., CALL OPTION AND PUT OPTION.

1. Call Options:

A contract that gives its owner the right but not the obligation to buy
an underlying asset-stock or any financial asset, at a specified price on or
before a specified date is known as a ‘Call option’. The owner makes a
profit provided he sells at a higher current price and buys at a lower
future price.

a. In-The-Money:

A call option is In-the-Money if the prevailing stock price (of the

underlying asset) is greater than the exercise price.

b. At-The-Money:

In case the call’s market price is the same as its exercise price, it
would be called at-the-money or at-the-market.

c. Out-Of-The-Money:

Similarly, if the market price of the stock is less than the exercise
price, it shall be called out-of-the-money.

56
 2. Put Options:

A contract that gives its owner the right but not the obligation to sell
an underlying asset-stock or any financial asset, at a specified price on or
before a specified date is known as a ‘Put option’. The owner makes a
profit provided he buys at a lower current price and sells at a higher
future price. Hence, no option will be exercised if the future price does
not increase.

4.3 UNDERLYING INSTRUMENTS

Options exist on a variety of underlying instruments ranging from
stock, indices to foreign currencies and commodities. The value of an
option depends heavily upon the price of its underlying asset.

1. Stocks:

Options on individual stocks are known as equity options and are the
most actively traded options on any exchange. In the US, options on
stocks are actively traded on the Chicago Board Options Exchange
(CBOE), the American Stock Exchange (AMEX), and the New York
Stock Exchange (NYSE), in India they are traded on the National Stock
Exchange (NSE), and the Bombay Stock Exchange (BSE). These
exchanges provide liquidity, competitive and structured markets for the
sale and purchase of standardized options. In the US, a stock option is
usually for 100 shares whereas in India, the number of underlying shares
on an option varies from 100 to 250 to 375 and so on. The exercise
prices are usually given as the number of units of currency of per share.
The price of a stock option is influenced by the price of the underlying
stock, remaining time until expiration, volatility of the underlying stock
price, cash dividends and the level of interest rates.

57
 2. Stock Index:

A stock index consists of a group of stock and measures the overall

value of the group. An option on such an index is called an index option.
Though indexes have been constructed to measure the combined
performance of a group such as equities, debt securities, foreign
currencies, cost of living, etc, stock indices are the most popular and
often used. The index options have gained popularity over the stock over
the stock options because there options enable the investors to trade in
options without taking or making the delivery of the stocks, and also can
be settled in cash. Though stock options exist for a large number of
stocks, investors find it a tedious to analyze and make use of them. As
such, they prefer analyzing the market as a whole to use index options
and act on their predications. The strike price is in terms of a level. The
holder of a call option will have a positive pay off when the value of the
index on expiration is more than the value given in the option. Index
option helps investors to get exposure to a market or in particular sector
or industry. The price of an index option is greatly affected by the
changes in the levels of the index, which is in turn affected by the
changes in the prices of the shares of the components comprising the
index.

3. Bonds:

Options on bonds are, mostly found on treasury bonds as they are

actively traded than any other bonds on an exchange. The options are
traded actively on the over-the-counter market, than on a recognized
exchange. Options on bonds are deliverable or settled in cash. Except
for the bond prices and specific values of the bond, the mechanics are
similar to that of stock options. In the case of a call option, the buyer will
profit from a fall in interest rates and a rise in bond prices, and in case of

58
a put option, the buyer will profit from a rise in interest rates and a fall in
bond prices. The strike price on these options is in terms of yield to
maturity. Prices of bond options are affected by the level of interest rates
in the country. An investor anticipating a decline in the interest rates
purchases call interest rates. The investors can also use instruments such
as caps, floors or collars to hedge interest rate risk.

4. Caps, Floors And Collars:

An interest rate cap and floor are special types of borrowings and
lending options which are meant for long term hedging.

On the next page you will see the various graphs or Caps, Floors and
Collars.

59
 a. Caps (Interest Rate Caps):
A cap is a series of interest rate options, which guarantee a fixed rate
payable on a borrowing over a specific time period at specific future
dates. If interest rates rise above the agreed cap rate then the seller pays
the difference between the cap rate and the interest rate to the purchaser.
A cap is usually bought to hedge against a rise in interest rates and yet is
not a part of the loan agreement and may be bought from a completely
different bank. In a cap, usually an upfront fee is any given time will
never exceed the current existing rates or the cap rate. The cap working
is depicted in the following graph

Figure 4.1: Interest Rate Cap

60
 b. Floors (Interest Rate Floors):
A floor is an agreement where the seller agrees to compensate the
buyer if interest rates fall below the agreed upon floor rate. It is similar to
a cap, but ensures that if the interest rate falls below certain agreed floor
limit, the floor limit interest rate will be paid.

Figure 4.2: Interest Rate Floor

61
 c. Collars:
A collar is a combination of a cap and a floor where you sell a floor at
a lower strike rate and buy a cap at a higher strike rate. Thus, they
provide protection against a rise in interest rates and some benefit from a
fall in interest rates. The pay off profile of a cap and a collar are given
below

Figure 4.3: Interest Rate Collar

5. Commodities:
Commodity options give the option buyer to purchase or sell a specific
quantity of a commodity at specific price. Commodity options help a
farmer in looking his selling price, by purchasing a put option to sell the
commodity at a strike price in case the price of the commodity falls.
Similarly, they help a trader to purchase the commodities in case there is
an increase in the purchase price.

62
 6. Currencies:
The largest portion of the currency option market is the interbank
market. Some of the stock exchanges list currency options also.
Currency options are used by the companies in order to hedge against the
adverse movement of exchange rates. A currency call is similar to a call
on a stock that gives the holder the right to buy a fixed amount of foreign
currency at a fixed exchange rate on or before the options expiration date.
A currency put gives the holder there right to sell a fixed amount of
foreign currency at a fixed exchange rate on or before the options
expiration date. For example, investors expecting an adverse movement
or exchange of Can$/US$ from for 1.12 to 1.14 (meaning Canadian
Dollar will be expensive for an American investors) will purchase a call
option on Can$/US$ to gain for a rise in exchange rates. The currency
options can be settled either through physical delivery or through cash.

Individual Currency Options

The underlying asset of these options is an individual currency.

Currency Baskets:

More popular known as a “basket option”, an option on a currency

basket is an option whose value is based on the value of a basket
comprising multiple currencies. It is availed by a company when it wants
to hedge a combined exposure in various currencies as it proves to be
inexpensive to purchase option on a basket of currencies than purchasing
individual options to hedge exposure on individual currencies. The price
of a basket option is based on the value or a currency basket, which is in
turn derived as the weighted sum of the underlying values of the
currencies.

63
 Options in the interbank market are quoted in terms of implied
volatility. Implied volatility is a measure or possible fluctuations in
future exchange rates. The greater the volatility measure the greater will
be the benefit for calls or puts.

7. Interest Rates:
Interest rates options have the underlying asset as a reference rate such
as the LIBOR and the strike price as an interest rate. These options are
not deliverable but are settled in cash based on an estimated amount and
the spread between strike rate and reference rate. The interest rate
options used mostly are European options. An interest rate option holder
gets the right to buy or sell the underlying cash instrument or the financial
futures contract. The treasurer may use these options to protect his
position form rising interest rates or falling interest rates by buying put
option or call options respectively.

The significance of options reaches beyond the profit motivated

trading. Today, many sophisticated institutional trader adopt options in
order to execute very complex strategies.

4.4 OPTION TRADING

Options that are traded on an exchange are called exchange traded

option. For example, stock options are traded on the Chicago Board
Options Exchange (CBOE), the American Stock Exchange (AMEX), and
the New York Stock Exchange (NYSE). Different types of traders such
as, market makers, floor brokers etc trade in an exchange. A market
maker can be defined as a person or a firm that quotes the buy and sell
price in a financial instrument or commodity, intending to make a profit
through bid/ask spread. A market maker creates liquidity in the market.
When the investors wish to sell or buy and have no counter parties for the

64
transaction to materialize, the market maker acts as a buyer to a seller and
a seller to a buyer facilitating the immediate execution of the transaction.
However, most of the market makers act as scalpers on a short term basis.
A scalper purchases and sells at a price higher than the purchase price.
He trades in a matter or few minutes before the prices move slightly
upwards.

1. Brokerage:
In an option market, the orders are done through brokers as such and
most of the strategies result in substantial brokerage commissions
because brokerage has to be paid on multiple legs. For example, while
executing a long straddle strategy, commissions have to be paid on
buying a call and buying a put. In fact, many clients do complain that the
brokerage house have pushed these strategies on them to generate
additional commissions.

2. Over-The-Counter (OTC) Dealers:

Any security that is not traded on an exchange because of its inability
to meet listing requirements is called over-the-counter security. Such
securities are called over-the-counter dealers in OTC market through
direct negotiation with one another over computer networks or by
telephone. OTC dealer can be an individual or a firm that is engaged in
the business of underwriting, trading and selling securities.

3. Settlement And Exercise:

Options can be settled in cash or delivered physically

At the timer of exercise, the option can be settled by physical delivery

or cash settled. A physical delivery of a call option on Aurobindo
Pharma gives the buyer or holder of the option the right to take delivery
or say, 350 shares of Aurobindo Pharma at a strike price of Rs. 540 a

65
share. Similarly, a physical delivery of a put option on Aurobindo
Pharma gives the holder the right to take delivery of 350 shares of the
stock at Rs. 560 a share. However, in case or cash settled option, the
difference or the exercise price and the market price on the exercise date
multiplied by a multiplier as fixed by the option market is paid to the
holder of the option. For example, a holder of call option on index with a
strike price of $120 exercises it when the exercise settlement value is
$140. Assuming the multiplier to be 100, the holder will receive an
amount of:

[(140-120)*100] = $2000

In general, exchanges sometimes impose position and exercise limits

to avoid a single individual or a group from having a significant stake in
the market.

Position Limits: A position limit is a maximum number of options that

can be held by an investor on one side or the market. Options are on one
side or the market in the case of long and short put or long put and short
call. These limits are published by exchanges and vary based on the
volume or trade in the underlying stock and number or outstanding
shares.

Exercise Limits: Exchanges may also fix an exercise limit which is the
number of options that can be exercise by an investor. Members of an
exchange dealing in options could be either individual or institutions. On
the other hand, the members of and over-the-counter market are usually
institutions such as banks and brokerage houses, who stand ready to buy
or sell and make a market.

66
4.5 THE BINOMIAL MODEL

The binomial model is a continuous time model “in the limit”. It is

called binomial because it assumes that during the most “period of time”
share prices will to only one or two values. Although this assumption
might seem to be a strange one on which to develop a practical valuation
model, it really is not if the investor thinks or a “period of time” as being
very short and of the eventual expiration date as being many periods from
now.

We now move on to consider option pricing formula. The basis of this

valuation formula is that it is possible to construct a risk-free hedged
portfolio by buying shares and writing call options on the shares. As the
resulting portfolio is risk free it would be expected that only a risk-free
rate of return would be obtained. This then enables the investors to obtain
a value for the call option.
A general formula for the value of a call option with one period to expiry
can be written as:

p1
Vc = H[ p− 1+ r ]

Where, Vc is the value of the call option with one period to expiry, r is the
risk-free rate of interest, Po is the current share price, P, is the lower value
of the share at the end period and H = (Vu- V1 )/ (Pu- P1 )is the hedging
ratio. Vu is the upper value of the option at the end of the period and V 1,
is the lower value of the option at the end of the period; P u is the upper
value of the share at the end of the period.
In the binomial option price formula it is required to value a call one
period before expiration. To illustrate, given the following information:
present price of share, Rs. 10, exercise price of call option Rs.10, risk-

67
free interest 25 per cent, assume that the share price will either increase to
Rs.15 or decrease to Rs. 5 by the exercise date. It should be possible to
construct a fully hedged position by buying shares and writing call
option.
TABLE 4.1: Cash Flows in Fully
Hedged Position Flows at T

Flow at 10 Possible share Rs. 5

prices Rs. 15
Buy one share -10 15 5
Write two calls +2C -10 -
5 5

Table-2 shows the cash flows at the beginning of the period and the
end of the period when one share is purchased and two calls written. It
can be seen that at the end of the period the net outcome will be same
irrespective of whether the Rs. 15 price or the Rs. 5 price prevails. The
reason for this is that if the share price at the end of the period is Rs. 15
then the share purchased will be worth Rs. 15 while the holder of the call
written will require two shares to be delivered for which Rs. 20 will be
paid. These shares will have to be purchased in the market at the price of
Rs. 15 each and a total cost of Rs. 30 giving a loss of Rs. 10. However, if
the price of the exercise date is Rs. 5, then the value of the one share held
will be Rs. 5 and the call will go unexercised and will have a value of
zero. Because the strategy results in a certain outcome whichever
possible share price results, the return on the strategy should be certain
return, i.e. the risk-free rate of return. We can, therefore, say
(10-2C) 1.25 = 5
C = Rs. 3
It can be observed from the above equation that investors have a net
investment of Rs.4 i.e. the cost of one share minus the premium received
68
on writing two calls, and as the outcome of this investment is certain,
investors would expect to earn the risk-free rate of return. In this case
investors require one share for every tow calls written. The share to
option ratio is often called the hedge ration or option date. In the
example, the option rate is 0.5. Option will have to be priced in
accordance with this model otherwise opportunities would occur for
dealers to earn riskless profits. Arbitrage activity would ensure that call
option are priced in accordance with the formula above.
While the foregoing illustrates the principles of option valuation, it
makes the non realistic assumption that there are only two possible prices
for the share at the end of the period. While it would be possible to
make the example slightly more realistic, by assuming sub periods, the
calculations would become more complicated without adding great to the
realism. Fortunately, Black and Scholes have devised an option valuation
formula which assumes that shares return is normally distributed and this
allows for a more realistic assessment of option values.
4.6 BLACK-SCHOLES MODEL

Every theory in science starts out with assumptions. When applying

his laws of motion, Isaac Newton assumed that the world was frictionless.
With the option formula, and more importantly the law of dynamic
replication that allowed virtually any derivative on earth to be price.
Black, Scholes and Merton could claim to be the Newton of finance. By
leaving aside the details, they could take their idea from one market to the
next from options on stocks to the hidden option on crude oil prices that a
company owns when it has oil drillings rights. It really was a universal
law of finance.

Fischer Black and Myron Scholes developed a precise model for

determining the equilibrium value of an option. The model is widely

69
used by those who deal with options to search for situations where the
market price of an option differs substantially from its fair value. In
particular, the model provides rich insight into the valuation of debt
relation to equity.

Assumption:

The Black Scholes option model is based on following assumption:

1. There are no transaction costs and no taxes.

2. The risk form interest rate is constant
3. The market operates continuously.
4. The share prices are continuously, i.e. there are no jumps in the
share prices; if one plots a graph of the share price against time, the
graph must be smooth. To be more specific, the share price is log
normally distributed for ay finite time interval.
5. The share pays no dividends
6. The option is of European type, that is, options that can be
exercised only at maturity
7. Shares can be sold short without penalty and short sellers receive
the full proceeds from the transaction.

Given these assumptions, the equilibrium value of an option

can be determined. Should the actual price of the option differ from
that given by model, the investor could establish a riskless hedged
position and a return in excess of the short-term interest rate. As
enterprise entered the scene, the excess return would eventually be
driven out and the price of the option would equal the value given
by the model.

The Specific Model:

70
 The black-scholes formula for estimating the fair value of a call option
(Vc) is

Vc= Ps [ Nd 1 ] −Px/e ( RF) (T )[Nd2]

Ps σ2
d1 = In
Px [
+ T RF+
2 ]
--------------------------------

Σ √T

Ps σ2
d2 = In
Px [
+ T RF−
2 ]
------------------------------

σ √T

= d1 - σ √ T

and where Ps = the current price of the share, Px = the exercise price of
the call, e = 2.7183, RF = the continuously compounded annual risk-
free rate, σ = the standard deviation of the continuously compounded
annual rate of return of the share, In = the natural log of the bracketed
number, T = the time remaining to expiration on an annual basis, and
Nd1 and Nd2 = the value of the cumulative normal distribution at d1 and
d2.

To illustrate, consider XYZ share to value a call option. Assume Ps

= Rs. 68.125, Px = Rs.60.00, RF = 0.1325 per year, and T = 2
months. In addition, the estimated continuous annual standard
deviation of returns on XYZ to be 0.4472 ( σ 2 = 02). By putting the
values in the above equations we get ;

71
 d1 =0.91

d2 = 0.72

Second, the value of Nd1 and Nd2 must be found. These

represent the cumulative probability of the normal standard
distribution from -∞ to dl and from -∞ to d2 respectively. Consider
first d1. The cumulative probability below the zero mean of the
standard normal distribution is 50 percent. The value of d 1, is 0.91,
meaning it is 0.91 standard deviation above the zero mean. The
standard deviation of 0.91 corresponds to a cumulative probability
of 0.3186. In total, Nd1 would be 05+ 0.3186 = 0.8186. Using a
similar procedure for d2 equal to 0.72 provides an Nd2 = O.7642.
Finally, we can calculate the call option's price by substituting in
the equation, we get
Vc = Rs. 10.92

Dividend Adjustment:

Cash dividends have three possible impacts on call valuation. First, if

the dividends are large enough, the calls might be exercised early.
Second, if dividends are unknown, risk-free hedge portfolio cannot be
formed. For these reasons, the calls cannot be valued without relying on
investor preference models such as the capital asset pricing model.
However, both these problems are relatively minor for most call options.
The third case consists of known cash dividends which are not large
enough to threaten an early exercise. If this is true, a relatively simple
adjustment can be made to the Black-Scholes model.

To illustrate, let Dt represent a known cash dividend to be paid on

day t from now. There may be one or more D, values, let only those

72
paid during the option's life are considered. The Black-Scholes model
can still be used, but now with an adjusted stock price P*s:
T

P*s = Ps – ∑ Dt /e RF∗t
t =1

If known cash dividends equals to Rs. 2.00 are to be paid exactly one and two
months from now:

P*s =Rs. 64.19

Put Valuation:

The valuation of a European put can be found by inserting the Black-

Scholes call price into the put-call parity model. The result is:

Pp = −Ps N−d 1+ P x /e RF∗T N −d 2

The cumulative normal density function is evaluated at negative d1

and d2 values.

Assume that the stock price is Rs.40, the put exercise price is Rs.40,
the expiration date is 4 months, the continuous risk- free interest rate
is 12%, and the standard deviation of continuously compound stock
returns is 30% per year so,

d1 = 0.26

N-d1 = 0.3974

d2 = 0.09

N-d2 = 0.4641

So from the above values, we get

73
 Pp = Rs.1.94

Delta:

When options traders or analysts get together, they almost certainly

use the term delta early in their conversation. Deltas are an important
by-product of the Black-Scholes model, and they provide particularly
useful information to investors who use options in portfolios.

Delta is defined as the change in option premium expected from a small

change in the strike price, all other things being the same. Symbolically,

∆C
∆=
∆S

Where AS is a small change in stock price and AC is the corresponding

change in the call price.

Consider a call option whose delta is 0.6. Suppose that the option
price is Rs.10 and the strike price is Rs. 100. Suppose an investor who
has sold 20 option contracts, that is, options to buy 2000 shares. The
investor's position could be hedged by buying 0.6 x 2000 = 1,200
shares. The gain (loss) on the option position would tend to be offset by
the loss (gain) on the stock position. For example, if the stock price
goes up by Rs. 2 (producing a gain of Rs. 2, 400 on the shares
purchased), the option price will tend to go up by 0.6 x Rs. 2 = Rs.1.2
(producing a loss of Rs. 2, 400 on the options written); if the stock price
goes down by Rs. 2 (producing a loss of Rs. 2, 400 on the shares
purchased), the option price will tend to go down by Rs. 0.60 (producing
a gain of Rs. 2,400 on the options written).

In the example, the delta of the investor’s option is 0.6 * (-2000) = -1200.
In other words the investor loses 1200 ∆ S when the stock price increases by

74
∆ S . The delta of the stock by definition 1.0 and the long position in 1200

shares has a delta of +1200. The delta of the investors overall positions,
therefore, zero. The delta of the asset position offsets the delta of the option
position. A position with a delta of zero is referred to a being delta neutral.
But delta neutral remains for a relatively short period of time Black-Scholes
valued options by setting up a delta neutral position and argued that the
return on the position should be the risk-free interest rate.

Theta:

The theta of a portfolio of option, Ө, is the rate of change of the value of

the portfolio as time passes with all else remaining the same. It is sometimes
referred to a time decay of the portfolio. Theta is almost always negative for
an option. (An exception to this could be an in-the-money European put
option on a non dividend paying stock or in-the-money European call option
on a currency with a very high interest rate). This is because as the time to
maturity decreases, the option tends to become less valuable.

Gamma:

The gamma of a portfolio on underlying assets is the rate of change of the

portfolio’s delta with respect to the price of the underlying asset. If gamma
is small, delta changes very slowly, and adjustments to keep a portfolio delta
neutral would only be made relatively infrequently. However, if gamma is
large in absolute terms, delta is highly sensitive to the price of underlying
asset. It is then quite risky to leave a delta neutral portfolio unchanged for
any length of time.

Vega:

75
 Vega, also referred to as Kappa or as Sigma or as Lambda, of a portfolio
of options is the rate of change of the value of the portfolio with respect to
the volatility of the underlying asset. If Vega is high in absolute terms,
volatility changes have relatively little impact on the value of the portfolio.
If a hedger requires a portfolio to be born gamma and Vega neutral, at least
two traded options dependent on the underlying asset must be used.

RHO:

The rho of a portfolio of options is the rate of change of the value of the
portfolio with respect to the interest rate. It measures the sensitivity of the
value of a portfolio to interest rates.

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 CHAPTER 5

SWAPS

5.1 Introduction

5.2 Definition

5.3 Types Of Swap

5.4 Valuing Swaps

5.5 Forward Swaps And Swaptions

5.6 Termination Of A Swap

77
5.1 INTRODUCTION
Swaps are transactions which obligates the two parties to the contract
to exchange a series of cash flows at specified intervals known as
payment or settlement dates. They can be regarded as portfolios of
forward's contracts. A contract whereby two parties agree to exchange
(Swap) payments, based on some notional principle amount is called as a
‘Swap’. In case of swap, only the payment flows are exchanged and not
the principle amount.

5.2 DEFINITIONS

Many scholars define swap in many ways. Few of them are given
below:

 An agreement or transaction in which two or more parties

exchange their cash flows at a predetermined series or payments.
 Exchange or interest rate payment for specific maturity on an
agreed upon notional principal.
 An agreement whereby one party exchanges with the other a set of
interest payments for another, say fixed rate to floating rate or vice
versa.

With the help of swap, a floating rate liability can be converted into
a fixed rate liability, ensuring that the volatility in the interest rates does
not increase the burden of payments or else, vice versa convert a fixed
rate liability into a floating rate liability when the interest rates fall
steeply in the market.

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5.3 TYPES OF SWAP
1. Commodity Swaps:
In a commodity swap, the counterparties make payments based on the
price of fixed amount or a certain commodity in which one party pays a
fixed price for the good and the other party pays a market rate over the
swap period.

2. Currency Swaps:
A currency swap is a mutual understanding of parties for exchange or
interest payments either fixed or floating on loan in new currency to an
equivalent loan in another currency. This may or may not involve initial
exchange of principal; a plain vanilla currency swap is a fixed-fixed
currency swap in which each party pays a fixed payment on the loan
taken by them.

With the rise in interest rate swaps, the currency swaps market also
rose from the earlier parallel and back to back loan structures which were
developed and designed in the United Kingdom as a mean of
circumventing foreign exchange controls and to prevent an outflow or
British capital. In the 1970s the British government imposed taxes on
foreign exchange transactions that involved its currency. Due to this, the
parallel loan became a widely accepted transaction by which these taxes
could be avoided. In 1979, these taxes on foreign exchange transactions
were removed and due to these British firms need not have to take back-
to-back loans. However, during the 1980s, banks modified those loans
and launched currency swaps. They achieved similar economic purposes
like those or parallel and back-to-back loans. Currency swaps effectively
decreased the use of these loans due to the following advantages:

79
 i. In currency swaps, termination or contract can be done if one party
defaults the other party and can claim damages.
ii. Since currency swap is not a loan, it does not appear as a liability
on the contracted party balance sheet unlike other loans.
iii. Currency swaps give greater liquidity. Due to this many banks
agree to take the risk in swaps transaction.
3. Equity Swaps:

An equity swap means an exchange or dividends earned and capital

gains on a portfolio, which is based on a stock index against period
interest payments. It is similar to an interest rate swap, in that it has a
fixed period, a fixed rate payer and a floating rate payer.

4. Interest Rate Swaps :

Interest rate swaps is an arrangement by which one party agrees to

exchange his series of fixed rate interest payments to a party in exchange
for his variable rate interest payments. The fixed rate payer takes a short
position in the forward contract whereas; the floating rate payer takes a
long position in the forward contract.

5. Others:

Other types of swaps include power swaps, weather swaps, etc. The
swaps that are privately negotiated financial contracts that allow two
parties to exchange specific weather risk exposures over a predetermined
period of time are called weather swaps. They are “over-the-counter”
instruments that can be customized to the parties specific needs. These
swaps are simply designed to help to protect against warmer than normal
winters, for example, by selling a swap at a predefined number of heating
degree days indexed at a specified weather station. There is no cost for a
swap, and, although there are standardized industry contracts.

80
5.4 VALUING SWAPS

Since swap is an exchange of two streams of cash flows it can be price

by determining the value of each stream of cash flows. The value of each
stream of cash flows is the net present value of the cash flows in the
stream. If the cash flow are in different currencies (as in currency
swaps), the present values are converted to a single currency at the
prevailing exchange rate. The price of the swap is the difference
between the values of the two cash flows. This comparison helps us in
pricing and valuing swaps.

1. Equivalence Of Swaps And Other Instruments:

Swaps and Assets: A currency swap is similar to a fixed or floating rate
bond which is issued in one currency, and whose proceeds cab be
converted into other currencies and used to purchase a fixed or floating
rate bond denominated in a different currency. An interest rate swap is
identical to a fixed or floating rate bond whose proceeds cab be used to
purchase a floating or fixed rate bond. Whose notional price is equivalent
to the face value of these hypothetical bonds. Equity swaps cab ne
compared to issuing one type of security and using the proceeds to
purchase another. At least one of the types of the securities should be a
stock or stock index.

a. Swaps And Forward Contracts:

A forward contract is an agreement for one party to make a fixed
payment to other party, while the latter party is obliged to make a variable
payment to the former. A swap can be said as a series of forward
contracts combined into single transactions. There are some differences
between swaps and forward contracts, for example. Swaps are a series of
equal fixed payments, nut a series of forward contracts, the component

81
contracts are mostly priced at different fixed rates. In case of interest rate
swap, the next payment that each party has to make is known beforehand,
but in a single forward contract it is unknown. Keeping aside these
differences, it is generally acceptable to compare a swap to series of
forward contracts.

b. Swaps And Future Contracts:

A swap can be compared to a future contract only to the extent to
which a future cab be compared to a forward. A future contract can be
compared to a forward contract only when the future interest rates are
known. Since swaps are usually used to manage uncertain interests, it
may not always be appropriate to compare a swap with a future contract.

c. Swap And Option:

A swap payment can be compared to buying a call and selling a put
and forcing the transacting party, when the underlying is below the
exercise rate at expiration, to make a net payment or resulting in receipt
of payment when the underlying is above the exercise rate. The
connection between swaps and options is very clear and straightforward
for interest rate instruments than currency and equity instruments.

2. Valuation Of Swap:
At the timer of entering into the swap both the parties will have the
same value for all inflows and outflows, but after entering into swap the
value may change due to changes in the interest rates. If the interest rates
increase, the value of the fixed rate payer will decrease and if the interest
rate decreases the value of fixed rate payer will increase. Depending on
the value increase, if a party in the swap wants to realize the gain, it can
reverse the existing swap with a new market swap.

82
 Swap can be valued on similar lines as bonds as they essentially
involve a series of cash flows at different points of time. We first have to
discount the inflows at an appropriate rate and determine the present
value. We repeat this process in the same way for outflows also. This
difference between the value of inflows and outflows is nothing but the
value of swap. Generally, the prevailing LIBOR rate is used for
discounting the cash flows associated with fixed rate.

3. Valuation Of Currency Swaps:

In the case of currency swaps, the valuation can be done considering
the swap as a portfolio of two bonds. So, the swap value will be the
difference between the current values of both the bonds, as per the
following formula:

V= PF – PL

Where,

V = value of the swap

PF = value of the foreign currency bond

PL= value of the local currency bond.

Suppose a Western firm is in need of $40 million to finance a foreign

investment. The French franc yields were higher than the US dollar
yields. The French firm would have to pay 9% on a 5-year US dollar
loan and 10% on a 5-year French franc loan. Similarly, a US firm needs
a loan of 291.2 million French francs for its French subsidiary but has an
easier access to the US bond market. The US firm has to pay 8% on a 5-
year US dollar loan and 11% on a 5-year French franc loan. Current spot
rate is 7.68 Fr/$. The US firm can borrow in $ at 8% and the French firm

83
in French franc at 10%. Then they swap their borrowings to meet their
requirements.

Let P$ and P F represent the values of the dollar and French franc
bonds given the market interest rates r $ and rF on the bonds in the two
countries. Then the French franc value of the swap for a spot exchange
rate S is,

Swap value = PF - SP$

This is the value of the swap to pay dollar and receive French franc.
The dollar value of the swap can be deduced for the French franc value of
the swap by dividing it by spot exchange rate S. The value of the swap
for the other party, which has agreed to pay francs and to receive dollar,
is exactly the opposite of that computed above.

At the time of issue, the two interest rates were assumed to be equal to
the market yield to maturity on five year risk-free bonds in dollars (8%)
and French francs (10%). Assume that after a year the yield curves in
dollars and French francs are flat and the interest rates have dropped to
7% and 8% on US dollar and French franc respectively. The exchange
rates drops to 7.56 FFr/$. A swap payment of French franc 4.928 million
has just been made.

The dollar bond was worth $40 million (its par value) when the swap
was constructed with a dollar interest rate of 8%. The value of the bond
after one year when the interest rate falls to 7% is,

P$ =3.2PVIFA +40 PVIF

= 41.355 million.

84
 Similarly the French franc bond was worth Fr 291.2 million (par
value) when the swap was contracted. After one year, the bond value is

PF =29.12 PVIFA + 291.2 PVIF

=310.49 million

The franc value of the swap is,

Swap value = 310.49 - 41.355 * 7.56

= - 2.1538

The dollar value of the swap will be,

Swap value = - 2.1538/7.56

= - 0.2849 million.

The practical difficulty encountered in this problem is the

determination of interest rates used on both legs of the swap. For each
cash flow on the fixed leg, we should use a zero coupon term structure.

4. Valuation Of Equity Swaps:

An equity swap means an exchange of dividends earned and capital
gains on a portfolio, which is based on a stock index against periodic
interest payments. It is similar to an interest rate swap, in that it has a
fixed period, a fixed rate payer and a floating rate payer.

Assuming that you are managing a portfolio of stocks invested in an

index fund. The underlying index is the S ¿P 500. You turn bearish
following the recent movement in the stock prices and you wish to hedge
your position against any adverse movement in the future. So, you can
use a swap where you pay the return on S&P 500 and receive a fixed
payment in exchange. Both fixed rate receipts and floating rate payments

85
are based on the notional principal i.e. your portfolio value. This is
possibly say, if you find another party which is interested in the S&P 500
investment and is ready to pay you the fixed interest returns on say,
sterling pounds and sterling interest rates.

5. Valuation Of Interest Rate Swaps:

While valuing the plain vanilla interest rate swap, the fixed leg should
be considered a fixed coupon bond and the floating rate should be
considered a floating rate note.

Considering that at maturity level the fixed and floating parties give
each other equal amount of money, the pricing of the swap becomes
simply the value of the fixed coupon bond minus the value of the floating
rate note. This is denoted by formula given below:

V = F B - FF

Where,

V = Value of the swap

FB = Value of the fixed coupon bond

FF = Value of the floating rate note.

In the above said formulae, the values of both the fixed leg and the
floating leg swaps will be different as market rates change after the initial
pricing of the swap. On the fixed leg, the cash flows do not change but
the discount factor changes and hence the value. While on the floating
side, both the cash flows and the discounting factor change and hence the
value change. Such kind of swap called an off-market swap.
This states that the value of an off-market swap can be neither positive
nor negative but not zero.

86
5.5 FORWARD SWAPS AND SWAPTIONS

Forward swaps are those which are arranged in which the

commencement date is set as a future date helping in locking the swap
rates and use them later as and when needed. They are known as deferred
swaps. This is attractive to these users who do not need funds
immediately but would like to benefit from the existing rates of interest.

While options on swaps or Swaptions can be written on any kind of

swap and give the holder the option to enter into swaps at a certain date in
future on terms agreed at the time of purchase of the swaption. They
ensure that the interest paid on a swap in future will not exceed a certain
pre-decided level. Swaptions give a right but not obligation to the buyer
to exercise his choice. Swaptions can be either American or European.
European swaptions are more popular and can be exercised only on
maturity, while the American ones can be exercised any time before
maturity.

Swaptions can be of two types:

1. Call Swaption:
A call swaption gives its buyer the right to enter into a swap as a fixed
rate payer. The writer of the call swaptions will be floating rate payer if
the option is exercised.

Assume that your firm wishes to enter into a fixed floating rate swap
because you expect the rates to rise and hence you want to pay a fixed
rate and receive a floating rate. But there is a speculation that the rates
may start falling after a certain period and hence you may buy a call
swaption sot that depending on the rate of movement in the future you
can enter into a swap deal or allow your option to expire.

87
 2. Put Swaption:
Here, the buyer gets the right to enter into a swap as a floating rate
payer. The writer becomes the fixed rate payer when the option is
exercised

5.6 TERMINATION OF A SWAP

Many swaps are terminated early by entering into a separate and

offsetting swap. Suppose a company is engaged in a swap to make fixed
payments of 5% and in return receive floating payment based on LIBOR,
with the payments made on 15 January and 15 July for 3 years. 3 years
remain on the swap. That company can offset the swap by entering into
an entirely new swap in which it makes the payment based on LIBOR
and receives a fixed rate with payments made on 15 January and 15 July
for 3 years. The swap fixed rate is determined by market conditions at
the time the swap is initiated. Thus the fixed rate on the new swap is not
likely to match the fixed rate on the old swap, but the effect of this
transaction is simply to have the floating payments offset: the fixed
payments will be out to known amount. Hence the risk associated with
the floating rate is eliminated. The default risk, however, is not
eliminated because both swaps remain in effect.

88
 CHAPTER 6

DERIVATIVES AND RISK MANAGEMENT

6.1 Risk Identification And Qualification

6.2 Decision To Manage Or Accept Risk Exposure

6.3 Risk Management Alternative

6.4 Strategy Development And Implementation

89
6.1 RISK IDENTIFICATION AND QUANTIFICATION

For financial intermediaries there are five main risk types, all of which
are capable of being managed to acceptable levels. These risks include:

1. Interest rate.

2. Price (valuation).

3. Prepayment.

4. Credit.

5. Exchange rate.

Once the type of risk to be managed has been identified, the next issue
becomes the objective quantification of that risk. Depending on the type
of risk, there are several commercially supported computer models
available. Regardless of the specific modeling approach employed, there
are at least three key elements that need to be included in the
quantification effort to enable subsequent risk management decisions.

1. Underlying Assets And Liabilities Creating The Risk Exposure:

Key issue is to examine both the asset and liability side of the
risk exposure to enable an understanding of the individual portfolio
exposure as well as the net exposure created by the combination.
2. Term Of Risk Exposure:
Key issue is to determine the length of time the exposure is
expected to exist. An important sub-issue is to determine if the
exposure is a onetime event, or if it is a continuing series of events.
3. Direction Of Risk Exposure:
Key issue is to determine the directional interest rate, price, or
exchange rate movement to which the underlying risk position is

90
 exposed. This is not a forecast; it is simply a determination of the
market environment within which the underlying risk position is
negatively (and positively) impacted.

As a result of addressing the foregoing risk identification and

quantification issues, it is fairly easy to construct a graphical
representation of the "as is" performance profile of the underlying
balance sheet or portfolio. This can be as simple as creating a graph of a
single security portfolio, or as complex as executing a series of
sophisticated balance sheet, cash flow, income statement, and
econometric models representing the relationships of a myriad of
interrelated business activities or portfolio holdings. Regardless of how
simple or complex the effort, an "as is" profile can, and must, be
produced before implementing strategies to alter the profile. The reasons
for this are fairly straightforward:

 Without an understanding of the "as is" profile, it is difficult, if not

impossible, to evaluate the effectiveness of any strategy
implemented to alter the "as is" profile.
 Regardless of how well intentioned management's risk
management efforts might be, without an understanding of the "as
is" profile, many risk management strategies actually end up
exacerbating risk exposure as opposed to managing it towards the
desired profile.
This "as is" performance profile will be very useful in establishing a
reference point by which all subsequent decisions can be evaluated and
facilitated.

91
6.2 DECISION TO MANAGE OR ACCEPT RISK
EXPOSURE

The driving force of any effort to manage risk is the conscious decision,
by management, to either accept or modify the risk exposure quantified as
being inherent in the underlying balance sheet or portfolio. Naturally, this
type of decision needs to be made within the context established by the
goals and objectives that make up the Company's business plan, and the
environment within which the resulting risk management strategies will
be implemented.

6.3 RISK MANAGEMENT ALTERNATIVES

Once a conscious decision has been made to manage a given risk

exposure, management's attention should then turn to an evaluation of the
effectiveness (risks, costs, and benefits) of the various risk management
alternatives. As a general rule, there are three main alternative risk
management categories from which to draw:

1. Policy Decisions:
This category is made up of the business policy decisions
management makes in their on-going effort to achieve their
competitive position and financial performance objectives. These
are usually the least costly to implement, but are somewhat limited
in their utility to manage all the exposure to be managed without
eliminating profit potential. Regardless of this limitation, this
alternative, at minimum, should be exhausted before utilizing
derivatives.

92
 2. Cash Market Transactions:
This category is made up of the conventional transactions
management employs to manage the Company's balance sheet in
conformance with industry practices and regulatory guidelines. For
financial intermediaries these are usually money market, fixed
income, mortgage-backed, and equity securities related
transactions. These alternatives are best utilized when there is
exposure remaining to be managed after management has
exhausted policy decision alternatives and before utilizing
derivatives.
3. Derivatives:
This category is made up of financial instruments that have been
derived from underlying instruments that have similar, if not the
same, characteristics as the assets and liabilities that make up the
Company's risk position (balance sheet or portfolio). These
instruments include; forwards, futures, options, swap, etc. Since
this category tends to have more inherent risks, derivative
alternatives should be utilized only when there is risk remaining to
be managed after management has exhausted all policy decision
and cash market transaction alternatives.

It is important to note that even though management may make a

conscious decision to manage a given portion of the Company's risk
exposure, and may deliberately act to conscientiously exhaust all policy
decision and cash market transaction alternatives, there may remain some
exposure still yet to be managed. When this occurs, management's
attention needs to be focused on evaluating the risk/reward profile
associated with utilizing derivatives to manage the remaining exposure.
Therefore, there are times, wherein, there is no practical alternative

93
available to management other than continued acceptance of the
unmanaged risk exposure.

6.4 RISK STRATEGY DEVELOPMENT AND

IMPLEMENTATION

Regardless of the type of risk exposure and how it was quantified,

regardless of why management decided to manage the exposure, and
regardless of the risk management category from which the strategy is
drawn, there are five basic issues that need to be addressed in order to
develop and implement a strategy in such a way as to minimize, as
opposed to exacerbate, the Company's exposure:

1. Establish a reference point from which strategies will be developed

and by which strategies will be evaluated. The "as is" performance
profile as previously described is helpful in this regard.
2. Clearly state and document the objectives underlying the strategy.
3. Ensure suitability of strategy, both initially and by tactical
adjustments on an on-going basis, by making sure that the
decisions, actions, and instruments making up the strategy and
tactics produce a profile that, when added to the "as is", mitigates
as opposed to exacerbates the underlying position's exposure. This
can be accomplished by modeling the effect the strategy and
related tactical adjustments have on the "as is" performance profile.
4. As a general rule there is more than one strategy and related set of
tactical adjustments that can be considered suitable for
accomplishing most objectives. Therefore, management needs to
objectively evaluate (in both favorable and unfavorable market
environments) and select the most suitable strategy for
implementation.

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 CHAPTER 7

FINDINGS, SUGGESTIONS, CONCLUSION

7.1 Findings
7.2 Suggestions
7.3 Conclusion

95
7.1 FINDINGS

 Derivatives market in India is still in its development stage. It is

not at par with worlds derivatives market
 Speculation has caused many small investors to lose their valuable
savings
 Derivatives instruments are only for higher value of transaction.
An individual trader finds it difficult to invest in derivative market.
 As it is still in development stage people are unaware of derivative
instruments available.
7.2 SUGGESTIONS

 Derivatives market should be developed in order to keep it at par

with other derivative markets in the world.

 Speculation should be discouraged.

 There must be more derivative instruments aimed at individual

investors.

 FEDAI and RBI should conduct seminars regarding the use of

derivatives to educate to various sections of traders which should
include individuals, money changers, bank dealers, corporate
dealers, etc.

7.3 CONCLUSION

The economic benefits of derivatives are not dependent on the size of

the institution trading them. The decision about whether to use
derivatives should be driven, not by the company’s size, but by its
strategic objectives. However, it is important that all users of derivatives,
regardless of size, understand how their contacts are structured, the

96
unique price and risk characteristics of those instruments, and how they
will perform under stressful and volatile economic conditions. Without a
clearly defined risk management strategy, use of financial derivatives can
be dangerous. It can threaten the accomplishment of a firms long range
objectives and result in unsafe and unsound practices that could lead to
the organization insolvency. But, when used wisely, financial derivatives
can increase shareholders value by providing a means to better a firms
risk exposures and cash flows. When using financial derivatives,
however, organizations should be careful to use only those instruments
that they understand and that fit best with their corporate risk
management philosophy.

The SEBI’s advisory committee to derivatives has proposed a set of

measures to improve liquidity in the markets. These measures once
approved by the SEBI board, would permit FII participation in all
derivatives products. The committee also suggested that banks funds
could be channeled through the stocks exchange clearing
corporation/house

The minimum value of a contract for stock derivatives at present is

fixed at RS.2 lakh and it is viewed as high for retail participation.
However, only a fraction of it has to be paid on the option contract in the
form of premium as the option price.

With only a marginal investment, one can take large, positions in the
market. The options market would pick up in Indian subcontinent fairly
quickly despite the nuances of the complex mathematics involved in the
valuation of the options, in view of intuitive understanding of options is
excellent. Hence there is reason to be hopeful that it would grow rapidly.

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BIBLIOGRAPHY

Following is the list of books referred:

 Derivatives Analysis and Valuation

- The ICFAI University Press
 Financial Derivatives: Risk Management
- V. K. Bhalla
 Option, Futures and Other Derivatives – 5th And 6th Revised
Editions
- John C. Hull
 Introduces Quantitative Finance
- Paul Wolmott

The following websites were used:

1. http://www.strategies-tactics.com/derivatives.htm#risk
2. http://www.numa.com/ref

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ANNEXURE

Questionnaire

Q1. What are derivatives in plain English?

Q2. What is the difference between derivatives and shares?

Q3. How are they used?

Q4. What is the attraction of derivatives?

Q5. What is gearing?

Q6. Are they very complex?

Q7. Are derivatives very risky?

Q8. Were derivatives the cause of Barings’ downfall?

Q9. How do I invest in derivatives?

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