JAWAHARLAL NEHRU TECHNOLOGICAL UNIVERSITY ANANTAPUR

MBA IV Semester L T P C

4 0 0 4
(17E00403) FINANCIAL DERIVATIVES

(Elective V)
Objective: The objective of this course is to make students efficient in the area of Financial
Derivatives, giving them the knowledge of basics in Financial Derivatives, Future Markets,
Option Strategies, etc.
* Standard discounting and statistical tables to be allowed in the examinations.
1. Introduction to Derivatives:Development and Growth of Derivative Markets, Types of
Derivatives, Uses of Derivatives, Financial and Derivative markets -Fundamental linkages
between spot & Derivative Markets, The Role of Derivatives Market in India.
2. Future and Forward Market: structure of forward and Future Markets, Mechanics of
future markets, Hedging Strategies, Using futures.Determination of forward and future
prices - Interest rate futures, Currency futures and Forwards
3. Options: Distinguish between Options and Futures, Structure of Options Market,
Principles of Option Pricing, Option Pricing Models: The Binomial Model, The Black
Scholes Merton Model.
4. Basic Option Strategies: Advanced Option Strategies, Trading with Options, Hedging
with Options, Currency Options.
5. Swaps: Concept and Nature of Swaps—Major Types of Financial Swaps –Interest Rate
Swaps –Currency Swaps –Commodity Swaps – Credit Risk in Swaps

Text Books:
 Financial Derivatives, Gupta, 1st Edition, PHI.
 Fundamentals of futures and options market, John C Hull: Pearson Education.

References:
 Financial Derivatives and Risk Management, OP Agarwal, HPH
 Commodities and Financial Derivatives, Kevin, PHI
 Fundamentals of Financial Derivatives, Swain.P.K, HPH
 Financial Derivatives, Mishra: Excel.
 Risk Management & Derivatives, Stulz, Cengage.
 Derivatives and Risk Management, Jayanth Rama Varma: TMH.
 Risk Management Insurance and Derivatives, G. Koteshwar: Himalaya
 NPTEL

Unit - I https://www.youtube.com/watch?v=7VC63ONIueA&t=650s
Introduction to Derivatives
Unit -II https://youtu.be/84Up9kFVl4A
Future and Forward Market
Unit - III https://www.youtube.com/watch?v=45nL3D_diFA
Structure of Options
Unit - IV https://www.youtube.com/watch?v=gTSJV4fkFH8
Basic Option Strategies
Unit - V https://www.youtube.com/watch?v=YDqoUBOvF2Y
Swaps

PPT

Unit - I Derivative Introduction

Unit -II Options, Futures & other derivatives

Unit - III Derivative Securities

Reference Books:

R1: JR Varma, Derivatives & Risk Management, TMH

R2: Hull JC , Options, Futures & Other Derivatives, Pearson
R3:Kevin, Commodity & Financial Derivatives, PHI
 NARAYANA ENGINEERING COLLEGE::NELLORE
Permanently affiliated to JNTUA, Ananthapuramu

(Accredited by NAAC with “A+” Grade)

STUDENTS LIST
S.NO ROLL NO NAME
1. 18711E0002 BABU REVATHI
2. 18711E0005 BONAMUKKALA SOWMYA
3. 18711E0006 CHOWTURU NAVEEN
4. 18711E0012 DHARAMAVARAM HARISHWAR
KUMAR
5. 18711E0024 GALLA SURYA TEJA
6. 18711E0027 GANGISETTY HARI PRIYA
7. 18711E0033 GANTA SANTOSH KUMAR
8. 18711E0035 GURRAM SRIKANTH
9. 18711E0037 KAIPAKAM JAYANTHI
10. 18711E0040 KORAKUTI SURENDRA
11. 18711E0048 LOKKU SRAVAN
12. 18711E0056 MAKKI ARAVIND
13. 18711E0058 MANIKALA PAVANI
14. 18711E0061 MOGALETI SAI KRISHNA
15. 18711E0064 NAPA SAI SARAN
16. 18711E0069 NASINA SAI CHARAN
17. 18711E0078 NEELI SAI ROHITH
18. 18711E0079 NELLORE VIJAY
19. 18711E0080 ONTERU NAVEEN KUMAR
20. 18711E0081 PALLA HYMA
21. 18711E0083 PANNEM KAVYA
22. 18711E0088 PAYASAM SRINIVASULU
23. 18711E0092 POTHIREDDY SRIKANTH
24. 18711E0096 PUTTA BHANU PRAKASH
25. 18711E00A1 RALLA HARI SANKAR
26. 18711E00A3 SARVEPALLI MANISHA
27. 18711E00A5 SHAIK CHAN BASHA
28. 18711E00A7 SHAIK RAJAQ
29. 18711E00A8 SYED ABDULANAS
30. 18711E00B5 TIKKAVARAPU KRISHNA SAI
31. 18711E00C0 VELURU MOHAN BABU
32. 18711E00C2 YADLA KAARTHEEK
33. 18711E00D1 BABU REVATHI
34. 18711E00D3 BONAMUKKALA SOWMYA
 NARAYANA ENGINEERING COLLEGE: NELLORE
DEPARTMENT OF MBA
MBA IV SEMESTER ACY: 2019-2020
Financial Derivatives
QUESTION BANK
Staff Name: Dr. GANGINENI DHANANJHAY

Unit-1 Introduction to Derivatives

1. Explain the growth and development of derivatives. Elaborate types of derivatives.

2. The role of derivatives market in India. Explain.

3. Explain the different types of financial derivative along with their features in brief.

4. Write a note on evaluation of derivative markets in India.

5. Explain the merits and demerits of financial derivatives.

6. Bring out the historical development of financial derivatives.

7. Explain the misuses of financial derivatives.

8. What do you meant by cash market? Discuss the fundamental linkage between spot and derivative market?

Unit-2 Future and Forward market

1. “Forward contracts are zero-sum games”. Explain. Also give the difference between the delivery price and the
forward price.

2. Calculate the forward price on a 6-month contract on a share, expected to pay no dividend during the period, which
is available at Rs 75, given that the risk-free rate of interest to be 8% p.a compounded continuously.

3. Explain the structure of forward and future market.

4. Calculate the price of a forward contract using the following data: Price of the share Rs 75 Time to expiration 9
months Dividend expected Rs 2.20 per share Time to dividend 4 months Continuously compounded risk-free rate of
return 12% per annum

5. Critically examine the expectation approach of futures price determination with examples.

6. “Hedging is the basic function of futures market”. Discuss the statement in the light of uses of futures contract.

7. Explain the relationship between forward and futures prices with examples.

8. Explain the following?

i) Currency futures ii) Interest rate futures

9. Define margin requirements for futures? Discuss the types of margin requirements?

Unit-3 Options
1. Differentiate between call and put options. What are the rights and obligations of the holders of long and short
positions in them?

2. Explain the distinction between options and futures contracts with suitable examples.

3. Explain the principles of option pricing.

4. What are the various assumptions of binomial pricing model? Also discuss one step binomial pricing model with
hypothetical examples.
5. Case study:

Consider the following: Stock price = Rs.50/- . Months to expiration = 3 months.

Risk free rate of interest = 10% p.a. Standard deviation of stock = 40% Exercise price = Rs.55/-.
Option type = European call.
Calculate value of call option as per Black Scholes model.
6. Explain the terminologies used in option market? Describe the participants in the option market?

7. What is the meaning of option? Discuss the types of option?

8. Define currency option? Explain the determinants and applications of the currency options?

9. If the spot price of a stock is Rs 60/- and strike price is Rs 68/-. Risk free rate of interest is 10% pa and standard
deviation of stock is 40%. Expiration date is 3 months and option type is European option. Calculate the value of call
option as per Black-Scholes model.

Unit-4 Basic option strategies

1. Critically examine the pros and cons of options trading in India.

2. Describe the trading strategies followed in option market.

3. Pricing of currency is not different from other financial options”. Comment on the statement with suitable examples.

4. What do you understand by the term spread in option trading? Discuss the types of spreads with suitable diagrams.

5. Define spreads? What are the types of spreads?

6. Discuss the basic of option strategies?

7. Discuss the advanced option strategies with examples?

8. Describe the strategies for hedging with options? Explain the concept of straddle and strangle?

Unit-5 Swaps
1. What is swap? Explain the nature of swaps.

2. How do you relate interest rate swaps with currency swaps and how do you price them?

3. Write an essay on Indian swap market.

4. Explain the process of pricing and valuing swaps.

5. What is a financial swap? Discuss the features of a swap contract with example.

6. “Plain Vanilla swap is simplest form of interest rate swap contract available in interest rates swaps market”. Discuss
with suitable examples along with its structure and mechanism.
7. What is currency swap? Explain its features and also show the three step flow of currency swaps with examples.

8. Explain the types and structure of commodity swaps?

9. What do you mean by equity swap? Explain its types and applications?

STAFF HOD PRINCIPAL

 NARAYANA ENGINEERING COLLEGE::NELLORE
Permanently affiliated to JNTUA, Ananthapuramu
(Accredited by NAAC with “A+” Grade)
COURSE PLAN
Course Details
Class :Second Year, MBA Semester: IV Year: 2019-20
Course Title : Financial Derivatives Course Code: 17E00404 Credits: 4
Program/Dept.: MBA Batch : 2018-20
Regulation: R-17 Faculty: Dr.G. Dhanunjaya

Planned Deliver Teaching referenc

S.No Date Unit Topics to be covered Date Aids e books
1 16/12/19  1 Unit-1:Introduction to Derivatives NPTEL R1
2 16/12/19   Development &growth of Derivatives markets PPT R1
18/12/19 Chalk/
3   Types of derivatives, Uses of derivatives Duster R2
18/12/19 Chalk/
4   Fundamental linkage b/w spot & derivatives Duster R1
19/12/19 Chalk/
5   Role, Need and structure of DM in India Duster R1
23/12/19 Chalk/
6   Traders in derivative market Duster R1
23/12/19 Chalk/
7   Uses and misuses of derivatives/ Case Study Duster R2
26/12/19 Chalk/
8   Finance Movie “ BIG SHORT” Duster R2
30/12/19 Chalk/
9   Finance Movie “ ROGUE TRADER” Duster R2
30/12/19 Chalk/
10  2 Unit-2:Structure of Forward Market Duster R2
11 02/01/2020   Structure of futures market NPTEL R1
06/01/20 Chalk/
12   Mechanics of futures market Duster R1
06/01/20 Chalk/
13   Hedging strategies Duster R1
14 08/01/20   Using futures markets PPT R1
08/01/20 Chalk/
15   Determination of forward and futures prices Duster R1
09/01/20 Chalk/
16   Problems Duster R2
13/01/20 Chalk/
17   Interest rate futures Duster R2
13/01/20 Chalk/
18   Currency futures and forwards Duster R1
20/01/20 Chalk/
19   Problems Duster R2
20 20/01/20   Case study R2
Chalk/
22/01/20
21 3  Unit-3: Meaning of option contract Duster R1
Chalk/
22/01/20
22   Difference b/w options & futures Duster R1
23 23/01/20   Structure of options market NPTEL R2
27/10/20 Chalk/
24   Principles of option pricing Duster R3
27/10/20 Chalk/
25   Factors determining option prices Duster R3
29/10/20 Chalk/
26   Option pricing model , Binominal model Duster R1
27 29/10/20   Principles of option pricing PPT  
30/01/20 Chalk/
28   Factors determining option prices Duster R2
03/02/20 Chalk/
29   Option pricing model , Binominal model Duster R2
Chalk/
03/02/20
30   Principles of option pricing Duster R2
31 05/02/20   Factors determining option prices Chalk/ R2
 Duster
Chalk/
05/02/20
32   Difference b/w options & futures Duster  R2
Chalk/
06/02/20
33   Problems Duster R2
Problems Chalk/
10/02/20
34   Duster R1
Problems Chalk/
10/02/20
35   Duster R1
Mid Examination I 12-02-20 to 15-02-20
Chalk/
17/02/20
36   Single period option model Duster R2
Chalk/
17/02/20
36   Multiple period option model Duster R1
Chalk/
19/02/20
37   Black- scholes Merton model, Duster R1
19/02/20 Chalk/
38   problems Duster R3
20/02/20 Chalk/
39   Case study Duster R3
24/02/20 Chalk/
40  4 Unit – 4 Advanced option strategies Duster R2
24/02/20 Chalk/
41   Bull, Bear spreads Duster R2
26/02/20 Chalk/
42   Straddles, Strangles Duster R2
43 26/02/20   Trading with options, strategies involved NPTEL R1
Chalk/
27/02/20
44   Hedging with options Duster R1
Chalk/
02/03/20
45   Currency options Duster R3
Chalk/
02/03/20
46   Case study Duster R3
Chalk/
04/03/20
47   Problems Duster R3
Chalk/
04/03/20
48   Currency options Duster R2
Chalk/
05/03/20
49 Case study Duster R2
Chalk/
09/03/20
50 Problems Duster R2
Chalk/
09/03/20
51 5 UNIT-5:Concept & Nature of Swaps Duster R1
52 11/03/20 Basic swap structure NPTEL R3
Chalk/
11/03/20
53 Major types of financial swaps Duster R3
Chalk/
12/02/20
54 Interest rateswaps Duster R2
Chalk/
16/03/20
55 Currency swaps Duster R2
Chalk/
16/03/20 Commodity swaps
56 Duster R2
Chalk/
18/03/20
57 Credit risk in swaps Duster R1
Chalk/
18/03/20
58 Concept & Nature of Swaps Duster R3
Chalk/
19/03/20
59 Basic swap structure Duster R3
Chalk/
23/03/20
60 Major types of financial swaps Duster R2
Chalk/
23/03/20
61 Interest rateswaps Duster R2
Chalk/
25/03/20
62 Currency swaps Duster R2
Chalk/
25/03/20 Commodity swaps
63 Duster R1
Chalk/
26/03/20
64 Credit risk in swaps Duster R3
65 30/03/20 Problems Chalk/
 Duster
Problems Chalk/
30/03/20
66 Duster
Problems Chalk/
01/04/20
67 Duster
Problems Chalk/
01/04/20
68 Duster
Chalk/
06/04/20
69 Case Study Duster
Case Study Chalk/
06/04/20
70 Duster
Case Study Chalk/
08/04/20
71 Duster
72 08/04/20 Revision
73 09/04/20 Revision

Second – Mid Exams

Refernce Books

R1 : JR Varma, Derivatives & Risk Management , TMH

R2: Hull JC , Options, Futures & Other Derivatives , Pearson

R3 : Kevin , Commodity & Financial Derivatives , PHI

FACULTY HOD PRINCIPAL

 Department of Management Studies (17E00403)

FINANCIAL DERIVATIVES (17E00403)

Unit - 1

Introduction to Derivatives: Development and Growth of Derivative Markets, Types of Derivatives, Uses of Derivatives,
Financial and Derivative markets -Fundamental linkages between spot & Derivative Markets, The Role of Derivatives
Market in India

Derivatives

Concept: ‘Derivatives’ refer to a broad class of financial instruments which mainly include options and futures.
These instruments derive their value from the price and other related variables of the underlying asset. A simple
example of derivative is butter, which is derivative of milk. The price of butter depends upon price of milk, which
in turn depends upon the demand and supply of milk.
Securities Contract Regulation Act (SCRA) 1956 defines Derivative as:

a) “A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or
contract for differences or any other form of security”.
b) “A contract which derives its value from the prices, or index of prices, of underlying securities”.

Underlying assets

Concept: Underlying asset is a term used in derivatives trading. An underlying asset is the security on which a derivative
contract is based upon

Underlying Assets in a Derivatives Contract

 Commodities including grain, coffee beans, orange juice;
 Precious metals like gold and silver;
 Foreign exchange rates or currencies;
 Bonds of different types
 Shares traded on recognized stock exchanges and Stock Index
 Short term securities such as T-bills; and
Hedgers:

Concept: Hedger is a user of the market, who enters into futures contract to manage the risk of adverse price fluctuation in
respect of his existing or future asset. Hedgers are those who have an underlying interest in the commodity and are using
futures market to insure themselves against adverse price fluctuations.

Speculators:

Concept: A trader, who trades or takes position without having exposure in the physical market, with the sole intention of
earning profit is a speculator.

Arbitrageurs:
Concept: A market participant who has the desire to take advantage of a difference between prices of more or less the
same assets or competing assets in 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.

Forward contract

Concept: A forward contract is a customized contract between the buyer and the seller where settlement takes place on a
specific date in future at a price agreed today. In case of a forward contract the price which is paid/ received by the parties
is decided at the time of entering into contract.

Definition: A forward contract is a commitment to purchase at a future date a given amount of a commodity or an asset at
a price agreed on today.

Concept: Futures contract is an agreement between two parties to buy or sell a specified quantity of an asset at a specified
price and at a specified time and place. Futures contracts are normally traded on an exchange which sets the certain
standardized norms for trading in futures contracts.

Definition: Futures is a standardized forward contact to buy (long) or sell (short) the underlying asset at a specified price at
a specified future date through a specified exchange. Futures contracts are traded on exchanges that work as a buyer or
seller for the counterparty.

Options contracts

Concept: Options are derivative contracts that gives the buyer right, but not the obligation to either buy or sell a specific
underlying security for a specified price on or before a specific date. date.

Definition: An ‘Option’ is a type of security that can be bought or sold at a specified price within a specified
period of time, in exchange for upfront payment.
Swaps contract
Concept: A swap is an agreement between two or more people or parties to exchange sets of cash flows over a
period in future. Swaps are agreements between two parties to exchange assets at predetermined intervals. Swaps
are generally customized transactions.
Warrants:
Concept: Longer-dated options are called warrants and are generally traded over-the-counter.
LEAPS:
Concept: The acronym LEAPS means long term equity anticipation securities. These are options having a
maturity of up to three years.
Baskets:
Concept: Basket options are options on portfolios of underlying assets. The index options are a form of basket
options
SPOT /CASH MARKET:

Concept: The spot market is a security or commodities market where goods, both perishable and non-perishable, are sold
for cash and delivered immediately or within a short period of time. Contracts sold on this market, which is also known as
the “cash market” or “physical market,” is also effective immediately.
Definition: A commodities or securities market in which goods are sold for cash and delivered immediately. Contracts
bought and sold on these markets are immediately effective.

Organized market, an exchange:

Concept: An exchange is highly organized market where traded securities, Commodities, foreign exchange, futures and
options contracts are sold and bought. Financial instruments like securities and commodities are bought and sold on
exchanges that use, make or change the present market price of the product.

Over- the –counter(OTC):

Concept: Over –the –counter or off exchange trading is to trade financial instruments Such as stocks , bonds, commodities
directly between two parties. It is contrasted with exchange trading which occurs via facilities constructed for the purpose
of trading. Over-the-counter markets provide trades that happen directly between a buyer and a seller.

Unit – 2

Future and Forward market: Structure of forward and Future Market Mechanics of future markets, Heading Strategies,
Using futures. Determination of forward and future pries – Interest rate futures, Currency futures and Forwards.

Forward Contract:

Concept: It is a contract between two parties entered today to buy or sell an asset on a specified future date at a price
fixed today.

Customized contract Vs standardized contract:

A. Customized Contract:

Concept: The contract whose terms and conditions are mutually set by the two parties is called “a customized contract”.
The chances of its default are high.

B. Standardized Contract:

Concept: The contract whose terms and conditions are set by the exchange through which the contract is performed is
called “a standardized contract”. The chances of its default are very low. “Futures contract” is a standard contract.

Underlying asset:

Concept: The asset on which a derivative contract is entered is called an “underlying asset”. The underlying asset may be a
commodity or a financial asset.

Long position:

Concept: The party in a derivatives contract agrees to buy an underlying asset on a future date will have “long position”.

Short position:

Concept: The party in a derivative contract which agrees to sell an underlying asset on a future date will have a “short
position”.
Spot position:

Concept: The price of the underlying asset which is quoted by a seller to the buyer for buying and selling “on the spot” or
“immediately” is called “spot position”.

Future spot price:

Concept: The spot price of the underlying asset which prevails on the expiry date is called “future spot price”.

Expiration date:

Concept: The date on which the derivative contract expires is called “expiration date”. It is also called “maturity date”.

Delivery Price:

Concept: The price of the underlying asset fixed on the date of agreement and at which the derivative contract (i.e forward
contract etc.) is going to be settled on the expiry date is known as “delivery price”.

Zero- sum – game (of a forward contract):

Concept: On the date of agreement or contract, the contract value is “zero” for both buyer and seller. But the value of the
underlying asset changes throughout the life of the contract. This value change brings a “benefit” for one party and a
“loss” for the other party. This characteristics feature of the derivative contract is called “Zero sum game” for the buyer
and seller.

Futures Market:

Concept: The market where “future contracts” are purchased and sold is called “a futures market”.

Futurs contract:

Concept: A contract between two parties entered today to buy or sell an asset “through an exchange” on a future date
fixed today at a price decided today is called “a futures contract”.

DEFINITION:

“Futures are exchange traded contracts to sell or buy financial instruments or physical commodities for future delivery at
an agreed price .There is an agreement to buy or sell a specified quantity of financial instrument/ commodity in a
designated future month at a price agreed upon by the buyer and seller. The contracts have certain standardized
specifications”.

Basis:

Concept: The difference between the “future price and the spot price” is called ‘basis’.

Initial margin:

Concept: The amount to be deposited by the purchaser and seller of the futures contract in the margin account when the
futures contract is first entered is known as “initial margin”.

Maintenance Margin:
Concept: The minimum amount to be kept always in the margin account is named as “maintenance margin”. Usually it will
be 75% of the initial margin.

Variation Margin:

Concept: The additional amount to be deposited by the client (buyer or seller of the asset) with the broker to increase the
balance of the margin amount to the level of initial margin is called “variation margin”.

It can also be explained as the difference between “initial margin and the balance in margin account”.

Marking to market:

Concept: In the futures market, all the transactions are settled on daily basis. The clients may get gains or losses on daily
basis.

The daily gain of the client will be added to the margin account balance and the daily loss will be deducted from it. This
system of daily settlement in the futures market is known as “marking to market”.

Clearing house:

Concept: It is the institution which acts as an intermediary between the two parties regarding their transactions. It
guarantees the performance of the transactions.

Settlement of futures contracts:

Physical delivery system:

Concept: The buyer will take the asset and pay cash. Similarly the seller will deliver the asset and take cash in settlement of
the transaction.

Cash Settlement:

Concept: Under this method the loser will not pay the difference between the futures price and future spot price in cash,
but it will be marked to market.

Hedging:

Concept: The art of taking a position by the investor in the future market which is opposite to the position taken in the
spot market to protect himself from a lose or risk.

Eg: If he is longs (buying) in the spot market then he will be short (selling) in the futures market and vice versa.

Hedge ratio:

Concept: The ratio of the size of the position taken in a futures contract to the size of the position taken in a spot contract
is called “hedge ratio”.

Formula:

Hedge ratio = units of assets in futures position/units of assets in spot position

Interest rate futures:

Concept: The futures contract relating to “interest rate” is called as “interest future”.

Currency Futures:

Concept: The futures contract relating to “currencies” is called a “currency future”.

Storage costs:

Concept: Expenses incurred for storage and maintaining an asset in safe custody are called “storage costs”.

Futures price under “cost of carry theory or approach”:

Formula:

Futures price = spot price + net carrying costs

Futures price under the “Expectation Theory or Approach”:

Formula:

Current futures price = spot price currently expected on the delivery date

Unit – 3

Options: Distinguish between Options and Futures, Structure of Options Market, Principles of Option Pricing, Option
Pricing Models: The Binomial Model, The Black Schools Merton Model.

“Option contract” (or an option):

Concept: An ‘option contract’ is a contract between two parties. One party gives an “option” (or a right) to another party
to buy or sell a specific asset at a specified price fixed today within a specified time.

The person giving the option is called “the option seller” and the person receiving the option is called “option buyer”.

For getting the option to buy or sell, the option buyer must pay some amount to the seller and that amount is called
“option premium”.

Option seller:

Concept: In an option contract, the person giving the option is called “option seller”. He is also called “writer”.

Option buyer:

Concept: In an option contract , the person receiving the option is known as “option buyer”. He is also called “option
receiver” or “option holder” or “option buyer”.

Broker:

Concept: The person acting as a mediator between the option seller and the option buyer is called “Broker”. He gets fees
or commission for his services.

Exercise price:
Concept: The price at which the underlying asset is sold by the asset seller to the asset buyer is called “exercise price”. At
this price the option contract will be executed.

Expiration Date:

Concept: The date after which the option becomes “void” is called “expiration date”. The option holder can exercise his
option to buy or sell on or before this date.

Exercise Date:

Concept: The date on which the option holder has exercised his option to buy or sells is known as the “Exercise date”.

Option premium (or option price):

Concept: The amount paid by the option buyer to the option seller for getting the option (or right) is named as “option
premium” or “option price”.

It is an ‘income’ to the option seller and an ‘expense’ to the option buyer.

It is non-refundable in nature

Call option:

Concept: In an option contract “the right to buy” an asset is called “call option”.

Put option:

Concept: In an option contract, “the right to sell” an asset is known as a “put option”.

American ‘option’ or American option contract:

Concept: Any option contract which can be exercised on the expiry date or any date before the expiration date is called
“an American option”.

European option or European option contract:

Concept: Any option contract, which can be exercised only on the expiration date, is known as an “European option”.

Exchange traded option:

Concept: Any option contract which can be traded (i.e purchased or sold) on any organized exchange is called “an
Exchange Traded option” (organized exchange means Govt. recognized exchange).

Over - counter option{ OTC}

Concept: Any option contract which can be traded through a dealer instead of an organized exchange is called “an OTC”
option.

Intrinsic value of the option:

Concept: The gain to the option buyer on the immediate exercising of the option is known as “intrinsic value”.

Time value of the option:

Concept: The difference between the “option price” and the “intrinsic value” of an option is called “time value of the
option”.

Formula

Time value ={ option price –intrinsic value}

“Transaction costs” in option trading:

Concept: Expenses to be incurred for trading in options are called “transaction cost”.

Egs. Brokarage, Tax, Stamp duty etc

Bid ask spread:

Formula

Bid-Ask spread= { Bid price- Offer or Ask price}

Concept: The difference between the ‘bid price’ (or purchase price) and the “offer price or ask price” (or selling price) is
called “bid-ask spread”.

Binomial option – pricing model:

Concept: It is a method used for pricing an option. It was proposed by “cox, Ross and Rubinstein” in the year 1979.

Under this technique the option is priced through the construction of a “binomial tree”. The tree shows the different
possible paths, the stock price may take during the life of the option.

Methods of binomial model:

A. Single period Binomial model:

Concept: It is also called “one step Binomial model. Under this method, we assume that the present stock price “may
increase” or “may decrease” after the expiration date.

B. Two – period Binomial model:

Concept: In the single – period binomial model, we get “one mod” where two outcomes are possible. This period can be
extended to “two periods”, in which case, it is called “two period binomial models”.

C. Multi period binomial model:

Concept: If the binomial model is “extended to more than two periods”, then it is called “multi period binomial models”.

(Note: “Node” means the point where the “up factor” and the “down factor” meet)

Black and schools model: ( or Black – Scholes – Merton model)

Concept: The model developed by Black, Schtoles and Merton for pricing an option is called “ Black scholes and Merton
model”, Scholes and Merton were awarded “Nobel prize” in economics in 1997 for it and “Black” did not share it because
he died in 1995.
 UNIT-4
Basic Option Strategies:
Basic Option Strategies: Advanced Option Strategies, Trading with Options, Hedging with Options, Currency Options.
Options

Concept: The options are important financial derivatives where the instruments have additional features of exercising an
option which is a right and not the obligation. Option may be defined as a contract between two parties where one gives
the other the right (not the obligation) to buy or sell an underlying asset as a specified price within or on a specific time.

Options contract:

Definition: An ‘Option’ is a type of security that can be bought or sold at a specified price within a specified period of time,
in exchange for a non-refundable upfront deposit

Premium

Concept: The price of an option

Cap:
Concept: A cap is an upper limit on an interest or payment rate.
Collar.
Concept: A collar is an investment strategy that uses options to limit to a specific range the possible range of
positive or negative returns on an investment in an underlying asset. To establish a collar, an investor
simultaneously purchases a put option and sells (writes) a call option on an asset.
Covered Call
Concept: With calls, one strategy is simply to buy a naked call option. You can also structure a basic covered call or buy-
write. This is a very popular strategy because it generates income and reduces some risk of being long stock alone.

Protective Collar
Concept: A protective collar strategy is performed by purchasing an out-of-the-money put option and simultaneously
writing an out-of-the-money call option for the same underlying asset and expiration. This strategy is often used by
investors after a long position in a stock has experienced substantial gains.

Butterfly Spread
Concept: All of the strategies up to this point have required a combination of two different positions or contracts.
In a long butterfly spread using call options, an investor will combine both a bull spread strategy and a bear
spread strategy, and use three different strike prices. All options are for the same underlying asset and expiration
date
Calendar Spreads
Concept: A calendar spread can be created by selling a call option with a certain strike price and buying a longer-
maturity call option with the same strike price. The longer the maturity of an option the more experience its. A
calendar spread, therefore required an initial investment.
Straddle
Concept: One popular combination is a straddle, which involves buying a call and a put with the same strike price and
expiration date.

Strips

Concept: A strip consists of a long position in one call and two puts with the same strike price and one put with the same
price and expiration data.

Basic strategies:

Long Call

Concept: Buying call options is the simplest and a popular form of entering into the derivatives market. By definition, call
option buyer has the right to buy the stock at the strike price until the expiration date. An investor will buy a call option
with the expectation of a price rise.

Short Call

Concept: When an investor sells a call option, he definitely expects that the stock price will not rise. Though the outlook of
the investor is not very positive, he is not utterly bearish since in order to profit the market need not decline; even if it
stands still, he will gain the premium

Long Put

Concept: By buying a put option, an investor is expressing a bearish view on the direction of the underling’s price. Put
options are extremely useful tools in markets where short selling is not permitted legally.

Short Put

Concept: The seller of a put option has an obligation to buy the underlying asset at the exercise price. Therefore, the put
seller expects that the underlying price will definitely not decline though he may not be sure about the price rising, he
should be certain that the stock will not go down. Put writing can also be considered as a strategy of acquiring the
underlying asset at or below the going market price.

Volatility Strategies

Concept: Option markets actually facilitate securitization of risk. Hence options are one of the most important and
accessible tools to construct strategies that benefit from the traders’ knowledge of volatility changes without bothering
about direction of the underlying price.

Hedge
Concept: A transaction that offsets an exposure to fluctuations in financial prices of some other contract or
business risk. It may consist of cash instruments or derivatives.
Hedging with options:

Concept: Hedging is a technique that is frequently used by many investors, not just options traders. ... Stock traders will
often use options to hedge against a fall in price of a specific stock, or portfolio of stocks, that they own. Options traders
can hedge existing positions, by taking up an opposing position.
Basic hedging principle:

Concept: Hedging risk involves engaging in a financial transaction that offsets a long position by taking a short position, or
offsets a short position by taking a additional long position

Long position : agree to buy securities at future date Hedges by locking in future interest rate if funds coming in future

Short position : agree to sell securities at future date Hedges by reducing price risk from change in interest rates if holding
bonds.

Currency options:

Concept:  Currency options are one of the most common ways for corporations, individuals or financial institutions to
hedge against adverse movements in exchange rates

Currency options

Definition: A currency option is a contract that gives the buyer the right, but not the obligation, to buy or sell a
certain currency at a specified exchange rate on or before a specified date.

Unit –5

Swaps: Concept and Nature of Swaps – Major Types of Financial Swaps – Interest Rate Swaps –
Currency Swaps – Commodity Swaps – Credit Risk in Swaps

Swaps:
Concept: The word “Swap” means “to barter” or “to give the exchange” or “to exchange one for another”.
A swap is a contract between two parties to deliver one sum of money against another sum of money at periodic
intervals. These two payments are known as “the legs or sides” of the swap.
Eg. A person borrows money from a money lender giving an asset as a collateral security. The Borrower will
pay interest regularly and at the time of maturity, he will repay the principal and get back his asset previously
given as a collateral security.
Counter parties in a Swap:
Concept: The two parties involved in a Swap contract (excluding the intermediaries) are called “Counter Parties”.
Facilitators in a Swap:
Concept: Swap agreements are usually arranged by some intermediaries and these intermediaries are called
“Facilitators”.
Examples of Facilitators are:
a) Big financial institutions
b) Banks having operations in different countries.
Classification of Swap facilitators:
Concept: Swap facilitators can be divided into two types namely
A) Brokers and
B) Swap dealers.
Swap Brokers:
Concept: The agent or the broker who brings together the counter parties of a swap is called a ‘Swap brokers’.
He will charge some commission for his services.
Swap dealers:
Concept: A Swap dealer is one who associates with the swap as a counter party to take risk. He is also known as
a “market maker”. He may also act as a Broker.
Classification of Swaps:
Concept: The Swaps can be classified into two types namely:
A) Commodity swaps and
B) Financial swaps.
Commodity Swaps:
Concept: A commodity swap is an agreement between two parties namely:
A) Commodity Buyer and
B) Commodity Seller
According to the agreement, the Buyer agrees to pay a fixed price for a particular quantity of a commodity to the
seller, who inturn agrees to ay to the buyer a price based on the prevailing market price for the same quantity.
Financial Swaps:
Concept: Swaps relating to financial transactions are called “Financial Swaps”. Examples of Financial Swaps are:
A) Interest – rate swaps
B) Currency swaps and
C) Equity swaps
Interest rate swaps:
Concept: It is an agreement between two parties to exchange interest payment for a certain period of time.
There are many types of interest rate swaps like:
a) Fixed for Floating rate swap
b) Floating for floating rate swap etc.
Types of Interest rate swaps:
Concept: The different types of interest rate swaps are:
A) Basis swaps
B) Forward swaps
C) Callable swaps
D) Puttable swaps
Basis swaps:
Concept: It is a swap where both the parties exchange (or swap) floating rate payments. Which are determined by
different indices, one rate may be based on ‘ MIBOR’ or ‘MIFOR’ and the other may be based on “Prime lending
rate or commercial paper rate or Bank rate” etc.
Forward swaps:
Concept: It is a swap where the parties enter into an agreement today but the effective date will be some time in
future.
Callable swaps:
Concept: It is a swap where the holder[ i.e., Fixed rate payer] has the right to terminate the swap at any time
before the maturity. This termination takes place when the interest rates fall and the required funds are available
in the market at a lower rate.
Puttable swaps:
Concept: It is a swap, when the seller of the swap [i.e Floating rate payer] gets the right to terminate the swap at
any time before the maturity date.
If the interest date rises, then the floating rate payer will terminate the swap.
Currency swaps:
Concept: It is an agreement between two parties to exchange a given amount in one currency for another currency
and to repay these currencies with interest in future.
Classification of currency swaps:
Concept: The currency swaps can be classified into two types namely:
A) Fixed to Fixed currency swap
B) Fixed to Floating currency swap
Fixed to Floating currency swaps:
Concept: It is a swap where a fixed interest obligation is one currency will be exchanged for a fixed interest
obligation in another currency.
Fixed to Floating currency swap:
Concept: It is a swap where a fixed rate obligation in one currency will be exchanged for a floating rate obligation
in another currency.
Equity swaps:
Concept: It is an agreement to exchange the total return realized on an equity index. The total return includes
dividends and capital gains. The interest rate may be a fixed rate or a floating rate of interest.
Eg. An equity swap agreement may allow a company to swap a fixed interest rate of 6% in exchange for the rate
of appreciation on a particular index like BSE or NSE index each year over the next four years.