Option Contract

An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying asset on or
before a stated date/day, at a stated price, for a price. The party taking a long position i.e. buying the option is
called buyer/ holder of the option and the party taking a short position i.e. selling the option is called the seller/
writer of the option.

The option buyer has the right but no obligation with regards to buying or selling the underlying asset, while
the option writer has the obligation in the contract. Therefore, option buyer/ holder will exercise his option
only when the situation is favorable to him, but, when he decides to exercise, option writer would be legally
bound to honor the contract.
Types of options

Options may be categorized into two main types:-

 Call Options:- Option, which gives buyer a right to buy the underlying asset, is called Call option
 Put Options:- Option which gives buyer a right to sell the underlying asset, is called Put option.

Pros & Cons of option trading

Pros Cons

 Cost efficient  Less liquidity

 High return potential  Time decay
 Lower Risk  Non availability of all stock option
 Strategies available  Sophisticated strategies

Long Call = Buyer of an option= long on option

 Buyer of an option is said to be “long on option”.
 As described above, he/she would have a right and no obligation with regard to buying/ selling the
underlying asset in the contract.
 When you are long on equity option contract:
o Buyer has right to exercise that option.
o Potential loss is limited to the premium amount paid for buying the option.
o Profit would depend on the level of underlying asset price at the time of exercise/expiry of the
contract.

Short Call =Seller of an option =short on option

 Seller of an option is said to be “short on option”.
 As described above, he/she would have obligation but no right with regard to selling/buying the underlying
asset in the contract.
 When you are short (i.e., the writer of) an equity option contract:-
o Maximum profit is the premium received.
o Can be assigned an exercised option any time during the life of option contract (for American
Options only). All option writers should be aware that assignment is a distinct possibility.
o Potential loss is theoretically unlimited as defined below.
 Option types & Option terms
Index option: These options have index as the underlying asset. For example options on Nifty, Sensex, etc.

Stock option: These options have individual stocks as the underlying asset. For example, option on ONGC,
NTPC etc.

Buyer of an option: The buyer of an option is one who has a right but not the obligation in the contract. For
owning this right, he pays a price to the seller of this right called ‘option premium’ to the option seller.

Writer of an option: The writer of an option is one who receives the option premium and is thereby obliged to
sell/buy the asset if the buyer of option exercises his right.

Option price/Premium: It is the price which the option buyer pays to the option seller.

Lot size: Lot size is the number of units of underlying asset in a contract.

Expiration Day: The day on which a derivative contract ceases to exist. It is the last trading date/day of the
contract.

Spot price (S): It is the price at which the underlying asset trades in the spot market.

Strike price or Exercise price (X): Strike price is the price per share for which the underlying security may be
purchased or sold by the option holder.
Option chain
An options chain, also known as an option matrix, is a listing of all available options contracts for a given
security. It shows all listed puts, calls, their expiration, strike prices, and volume and pricing information for a
single underlying asset within a given maturity period. The chain will typically be categorized by expiration
date and segmented by calls vs. puts.

An options chain provides detailed quote and price information and should not be confused with an options
series or cycle, which instead simply denotes the available strike prices or expiration dates.
Key points
 An options chain is a table displaying options quotes for a particular underlying security.
 The options chain matrix is updated in real-time showing the last price, trading volume, and best bid and
offer for the calls and puts of an options series, typically segmented by expiration date.
 An option's strike price is also listed, which is the stock price at which the investor buys the stock if the
option is exercised.

Option style
Options style relates to when the options can be exercised. The two styles are:

American option: The owner of such option can exercise his right at any time on or before the expiry date/day
of the contract.

European option: The owner of such option can exercise his right only on the expiry date/day of the contract.
 Types of option payoff
The Optionality characteristics of options results in a nonlinear payoff for options. It means that the losses for
the buyer of an option are limited; however the profits are potentially unlimited. For a writer, the payoff is
exactly the opposite. His profits are limited to the option premium; however his losses are potentially
unlimited.

 Payoff profile of buyer of asset: Long Asset

 Payoff profile for seller of asset: Short Asset
 Payoff profile of buyer of call options: Long call
 Payoff profile for writer of call options: short call
 Payoff profile of buyer of put options: Long put
 Payoff profile for writer of put options: short put

Status of an option
In the money option: This option would give holder a positive cash flow, if it were exercised immediately. A
call option is said to be ITM, when spot price is higher than strike price. And, a put option is said to be ITM
when spot price is lower than strike price. In our examples, call option is in the money.

At the money option: ATM option would lead to zero cash flow if it were exercised immediately. For both
call and put ATM options, strike price is equal to spot price.

Out of the money option: OTM is one with strike price worse than the spot price for the holder of option. In
other words, This option would give the holder a negative cash flow if it were exercised immediately. A call
option is said to be OTM, when spot price is lower than strike price. And a put option is said to be OTM when
spot price is higher than strike price. In our examples, put option is out of the money.

Option premiums
An option premium is the current market price of an option contract. It is thus the income received by the seller
(writer) of an option contract to another party. In-the-money option premiums are composed of two factors:
intrinsic and extrinsic value. Out-of-the-money options' premiums consist solely of extrinsic value.

Factors affecting premiums

 Price of underlying security
 Strike price
 Volatility
 Time to expiration
 Dividends
 Introduction to Swaps
Swaps represent the newest category of Derivatives. Swaps were initially conceived as a method to avoid
paying foreign currency exchange taxes by companies. The first such public agreement took place between
IBM and World Bank in 1980, in which the former exchanged its stock of Swiss Francs and German Marks for
the latter’s US Dollars. Swaps have also been widely implicated as a significant cause of the 2008 global
economic crisis. Since then, Swaps have become more regulated, widely shifting from being traded on the
Over Counter (OTC) markets to the Exchange Traded markets.

Swap agreement
 Swaps are bilateral contracts in which the two parties agree to exchange revenue streams from two
different sources for a predetermined period.
 Swaps are usually made and brokered by large banks and corporations. These institutions are known
as market makers.
 Each revenue stream is called a leg.
 Traders use swaps for hedging. They can also gain access to new markets by swapping with investors
from the new markets.

Reasons for trading in swap

Risk hedging : One of the primary functions of swaps is the hedging of risks. For example, interest rate swaps
can hedge against interest rate fluctuations, and currency swaps are used to hedge against currency exchange
rate fluctuations.

Access to new markets : Companies can use swaps as a tool for accessing previously unavailable markets. For
example, a US company can opt to enter into a currency swap with a British company to access the more
attractive dollar-to-pound exchange rate, because the UK-based firm can borrow domestically at a lower rate.
Types of swaps
Interest Rate Swaps are bilateral contracts. The parties agree to exchange revenue streams from two
different sources for a given period. It involves the swapping of a fixed interest rate with a floating interest
rate.

Currency Swaps are bilateral contracts in which the two parties interchange the underlying asset and its
interest in one currency with the same in another currency. Currency Swaps are used to escape foreign
currency exchange taxes and for protection against currency exchange rate fluctuations.

Commodity Swaps are bilateral contracts in which the two parties exchange the market price of an
underlying asset with a predetermined fixed price. Commodity Swaps generally involve crude oil. Investors
use these as protection against commodity price fluctuations.

Equity-Debt Swaps refer to bilateral agreements in which the debt holder gains an equity position in
return for the cancellation of their debt. Equity-Debt Swaps are used by struggling companies as refinancing
deals.
Total Return Swaps refer to bilateral contracts in which the buyer, also called the receiver, collects all
revenue generated by an underlying asset without owning it. In return, the buyer pays the seller a
predetermined amount for the contract as the set rate of the underlying asset. Hedge funds prefer these Swaps
as they provide greater asset exposure at a minimal cost.

Inflation Swaps are bilateral contracts in which the two parties interchange the fixed-rate payoffs on a
notional principal amount for the floating rate payoffs linked to inflation indices.

Credit Default Swaps refers to bilateral agreements in which one party receives a fixed amount in
return for compensating the other party if the default of the underlying assets. These are generally used to bail
out companies and other institutions to keep them running.
 Interest Rate Swap
 Interest Rate Swaps are bilateral contracts. The parties agree to exchange revenue streams from two
different sources for a given period. It involves the swapping of a fixed interest rate with a floating interest
rate.
 Interest rate swaps are forward contracts where one stream of future interest payments is exchanged for
another based on a specified principal amount.
 Interest rate swaps can exchange fixed or floating rates in order to reduce or increase exposure to
fluctuations in interest rates.
 Interest rate swaps are sometimes called plain vanilla swaps, since they were the original and often the
simplest such swap instruments.

Uses of IRS
 One of the uses to which interest rate swaps put to is hedging. In case an organization is of the view that
the interest rate would increase in the coming times, and there is a loan against which he/she is paying
interest.
 The banks use interest rate swaps to manage interest rate risk. They tend to distribute their interest rate risk
by creating smaller swaps and distributing them in the market through an inter-dealer broker.
 A huge tool for fixed income investors. They use it for speculations and market creation.
 The interest rate swap works as an amazing portfolio management tool. It helps in adjusting the risk related
to interest rate volatility.

Risks associated with IRS

 Interest rate swaps involve two primary risks: interest rate risk and credit risk, which is known in the swaps
market as counterparty risk.
 Actual interest rate movements do not always match expectations.
 A receiver (the counterparty receiving a fixed-rate payment stream) profits if interest rates fall and lose if
interest rates rise.
 Conversely, the payer (the counterparty paying fixed) profits if rates rise and lose if rates fall.
 These interest rate swaps are also subject to the counterparty risk or better known as credit risk.
 This is the risk that the other party in the contract will default on its responsibility.
 This is more so because most of these swap contracts are OTC contracts.
 This risk has been partially mitigated since the financial crisis as a large portion of swap contracts are now
being cleared through central counterparties (CCPs). But, the risk still remains.

Interest rate swap application: hedging

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.

Swaps may be used to hedge against adverse interest rate movements or to achieve a desired balanced between
fixed and variable rate debt. Interest rate swaps allow both counterparties to benefit from the interest payment
exchange by obtaining better borrowing rates than they are offered by a bank.
 Types of interest rate swap
 Fixed-to-Floating
 Float-to-Float
 Floating-to-Fixed

Fixed-to-Floating : A company can issue a bond at a very attractive fixed interest rate to its investors. The
company's management feels that it can get a better cash flow from a floating rate. In this case, that company
can enter into a swap with a counterparty bank in which the company receives a fixed rate and pays a floating
rate.

Float-to-Float : Companies sometimes enter into a swap to change the type or tenor of the floating rate index
that they pay; this is known as a basis swap. A company can swap from three-month LIBOR to six-month
LIBOR, for example, either because the rate is more attractive or it matches other payment flows. A company
can also switch to a different index, such as the federal funds rate, commercial paper, or the Treasury bill rate.

Floating-to-Fixed: A company that does not have access to a fixed-rate loan may borrow at a floating rate and
enter into a swap to achieve a fixed rate. The floating-rate tenor, reset, and payment dates on the loan are
mirrored on the swap and netted. The fixed-rate leg of the swap becomes the company's borrowing rate.

LIBOR

 LIBOR is the benchmark interest rate at which major global banks lend to one another.
 LIBOR is administered by the Intercontinental Exchange, which asks major global banks how much they
would charge other banks for short-term loans.
 LIBOR has been subject to manipulation, scandal, and methodological critique, making it less credible
today as a benchmark rate.
 LIBOR is being replaced by the Secured Overnight Financing Rate (SOFR) on June 30, 2023, with phase-
out of its use beginning after 2021.

LIBOR Rigging

 The Libor scandal was a series of fraudulent actions connected to the Libor (London Inter-bank Offered
Rate) and also the resulting investigation and reaction.
 Libor is an average interest rate calculated through submissions of interest rates by major banks across the
world.
 The scandal arose when it was discovered that banks were falsely inflating or deflating their rates so as to
profit from trades, or to give the impression that they were more creditworthy than they were.
 Libor underpins approximately $350 trillion in derivatives.
 It is currently administered by Intercontinental Exchange, which took over running the Libor in January
2014.
 Equity Swap
 An equity swap is an exchange of future cash flows between two parties that allows each party to diversify
its income for a specified period of time while still holding its original assets.
 An equity swap is similar to an interest rate swap, but rather than one leg being the "fixed" side, it is based
on the return of an equity index.
 These swaps are highly customizable and are traded over-the-counter. Most equity swaps are conducted
between large financing firms such as auto financiers, investment banks, and lending institutions.
 The interest rate leg is often referenced to LIBOR while the equity leg is often referenced to a major stock
index such as the S&P 500.
 The stream of payments in an equity swap is known as the legs. One leg is the payment stream of the
performance of an equity security or equity index (such as the S&P 500) over a specified period, which is
based on the specified notional value. The second leg is typically based on the LIBOR, a fixed rate, or
another equity's or index's returns.

FX swap
A foreign currency swap, also known as an FX swap, is an agreement to exchange currency between two
foreign parties. The agreement consists of swapping principal and interest payments on a loan made in one
currency for principal and interest payments of a loan of equal value in another currency. One party borrows
currency from a second party as it simultaneously lends another currency to that party.

Key points:-

 A foreign exchange swap refers to an agreement to simultaneously borrow one currency and lend
another currency at an initial date, then exchanging the amounts at maturity.
 Leg 1 is the transaction at the prevailing spot rate. Leg 2 is the transaction at the predetermined forward
rate.
 Short-dated foreign exchange swaps include overnight, tom-next, spot-next and spot-week
 Foreign exchange swaps and cross currency swaps differ in interest payments .

Types of FX trades: example

There are two main types of currency swaps. The fixed-for-fixed currency swap involves exchanging fixed
interest payments in one currency for fixed interest payments in another. In the fixed-for-floating swap, fixed
interest payments in one currency are exchanged for floating interest payments in another. In the latter type of
swap, the principal amount of the underlying loan is not exchanged.

Some institutions use currency swaps to reduce exposure to anticipated fluctuations in exchange rates. If U.S.
Company A and Swiss Company B are looking to obtain each other’s currencies (Swiss francs and USD,
respectively), the two companies can reduce their respective exposures via a currency swap.

Ex: Party A is Canadian and needs EUR. Party B is European and needs CAD. The parties enter into a foreign
exchange swap today with a maturity of six months. They agree to swap 1,000,000 EUR, or equivalently
1,500,000 CAD at the spot rate of 1.5 EUR/CAD. They also agree on a forward rate of 1.6 EUR/CAD because
they expect the Canadian Dollar to depreciate relative to the Euro.
Today, Party A receives 1,000,000 Euros and gives 1,500,000 Canadian Dollars to Party B. In six months’
time, Party A returns 1,000,000 EUR and receives (1,000,000 EUR * 1.6 EUR/CAD = 1,600,000 CAD) from
Party B, ending the foreign exchange swap.

For a foreign exchange swap to work, both parties must own a currency and need the currency that the
counterparty owns. There are two “legs”.

Leg 1 at the Initial Date

The first leg is a transaction at the prevailing spot rate. The parties swap amounts of the same value in their respective
currencies at the spot rate. The spot rate is the exchange rate at the initial date.

Leg 2 at Maturity

The second leg is a transaction at the predetermined forward rate at maturity. The parties swap amounts again,
so that each party receives the currency they loaned and returns the currency they borrowed.

Credit Default Swap (CDS)

A credit default swap (CDS) is a financial derivative or contract that allows an investor to "swap" or offset his
or her credit risk with that of another investor. For example, if a lender is worried that a borrower is going
to default on a loan, the lender could use a CDS to offset or swap that risk.

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.

Credit default swaps are the most common type of OTC credit derivatives and are often used to transfer credit
exposure on fixed income products in order to hedge risk. Credit default swaps are customized between
the two counterparties involved, which makes them opaque, illiquid, and hard to track for regulators.

Example of a Credit Default Swap

Mr. X is a creditor of ABC Company and holds a 10-year bond with a par value of $1,000 and an annual
coupon rate of 10%. The company is facing deteriorating market conditions, causing creditors to question the
going concern of the company. Mr. X decides to enter into a credit default swap with Mr. Y to ensure that he
does not lose all of his money if ABC Company defaults. The credit default swap comes with the following
terms:

Mr. X (the buyer) provides Mr. Y (the seller) with bi-annual payments of $50;

If ABC Company experiences a credit event (bankruptcy, payment default, or a debt restructuring), the credit
default swap will trigger, and Mr. Y will pay Mr X the remaining interest on the bond.

Risk involved in CDS trading

One of the risks of a credit default swap is that the buyer may default on the contract, thereby denying the
seller the expected revenue. The seller transfers the CDS to another party as a form of protection against risk,
but it may lead to default. Where the original buyer drops out of the agreement, the seller may be forced to sell
a new CDS to a third party to recoup the initial investment. However, the new CDS may sell at a lower price
than the original CDS, leading to a loss.

The seller of a credit default swap also faces a jump-to-jump risk. The seller may be collecting
monthly premiums from the new buyer with the hope that the original buyer will pay as agreed. However, a
default on the part of the buyer creates an immediate obligation on the seller to pay the millions or billions
owed to protection buyers.

Both the buyer and seller of CDS take on counterparty risk

The buyer takes the risk that the seller may default. If AAA-Bank and Risky Corp. default simultaneously
("double default"), the buyer loses its protection against default by the reference entity. If AAA-Bank defaults
but Risky Corp. does not, the buyer might need to replace the defaulted CDS at a higher cost.

The seller takes the risk that the buyer may default on the contract, depriving the seller of the expected revenue
stream. More importantly, a seller normally limits its risk by buying offsetting protection from another party —
that is, it hedges its exposure. If the original buyer drops out, the seller squares its position by either unwinding
the hedge transaction or by selling a new CDS to a third party. Depending on market conditions, that may be at
a lower price than the original CDS and may therefore involve a loss to the seller.

Types of CDS
1.Credit default swaps on single entities: In this form, the swap is on a single entity.

2.Credit default swaps on a basket of entities: In this the swap is on a bunch of entities combined

3.Credit default index swaps: this includes a portfolio of single entity swaps

4. First-loss and tranche-loss credit default swaps: In this type, the buyer is compensated for any losses from
the credit events unlike that in the first loss credit default swap which only compensates the loss from the first
credit event

Finally, the value of a default swap depends on the probability of entity or the counterparty or the correlation
between them.

Example: The most common example for a CDS is between a company, bank and Insurance firm:

Suppose Bank A buys a bond which issued by a XYZ Company. In order to hedge the default of XYZ
Company, Bank A buys a credit default swap (CDS) from Insurance Company. The bank keeps paying fixed
periodic payments to the insurance company, in exchange of the default protection.
 Credit Events
As defined by the International Swaps and Derivatives Association (ISDA), the six credit events include:

 Bankruptcy
 Obligation acceleration
 Obligation default
 Payment default
 Repudiation/Moratorium
 Debt restructuring

Failure to pay = payment default

 A payment default occurs when an individual or organization is unable to make payments on their debts on
a timely basis.
 Continual payment defaults are a precursor to bankruptcy
 Payment default and bankruptcy are often confused with one another: A bankruptcy is telling your
creditors that you will not be able to pay them in full, and a payment default is telling your creditors that
you will not be able to make a payment when it is due.

Example of a Payment Default :-

ABC Company is a cyclical business that generates extremely volatile quarterly earnings. In its most recent
quarter, ABC Company suffered a steep decrease in revenues due to a trade war between the US and China. It
causes ABC Company to default on its periodic interest payments to creditors.

Bankruptcy
 Bankruptcy is a legal proceeding involving a person or business that is unable to repay their outstanding
debts.
 All of the debtor's assets are measured and evaluated, and the assets may be used to repay a portion of
outstanding debt.
 Bankruptcy is a legal process that ensues when an individual or organization is unable to repay their
outstanding debts. It is filed by the debtor (or, less commonly, the creditor). A company that is bankrupt is
also insolvent.
 Notable companies that have filed for bankruptcy are Marvel Entertainment in 1996, Apple in 1997,
General Motors in 2013.

Example of a Bankruptcy

ABC Company is facing deteriorating market conditions, causing the company to generate revenue that is
significantly lower than projections. Due to its inability to generate profits, the company is unable to pay its
outstanding debts to creditors and is eventually forced to file for bankruptcy.

Dewan Housing Finance Ltd. (DHFL)

 DHFL is a NBFC that was established in the year 1984 by Rajesh Kumar Wadhawan. The company was
set up in order to assist the lower and middle-income groups to avail housing finance in India’s tier 2 and
tier 3 cities. DHFL was the 2nd housing finance company to be set up after HDFC.
 The company performed well for over 3 decades maintaining good growth and even acquiring companies
like Deutsche Postbank Home Finance. The company also took on slum development and slum
rehabilitation projects in Maharashtra.
 These projects and several others were financed through debt raised by the company. This orchestrated
development of DHFL was however cut short after Cobra post, a group of journalists published an expose
on DHFL on 29 January 2019.
 According to the expose DHFL had diverted the Rs. 31,000 crores from the loans they had taken to various
shell companies for the personal gains of its promoters which included Kapil Wadhawan, Aruna
Wadhawan and Dheeraj Wadhawan.

8 Biggest Bankruptcies in India

 Dewan Housing Finance Ltd. – US$13.93 billion

 Bhushan Power and Steel – US$6.9 billion
 Essar Steel (US$6.9 billion) – Biggest Bankruptcies in India
 Lanco Infra – US$ 6.3 billion
 Bhushan Steel (US$6.2 billion) – Biggest Bankruptcies in India
 Reliance Communications – US$4.6 billion
 Alok Industries – US$4.1 billion
 Jet Airways – US$2 billion

Debt restructuring
Debt restructuring refers to a change in the terms of the debt, causing the debt to be less favorable to debt
holders. Common examples of debt restructuring include a decrease in the principal amount to be paid, a
decline in the coupon rate, a postponement of payment o

bligations, a longer maturity time, or a change in the ranking of priority of payment.

ABC Company is cash-strapped and decides to restructure its debt to ensure the going concern of the
company. In the past, the company issued 20-year bonds with a face value of $1,500 and an annual coupon rate
of 5%. The company then restructures the debt to a 20-year bond with a face value of $1,500 and an annual
coupon rate of 2%.

Moratorium
A moratorium is a temporary suspension of activity until future events warrant lifting of the suspension or
related issues have been resolved. Moratoriums are often enacted in response to temporary financial hardships.

A moratorium is often effected in response to a crisis that disrupts normal routine. In the aftermath of
earthquakes, floods, droughts or disease outbreaks, an emergency moratorium on some financial activities may
be granted by a government or the central bank. It is lifted when normalcy returns.

Ex: Laxmi vilas bank, Punjab & Maharashtra cooperative bank.

Recovery rate
Recovery rate is the extent to which principal and accrued interest on defaulted debt can be recovered,
expressed as a percentage of face value. The recovery rate can also be defined as the value of a security when it
emerges from default or bankruptcy.

The recovery rate is the estimated percent of a loan or obligation that will still be repaid to creditors in the
event of a default or bankruptcy.

In a firm's capital structure, the recovery rate on senior collateralized debt will often have the highest recovery
rate, while equity holders can often expect a recovery rate of close to zero.

Following the wave of defaults following the 2008 financial crisis, the estimated recovery rate across debt
interests was around 49.5%, lower than the 51.1% recovery rate observed over the previous decade.