UNIT -1

What Is a Derivative? Vanessa Sky

The term derivative refers to a type of financial contract whose value is dependent on an
underlying asset, group of assets, or benchmark. A derivative is set between two or more parties
that can trade on an exchange or over-the-counter (OTC).

These contracts can be used to trade any number of assets and carry their own risks. Prices for
derivatives derive from fluctuations in the underlying asset. These financial securities are
commonly used to access certain markets and may be traded to hedge against risk. Derivatives
can be used to either mitigate risk (hedging) or assume risk with the expectation of
commensurate reward (speculation). Derivatives can move risk (and the accompanying rewards)
from the risk-averse to the risk seekers.

Key Takeaways

 Derivatives are financial contracts, set between two or more parties, that derive their
value from an underlying asset, group of assets, or benchmark.
 A derivative can trade on an exchange or over-the-counter.
 Prices for derivatives derive from fluctuations in the underlying asset.
 Derivatives are usually leveraged instruments, which increases their potential risks and
rewards.
 Common derivatives include futures contracts, forwards, options, and swaps.

DERIVATIVES AND RISK MANAGEMENT

The term derivative refers to a type of financial contract whose value is dependent on an underlying
asset, group of assets, or benchmark. A derivative is set between two or more parties that can trade on
an exchange or over-the-counter (OTC). These contracts can be used to trade any number of assets and
carry their own risks. Prices for derivatives derive from fluctuations in the underlying asset. These
financial securities are commonly used to access certain markets and may be traded to hedge against
risk.

 Derivatives are financial contracts, set between two or more parties, that derive their
value from an underlying asset, group of assets, or benchmark.
 A derivative can trade on an exchange or over-the-counter.
 Prices for derivatives derive from fluctuations in the underlying asset.
 Derivatives are usually leveraged instruments, which increases their potential risks and
rewards.
 Common derivatives include futures contracts, forwards, options, and swaps.

PARTICIPANTS:
  Hedgers: These are risk-averse traders in stock markets. They aim at derivative markets to
secure their investment portfolio against the market risk and price movements. They do this by
assuming an opposite position in the derivatives market. In this manner, they transfer the risk of
loss to those others who are ready to take it. In return for the hedging available, they need to
pay a premium to the risk-taker. Imagine that you hold 100 shares of XYZ company which are
currently priced at Rs. 120. Your aim is to sell these shares after three months. However, you
don’t want to make losses due to a fall in market price. At the same time, you don’t want to lose
an opportunity to earn profits by selling them at a higher price in future. In this situation, you
can buy a put option by paying a nominal premium that will take care of both the above
requirements.

 Speculators: These are risk-takers of the derivative market. They want to embrace risk in order
to earn profits. They have a completely opposite point of view as compared to the hedgers. This
difference of opinion helps them to make huge profits if the bets turn correct. In the above
example, you bought a put option to secure yourself from a fall in stock prices. Your
counterparty i.e. the speculator will bet that the stock price won’t fall. If the stock prices don’t
fall, then you won’t exercise your put option. Hence, the speculator keeps the premium and
makes a profit.

 Margin traders: A margin refers to the minimum amount that you need to deposit with the
broker to participate in the derivative market. It is used to reflect your losses and gains on a
daily basis as per market movements. It enables to get leverage in derivative trades and
maintain a large outstanding position. Imagine that with a sum of Rs. 2 lakh you buy 200 shares
of ABC Ltd. of Rs 1000 each in the stock market. However, in the derivative market, you can own
a three times bigger position i.e. Rs 6 lakh with the same amount. A slight price change will lead
to bigger gains/losses in the derivative market as compared to the stock market.

 Arbitrageurs: These utilize the low-risk market imperfections to make profits. They
simultaneously buy low-priced securities in one market and sell them at a higher price in
another market. This can happen only when the same security is quoted at different prices in
different markets. Suppose an equity share is quoted at Rs 1000 in the stock market and at Rs
105 in the futures market. An arbitrageur would buy the stock at Rs 1000 in the stock market
and sell it at Rs 1050 in the futures market. In this process, he/she earns a low-risk profit of Rs
50.

TYPES OF DERIVATIVE CONTRACT

FORWAD MARKET:

A forward market is an over-the-counter marketplace that sets the price of

a financial instrument or asset for future delivery. Forward markets are used
for trading a range of instruments, but the term is primarily used with
reference to the foreign exchange market. It can also apply to markets for
securities and interest rates as well as commodities.
  Forward contracts differ from future contracts in that they are
customizable in terms of size and length, or maturity term.
 Forward contract pricing is based on interest rate discrepancies.
 The most commonly traded currencies in the forward market are the
same as on the spot market: EUR/USD, USD/JPY and GBP/USD.

How a Forward Market Works

Forward markets create forward contracts. The forward contracts are meant to

be used for speculative purposes, as well as for hedging. Forward contracts are
transacted between banks and banks to customers.

The forward market offers both forward and futures contracts. The two differ
in that forward contracts can be customized to the holder’s requests, whereas
futures contracts tend to be standardized regarding maturity and order size.

Forward Contract

A forward contract allows a party to buy or sell an asset at a predetermined

price within a specified time in the future. Forward contracts can be
customized to a commodity, delivery date, and order size. Commodities can
include grains, natural gas, oil, precious metals, and more. Based on the
contract, a forward settlement can either be a recurring monthly cash payment
or on a once-delivered basis.

For example, Sam wants to buy gold to diversify his portfolio and hedge
himself against any downside from the S&P 500. At the moment, gold is
$2,000 per ounce. He believes gold will skyrocket in one year to $2,500/oz and
decides to enter into a position with a gold producer, with an asking price of
$2,000/oz one year from now.

It means the gold producer must give Sam his gold in one year for the price of
$2,000/oz regardless of what the market price is then. The payment can be
conducted on a predetermined basis, whether that may be monthly, quarterly,
yearly, or when the goods are delivered.

Forward contracts are known to be OTC (over-the-counter) instruments, since

they are not traded on a centralized exchange. That being said, they are
exposed to a higher degree of default risk but also offer a higher potential
return.

Futures Contract

A futures contract refers to an agreement that allows a party to buy or sell an

asset at a predetermined price within a specified time in the future. Futures are
standardized contracts, particularly in the quantity of ordering size and date.

Buyers who enter a futures contract are obligated to buy the goods from the
seller based on what is written in the contract when the delivery date arrives.
Vice-versa, the seller is obligated to sell the goods to the buyer on the delivery
date based on the price written in the contract, regardless of what the market
price is on the exchange date

Swaps

Swaps are another common type of derivative, often used to exchange one kind of cash flow
with another. For example, a trader might use an interest rate swap to switch from a variable
interest rate loan to a fixed interest rate loan, or vice versa.

Imagine that Company XYZ borrows $1,000,000 and pays a variable interest rate on the loan
that is currently 6%. XYZ may be concerned about rising interest rates that will increase the
costs of this loan or encounter a lender that is reluctant to extend more credit while the company
has this variable rate risk.

Assume XYZ creates a swap with Company QRS, which is willing to exchange the payments
owed on the variable-rate loan for the payments owed on a fixed-rate loan of 7%. That means
that XYZ will pay 7% to QRS on its $1,000,000 principal, and QRS will pay XYZ 6% interest
on the same principal. At the beginning of the swap, XYZ will just pay QRS the 1% difference
between the two swap rates.

If interest rates fall so that the variable rate on the original loan is now 5%, Company XYZ will
have to pay Company QRS the 2% difference on the loan. If interest rates rise to 8%, then QRS
would have to pay XYZ the 1% difference between the two swap rates. Regardless of how
interest rates change, the swap has achieved XYZ's original objective of turning a variable-rate
loan into a fixed-rate loan.

Swaps can also be constructed to exchange currency exchange rate risk or the risk of default on a
loan or cash flows from other business activities. Swaps related to the cash flows and potential
defaults of mortgage bonds are an extremely popular kind of derivative. In fact, they've been a
bit too popular in the past. It was the counterparty risk of swaps like this that eventually spiraled
into the credit crisis of 2008.

Options

An options contract is similar to a futures contract in that it is an agreement between two parties
to buy or sell an asset at a predetermined future date for a specific price. The key difference
between options and futures is that with an option, the buyer is not obliged to exercise their
agreement to buy or sell. It is an opportunity only, not an obligation, as futures are. As with
futures, options may be used to hedge or speculate on the price of the underlying asset.

In terms of timing your right to buy or sell, it depends on the "style" of the option. An American
option allows holders to exercise the option rights at any time before and including the day of
expiration. A European option can be executed only on the day of expiration. Most stocks and
exchange-traded funds have American-style options while equity indices, including the S&P
500, have European-style options.

Imagine an investor owns 100 shares of a stock worth $50 per share. They believe the stock's
value will rise in the future. However, this investor is concerned about potential risks and decides
to hedge their position with an option. The investor could buy a put option that gives them the
right to sell 100 shares of the underlying stock for $50 per share—known as the strike price—
until a specific day in the future—known as the expiration date.

Assume the stock falls in value to $40 per share by expiration and the put option buyer decides to
exercise their option and sell the stock for the original strike price of $50 per share. If the put
option cost the investor $200 to purchase, then they have only lost the cost of the option because
the strike price was equal to the price of the stock when they originally bought the put. A
strategy like this is called a protective put because it hedges the stock's downside risk.

Alternatively, assume an investor doesn't own the stock currently worth $50 per share. They
believe its value will rise over the next month. This investor could buy a call option that gives
them the right to buy the stock for $50 before or at expiration. Assume this call option cost $200
and the stock rose to $60 before expiration. The buyer can now exercise their option and buy a
stock worth $60 per share for the $50 strike price for an initial profit of $10 per share. A call
option represents 100 shares, so the real profit is $1,000 less the cost of the option—the premium
—and any brokerage commission fees.

1. Call options

Calls give the buyer the right, but not the obligation, to buy the underlying asset at the strike
price specified in the option contract. Investors buy calls when they believe the price of the
underlying asset will increase and sell calls if they believe it will decrease.
2. Put options

Puts give the buyer the right, but not the obligation, to sell the underlying asset at the strike price
specified in the contract. The writer (seller) of the put option is obligated to buy the asset if the
put buyer exercises their option. Investors buy puts when they believe the price of the underlying
asset will decrease and sell puts if they believe it will increase.

Specifications of future contracts

Following are the salient features of futures contracts:

1. Futures are highly standardised contracts that provide for performance of contracts through
either deferred delivery of asset or final cash settlement;
2. These contracts trade on organized futures exchanges with a clearing association that acts
as a middleman between the contracting parties;
3. Contract seller is called 'short' and purchaser 'long'. Both parties pay margin to the clearing
association. This is used as performance bond by contracting parties;
4. Margins paid are generally marked to market-price everyday;
5. Each futures contract has an associated month that represents the month of contract delivery
or final settlement. These contracts are identified with their delivery months like July-
Treasury bill, December $/DM etc.
6. Every futures contract represents a specific quantity. It is not negotiated by the parties to
the contract. One can buy or sell a number of futures contracts to match one's required
quantity. Because of this feature, 100% hedging is not possible. There may be over or
under-hedging to some extent.

12. When the index moves up, the long futures position starts making losses.
13. The payoff for a person who sells a futures contract is similar to the payoff for a person
who shorts an asset.
4.5 Cash Settlement vs Physical Settlement
Settlement is the act of consummating the contract, and can be done in the following ways:
1. Physical delivery: The amount specified of the underlying asset of the contract is delivered
by the seller of the contract to the exchange, and by the exchange to the buyers of the
contract. Physical delivery is common with commodities and bonds. In practice, it occurs
only on a minority of contracts. Most are cancelled out by purchasing a covering position-
that is, buying a contract to cancel out an earlier sale (covering a short), or selling a
contract to liquidate an earlier purchase (covering a long). This form of settlement involves
delivery of contract, and is most popular in commodity futures. The party with the short
position (seller) sends a notice of intention to the exchange who then selects a party with
outstanding long position to accept the delivery.
2. Cash settlement: Cash payment is made based on the underlying reference rate, such as a
short term interest rate index such as Euribor, or the closing value of a stock market index.
This is mostly used for settling stock indices futures. Stock indices cannot be delivered
physically. This is because that will involve transaction in constituent stocks (underlying
the index) in various proportions, which is not practically possible and involves higher
transaction cost. On expiry of the settlement period, the exchange sets the final settlement
price equal to the spot price of the asset on that day. For example, suppose an investor
takes long position in near month NSE Nifty Futures with delivery price at 3100. On
maturity, if the index is at 3200 with near month short futures at 3225, then the investor
gains ` 100 through cash settlement

SOURCES OF FINANCIAL RISK:

Financial Risk: Financial Risk as the term suggests is the risk that involves financial loss to firms. Financial
risk generally arises due to instability and losses in the financial market caused by movements in stock
prices, currencies, interest rates and more.

 Market Risk:

This type of risk arises due to the movement in prices of financial instrument. Market risk can be
classified as Directional Risk and Non-Directional Risk. Directional risk is caused due to movement in
stock price, interest rates and more. Non-Directional risk, on the other hand, can be volatility risks.

 Credit Risk:

This type of risk arises when one fails to fulfill their obligations towards their counterparties. Credit risk
can be classified into Sovereign Risk and Settlement Risk. Sovereign risk usually arises due to difficult
foreign exchange policies. Settlement risk, on the other hand, arises when one party makes the payment
while the other party fails to fulfill the obligations.

What Is Default Risk?

Default risk is the risk that a lender takes on in the chance that a borrower will be unable to make
the required payments on their debt obligation. Lenders and investors are exposed to default risk
in virtually all forms of credit extensions. A higher level of default risk leads to a higher required
return, and in turn, a higher interest rate

 Default risk is the risk that a lender takes on in the chance that a borrower won’t be able
to make required debt payments.
 A free cash flow figure that is near zero or negative could indicate a higher default risk.
 Default risk can be gauged by using FICO scores for consumer credit and credit ratings
for corporate and government debt issues.
 Rating agencies break down credit ratings for corporations and debt into either
investment grade or non-investment grade.

What Is Interest Rate Risk?

Interest rate risk is the potential for investment losses that result from a change in interest rates.
If interest rates rise, for instance, the value of a bond or other fixed-income investment will
decline. The change in a bond's price given a change in interest rates is known as its duration.

Interest rate risk can be reduced by holding bonds of different durations, and investors may also
allay interest rate risk by hedging fixed-income investments with interest rate swaps, options, or
other interest rate derivatives.

Example of Interest Rate Risk

For example, say an investor buys a five-year, $500 bond with a 3% coupon. Then, interest rates
rise to 4%. The investor will have trouble selling the bond when newer bond offerings with more
attractive rates enter the market. The lower demand also triggers lower prices on the secondary
market. The market value of the bond may drop below its original purchase price. 

The reverse is also true. A bond yielding a 5% return holds more value if interest rates decrease
below this level since the bondholder receives a favorable fixed rate of return relative to the
market.

Purchasing Power Risk

Purchasing power risk is the possibility that you will not be able to buy as much with your
savings in the future. It represents a loss of value due to inflation.

What is It?
Purchasing power refers to what you are able to buy with a given sum of money. The risk, then,
is that you may be able to buy less with a given sum of money in the future.

Think about this in the context of your savings. When you set aside money for saving and
investing you inherently give up buying something with that dollar today, to be able to buy
something later. In simple terms, for every $1 you save today that’s $1 less you can spend today,
but it gives you $1 more to spend later.

The idea of purchasing power takes this simple fact a step further and asks what that dollar could
have bought today, and what it will be able to buy later – whenever “later” is. That’s a logical
question since we all recognize that a single dollar won’t go as far in the future.

Although saving is good, and I’m certainly not telling you to stop, it does expose you to the
possibility that you could have bought more today than what you will be able to buy in the future
if your purchasing power falls.
 Basis for
Systematic Risk Unsystematic Risk
Comparison
Systematic risk refers to the hazard Unsystematic risk refers to the risk
Meaning which is associated with the market or associated with a particular security,
market segment as a whole. company or industry.
Nature Uncontrollable Controllable
Factors External factors Internal factors
Affects Large number of securities in the market. Only particular company.
Interest risk, market risk and purchasing
Types Business risk and financial risk
power risk.
Protection Asset allocation Portfolio diversification

UNIT-3

The Role of the Speculator

Speculators enter the futures market when they anticipate prices are going to change. While they
put their money at risk, they won’t do so without first trying to determine to the best of their
ability whether prices are moving up or down.

Speculators analyze the market and forecast futures price movement as best they can. They may
engage in the study of the external events that affect price movement or apply historical price
movement patterns to the current market. In any case, the smart speculator doesn’t operate blind.

A speculator who anticipates upward price movement would want to take advantage by buying
futures contracts.

If predictions are correct, then the contracts can be sold later at a profit. If it’s expected that
prices were going to move downward, the speculator would want to sell now and, if all goes as
planned, buy back later at a lower price.

Hedging
The producers and users of commodities who use the futures market are called hedgers. Buying
and selling futures as a risk management tool is called hedging.

Commodity prices in the cash markets have a fundamental relationship to the futures prices.
When the forces of supply and demand shift and drive prices up and down in the cash markets,
futures prices tend to rise and fall in a parallel fashion. So, for example, if cattle prices in the
cash markets started to rise, the live cattle futures would start to rise in roughly the same way.
But not exactly. They don’t tend to move in exact amounts. Hedgers take advantage of this
relationship between cash and futures prices.

Hedging is buying or selling futures contracts as a temporary substitute for buying or selling the
commodity at a later date in the cash market. We’ll show how that works.

What Is a Futures Contract?

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at
a predetermined price at a specified time in the future. Futures contracts are standardized for
quality and quantity to facilitate trading on a futures exchange.

The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset
when the futures contract expires. The seller of the futures contract is taking on the obligation to
provide and deliver the underlying asset at the expiration date. 

Key Takeaways

 Futures contracts are financial derivatives that oblige the buyer to purchase some
underlying asset (or the seller to sell that asset) at a predetermined future price and date.
 A futures contract allows an investor to speculate on the direction of a security,
commodity, or financial instrument, either long or short, using leverage.
 Futures are also often used to hedge the price movement of the underlying asset to help
prevent losses from unfavorable price changes.

Future clearing house

Each futures exchange has a clearing association which operates in conjunction with the
exchange in a manner similar to a bank clearing house.

Membership in the clearing association is composed exclusively of well-capitalized members of

the exchange and corporations or partnerships one of whose officials must be an exchange
member Exchange members who do not join the clearing association must clear their trades
through a member of the association.

Every clearing-house member must put up fixed original margins and maintain them with the
clearing house in the event of adverse price fluctuations. In such instances, the clearing house
may call for additional margins throughout the day without waiting for routine end-of-day
settlement.

It is worth noting here that parties to a trade who disagree about the information they exchanged
in the pit (such as the price, number of contracts or month of the trade) must settle their
differences and clear the trade before they are allowed to return to the floor the next morning.
Disputes rarely arise, but if they do, exchanges have steps to follow in helping to resolve them.
Whether you're a broker by trade or new to the market and looking for ways to make big gains,
chances are you've heard a lot about margin. Margin is a crucial concept for those dealing in
commodity futures and derivatives of all classes. Futures margin is a good-faith deposit or an
amount of money that one needs to post into their account to control a futures contract. Margins
in the futures markets are not down payments like stock margins. Instead, they are performance
bonds designed to ensure that traders can meet their financial obligations.1

Future margin and trading on margin have distinct meanings. Simply put, trading on margin is a
way to invest on credit, by taking out a loan from your current brokerage fund to buy stocks or
other securities.2 Future margin is a figure: the amount money you are required to keep in your
account to enter into a futures position, as a percentage of the full value of the futures contract.

Futures margin rates are set by futures exchanges, not by brokers. At times though, brokerage
firms will add an extra fee to the margin rate set by the exchange, in order to lower their risk
exposure.3 The margin is set based on how stable the market is (or isn't), and the risk of changes
in pricing. When market volatility or price variance moves higher in a futures market, the margin
rates rise.4 When trading stocks, the margin is much simpler: the equity market allows people to
trade using up to 50% margin.5 You can buy or sell up to $100,000 worth of stock for $50,000.

Key Figures in Margin Futures Contracts

In the world of futures contracts, the margin rate is much lower. In a standard futures contract,
the margin rate varies between 3% and 12% of the total value of the contract.6

Initial Margin

The initial futures margin is the amount of money that you need in order to open a buy or sell on
position on a futures contract.7 Initial margin is also called "original margin," or the same
amount posted when the trade first takes place.

For example, suppose an initial margin of 5%. The buyer of a contract of wheat futures that is
valued at $32,500 ($6.50 x 5,000 bushels) may only have to post $1,700 in margin, 5% of the
contract value. (They may need to post more to cover any brokerage fees.)

Maintenance Margin

The maintenance margin is the amount of money you need to keep in your fund at any given
time to cover your losses; if a futures position suffers a loss, you will need to put enough money
in your account to return the margin to the initial or original margin level.5

For example, suppose the margin on a corn futures contract is $1,000, and the maintenance
margin is $700. The purchase of a corn futures contract requires $1,000 in initial margin. If the
price of corn drops by 7 cents, or $350, you must post an additional $350 in margin to bring the
level back to the initial level.
Margin Calls

Margin calls are triggered when the value of an account drops below the maintenance level.8 For
example, say you hold five futures contracts that have an initial margin of $10,000 and a
maintenance margin of $7,000. When the value of your account falls to $6,500 a margin call will
require you to put $3,500 more in your account to return the account to the initial margin level.
The margin call is eliminated if you close or sell your futures contract.

Calculating Futures Margin

Exchanges calculate futures margin rates using a program called SPAN. This program measures
many figures to arrive at a final number for initial and maintenance margin in each futures
market. The biggest factor in setting margins is the volatility in each futures market, or how
stable (or unstable) it might be in the future. The exchanges adjust their margin settings based on
market conditions.

Future trading position

What Is a Long Position?

The term long position describes what an investor has purchased when they buy a security or
derivative with the expectation that it will rise in value.

Key Takeaways

 A long—or a long position—refers to the purchase of an asset with the expectation it will
increase in value—a bullish attitude.
 A long position in options contracts indicates the holder owns the underlying asset.
 A long position is the opposite of a short position.
 In options, being long can refer either to outright ownership of an asset or being the
holder of an option on the asset.
 Being long on a stock or bond investment is a measurement of time.

What is a Short (or Short Position)

A short, or a short position, is created when a trader sells a security first with the intention of
repurchasing it or covering it later at a lower price. A trader may decide to short a security when
she believes that the price of that security is likely to decrease in the near future. There are two
types of short positions: naked and covered. A naked short is when a trader sells a security
without having possession of it.
However, that practice is illegal in the U.S. for equities. A covered short is when a trader
borrows the shares from a stock loan department; in return, the trader pays a borrow-rate during
the time the short position is in place.

In the futures or foreign exchange markets, short positions can be created at any time.

Key Takeaways

 A short position refers to a trading technique in which an investor sells a security with
plans to buy it later.
 Shorting is a strategy used when an investor anticipates the price of a security will fall in
the short term.
 In common practice, short sellers borrow shares of stock from an investment bank or
other financial institution, paying a fee to borrow the shares while the short position is in
place.

UNIT-4
If you have a loan with a variable rate, you keep a close eye on interest rates. A change in
interest rates effects your borrowing costs and can make it difficult to anticipate what you’ll pay
month-to-month. Changes in variable rate indexes can make it difficult to forecast debt service
levels. If you would like to secure a fixed cost of debt service but not move to a traditional fixed
rate loan, an interest rate swap could be a good fit.

Interest rate swaps are a useful tool for hedging against variable interest rate risk. For both
existing and anticipated loans, an interest rate swap has several strategic benefits

How an interest rate swap works.

Ultimately, an interest rate swap turns the interest on a variable rate loan into a fixed cost based
upon an interest rate benchmark such as the Secured Overnight Financing Rate (SOFR).* It does
so through an exchange of interest payments between the borrower and the lender. (The parties
do not exchange a principal amount.)

With an interest rate swap, the borrower still pays the variable rate interest payment on the loan
each month. For many loans, this is determined according to the applicable benchmark,
(generally SOFR, plus a spread adjustment) plus a credit spread. Then, the borrower makes an
additional payment to the lender based on the swap rate. The swap rate is determined when the
swap is set up with the lender and is unchanging from month to month. Finally, the lender
rebates the variable rate amount (calculated as the portion of the rate attributable to the
applicable benchmark), so that ultimately the borrower pays a fixed rate.
How to Value Interest Rate Swaps
By

Elvin Mirzayev

Updated August 19, 2021

Reviewed by

Samantha Silberstein

A wide variety of swaps are utilized in the over-the-counter (OTC) market in order to hedge
risks, including interest rate swaps, credit default swaps, asset swaps, and currency swaps. In
general, swaps are derivative contracts through which two private parties—usually businesses
and financial institutions—exchange the cash flows or liabilities from two different financial
instruments.

A plain vanilla swap is the simplest type of swap in the market, often used to hedge floating
interest rate exposure. Interest rate swaps are a type of plain vanilla swap. Interest rate swaps
convert floating interest payments into fixed interest payments (and vice versa).

Key Takeaways
  In general, swaps are derivative contracts through which two parties—usually businesses and
financial institutions—exchange the cash flows or liabilities from two
different financial instruments.
 A wide variety of swaps are utilized in finance in order to hedge risks, including interest rate
swaps, credit default swaps, asset swaps, and currency swaps.
 Interest rate swaps convert floating interest payments into fixed interest payments (and vice
versa).
 The two parties in an interest rate swap are often referred to as counterparties; the
counterparty making payments on a floating rate typically utilizes a benchmark interest rate.
 Payments from fixed interest rate counterparties are benchmarked to U.S. Treasury Bonds.
 Interest rate swaps can prove to be valuable tools when financial institutions utilize them
effectively. 

The two parties in an interest rate swap are often referred to as counterparties. The counterparty
making payments on a floating rate typically utilizes benchmark interest rates, such as the
London Interbank Offered Rate (LIBOR).1 Payments from fixed interest rate counterparties are
benchmarked to U.S. Treasury Bonds.2

Two parties may decide to enter into an interest rate swap for a variety of different reasons,
including the desire to change the nature of the assets or liabilities in order to protect against
anticipated adverse interest rate movements. Like most derivative instruments, plain vanilla
swaps have zero value at the initiation. This value changes over time, however, due to changes in
factors affecting the value of the underlying rates. And like all derivatives, swaps are zero-sum
instruments, so any positive value increase to one party is a loss to the other.

What is a Currency Swap Contract?

A currency swap contract (also known as a cross-currency swap contract) is a derivative contract
between two parties that involves the exchange of interest payments, as well as the exchange of
principal amounts in certain cases, that are denominated in different currencies. Although
currency swap contracts generally imply the exchange of principal amounts, some swaps may
require only the transfer of the interest payments.
Breaking Down Currency Swap Contracts

A currency swap consists of two streams (legs) of fixed or floating interest payments
denominated in two currencies. The transfer of interest payments occurs on predetermined dates.
In addition, if the swap counterparties previously agreed to exchange principal amounts, those
amounts must also be exchanged on the maturity date at the same exchange rate.

Currency swaps are primarily used to hedge potential risks associated with fluctuations in
currency exchange rates or to obtain lower interest rates on loans in a foreign currency. The
swaps are commonly used by companies that operate in different countries. For example, if a
company is conducting business abroad, it would often use currency swaps to retrieve more
favorable loan rates in their local currency, as opposed to borrowing money from a foreign bank.

For example, a company may take a loan in the domestic currency and enter a swap contract with
a foreign company to obtain a more favorable interest rate on the foreign currency that is
otherwise is unavailable.

How Do Currency Swap Contracts Work?

In order to understand the mechanism behind currency swap contracts, let’s consider the
following example. Company A is a US-based company that is planning to expand its operations
in Europe. Company A requires €850,000 to finance its European expansion.

On the other hand, Company B is a German company that operates in the United States.
Company B wants to acquire a company in the United States to diversify its business. The
acquisition deal requires US$1 million in financing.

Neither Company A nor Company B holds enough cash to finance their respective projects.
Thus, both companies will seek to obtain the necessary funds through debt financing. Company
A and Company B will prefer to borrow in their domestic currencies (that can be borrowed at a
lower interest rate) and then enter into the currency swap agreement with each other.

The currency swap between Company A and Company B can be designed in the following
manner. Company A obtains a credit line of $1 million from Bank A with a fixed interest rate of
3.5%. At the same time, Company B borrows €850,000 from Bank B with the floating interest
rate of 6-month LIBOR. The companies decide to create a swap agreement with each other.

According to the agreement, Company A and Company B must exchange the principal amounts
($1 million and €850,000) at the beginning of the transaction. In addition, the parties must
exchange the interest payments semi-annually.

Company A must pay Company B the floating rate interest payments denominated in euros,
while Company B will pay Company A the fixed interest rate payments in US dollars. On the
maturity date, the companies will exchange back the principal amounts at the same rate ($1 =
€0.85).
Types of Currency Swap Contracts

Similar to interest rate swaps, currency swaps can be classified based on the types of legs
involved in the contract. The most commonly encountered types of currency swaps include the
following:

 Fixed vs. Float: One leg of the currency swap represents a stream of fixed interest rate
payments while another leg is a stream of floating interest rate payments.
 Float vs. Float (Basis Swap): The float vs. float swap is commonly referred to as basis
swap. In a basis swap, both swaps’ legs both represent floating interest rate payments.
 Fixed vs. Fixed: Both streams of currency swap contracts involve fixed interest rate
payments.

For example, when conducting a currency swap between USD to CAD, a party that decides to
pay a fixed interest rate on a CAD loan can exchange that for a fixed or floating interest rate in
USD. Another example would be concerning the floating rate. If a party wishes to exchange a
floating rate on a CAD loan, they would be able to trade it for a floating or fixed rate in USD as
well.

The interest rate payments are calculated on a quarterly or semi-annually basis.

How a Currency Swap is Priced

Pricing is expressed as a value based on LIBOR +/- spread, which is based on the credit risk
between the exchanging parties. LIBOR is considered a benchmark interest rate that major global
banks lend to each other in the interbank market for short-term borrowings. The spread stems
from the credit risk, which is a premium that is based on the likelihood that the party is capable
of paying back the debt that they had borrowed with interest.

What Is a Credit Default Swap (CDS)?

The term credit default swap (CDS) refers to a financial derivative that allows an investor to
swap or offset their credit risk with that of another investor. To swap the risk of default, the
lender buys a CDS from another investor who agrees to reimburse the lender in the case the
borrower defaults. Most CDS contracts are maintained via an ongoing premium payment similar
to the regular premiums due on an insurance policy. A lender who is worried about a borrower
defaulting on a loan often uses a CDS to offset or swap that risk.

Key Takeaways

 Credit default swaps are credit derivative contracts that enable investors to swap credit
risk on a company, a country, or another entity with a different counterparty.
 Lenders purchase CDSs from investors who agree to pay the lender if the borrower ever
defaults on its obligation(s).
  CDSs are traded over-the-counter and are often used to transfer credit exposure on fixed
income products in order to hedge risk.
 There are normally three parties involved in a CDS: the debt issuer, the buyer, and the
seller of the CDS.
 Contracts are customized between the counterparties involved, which makes them
opaque, illiquid, and hard to track for regulators.

How Credit Default Swaps (CDSs) Work

A credit default swap is a derivative contract that transfers the credit exposure of fixed
income products. It may involve bonds or other related securities—basically loans that the issuer
receives from the lender. If a company sells a bond with a $100 face value and a 10-
year maturity to a buyer, the company agrees to pay back the $100 to the buyer at the end of the
10-year period as well as regular interest payments over the course of the bond's life. Because the
debt issuer cannot guarantee that it will be able to repay the premium, the debt buyer assumes the
risk.

CDSs require at least three parties:

 The first party is the institution that issues the debt. This party is also known as the
borrower.
 The debt buyer is the second party, who will also be the CDS buyer if the parties decide
to engage in the contract.
 The CDS seller is the third entity involved in the CDS. This entity is most often a large
bank or insurance company that guarantees the underlying debt between the issuer and
the buyer.

UNIT-2
What is Options Trading?
Options trading allows you to buy or sell stocks, ETFs etc. at a specific price within a specific
date. This type of trading also gives buyers the flexibility to not buy the security at the specified
price or date.

While it is a little more complex than stock trading, options can help you make relatively larger
profits if the price of the security goes up. That’s because you don’t have to pay the full price for
the security in an options contract. In the same way, options trading can restrict your losses if the
price of the security goes down, which is known as hedging.

The right to buy a security is known as ‘Call’, while the right to sell is called ‘Put’.

They can be used as:

  Leverage:Options trading help you profit from changes in share prices without putting down the
full price of the share. You get control over the shares without buying them outright.
 Hedging : They can also be used to protect yourself from fluctuations in the price of a share and
letting you buy or sell the shares at a pre-determined price for a specified period of time.

Margins are an essential part of Options trading. It is the money or security a trader has to
deposit in his account while trading in Options. Margin requirements are decided by BSE and
NSE. The margins on Options vary depending on the type of Option and the underlying.

Margins on Options are different in nature from margins on stocks and futures. Margins on
Options act as collateral whereas those in stocks act as leverage and increase the buying power of
a trader.

What are different types of margins in Options Trading?

How Options Margins are calculated?
Margins on Options comprises:

 Initial Margin or SPAN margin

 Exposure margin
 Assignment Margin

Let's understand the different types of margins in detail now-

What is Initial or SPAN Margin? How is it Calculated?

Initial margin is the minimum margin requirement for initiating an Options trade in the market.
The margin is calculated based on a portfolio based approach wherein a collection of Option
positions are grouped and different loss scenarios are considered. The margin is calculated using
software called SPAN (Standard Portfolio Analysis of Risk).

The SPAN or initial margins are revised 6 times in a trading day. The initial margin varies for
stocks and indexes and depends on the risk associated and historical volatility of the particular
stock.

What is exposure margin and how is it calculated?

In addition to initial or SPAN margin, traders also need to deposit exposure margin. The
exposure margins for stock options and index options are as follows:

For Index options: 3% of the notional value of open positions.

For Stock options: The higher of 5% or 1.5 standard deviations of the notional value of the gross
open position in options on individual securities in a particular underlying.
The standard deviation of the underlying stock is computed on a rolling and monthly basis at the
end of each month. The notional value is the value of the number of shares of the underlying in
the contract based on the last trading price.

What is Assignment Margin?

The assignment margin is collected in addition to initial and exposure margin. This is collected
on assignment from the sellers of the Options contracts. It is charged on the net exercise
settlement value payable by the traders who are writing Options.

Margins for options buyers and sellers

Simply put, traders who are buying Options do not need to pay or deposit margins. They only
need to pay the premium for the contract. This is because when you buy a Call or a Put Option,
your potential loss is limited to the premium amount paid. You cannot lose more than the
premium amount paid to buy the Options whereas your profit can be unlimited. As the risk is
already covered by the premium amount, so there's no need to deposit a margin for Options
buyers.

Options sellers have to deposit and maintain the margin as per the regulations of the exchange. It
is because when you sell a Call or a Put Option, you receive a premium amount for the trade.
This premium received is the maximum profit, you can make from the trade. However, the loss
can be unlimited and depends on the closing price of the underlying.

The Binomial Option Pricing Model is a risk-neutral method for valuing path-dependent options
(e.g., American options). It is a popular tool for stock options evaluation, and investors use the
model to evaluate the right to buy or sell at specific prices over time.

Under this model, the current value of an option is equal to the present value of the probability-
weighted future payoffs.

It is different from the Black-Scholes model, which is more suitable for path-independent
options, which cannot be exercised before their due date.

Binomial Option Pricing Model

An investor knows the current stock price at any given moment. They will try to guess the stock
price movements in the future. Under this model, we split the time to expiration of the option
into equal periods (weeks, months, quarters). Then the model follows an iterative method to
evaluate each period, considering either an up or down movement and the respective
probabilities. Effectively, the model creates a binomial distribution of possible stock prices.

It’s mostly useful for American-style options, which investors can exercise at any given time.
The model also assumes there’s no arbitrage, meaning there’s no buying while selling at a higher
price. Having no-arbitrage ensures the value of the asset remains the same, which is a
requirement for the Binomial Option Pricing model to work.

Assumptions

When setting up a binomial option pricing model, we need to be aware of the underlying
assumptions, to understand the limitations of this approach better.

 At every point in time, the price can go to only two possible new prices, one up and one
down (this is in the name, binomial);
 The underlying asset pays no dividends;
 The interest rate (discount factor) is a constant throughout the period;
 The market is frictionless, and there are no transaction costs and no taxes;
 Investors are risk-neutral, indifferent to risk;
 The risk-free rate remains constant.

Advantages and disadvantages

(+) The model is mathematically simple to calculate;

(+) Binomial Option Pricing is useful for American options, where the holder has the right to
exercise at any time up until expiration.

(-) A significant advantage is a multi-period view the model provides for the underlying asset’s
price and the transparency of the option’s value over time.

(-) A notable disadvantage is that the computational complexity rises a lot in multi-period
models.

(-) The most significant limitation of the model is the inherent necessity to predict future prices.

How to Calculate the Model

If we set the current (spot) price of an option as S, then we can have two price movements at any
given moment. The price can either go up to S+ or down to S-.

On this basis, we calculate the up(u) and down(d) factors.

Call Options

A call option entitles its holder to purchase the underlying asset or stock at the exercise price PX.

A call option is in-the-money when the spot price is above the exercise price (S > PX).

When we have an up movement, the payoff of the call option is the maximum between zero and
the spot price multiplied by the up factor and reduced with the exercise price. To visualize that,
here’s the formula:

A downward movement gives a payoff of:

The Binomial model effectively weighs the different payoffs with their respective probabilities
and discounts them to the present value.

Put Options

A put option entitles the holder to sell at the exercise price PX.

When the price goes down or up, we calculate a put option as follows:

Binomial Trees
Binomial Trees
The binomial tree is the best way to represent the model visually. They show the option payoff
and probability at different nodes. Nodes outline the paths the price of the underlying asset may
take over time.

We can represent a general one-period call option like this.

We can also present it as a formula:

The put option uses the same formula as the call option.

Where:

 π is the probability of an up move;

 r is the discount rate.

To arrive at the probability of an up move we employ the formula:

Where:

 t is the period multiplier (t = 0.5 for a 6-month period);

 r is the discount rate;
 d is the down factor
 u is the up factor.

In the case of a multi-period option, we can accumulate the additional stages by multiplying the
up/down factors for every price movement. If we have an up move, followed by a down move,
then we will udS in our formulas.

Binomial Tree Example

As an example, we can look at a call option with six months till maturity, and build a binomial
tree with a period of three months.

We will set the following assumptions:

To set up our model, we need to calculate some parameters. We expect the price to either go up
with 20% or down with 10% within a single time step. Applying the probability formula from
above, we arrive at our model variables.

The next step is to construct the binomial tree for our model.
We set up the two time-steps for our period and end up with three positions in time – present, in
three months and six months. Using the up and down factors, we can calculate the stock price at
each of the nodes.

The next step is to calculate the option value at the terminal date (t=0.50). It equals the maximum
of zero and the difference between the current price at t=0.50 and the strike price.

Working backward, we calculate the option value at t=0.25 and the present. We do this by
weighing the possible future values with the up and down move probabilities and discounting
them with the risk-free rate.
That way, we arrive at the present value of the option, at 6.40 euros

What Is the Black-Scholes Model?

The Black-Scholes model, also known as the Black-Scholes-Merton (BSM) model, is one of the
most important concepts in modern financial theory. This mathematical equation estimates the
theoretical value of derivatives based on other investment instruments, taking into account the
impact of time and other risk factors. Developed in 1973, it is still regarded as one of the best
ways for pricing an options contract.

Key Takeaways

 The Black-Scholes model, aka the Black-Scholes-Merton (BSM) model, is a differential equation
widely used to price options contracts.
 The Black-Scholes model requires five input variables: the strike price of an option, the current
stock price, the time to expiration, the risk-free rate, and the volatility.
 Though usually accurate, the Black-Scholes model makes certain assumptions that can lead to
predictions that deviate from the real-world results.
 The standard BSM model is only used to price European options, as it does not take into account
that American options could be exercised before the expiration date.

How the Black-Scholes Model Works

Black-Scholes posits that instruments, such as stock shares or futures contracts, will have a
lognormal distribution of prices following a random walk with constant drift and volatility.
Using this assumption and factoring in other important variables, the equation derives the price
of a European-style call option.

The Black-Scholes equation requires five variables. These inputs are volatility, the price of
the underlying asset, the strike price of the option, the time until expiration of the option, and the
risk-free interest rate. With these variables, it is theoretically possible for options sellers to set
rational prices for the options that they are selling.

Furthermore, the model predicts that the price of heavily traded assets follows a geometric
Brownian motion with constant drift and volatility. When applied to a stock option, the model
incorporates the constant price variation of the stock, the time value of money, the option's strike
price, and the time to the option's expiry.

Black-Scholes Assumptions

The Black-Scholes model makes certain assumptions:

 No dividends are paid out during the life of the option.

 Markets are random (i.e., market movements cannot be predicted).
 There are no transaction costs in buying the option.
 The risk-free rate and volatility of the underlying asset are known and constant.
 The returns of the underlying asset are normally distributed.
 The option is European and can only be exercised at expiration.

While the original Black-Scholes model didn't consider the effects of dividends paid during the
life of the option, the model is frequently adapted to account for dividends by determining
the ex-dividend date value of the underlying stock. The model is also modified by many option-
selling market makers to account for the effect of options that can be exercised before expiration.

Alternatively, for the pricing of the more commonly traded American-style options, firms will
use a binomial or trinomial model or the Bjerksund-Stensland model.

The Black-Scholes Model Formula

The mathematics involved in the formula are complicated and can be intimidating. Fortunately,
you don't need to know or even understand the math to use Black-Scholes modeling in your own
strategies. Options traders have access to a variety of online options calculators, and many of
today's trading platforms boast robust options analysis tools, including indicators and
spreadsheets that perform the calculations and output the options pricing values.

The Black-Scholes call option formula is calculated by multiplying the stock price by the
cumulative standard normal probability distribution function. Thereafter, the net present value
(NPV) of the strike price multiplied by the cumulative standard normal distribution is subtracted
from the resulting value of the previous calculation.

What Is an Index Option?

An index option is a financial derivative that gives the holder the right (but not the obligation) to
buy or sell the value of an underlying index, such as the S&P 500 index, at the stated exercise
price. No actual stocks are bought or sold. Often, an index option will utilize an index futures
contract as its underlying asset.

Index options are always cash-settled and are typically European-style options, meaning they
settle only on the date of maturity and have no provision for early exercise.
Key Takeaways

 Index options are options contracts that utilize a benchmark index, or a futures contract based
on that index, as its underlying instrument.
 Index options are typically European style and settle in cash for the value of the index at
expiration.
 Like all options, index options will give the buyer the right, but not the obligation, to either go
long (for a call) or short (for a put) the value of the index at a pre-specified strike price.

Index Option Example

Imagine a hypothetical index called Index X, which currently has a level of 500. Assume an
investor decides to purchase a call option on Index X with a strike price of 505. If this 505 call
option is priced at $11, the entire contract costs $1,100—or $11 x a 100 multiplier.

It is important to note the underlying asset in this contract is not any individual stock or set of
stocks, but rather the cash level of the index adjusted by the multiplier. In this example, it is
$50,000, or 500 x $100. Instead of investing $50,000 in the stocks of the index, an investor can
buy the option at $1,100 and utilize the remaining $48,900 elsewhere.

What are OTC Options?

OTC options are exotic options that trade in the over-the-counter market rather than on a formal
exchange like exchange traded option contracts.

Key Takeaways

 OTC options are exotic options that trade in the over-the-counter market rather than on a
formal exchange like exchange traded option contracts.
 OTC options are the result of a private transaction between the buyer and the seller.
 OTC option strike prices and expiration dates are not standardized, which allows participants to
define their own terms, and there is no secondary market.

UNIT-5
Hedging schemes
What Is Delta Hedging?
Delta hedging is an options trading strategy that aims to reduce, or hedge, the directional risk
associated with price movements in the underlying asset. The approach uses options to offset the
risk to either a single other option holding or an entire portfolio of holdings. The investor tries to
reach a delta neutral state and not have a directional bias on the hedge.

Closely related is delta-gamma hedging, which is an options strategy that combines

both delta and gamma hedges to mitigate the risk of changes in the underlying asset and in the
delta itself.

Key Takeaways

 Delta hedging is an options strategy that seeks to be directionally neutral by establishing

offsetting long and short positions in the same underlying.
 By reducing directional risk, delta hedging can isolate volatility changes for an options trader.
 One of the drawbacks of delta hedging is the necessity of constantly watching and adjusting
positions involved. It can also incur trading costs as delta hedges are added and removed as the
underlying price changes.

The behavior of delta is dependent on if it is:

 In-the-money or currently profitable

 At-the-money at the same price as the strike
 Out-of-the-money not currently profitable

What Is Theta?
The term theta refers to the rate of decline in the value of an option due to the passage of time. It
can also be referred to as the time decay of an option. This means an option loses value as time
moves closer to its maturity, as long as everything is held constant. Theta is generally expressed
as a negative number and can be thought of as the amount by which an option's value declines
every day.1

Key Takeaways

 Theta refers to the rate of decline in the value of an option over time.
 If all other variables are constant, an option will lose value as time draws closer to its maturity.
 Theta, usually expressed as a negative number, indicates how much the option's value will
decline every day up to maturity

What Is Gamma Hedging?

Gamma hedging is a trading strategy that tries to maintain a constant delta in an options position,
often one that is delta-neutral, as the underlying asset changes price. It is used to reduce the risk
created when the underlying security makes strong up or down moves, particularly during the
last days before expiration.

An option position's gamma is the rate of change in its delta for every 1-point move in the
underlying asset's price. Gamma is an important measure of the convexity of a derivative's value,
in relation to the underlying asset. A delta hedge strategy, in comparison, only reduces the effect
of relatively small underlying price changes on the options price.

Key Takeaways

 Gamma hedging is a sophisticated options strategy used to reduce an option position's exposure
to large movements in the underlying security.
 Gamma hedging is also employed at an option's expiration to immunize the effect of rapid
changes in the underlying asset's price that can occur as the time to expiry nears.
 Gamma hedging is often used in conjunction with delta hedging.

RELATIONSHIP BETWEEN THEM