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Mission RBI 2018 - Financial System

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. For
example, wheat farmers may wish to sell their harvest at a future date to eliminate the
risk of a change in prices by that date. Such a transaction is an example of a derivative.
The price of this derivative is driven by the spot price of wheat which is the ‘underlying’.

The International Monetary Fund defines derivatives as “financial instruments that are
linked to a specific financial instrument or indicator or commodity and through which
specific financial risks can be traded in financial markets in their own right. The value of
a financial derivative derives from the price of an underlying item, such as an asset or
index. Unlike debt securities, no principal is advanced to be repaid and no investment
income accrues”.

What kind of underlying assets are derivatives generally available on?


Common underlying assets for derivatives are:
• Equity Shares
• Equity Indices
• Debt Market Securities
• Interest Rates
• Foreign Exchange
• Commodities

Products, participants and functions:


Derivative contracts have several variants. The most common variants are forwards,
futures, options and swaps. The following three broad categories of participants
hedgers, speculators, and arbitrageurs trade in the derivatives market.

• Hedgers face risk associated with the price of an asset. They use futures or options
markets to reduce or eliminate this risk. Hedging is a position taken in futures for the
purpose of reducing exposure to one or more types of risk. • The hedging strategy can
be undertaken in all the markets like futures, forwards, options, SWAP etc.

Hedging means reducing or controlling risk. This is done by taking a position in the
futures market that is opposite to the one in the physical/cash market with the objective
of reducing or limiting risks associated with price changes.

Hedging is a two-step process. A gain or loss in the spot position due to changes in
price levels will be countered by changes in the value of a futures position. For instance,
a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If
there is a fall in price, the loss in the cash market position will be countered by a gain in
futures position.
Mission RBI 2018 - Financial System

•Speculators use derivatives to bet on the future direction of the markets. Their
objective is to gain when the prices move as per their expectation.

• 3 types based on duration:

i. SCALPERS – hold for very short time (in minutes).


ii. DAY TRADERS- one trading day.
iii. POSITION TRADERS- long period (week, month, a year).

• Arbitrageurs are in business to take advantage of a discrepancy between prices in


two different markets. If, for example, they see the futures price of an asset getting out
of line with the cash price, they will take offsetting positions in the two markets to lock in
a profit. Arbitrageurs try to make risk-less profit by simultaneously entering in to
transactions in two or more market.

Types of derivatives:

Exchange-traded derivatives:
• Exchange-traded derivatives are contracts that trade on an organized exchange.
Contracts can be bought and sold any time the exchange is open.
• The contracts have standardized terms set by the exchange or the clearing
house.
• Prices are publicly available.

Over-the-counter derivatives:
• Over-the-counter derivatives result from agreements between two parties.
• The parties can negotiate contract terms that are mutually acceptable.
• Contracts can be terminated only with the agreement of the other party.
• Prices are not publicly available.

Standardized derivative: Standardized derivatives are as specified by exchanges and


have simple standard features like simple expiration date and strike price. These are
also called vanilla derivatives or plain vanilla derivatives. These are exchange-
traded derivatives. Eg. Futures, Options, Swaps.

Exotic derivatives are the derivatives which are more complex than commonly traded
"vanilla" products. This complexity usually relates to determination of payoff. The
category may have many non-standard features, developed for special classes of
investors, for a particular client or a particular market. These are generally not exchange
traded and are structured between parties on their own. Such contracts are \custom-
built" for a client by a large financial house in what is known as the \over the counter"
derivatives market. These contracts are not exchange-traded. This area is also called
the \OTC Derivatives Industry". Eg. Forwards. (RBI PHASE 1 2017)
Mission RBI 2018 - Financial System

The most commonly used derivatives contracts are forwards, futures and options
which we shall discuss in detail later. Here we take a brief look at various
derivatives contracts that have come to be used.
Forwards: A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today’s pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange-traded
contracts.
Options: Options are of two types – calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or
before a given future date. Puts give the buyer the right, but not the obligation to sell a
given quantity of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of upto one year, the majority of options traded
on options exchanges having maximum maturity of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long Term Equity Anticipation Securities. These
are options having a maturity of up to three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a form
of basket options.
Swaps: Swaps are private agreements between two parties to exchange cash flows in
the future according to a prearranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency
• Currency Swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those
in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at
the expiry of the options. Thus, swaptions is an option on a forward swap. Rather than
have calls and puts, the swaptions market has receiver swaptions and payer swaptions
A receiver swaption is an option to receive fixed and pay floating. A payer swaption is
an option to pay fixed and receive floating.
Mission RBI 2018 - Financial System

Derivatives Market in India: 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 SCRA was amended in December 1999 to include derivatives within the ambit of
‘Securities’ and the regulatory framework was 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 recognised stock exchange, thus precluding OTC derivatives.
Derivatives trading commenced in India in June 2000 after SEBI granted the final
approval to this effect in May 2000. SEBI permitted the derivatives 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 (Sensex) index.
This was followed by approval for trading in options which commenced in June 2001
Options on individual securities commenced in July 2001. Futures contracts on
individual stocks were launched in November 2001.

“SCRA: The Securities Contracts (Regulation) Act, 1956 also known as SCRA is
an Act of the Parliament of India enacted to prevent undesirable exchanges in
securities and to control the working of stock exchange in India. It came into
force on February 20, 1957.”
Mission RBI 2018 - Financial System

Forwards: In a forward contract, two parties agree to do a trade at some future date, at
a stated price and quantity. No money changes hands at the time the deal is signed.
One of the parties to the contract assumes a long position and agrees to buy the
underlying asset on a certain specified future date for a certain specified price. The
other party assumes a short position and agrees to sell the asset on the same date for
the same price. Other contract details like delivery date, price and quantity are
negotiated bilaterally by the parties to the contract. The forward contracts are normally
traded over the counter (OTC).

The salient features of forward contracts are:


• They are bilateral contracts (without any exchange between them) and hence
exposed to counter–party risk.
• Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
• The contract price is generally not available in public domain.
• On the expiration date, the contract has to be settled by delivery of the asset.
• If the party wishes to reverse the contract, it has to compulsorily go to the same
counterparty, which often results in high prices being charged.
• Settlement will take place sometime in future (can be based on convenience of
the parties)
• No margins are generally payable by any of the parties to the other.

Example: Assume that you buy a commodity from a seller for delivery in approximately
1 month. You commit to pay the Rs.100 when the commodity is delivered. You are
buying forward and taking delivery in a month from today. The seller is selling you a
forward since he promises to deliver in a month at Rs.100.

Where the buyer makes a gain, the gain is the mirror image of the seller's loss. If the
price of the commodity starts moving up to Rs. 110, the buyer makes a gain of Rs.10
and the seller makes a loss of Rs.10. If the price of the commodity starts decreasing up
to Rs. 80, the buyer makes a loss of Rs.20 and the seller makes a gain of Rs.20.

The commodity is the "deliverable instrument." This forward position entails a risk.
Whichever way the price of the commodity moves, one party has an interest to default
because it suffers a loss. If the price of the commodity drops to Rs. 60 in the open
market, the buyer might prefer to buy at Rs. 60 from open market, and not at original
price of Rs.100 from the seller with which forward contract was made. If the price of the
commodity rises to Rs. 150, the seller has an incentive not to deliver and so default on
its commitment to sell to the buyer at Rs. 100.

In an organized market, the seller//buyer would have to post the loss in the
dedicated margin account. The loss is cashed out and cannot be avoided by the
seller.
Mission RBI 2018 - Financial System

Futures: Futures markets were designed to solve the problems that exist in forward
markets. A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. But unlike forward contracts, the futures
contracts are standardized and exchange traded. To facilitate liquidity in the futures
contracts, the exchange specifies certain standard features of the contract. It is a
standardized contract with standard underlying instrument, a standard quantity and
quality of the underlying instrument that can be delivered, (or which can be used for
reference purposes in settlement) and a standard timing of such settlement. In futures
markets, unlike in forward markets, increasing the time to expiration does not increase
the counterparty risk.

A futures contract may be offset prior to maturity by entering into an equal and opposite
transaction. More than 99% of futures transactions are offset this way. The standardized
items in a futures contract are:
• Quantity of the underlying
• Quality of the underlying
• The date and the month of delivery
• The units of price quotation and minimum price change
• Settlement is done on daily basis

All future contracts are marked to market to the daily settlement price at the end of each
day. The daily settlement price or MTM (marked to market) settlement price is calculated
as the last half an hour weighted average price of the contract.

Final settlement price is the closing price of relevant underlying index/security in cash
market, on the last trading day of the contract. The closing price of the underlying
index/security is the last half an hour weighted average value.

Futures terminology:
• Spot price: The price at which an asset trades in the spot market.

• Futures price: The price at which the futures contract trades in the futures
market. Contract cycle: The period over which a contract trades. The index
futures contracts on the NSE have one month, two-month and three-month
expiry cycles which expire on the last Thursday of the month. If the last Thursday
is a holiday, Futures and Options will expire on the previous working day. Thus a
January expiration contract expires on the last Thursday of January and a
February expiration contract ceases trading on the last Thursday of February. On
the next working day following the last Thursday, a new contract having a three-
month expiry is introduced for trading.

• Expiry date: It is the date specified in the futures contract. This is the last day on
which the contract will be traded, at the end of which it will cease to exist.

• Contract size: The amount of asset that has to be delivered under one contract.
Also called as lot size.
Mission RBI 2018 - Financial System

• Basis: In the context of financial futures, basis can be defined as the futures
price minus the spot price. There will be a different basis for each delivery month
for each contract.

• Cost of carry: The relationship between futures prices and spot prices can be
summarized in terms of what is known as the cost of carry. This measures the
storage cost plus the interest that is paid to finance the asset less the income
earned on the asset.

• Initial margin: The amount that must be deposited in the margin account at the
time a futures contract is first entered into is known as initial margin.

• Marked-to-market (MTM): In the futures market, at the end of each trading day,
the margin account is adjusted to reflect the investor’s gain or loss depending
upon the futures closing price. This is called marked–to–market.

• Available margin: Available margin is calculated by deducting MTM loss from


margin blocked at position level.

• Maintenance margin /Minimum Margin: This is somewhat lower than the initial
margin. This is set to ensure that the balance in the margin account never
becomes negative. If the balance in the margin account falls below the
maintenance margin, the investor receives a margin call and is expected to top
up the margin account to the initial margin level before trading commences on
the next day.

• Tick size: the minimum amount is decided by the Exchange( currently 0.05 rs ).

• Striking price: the price of the underlying asset specified in the contract.(delivery
price).
• Future Payoffs: A payoff is the likely profit/loss that would accrue to a market
participant with change in the price of the underlying asset. This is generally
depicted in the form of payoff diagrams which show the price of the underlying
asset on the X-axis and the profits/losses on the Y-axis. Futures contracts have
linear payoffs. In simple words, it means that the losses as well as profits for the
buyer and the seller of a futures contract are unlimited.
• Long Position: One of the parties to the contract assumes a long position and
agrees to buy the underlying asset on a certain specified future date for a certain
specified price.
• Short Position: The other party assumes a short position and agrees to sell the
asset on the same date for the same price.
Mission RBI 2018 - Financial System

Pricing of Stock Futures: The theoretical price of a future contract is sum of the current
spot price and cost of carry. However, the actual price of futures contract very much
depends upon the demand and supply of the underlying stock. Generally, the futures
prices are higher than the spot prices of the underlying stocks.

Futures Price = Spot Price + Cost of Carry : F= S + C


Cost of carry is the interest cost of a similar position in cash market and carried to
maturity of the futures contract less any dividend expected till the expiry of the contract.

Example Spot Price of Infosys = 1600, Interest Rate = 7% p.a. Futures Price of 1 month
contract=1600 + 1600*0.07*30/ 365 = 1600 + 11.51 = 1611.51.
This can also be expressed as: F = S (1 + r)T

In case of concept of continuous compounding, the cost of carry model used for pricing
futures is also given below: F = SerT
Where:
r =Cost of financing (using continuously compounded interest rate) (MIBOR)
MIBOR - Mumbai Inter-Bank Offer Rate
T Time till expiration in years
e = 2.71828
F = Future Price
S = Spot price

Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be
invested at 11% per annum. The fair value of a one-month futures contract on XYZ is
calculated as follows:
F = SerT
F = 1150 e0.11x1/12
F = 1160
Note: To take the buy/sell position on index/stock futures, you have to place
certain % of order value as margin, no need to pay full amount.

For example, you have to buy position in Fut-ACC- 26-Oct-2017 for 400 shares ( 1
lot) @ 1650 and Initial Margin % for ACC is 25%. In that case, margin requited to
buy would be 660000 * 25% = 165000/-.

If price of future on expiry or at the time of squaring off of an order rises to 1680
then profit earned is: 1680-1650 = 30* 400= Rs 12000.

If price of future on expiry or at the time of squaring off of an order decreases to


1630 then loss is: 1650-1630 = 20* 400= Rs 8000.
Mission RBI 2018 - Financial System

Question asked in RBI 2017 PHASE 2


If a person buys a stock in equity cash/spot market at Rs. 400 and sells the stock
at Rs. 440.

He/she buys the future of the stock at Rs. 400 by paying 20% margin money and
sells the future at Rs. 440.
Then returns on investments in both the cases are:

a. 50% and 50%


b. 10 % and 10%
c. 10% and 50%
d. 50% and 10 %
e. 10 % and 20%

In 1st case Profit/return on investment is : 440-400 = 40


Investment made is Rs. 400
% Profit/return on investment is = 40/400X100= 10 %

In 2nd case Profit/return on investment is : 440-400 = 40


Investment made is 20% of 400 = 80
% Profit/return on investment is = 40/80X100= 50 %

Hence correct option is c.

Index Futures: Stock index future is an index derivative that draws its value from an
underlying stock index like Nifty or Sensex and helps a trader to take a view on the
market as a whole. Index futures permits speculation and if a trader anticipates a
major rally in the market he can simply buy a futures contract and hope for a price
rise on the futures contract when the rally occurs.

In India we have index futures contracts based on CNX Nifty and the BSE Sensex and
near 3 months duration contracts are available at all times. Each contract expires on
the last Thursday of the expiry month and simultaneously a new contract is
introduced for trading after expiry of a contract.NSE is the largest derivative
exchange in India. The first exchange traded financial derivative in India was
commenced with the trading of Index futures on NSE.

Index futures contracts of BSE Sensex 30 has a lot size of 15 and CNX Nifty 50 has a
lot size of 75.
Mission RBI 2018 - Financial System

Currency Futures: A Currency Futures contract is a standardized version of a Forward


contract that is traded on a regulated Exchange. It is an agreement to buy or sell a
specified quantity of an underlying Currency on a specified date in the future at a
specified rate. In India, currently only USD/INR, EUR/INR, GBP/INR and JPY/INR are
available for trading on various Exchanges. Currency Futures allow investors to take a
view on the movement of the Indian Rupee against other Currencies. This can be
used to protect one's business from Currency risks due to fluctuation of the
exchange rates.
Features of currency trading in India:
Last trading day: Two working days prior to the last business day of the expiry month
at 12:30 pm.

Contract Months: 12 near calendar months.

Tick size: 0.25 paise or INR 0.0025

Trading hours: Monday to Friday 9:00 a.m. to 5:00 p.m.

Final settlement day: Last working day (excluding Saturdays) of the expiry month.
The last working day will be the same as that for Interbank Settlements in Mumbai.

Settlement: Daily settlement: T+1 , Final settlement : T + 2

Daily settlement price (DSP): Calculated on the basis of the last half an hour
weighted average price.

Final settlement price(FSP): All currency futures & options contracts on exchange
are net settled in cash in Indian Rupee. The final settlement price is the RBI
Reference rate for each currency pair published on the last trading day (Excluding
Saturdays and FEDAI holidays) for the expiry month.
FEDAI: Foreign Exchange Dealers Association of India. Headquarter at Mumbai.

The size of each contract for different currency pairs on the exchange are as follows:
Currency Pair Contract Size

USDINR USD 1000


EURINR EUR 1000
GBPINR GBP 1000
JPYINR JPY 100,000
Mission RBI 2018 - Financial System

Terminology:

Base currency and quote currency: The first currency in the currency pair is referred
to as the base currency and second currency is called the quote currency. For
example, in the USDINR currency pair, USD is the base currency and INR is the quote
currency.

Bid price and ask price: Bid refers to the price at which the market is willing to buy a
specific currency. Ask refers to the price at which the market is willing to sell a
specific currency. The difference between the bid and ask price is referred to as the
bid-ask spread.

Currency appreciation and depreciation mean: Let's assume that the current
exchange rate of the USD to the INR is INR 55. When the value of the Rupee moves
up to INR 54/USD, we would say that the Rupee has appreciated in value against the
USD. It means we can buy USD100 for INR 5,400 instead of INR 5,500.

Similarly, when the value of the Rupee moves down to INR 56/USD, we would say
that the Rupee has depreciated in value against the USD. It means we can buy
USD100 for INR5,600 instead of INR 5,500.

Calendar Spread : A calendar spread is a position in an underlying with one maturity


which is hedged by an offsetting position in the same underlying with a different
maturity: for example, a short position in a July futures contract on USD-INR and a
long position in the August futures contract on USD-INR is a calendar spread.
Calendar spreads attract lower margins because they are not exposed to market risk
of the underlying. If the underlying rises, the July contract would make a profit while
the August contract would make a loss.
Mission RBI 2018 - Financial System

Options: Options are fundamentally different from forward and futures contracts. An
option gives the holder of the option the right to do something. The holder does not
have to exercise this right. In contrast, in a forward or futures contract, the two
parties have committed themselves to doing something. Whereas it costs nothing
(except margin requirements) to enter into a futures contract, the purchase of an
option requires an upfront payment.

Types of options:
• Call option: A call option gives the holder the right but not the obligation to buy an
asset on or before a predetermined date for a certain price.

• Put option: A put option gives the holder the right but not the obligation to sell an
asset on or before a predetermined date for a certain price.

American options: American options are options that can be sold and exercised at
any time upto the expiration date. Options in stocks that have been recently
launched in the Indian market are "American Options".

European options: European options are options that can be sold any time but can
be exercised only on the expiration date itself. European options are easier to
analyze than American options, and properties of an American option are frequently
deduced from those of its European counterpart. Currently, in India index options
are European in nature.

Note: Don’t be confused between selling and exercising. Selling means selling the
option at the option premium whatever it may be. Exercising means, force the
contract seller to give you the price difference (Spot price - strike price).

Options terminology:
Index options: These options have the index as the underlying. Like index futures
contracts, index options contracts are also cash settled.

Stock options: Stock options are options on individual stocks.

Buyer of an option: The buyer of an option is the one who by paying the option
premium buys the right but not the obligation to exercise his option on the seller/
writer.
Mission RBI 2018 - Financial System

Writer of an option: The writer of a call/put option is the one who receives the
option premium and is thereby obliged to sell/buy the asset if the buyer wishes to
exercise his option.

Option price: Option price is the price which the option buyer pays to the option
seller. It is also referred to as the option premium.

Expiration date: The date specified in the options contract is known as the expiration
date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or
the exercise price.

In-the-money option: An in-the-money (ITM) option is an option that would lead to


a positive cash flow to the holder if it were exercised immediately. (i.e. for call option
spot price > strike price) and vice versa for put option.

At-the-money option: An at-the-money (ATM) option is an option that would lead to


zero cash flow if it were exercised immediately. (i.e. for call and put option spot price
= strike price)

Out-of-the-money option: An out-of-the-money (OTM) option is an option that


would lead to a negative cash flow it was exercised immediately. (i.e. for call option
spot price < strike price) and vice versa for put option.

Intrinsic value of an option: The option premium can be broken down into two
components–intrinsic value and time value. Intrinsic value of an option is the
difference between the market value of the underlying security/index in a traded
option and the strike price. The intrinsic value of a call is the amount when the
option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. (i.e. for call
option Spot Price - Strike Price) and vice versa for put option.

Time value of an option: The time value of an option is the difference between its
premium and its intrinsic value. Both calls and puts have time value. An option that is
OTM or ATM has only time value. Usually, the maximum time value exists when the
option is ATM. The longer the time to expiration, the greater is an option’s time
value, all else equal. At expiration, an option should have no time value. i.e. (Option
Premium – intrinsic value).
Mission RBI 2018 - Financial System

Volatility: Volatility is the tendency of the underlying security’s market price to


fluctuate either up or down. It reflects a price change’s magnitude; it does not imply
a bias toward price movement in one direction or the other. Thus, it is a major factor
in determining an option’s premium. Generally, as the volatility of an under-lying
stock increases, the premiums of both calls and puts overlying that stock increase,
and vice versa.

Open Interest (OI): Open interest is the total number of options and/or futures
contracts that are not closed out on a particular day, that is contracts that have been
purchased and are still outstanding and not been sold and vice versa.

Contract cycle: The period over which a contract trades. The option contracts on the
NSE have one month, two-month and three-month expiry cycles which expire on the
last Thursday of the month. If the last Thursday is a holiday, Futures and Options will
expire on the previous working day. Thus a January expiration contract expires on the
last Thursday of January and a February expiration contract ceases trading on the last
Thursday of February. On the next working day following the last Thursday, a new
contract having a three-month expiry is introduced for trading. Cash settlement on T+1
basis. Daily settlement price is net premium value and final settlement price is
closing price of underlying.

Greeks: The options premium is determined by the three factors mentioned earlier –
intrinsic value, time value and volatility. But there are more sophisticated tools used
to measure the potential variations of options premiums. They are as follows:

Delta, Gamma, Theta, Vega, Rho

Delta: Delta is the measure of an option’s sensitivity to changes in the price of the
underlying asset. Therefore, it is the degree to which an option price will move given
a change in the underlying stock or index price, all else being equal.

Change in option premium


Delta= --------------------------------
Change in underlying price

Gamma: This is the rate at which the delta value of an option increases or decreases
as a result of a move in the price of the underlying instrument.
Change in an option delta
Gamma = -------------------------------------
Change in underlying price
Mission RBI 2018 - Financial System

Theta: It is a measure of an option’s sensitivity to time decay. Theta is the change in


option price given a one-day decrease in time to expiration. It is a measure of time
decay (or time shrunk). Theta is generally used to gain an idea of how time decay is
affecting your portfolio.

Change in an option premium


Theta= --------------------------------------
Change in time to expiry
Theta is usually negative for an option as with a decrease in time, the option value
decreases. This is due to the fact that the uncertainty element in the price decreases.

Vega: This is a measure of the sensitivity of an option price to changes in market


volatility. It is the change of an option premium for a given change – typically 1% – in
the underlying volatility.
Change in an option premium
Vega= -----------------------------------------
Change in volatility

Rho: The change in option price given a one percentage point change in the risk-free
interest rate. Rho measures the change in an option’s price per unit increase typically
1% – in the cost of funding the underlying.
Change in an option premium
Rho= ---------------------------------------------------
Change in cost of funding underlying

Options Pricing Models: Options have existed—at least in concept—since antiquity.


It wasn’t until publication of the Black-scholes (1973) option pricing formula that a
theoretically consistent framework for pricing options became available. That
framework was a direct result of work by Robert Merton as well as Fisher Black and
Myron Scholes. In 1997, Scholes and Merton won the Nobel Prize in economics for
this work. Black had died in 1995, but otherwise would have shared the prize.
The factors affecting the option price are: (i) The spot price of the underlying, (ii)
exercise price, (iii) risk-free interest rate, (iv) volatility of the underlying, (v) time to
expiration and (vi) dividends on the underlying (stock or index).
Mission RBI 2018 - Financial System

Example of Option contracts:

Reliance Industries Call options:


Premium or Price
Underlying Expiry Date Strike Price Lot Size at which contract
was made
RELIND 26-Oct-2017 760.00 1000 35.00
RELIND 26-Oct-2017 770.00 1000 30.00
RELIND 26-Oct-2017 780.00 1000 25.00
RELIND 26-Oct-2017 790.00 1000 19.00
RELIND 26-Oct-2017 800.00 1000 15.00
Spot Price = 780.00

1st case suppose spot price/settlement Price at the expiry increases to Rs. 830.00

Then Call Option pay off:

Call Option pay off on Profit / loss = (Option pay off


Premium or Price/unit at
Expiry shall be as= – Premium per unit x 1000)
Strike Price Lot Size which contract was
(Spot Price-Strike Price) x
made
lot size
760.00 1000 35.00 70x1000= 70000 70000-35000=35000

770.00 1000 30.00 60x1000=60000 60000-30000=30000

780.00 1000 25.00 50x1000=50000 50000-25000=25000

790.00 1000 19.00 40x1000=40000 40000-19000=31000

800.00 1000 15.00 30x1000=30000 30000-15000=15000

2nd case suppose spot price/settlement Price at the expiry decreases to Rs. 770.00.

In a call option if spot or settlement price on expiry is below strike price then all
such options which have strike price equal to or greater than the spot/settlement
price, shall have zero payoff or zero intrinsic/premium value.

At the expiry Premium is equal to intrinsic value as time value is zero on expiry.
Call Option pay off on Profit / Loss = (Option pay
Premium or Price/unit at
Expiry shall be as= off- Premium per unit x 1000)
Strike Price Lot Size which contract was
(Spot Price-Strike Price) x
made
lot size
760.00 1000 35.00 10x1000=15000 10000 – 35000 = -25000

770.00 1000 30.00 0 0- 30000 = -30000

780.00 1000 25.00 0 0- 25000= -250000

790.00 1000 19.00 0 0-19000 = -19000

800.00 1000 15.00 0 0-15000= -15000


Mission RBI 2018 - Financial System

Reliance Industries Put options:

Premium or Price
Underlying Expiry Date Strike Price Lot Size at which contract
was made
RELIND 26-Oct-2017 760.00 1000 10
RELIND 26-Oct-2017 770.00 1000 15
RELIND 26-Oct-2017 780.00 1000 20
RELIND 26-Oct-2017 790.00 1000 25
RELIND 26-Oct-2017 800.00 1000 30
Spot Price = 780.00

1st case suppose spot price/settlement Price at the expiry decreases to Rs. 740.00

Then Put Option pay off:

Put Option pay off on Expiry Profit / loss = (Option pay off
Premium or Price/unit at
shall be as= – Premium per unit x 1000)
Strike Price Lot Size which contract was
(Strike Price - Spot Price) x
made
lot size
760.00 1000 10 20x1000= 20000 20000-10000=10000

770.00 1000 15 30x1000=30000 30000-15000=15000

780.00 1000 20 40x1000=40000 40000-20000=20000

790.00 1000 25 50x1000=50000 50000-25000=25000

800.00 1000 30 60x1000=60000 60000-30000=30000

2nd case suppose spot price/settlement Price at the expiry increases to Rs. 785.00.

In a put option if spot or settlement price on expiry is above strike price then all
such options which have strike price equal to or lesser than the spot/settlement
price, shall have zero payoff or zero intrinsic/premium value.

At the expiry Premium is equal to intrinsic value as time value is zero on expiry.

Put Option pay off on Expiry Profit / Loss = (Option pay


Premium or Price/unit at
shall be as= off- Premium per unit x 1000)
Strike Price Lot Size which contract was
(Spot Price-Strike Price) x
made
lot size
760.00 1000 10 0 0-10000= -10000

770.00 1000 15 0 0-15000= -15000

780.00 1000 20 0 0-20000 = -20000

790.00 1000 25 5x1000=5000 5000-25000= -20000

800.00 1000 30 15x1000=15000 15000-30000= -15000


Mission RBI 2018 - Financial System

Interest Rate Derivatives: Deregulation of interest rate exposed market participants


to a wide variety of risks. To manage and control these risks and to deepen money
market, scheduled commercial banks, primary dealers and all India financial
institutions have been permitted to undertake forward rate agreements (FRAs) and
interest rate swaps (IRSs).

A forward rate agreement (FRA) is a financial contract between two parties to


exchange interest payments for a ‘notional principal’ amount on settlement date, for
a specified period from start date to maturity date. Accordingly, on the settlement
date, based on contract (fixed) and the settlement rate, cash payments are made by
the parties to one another. The settlement rate is the agreed benchmark/ reference
rate prevailing on the settlement date.

An interest rate swap (IRS) is a financial contract between two parties exchanging or
swapping a stream of interest payments for a ‘notional principal’ amount on multiple
occasions during a specified period. Such contracts generally involve exchange of a
‘fixed to floating’ rates of interest. Accordingly, on each payment date–that occurs
during the swap period–cash payments based on fixed/ floating and floating rates,
are made by the parties to one another.

FRAs/IRSs provide means for hedging the interest rate risk arising on account of
lendings or borrowings made at fixed/variable interest rates.

Scheduled commercial banks (excluding Regional Rural Banks), primary dealers (PDs)
and all-India financial institutions (FIs) undertake FRAs/ IRSs as a product for their
own balance sheet management or for market making. Banks/FIs/PDS offer these
products to corporate for hedging their (corporates) own balance sheet exposures.

In view of the robust methodology of computation of these rates and their extensive
use by market participants, these have been co-branded with Fixed Income and
Money Market Derivatives Association (FIMMDA) from March 4, 2002. These are
now known as FIMMDA-NSE MIBID/MIBOR from March 4, 2002.

These rates are used as benchmarks for majority of deals struck for interest rate
swaps, forward rate agreements, floating rate debentures and term deposits.
Mission RBI 2018 - Financial System

Swaps: Swaps are private agreements between two parties to exchange cash flows
in the future according to a prearranged formula. They can be regarded as portfolios
of forward contracts.
Types of Swap: Swaps are generally of the following types:
1. Interest Rate Swap:
Where cash flows at a fixed rate of interest are exchanged for those referenced to a
floating rate. An interest rate swap is a contractual agreement to exchange a series
of cash flows. One leg of cash flow is based on a fixed interest rate and the other leg
is based on a floating interest rate over a period of time.
Example of such swaps in the Indian market are:
Overnight Index Swaps (OIS) – Fixed v/s NSE Overnight MIBOR Index
Mumbai Inter-bank Forward Offer Rate (MIFOR) Swap – Fixed V/s Implied INR yield
derived from the USD/INR premium and the relevant USD Libor for that tenor,
usually 6 months.
INBMK Swap – Fixed v/s 1 year INBMK rate. The 1 year INBMK rate is derived from
the rate on the benchmark Indian Government of India securities

A fixed rate of interest is one where the interest on the loan does not change until
the loan is settled. But in the case of floating interest rate, the interest rate
fluctuates according to the market forces of supply and demand. As a result, the
interest rate may go down or it may rise also. But, when the interest rate comes
down, the borrower can take advantage of it by swapping it with the help of the
lender.
Types of Interest Rate Swaps:
1. A Plain Vanilla Swap: This is the simplest form of Interest rate swaps where a fixed
rate is exchanged for a floating rate or vice versa on a given notional principal at pre-
agreed intervals during the life of the contract.
2. A Basis Swap: In a floating to floating swap, it is possible to exchange the floating
rates based on different benchmark rates. For example, we may agree to exchange
3m Mibor for 91 days T Bills rate. Such a swap is called a Basis Swap.
3. An Amortizing swap: As the name suggests, swaps that provide for reduction in
notional principal amount corresponding to the amortization of a loan, are called
amortizing swaps.
4. Step-up Swap: This is the opposite of an amortizing swap. In this variety the
notional principal increases as per a pre- agreed schedule.
Mission RBI 2018 - Financial System

5. Extendable Swap: When one of the counter parties has the right to extend the
maturity of the swap beyond its original life, the swap is said to be an extendable
swap.
6. Delayed Start Swaps/Deferred Swaps/ Forward Swaps:When it is agreed
between the counter parties that the swap will come into effect on a future date, it
is termed as a delayed start swap or deferred swap or a forward swap.
7. Differential Swaps: Interest rate swaps which are structured in such a way that
one leg of the swap provides for payment of interest at a rate pertaining to a
currency other than the currency of the underlying principal amount. The other leg
provides for payment of interest at the rate and currency of the underlying principal.

For example, a corporate can choose to enter into a differential swap by which it
could bind itself to pay 3m USD Libor on a principal of Rs. 100 crores and receive 12%
fixed in the Indian currency. The interest on both the legs will be computed on the
notional principal of Rs. 100 crores. The swap is thus a combination of currency and
plain interest rate swaps. There is no currency risk in this arrangement.

2. Currency Swap: Where cash flows in one currency are exchanged for cash flows in
another currency. A currency swap is contractually similar to an interest rate swap.
The main differences are:
i. Each interest rate is in a different currency,
ii. The notional amount is now replaced by two principal amounts – one in each
currency, and
iii. These principal amounts are typically exchanged at the start of the swap and then
re-exchanged at maturity.
The major difference between a generic interest rate swap (IRS) and a generic
currency swap is that the latter includes not only the exchange of interest rate
payments but also the exchange of principal amounts both initially and on
termination. Since the payments made by both parties are in different currencies,
the payments need not be netted.
Types: Currency Swaps can categorized based on how interest rates are structured:
(a) Fixed for Fixed Currency Swap: The interest payments exchanged are payable
under Fixed Rate Basis for both the contracting parties.
(b) Fixed for Floating Currency Swap or Plain Vanilla Swap: Interest payments
exchanged are payable under Fixed Rate Basis for one party and Floating Rate basis
the other party.
(c) Floating for Floating Currency Swap or basis swap: Interest payments exchanged
are payable under Floating Rate Basis for both the parties. However, the base for
fixing the floating rates is the same for both the parties, i.e. LIBOR or MIBOR etc.
Mission RBI 2018 - Financial System

CREDIT DEFAULT SWAP (CDS) : CDS is in operation in India since October


2011 — launched in only corporate bonds. The eligible participants are commercial
banks, primary dealers, NBFCs, insurance companies and mutual funds.

CDS is a credit derivative transaction in which two parties enter into an agreement,
whereby one party (called as the ‘protection buyer’) pays the other party (called as
the ‘protection seller’) periodic payments for the specified life of the agreement. The
protection seller makes no payment unless a credit event relating to a pre¬
determined reference asset occurs. If such an event occurs, it triggers the Protection
Seller’s settlement obligation, which can be either cash or physical (India follows
physical settlement). It means, CDS is a credit derivative that can he used to transfer
credit risk from the investor exposed to the risk (called protection buyer,) to an
investor willing to take risk (called protection seller). It operates like an insurance
policy. In an insurance policy, the insurance firm pays the loss amount to the insured
party. Similarly, the buyer of the CDS— the bank or institution that has invested in a
corporate bond issue— seeks to mitigate the losses it may suffer on account of a
default by the bond issuer.

Credit default swaps allow one party to ‘buy’ protection from another party for
losses that might be incurred as a result of default by a specified reference
instrument (a bond issue in India). The ‘buyer’ of protection pays a premium to the
seller, and the ‘seller’ of protection agrees to compensate the buyer for losses
incurred upon the occurrence of any one of the several specified ‘credit events’. Thus
CDS offers the buyer a chance to transfer the credit risk of financial assets to the
seller without actually transferring ownership of the assets themselves.