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Sanjay Saraf

Rough Note:
Bullish: Daam Badega
Bearish: Daam Girega
Options both OTC and exchange traded
22 August 2016

Class 1(Introduction)
We divide the entire topic into the following parts: 1. Introduction 2. Forward
Rate Agreement (FRA) 3. Financial Swap 4. Futures 5. Options 6. Other types of
Derivatives
1.
Introduction
1.
Definition: It is a financial contract which derives its value from
some underlying asset, reference rate(LIBOR), Index(Nifty), etc.
It is an instrument designed for betting
1.
Types of Derivatives:
Forward Commitment
-Both sided betting (Ex Forward, future, financial Swap)
A.

Contingent Claims
- One sided betting (Ex: Opt
Cap& Floor)

Types of Derivatives
Forward Contract: Both sided Betting, Long Position (F+) will gain if
the price rises, Short Position (F-) will gain if the price falls, OTC traded,
Normally no Margin Requirement, not repriced
Futures Contract: Similar to forward contract but they are exchange
traded. Strict Margin Requirement, Mark to market
Financial Swap: It is a portfolio of forward contract.
Call Option: Upside Betting, C+(Call Buyer) : Right to buy(Right to
enjoy the upside without paying the downside) C-(Call Seller) : Obligation to
sell (Obligation to pay the upside without enjoying downside), Obviously C+
will pay to C- an upfront call premium(Hak ka daam)
Put Option: Downside Betting. P+ : (Put Buyer)Right to sell (Right to
enjoy the downside without paying the upside) P-(Put Seller): Obligation to
buy ( Obligation to pay the downside without receiving the upside)
Obviously P+ will pay to P- an upfront put premium.

Ex: You bought a put option on a stock at a strike price of 500, for a premium of
60. What would be your payoff and profit if on maturity : a) S=590 b) S=430
Ans) a: Put lapses i.e. payoff = nil and loss=60, initial premium paid
b: Put exercised in our favour. Therefore payoff=70, Profit = 70-60=10
Ex 2. You sold a call option(C-) on a stock at a strike price or exercise price of 800
for a premium of 90. What would be you payoff and profit if on maturity
a)S=1000
s=500

Ans) a: Call exercised against us. Therefore payoff = -200 and loss = 20090=110
b: Call lapses, payoff=nil, Profit = 90

Food for thought: Option buyer (C+ or P+ )runs a high probability of losing a
small amount with a very low probability of winning a huge amount.
A.
1.

Types of Derivatives
Exchange Traded: Standardized, Futures, Strict Margin Requirement,
Virtually no counterparty default risk, Marked to market everyday wit the
difference being adjusted in the margin so there is daily settlement of gains
and losses, Highly Regulated, Highly Liquid (ability to enter and exit as
many times) , more suitable for speculation, this are generally squared off
prior to maturity, ex: futures
2.
Over the Counter: Customized, Counterparty Risk, Normally no
Margin Requirement, there is no re-pricing so gains and looses gets
accumulated, less regulated, Lack of liquidity, favourable for hedging
(specialization is required), this are generally settled on maturity, ex:
forward & swaps
1.
Players in the derivative markets:
Hedgers

Speculators

They have an existing exposure.

They have no exposure but a strong price belief.

They take up a long or shot position They take a long or short position in the derivative
in the derivative to reduce the
to profit from their price belief Knowing fully well
exposure.
that they can lose.

Note: All derivatives are priced according to the prevention of arbitrage


principle
A.
Why derivatives are preferred over cash market?
Leverage: Derivatives provide leverage. Taking a big exposure by putting in
a small amount.
Liquidity: Derivatives have higher liquidity
Transaction cost: Derivatives have lower transaction cost
Shorting: Shorting is easier done through derivatives.

Class 2(Forward Rate agreement/FRA)


1.

FRA is a forward contract on LIBOR (London Inter Bank Offered Rate)


i.e. FRA is designed to bet on LIBOR. It is an OTC derivative in which banks
act as market makers and provide Bid-Ask Quotes.
Suppose a bank is quoting a 6x9 FRA at 8%/10%. This FRA is a bet on 3
Month LIBOR after 6 month.
--> Buying this FRA is theoretically a contract to borrow a certain amount
say $500 Million after 6 months for 3Month at 10%
--> Selling this FRA is theoretically a contract to invest a certain amount say
$500 Million after 6 months for 3Month at 8%
However no actual borrowing or investment takes place. Instead FRA is cash
settled at the present value of the difference between actual LIBOR and FRA
rate.

Ex: A bank quotes a 2x7 FRA at 9%/11%. You sell this FRA on a notional
principle of $800 Million. What would be your profit or loss if after 2 months,
the 5 month LIBOR turns out to be (a) 7% (b) 13%
Solution: We have F- at 9%
1.
L= 7<9 so the customer wins and will receive PV of the difference
i.e. {(9-7)% x 800 x 5/12}/(1+.07x5/12)
$6.48 Million
1.
L=13>9 so the customer losses and will have to pay PV of the
difference i.e. {(13-9)% x 800 x 5/12}/(1+0.13x5/12)
$12.65 Million (approx.)
1.

FRA is priced according to the prevention of arbitrage principle:


Forward Rate= Bigger rate/ Smaller factor -1 -->Annualised
If market rate or below or above that, there is an arbitrage opportunity
Example: Consider 9 month LIBOR = 12%, 6 Month LIBOR = 11%, A) What
should be the price of 6x9 FRA B) Show the process of Arbitrage if the 6x9
FRA quotes at 9%/10%
Solution: 9 Month LIBOR=12% (9% periodically)
6 Month LIBOR=11% (5.5% Periodically)
{(1.09/1.055)-1}x12/3
13.27%
Since the actual quote i.e. 9%/10% is less than 13.27%, FRA is
under priced and we should buy(Contract to borrow)

2.
5
%
Step1: Borrow $500 Million at 6 Months LIBOR Therefore outflow after 6
Months = 500x1.055=527.5
Step 2: Contract to Borrow $527.5 Million through FRA after 6 months for 3
months.

Therefore Outflow after 9 Months= 527.5x1.025=540.6875 Million


Dollars
Step3: Invest $500 Million at 9 month LIBOR. Therefore inflow after
9months= 500x1.09=545 Million Dollar
Therefore arbitrage profit = 545-540.6875=4.3125 Million Dollar

A.

Show the Process of Arbitrage if the actual Quote for 6x9 FRA is
15%/16%
Ans) Since the actual quote is greater than 13.27%, FRA is overpriced and we
should sell (Contract to invest)

Step1: Borrow $500 Million at 9 month LIBOR. Therefore outflow after 9


Month= 500x1.09=545 Million Dollar
Step2: Invest $500 Million at 6month LIBOR. Therefore inflow after
6months= 500x1.055=527.5 Million Dollar
Step 3: Contract to invest $527.5 Million after 6months for 3 Months
through the FRA. Therefore inflow after 9 months- 527.5x1.0375=547.2812
Million Dollar
Therefore Arbitrage profit= 547.28-545 = 2.28 Million Dollar
1.

FRA can also be used for Hedging purpose:


A prospective borrower is afraid of interest rate rising and can lock
in the cost of borrowing by buying an FRA
A prospective investor is afraid of interest rate falling and can lock
in Return on investment by selling an FRA

Financial Swaps

A Financial Swap is a portfolio of forward contracts i.e. it involves


multiple times betting.It is also defined as an exchange of a stream of cash
flows.
A Plan Vanilla Interest Rate Swap involves swapping Floating
Payment V/S Fixed Payments based on a notional principle and with netting
feature.
Suppose on 1st Jan 2012, A and B enter into a 1 Year, quarterly pay LIBOR
V/S fixed Swap as shown below:

Q.) Notional Principle = $800 Million . Basically A is betting that LIBOR


will rise above 10 while B is betting otherwise
Suppose the 3 Month LIBOR on various reset Date happen to be
Dates

3ML(month
Libor)

1/1/12
1/4/12
1/7/12
1/10/12

9%
13%
8%
15%

Find out the net payment at the end of each quarter?


Ans. 1st Quarter: Relevant LIBOR=9<10. Therefore B wins and receives
(10-9)%x800x3/12=2 Million Dollar
2nd Quarter: Relevant LIBOR=13>10. Therefore A wins and
receives (13-10)x800x3/12=6 Million Dollar
3rd Quarter: Relevant LIBOR=8>10. Therefore B wins and
receives (10-8)x800x3/12=4 Million Dollar
4th Quarter: Relevant LIBOR=15>10. Therefore A wins and
receives (15-10)% x800x3/12=10 Million Dollar
Note: In India there is special type of Interest Rate swap known as the
overnight Index Swap (OIS) in this Swap the floating leg i.e. MIBOR (Mumbai
Inter Bank Offered rate) is subject to daily compounding
A.

On 20th July Thursday X ltd entered into a 6 day OIS with a bank for
a notional principle of Rs. 800 Lakhs. The fixed rate of the swap was 11%
The following taable shows the MIBOR for each day
20/07
21/07
22/07
24/07
25/07

Thursda
y
Friday
Saturday
Monday
Tuesday

12%
11.5%
10%
13%
12.5%

Compute the net payment at the end of the swap(Assume X Ltd. is the fixed
rate receiver )

Sol) The Swap is as shown below:

Payment for the fixed leg=11% of 800 x 6/365 = Rs. 1.45 Lakhs
In an OIS MIBOR is subject to daily compounding
Therefore Effective MIBOR for six days = (1+0.12/365)x (1+
0.115/365)x{1+(2x.1/365)}x(1+.13/365)(1+0.125/365)-1
=(1.000329X1.000315X1.000548X1.000356X1.000
342)-1
= 0.19%
Therefore payment for the floating leg = 0.19% of 800
= Rs.1.52 Lakhs
Net Payment to be made by X = 1.52-1.45=Rs 0.07 Lakhs
1.

Swap Quotation: Bank act as market makers and provide Bid-Ask


quotes. The quotes represent fixed rates v/s a floating rate say LIBOR. The
fixed quotes are generally expressed as a spread over treasury yield.
Suppose a bank quotes 5 year Fixed to floating swap at a spread of
30/80 basis points over 5 year treasury v/s LIBOR. 5 Year treasury presently
yield 9%. So the quote is 9.3%/9.8$ v/s LIBOR
This Means that the bank is willing to enter into the following two types of
swap:
1.
Bank pays 9.3% fixed and receives LIBOR
2.
Bank receives 9.8% fixed and pays LIBOR
So if the bank is equally struck on both side of the court, it locks in a spread
of 0.5%(9.8-9.3) subject to counterparty default risk.

1.

Problems based on swap quotation:

Swap can be used to reduce the cost of preferred form of funding.


Swaps can be used to convert the nature of funding

A swap bank is quoting 5 year fixed to floating swap at 80/110 basis


point over treasury v/s LIBOR. Treasuries are yielding 9.5.
Firm A wants to borrow fixed rate funds it could do at 13%. Instead floating
funds are available at a spread of LIBOR+1.2% . Explain how firm A can
reduce the cost of straight funding.

Ans) Firm A wants to borrow fixed rate funds (13%). Since this rate is too high,
we advice firm A to borrow floating rate funds (L+1.2). It should then convert
floating rate funding into fixed rate funding via a swap in which it receives
LIBOR and paays fixed i.e. 10.6%.
Therefore effective cost = Outflow-Inflow
= LIBOR+1.2+10.6-LIBOR
= 11.8% which is less then 13%
The swap is structured as shown below:

A.

(Continued previous) Firm B had borrowed 7year fixed rate fund 2


years ago at 11.5%. It now expects interest rates to fall. And wishes to
convert its fixed funding to floating funding. How can it do so LIBOR in
subsequent years happens to be 10, 12, 14,15 and 16% . Do you think it
was prudent for Firm B to convert the nature of funding.
Ans) Firm B has already borrowed at 11.5% fixed and wants to convert it into
floating. It should therefore enter into a swap wherein it receives fixed i.e. 10.3%
and pays
LIBOR.
Effective cost = Outflow-Inflow
= 11.5+L-10.3
= L+1.2
The Swap is structured as shown below:

Average LIBOR =10+12+14+15+16/5=13.4%


Therefore effective cost with the swap= L+1.2=13.4% + 1.2%
=14.6% which is greater than 11.5% so it is not
prudent for firm B to have converted the nature of
its funding.

Class 3
FRA Homework
A.

2x5 FRA is trading at 8%/9%. A trader went short on the


FRA on the notional principle of $500,000. If 3 Month KIBOR
after 2 Months turns out to be A)13.5% B) 6.5%
Ans) A:

B: Profit=1845.02
A.
Ans)

Given 3 Month LIBOR is 9% and 9 Month LIBOR is 12% find out the
price of 3x9 FRA

A.

Suppose in the previous sum the 3x9 FRA is quoted at 17%/18% .


Show the process of arbitrage

A.
What if 3x9 FRA is quoted at 9%/10%. Show the arbitrage
Ans) Buy the FRA
A.
What if 3x9 FRA is quoted at 13%/14%. Show the arbitrage
Ans) No arbitrage

SWAP Homework
Note:
LIBOR is the rate of borrowings between large multinational banks and it changes
every moment.