10 Summary of Derivatives 1

11 Options on Various Underlying Assets

12 Exotic Options and Option Trading Strategies
13 The Risk Neutral Probability
The Binomial Tree Pricing Theory Application of Binomial Tree Pricing
14 BSM Pricing of Options Greeks and Delta and Vega Hedging
15 Structured Products
16 Structuring Swaps- IRS and Currency Swaps- Principles-theory of Comparative advantage and
theory of absolute advantage
17 Introduction to Real Options
18 Use Derivatives in the Business – A Comprehensive Case

Session 1:
How to calculate interest rate:

INTEREST RATE FOR POUND:

P*r*t
= 1000000*5/100*(Actual Day count/356)

INTEREST RATE FOR DOLLAR:

= P*(Actual/360)*(5% Or Any Other Interest)

WAYS IN WHICH CURRENCIES ARE QUOTED:A

European terms
US terms
Cross rate

Base currency and quoted currency

When you quote derivates:

Fixed and variable part
Fixed- called base currency
Variable – quoted currency

When the Fixed part is USD:

1 USD= 76 INR
1 USD= 3.675 AED
1 USD= 115 Yen etc
This is a European term quotes – anything outside of European and outside of USD

1 Euro = 1.3050 USD

Where the variable currency is the USD
This is the US Terms quotes

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conventionally- important to know how currency is quotes

Cross rates-
1 euro= 3.57 AED
When USD is not a part of it.

The derivative price and value is derived from spot price

Derivative: A financial contract whose value is derived from an underlying asset
And the spot price is the value of the asset.

Basic building block of derivatives:

Forwards:
- A contract to buy or sell an asset at a future date, the rate is fixed today
- ONLY OTC market product – unregulated, between the buyer and seller you can
customize the product
- Flexy market
- CANNOT BE TRADED ON THE EXCHANGE
- Obligation to perform
Future:
- Exchange traded contract - these are regulated(an entity controlled by the government.
And less settlement risk
- Prices are supposed to be transparent
- Fixed and standard products
- Obligation to perform

Options:
- Buyer has the right buy not the obligation
- The seller has the obligation but not the right

Forward Vs Option:
- In forwards- there is an obligation to perform for both parties,
- In option- the buyer of the option doesn’t have the obligation to perform but the seller
does

Swap:
- Exchange of different cash flow’s but in this rate we are focusing specifically only on
interest rates
- Fixed interest rates Vs floating interest rates which is called interest rate swaps

Use of derivatives : Hedging:

To mitigate risk – market risk
Types of financial Risks:

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 - Credit risk- credit derivatives
- Int. rate risk /Market risk
- Liquidity risk
Leverage: taking a loan is leverage
Trade larger amt with a small amt of margin- if we have 10% with a 100,000 pounds =
100,000/.10

Risk: uncertainty
Measure: SD and Average loss
Year 1 2 3 Avg loss
2% 3% 4% 3%

Uncertainity is that u can loose 3%+ 2% or you loose between 3%-2%

Hence you will loose between 1% - 5%
That is uncertainity, chance of loss- due to changes

Market risk: chance of

Right to buy and right to sell:

Right to buy an asset in the future is called a forward purchase contract

Right to sell an asset in the future is called a forward sale contract.

Who would need a forward sale:
An Exporter would need this; fix a price – who thinks the price would fluctuate.

Deriving the current value of our instrument based on the current market price- mark to market
• Contract delivery takes place on due date-
- contract is delivered, got the pounds, obligation completed
• Contract is cancelled on due date-
- His pounds dint come, he has an obligation to perform- hence he would have to bear
the conseq.- booked the contract at 93, current at 95, hence he would have to pay 2
rupee and bear the consequences.
• Contract is extended on due date:
-cancel the old and book a new contract,if the rate is 95, pay the difference and book a new
contract. Foreign exchange swaps:
• Early delivery– before due date
- Deliver it after 2 months- deliver at spot rate- and cancel the old contract- pay the loss or
the profit
- Sell at spot- cancel it and buy back to cancel the old contract.
• Cancellation of contract before due date
- Make a forward purchase
• Contract is extended before due date
- Sell this contract- fwd purchase for 1 months-

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 - If u have a 4 month contract-
- Original contract fwd sale : 3 months
- 2nd month – customer extends 1 more month
- Hence- forward purchase here to cancel the contract
- Forward sale – 2 months
-

Booking forward contract Option delivery

forward contract be booked if date of delivery not known?
A contract can be delivered between 2 dates:
1: 1 2 3

If the person says I want to deliver it in the 3rd month-

Hence: a contract can be booked for delivery between 2 dates:
A expects to receive 1 million pound in may
Not sure when
Hence he can book a Fwd contract between 1st may – 31st may

Calculate rate of contract on 1st may – 92.50

Calculate rate of contract on 31st may – 93

Which ever is worse- he will quote to the customer- 93 will be quoted to the customer
And the customer will have the option to deliver on any date- contract with an option delivery

Risk here:
On the due date the rate could be higher or lower- suppose he booked at 96 and the current
rate is 97, he lost money .he could have sold at 97, but he already sold at 96.

IF the rate was 92, then he is at profit.

Hence there is a risk of obligation to perform- even If the rate is against him- he will have to
perform.

With a Forward contract:

Irrespective of the outcome(in favor or against) the buyer of the contract has the obligation to
perform

With an option-
The buyer of the contract doesn’t have the obligation to perform,

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How to calculate the forward rate:
Forward rate: what constitutes the fwd rate:
Interest rate differential :
1 GBP = 90 INR (spot rate)

1 year GBP 1 year INR

Int rate = 3% int rate = 8%

1 year pound int rate = 3%

1 year INR int rate = 8%

In some currencies- you cannot book it outside

INR- no euro currency
Hence- you will have to take a libor rate close to interest rate

1 Year Forward rate =

1GBP= Spot rate x (1+ INR interest Rate)/(1+GBP interest rate)

1GBP= 90*(1+8%/)(1+3%)
1 GBP for 1 year = 94.36
Hence, the 1 year GBP forward rate = 94.36

Hence the forward difference = 94.36-90 = 4.36

Int rate differential (8%-3%) = 5% =90*5% = 4.5

5% of 90 is the forward rate

Hence the forward rate could be:

90+/- 4.5,
The currency bearing the lower rate is always at the premium in the fwd market,
Hence 1GBP = 90+4.5 = 94.5 <====
1 GBP = 90-4.5 = 85.5

Because pound will be at a premium- its interest rate 3%, hence you will add it.

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When we book a forward contract: what is the payoff from the forward purchase or sale?
Means what is the risk profile:

Pay-off from a Forward Purchase Position

If the price of the asset goes up- unlimited profits

If the price falls- unlimited losses

Booked fwd purchase at 93

Pay-off from a Forward Sale Position

If the price of the asset goes up- Unlimited Losses

If the price falls- unlimited Profits

Booked fwd purchase at 93

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Options:
An Option is a contract to buy or sell an underlying asset at a future date at a price decided
today

When is the seller not wanting the right but the obligation ? because he gets a fee in return

The right to buy- Call Option – the buyer- buy call or put
The right to Sell- Put Option – the seller- buy or sell

Variables that influence the value of call options:

 Level of interest
 Time to expiration of the option
 Exercise price
 Stock price volatility

What is the price or strike price: rate that is agreed to buy the foreign currency
For one spot price- we can have multiple strike prices

Booking call strike at 89 and spot at 90 – intrinsic value 1 – opposite for put option
In the money – 89 – intrinsic worth
At the money – 90 – same rate
Out of money – 91 – worse than spot rate

Expects to receive pounds :

Receive 1 million pounds – Put Option- (cuz he will sell something- so he will buy a put option)

Spot 92
90 – out of money -
92- has right but not obligation
95- in the money

- When we book a put contract- what would we prefer: in the money or out of money

In-the-money contracts will be pricier than at-the-money contracts and out- of-the-money
contracts

When do we book a forward contract vs option contract

Greater the time period, greater the time value

It also depends on interest rates and volatility – greater the fluctuation, greater the time value

For an institution or bank- out of money is ideal and for the buyer- in the money

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The best option at expiration- out of money – Call option (spot price) lower than strike price-
Otherwise buy at the strike rate

If spot is higher than the strike price- which is the out of the money – it is better

Speculators- in the money is a better options

Futures:
- Like forward contract- but they are exchange traded
- Standardized contract – customized contract
- Such as size of the contract, margin- mark to market done on a daily basis- moneyness-
which means it has intrinsic value
- Important aspect of exchange trading- counter party on both sides, leading to a lower
settlement risk

Interest rate swap:

- Need for an interest rate swap: we have a view that the interest rate will drop.
- If we have a view that there is an exposure to a fixed contract, if we are locked into a
fixed interest rate, we cannot benefit from an interest rate drop.
- Hence, alter our cashflow into a floating rate exposure, by swapping it.
- This is because- the views of people are different, the other guy wants stability or
maybe one guy wants to convert his fixed into floating.

Cross Currency Swap:

- Bullet repayment- repay in 5 years.
- Refer to lalslit notes diagram.

Note: Forward sale: buy a put

All commercial banks outside USA have a dollar account-

How do u describe a dollar account: Nostro accounts (foreign accounts)

Banks within the country- local bank

Correspondent banking relationship

Session 2:
If you buy a call- you long the call
If you sell a call option- you short the call

If you buy a put option- you long the put option

If you sell a put option- you short the put option

You buy a call option- why?

Reason 1: leverage

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If you have a bullish view-
Eg) we buy 100 shares of ABC corp
Current price = 50
Hence- we spend 100*50=5000 currency units

Suppose it goes to: 55

Hence – now the actual value = 100*55- 5500 currency units
(5500-5000) =500
We make = 500/5000
=10%

Eg 2) We buy a call option

ABC shares
Same 100 shares
Strike price =50 at 5 per share
Inc of strike p=55 =premium paid = 3

=100*5=500
=100*3 =300
Diff. =200
Profit = 200/300 = 66.66%
Options are a good way to trade,

All options- whether in the the money or out of, will have the time value of money- irrespective
of whether they have an intrinsic or extrinsic value.

Session 3: Options pricing:

CDS : we have a pool of assets Eg) Cr Card Receivables, credited to a SPV- the SPV sells it to
Institutions, and they rate the entire pool
Check document options spread- everything on exotic and other options.

Session 4: Binomial Options Pricing:

1. Risk less portfolio approach
Risk neutral

Suppose the current price of the stock is AED100 and the risk-free rate is 10%
We want to find the price of a call option on this asset
Spot price = 100
Strike = 100
Rf = 10%
No assumptions on volatility

Construct a riskless portfolio

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Write a call- find the value of the call – to hedge it – use delta hedging
Delta hedging- if the call increases in value- it would be out of money – hence we hedge by
buying the asset.
Rise by 10%,
SHORT CALL,sinceLONGtheASSET:
rf= 110
10% Value of
Call=10
H x110-10

Stock Price
100AED
Strike
price=100A
ED
90
Value of H x90-0
Fall by 10%, Call=0

since the rf=

10%

Since we are writing a call-

Suppose the hedge (H) – how much of the asset do we want to buy
Amount of asset *price = value of asset
Because it’s a riskless portfolio = value of portfolio will be the same

Solving for H
H*110-10 = H*90
H=.5(Hedge Ratio) – H*spot price = Initial investment

Hence- value of the portfolio= .5*110-10 = 55-10= 45

Value of the portfolio= 0.5*90=45

We will write a call option (find the price of the call option) and buy an appropriate amount of
an asset-
Construction of a riskless portfolio: so that we have no risk- hence find the value of that option.

The up or down move is an assumption made- by the writer/trader

The risk free rate is an assumption

Total investment is 50

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Time = .5 years
Rate = 10%
Realized – 45
PV =(10%,.5,0,-45) = 42.90
Price of the call premium = 50-42.90= 7.1
LONG PUT + LONG STOCK

Item Value

Spot Price 100

Strike Price 100

UpMove 1.10

Downmove 0.90

Interest Rate 10%

Time 0.5

what will be the value of the put , the value of the portfolio - find the hedge ratio
Rise in price 110
fall in price 90 Put premium- long premium- hence- we - who purchased it paid
solving for H 0.5
initial investment 55 Call Vs Put
Call option put option
Portfolio value 50
H*110 H*90+10
55 45 (VALUE OF PORTFOLIO = 55)
Value of portfolio 55 (this is after paying the premium, since it is a put option)
Value of portfolio 52.3176183

Value of all premium $2.32

RISK NEUTRAL VALUATION:

It e m V a lu e
Stock price 50
Strike price for call 50
Maturity 2 years
Risk-free rate of interest 5%
Upmove 1.10
Down move 0.90

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 =55*1.10= 60.50
=60.5-50
= 10.5 (VALUE OF OPTION-
UP MOVE)
MATURITY =2 YEARS
=55*.95=52.50
VALUE = 52.50-50= 2.50
50*1.10= 55 VALUE OF DOWN MOVE

50

50*(50-1.05)= 47.5
=47.5*.95 = 45.125

Probability of move and down move :

Probability Q= (EXP( r xt ) –D)/(U-D)
Probability Q= 1+r-down move /(Upmove – downmove)
=1+5%-.95/(1.10-.95)
Q = .1/.15= .6667

Value of Upmove or downmove = 1-.667=33%

(this is the risk neutral probability )

Value of option:
Probility of Upmove (10.5)+prob of downmove (2.5) /1.05 (risk free rate)
=Value of Option B
= (.67*10.50) + (.33*2.25) / (1.05)
= 7.407142857

Note:
With an increase in volatility- the call option value also increases.
when volatility reduces, the price reduces, traders buy the option
option traders trade on volatility
they buy the option when expect volatility to rise, sell the option when they expect volatility to
reduce.

They look at historical numbers,

Determine via their experience, what ideal numbers should be.
Risk neutral valuations are- the return on a security is equal to the risk free rate ,
the future price of a stock is independent of risk preference.

DELTA:

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Change in option price for unit change is asset price
- If the asset price changes by $1, what will be the change in asset price.
- Can be positive or negative –
- Long call option- delta- 0 to 1
- Short put option - long delta- 0-1
- When price rises- value of the call option increases
- If the price falls- value of the option decreases

Long Delta:
Short put- long call or short put
We have written a put- (selling a put) – (Short Put)
Normally if you buy a put- if the price goes down- the value of the put option increases

if you short a put- a short put- we have written a put- if the price of the underlying goes down-
the value of the out option increases; these are long delta

Long Delta: (Long Call, Short Put ) - +ve Delta

Long call – if the price goes down- value of the call option increases
Short put- if the price goes down- the value of the put option increases

Short Delta : (Short Call, Long Put) - -ve Delta

Short call – negative delta or long put
In a short call- if the price goes down, the value of the option increases
- If price increases- value decreases
In a long put- if the price goes down- value increases
- If price increases- value decreases
Why should we do delta hedging?
Remove the risk from the position;
We got a call option- because price of the option went up; we hedge it using delta because:
Higher the delta, higher the value of the option,

If the price of the asset goes up by $1,

Options: when the underlying option has a delta of 1 :
At the money – delta - .5
In the money – delta – 1
Out of money – delta- 0

GAMMA:
A change in delta- for a unit change in asset price.
No. of shares – 500
10 long call – delta .50

If delta rises:

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.6
=100*6= 600
Hence now we sell 100 shares more make it 0
- Gamma can be positive or negative
- Long positions- long call or long put have positive gamma
- +ve gamma – 1% inc in price- delta inc
- 1 % fall in price- delta falls
- Short position- short call or short put: - ve(negative) gamma
- 1% increase in price- delta falls
- 1% dec in price- delta increase
Long calls long put +ve Gamma which
1% inc in price- delta increases
1% Dec in price – Delta decreases

Short call short put- -Ve Gamma – which means +ve delta
1% increase in price – delta decreases
1% decrease in price- Delta increases

Long put- -ve delta

Long Call - +ve delta

Short call - -ve delta

Short put - +ve delta

Eg) Long Put - ve delta

If price rises- -ve delta increases (becomes more negative)
If price falls- -ve delta reduces (moves towards +ve)

The difference between the value of a call option and a put option with the same exercise price
is due to primarily:
- The differential between the current stock price and the exercise price

VEGA:
A change in option price due to the change in volatility
Increase in volatility- increase in price
Decrease in volatility- decrease in price

Long and short/ Call and put- +ve or -Ve depending on the position

Long Call/Put Option - +Ve Vega

Short Call/Put Options – Negative Vega

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If price increases- long position benefit, short position loose
How to hedge VEGA?

necessary to use some combination of buying and selling puts or calls.

limit the volatility risk is by using spreads.

THETA:
Used to determine the sensitivity of the option value to time.

Long position- -ve theta

Short position- +ve theta

Structured Products:

Structured Products are innovative products that are used to manage the wealth of high net
worth individuals
- Increase the returns but keep the capital intact – Cap guaranteed products
- if we feel the markets are going to stay stagnant and not move- we can increase the return of
our instrument- participation risk
High risk asset classes – provide you high return – they may loose capital
Hence we need structured products
Helps in every market expectation
- Both in risky as well as low risk profile
Sometimes the issuer can provide us with liquidity- he can buy back the product

4 basic types:
Capital guaranteed- shark notes , unlimited price increase- structure it by – buying a ZCB for
any underlying asset- paying premium
Yield enhancements – market is moving side ways- so u want to enhance your yield- it is
structured by buying a coupon bond and short a put- that enhances the yield of the bond- risk-
price will go down- you will be landed with the dud stock- usually viewed for 1 year
Participation certificate- issuer constructs the index – if we want to participate only on the
bullish side- we can always sell the underside – hence – we can have a bearish and bullish
certificate- if the prices fall- bullish tracker certificate.
Leverage product- warrant- construct a certificate;

A strongly bullish view- knock in option – price much above the barrier
Mildly bullish – but we want to reduce the cost- then knock out option

Unlimited price increase – Capital guaranteed product

If we don’t have the premium amount to pay- our participation can be higher or lower
We pay 100 but the cost is 15- so we get to participate more .

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Interest Rate Swaps and currency swaps :
Swaps:
Contractual agreements- exchanging a series of cashflows
They relate to debt services mainly.
Banks- when they want to help troubled companies- they exchange debt for equity- that’s
called an debt equity swap.

Interest rate swaps:

 There is no actual exchange, its only notional
 Floating rate index to a fixed rate payment
 Its in the same currency
 Alteration in the cash flow- between fixed rate and floating rate
 A fixed rate payer swaps because he thinks floating rate is going to fall
 The bank paying fixed – wants to pay a floating rate- because its assets are in floating- and
its receiving a floating rate.
 IRS- helps reduce the cost of funding

Swap bank: when two companies do a swap- they look for a broker or a dealer.
If it’s a broker- he earns a commission but is not a part of the swap/ transaction.
He is just a facilitator and is not a counter party to the transaction.
If he is a dealer- he is a part of the transaction and actual CF’s pass through him. He
becomes a swap counterparty.

LIBOR rates are floating : over night, 1 month, 2 month, 6 months and 1 year
How do we get a fixed rate?
Amount* actual days/365*rate

Floating rate:
Amount *182 days/360*rate

US- 365
Euro – 360

What drives the swap market:

The prime factor is credit risk – firms that are most creditworthy borrow at cheaper rates, the
not so credit worthy ones- borrow at a higher rate
Many not credit worthy companies can borrow at a higher cost in the floating but not fixed.

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Interest rate swap solution

A borrows in the fixed market where it has an advantage

Hence borrows at 8%

Find out: what is at stake: how much profit can the bank make-
That is called- QST
A can borrow at 8% or L
B can borrow at 9% or L+.50
Difference -1 % -.5% = quality spread differential (QSD)
The advantage which A has is lost to some extent by B borrowing at LIBOR +50
Hence, B made profit of 50 basis points- by borrowing in a market where they have an
advantage.
By borrowing in a market they have an advantage there is a possibility they will make a profit-
reducing the cost of funding.

Hence- there is 50 bp to be spread.

The quality spread is 50 bp

A borrows at 8%
B borrows at Libor +50
QSD – 50 to be shared by both banks

A is better- so borrows at 8%
B borrows at LIBOR +50

A pays to the outside Lender at 8% and to the swap bank pays at LIBOR.

Finding the market value or the current rate of a swap is called- mark to market
When valuing the swaps
If the rates rise- for a fixed rate payer- it doesn’t matter
For a fixed rate receiver- he will have to pay a higher rate on the floating

When we enter into a swap- the person whose value has gone down- will have to pose
collateral

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Cross Currency swaps:
- Exchange in liabilities as well

Borrowing and converting into foreign currency today means that – when they return the
money in foreign currency- there is a possibility the forex. Could appreciate- hence- hedge
The risk is – if one party defaults- the counter party will default too.

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