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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 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.

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.

1.

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.

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.

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)

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.

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

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:

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%

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 )

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.

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.

Swaps can be used to convert the nature of funding

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.

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:

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.

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.

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.

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