Index

Author & Profile 2

Preface 3

SECTION A: INVESTMENT DECISIONS

1. Investment Decisions, Project Planning and Control 4

2. Evaluation of Risky Proposals for Investment Decisions 19

3. Leasing Decisions 22

SECTION B: FINANCIAL MARKETS AND INSTITUTIONS

4. Institutions in Financial Markets 23

5. Instruments in Financial Markets 24

6. Capital Markets 28

7. Commodity Exchanges 29

SECTION C: SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

8. Security Analysis & Portfolio Management 31

9. Financial Risks 51

SECTION D: FINANCIAL RISK MANAGEMENT

10. Financial Derivatives – Instruments for Risk Management 52

11. Financial Risk Management in International Operations 97

Schedules

Time Value of Money Formulas 105

Risk & Return Measurements 106

**********************************************************************************************

Some matter included here is from existing publications of the author. The author reserves the right to use the
material in this workbook for his academic & professional activities, without requiring separate permission from the
WIRC of ICMAI. Due credit will be given to the publishers whenever such material is used by the author.

Images courtesy Google search. No copyright infringement intended. All copyrights acknowledged. All rights to
tables, notes & images used are owned by the respective owners &/or originators.

Disclaimer:

E&oe. Without prejudice, without recourse

1
 Vidya Dhanam Sarvadhana Pradhanam

(The Wealth of Knowledge Is the Greatest Wealth)

CMA Manohar V Dansingani

Author Profile:

Registered External Expert with the European Union

Examination Marker for Institute and Faculty of Actuaries

Resource Person for the Institute of Cost Accountants of India

Faculty & Trainer for the Institute of Company Secretaries of India

Reviewer for Palgrave Communications

CPE Trainer for NISM (educational initiative of SEBI)

Resource Person for NCFE (promoted by RBI, SEBI, IRDAI & PFRDA)

Visiting/Guest Faculty at Premier Institutes

Facilitated two online course-packs on the Harvard Business Publishing Education website

Author of 7 books + a Workbook for Paper 20 for Final, Group IV students for the Pune Chapter of ICMAI

Online courses on Udemy have students from 39 countries & are available in 14 languages.

Free educational videos – “Funda-Mentally Simple”, on YouTube

Publications & work included in IFAC Global Knowledge Gateway, ICMAI Knowledge Bank, Portfolio Organizer,
Treasury Management, The Management Accountant.

Former (Founder President) – Pune Chapter of Institute of Management Accountants, & was a Question Writer for IMA

Awards

National Merit Scholar

Member – Million Dollar Round Table (now retired)

Gold Level Faculty at IMA Leadership Academy

Best Faculty (Final Level) ICMAI Pune

Principles

a) Vidya Dhanam Sarvadhana Pradhanam (The Wealth of Knowledge is The Greatest Wealth)

b) Good Is Not Enough…..Excellence Is The Goal

https://www.amazon.com/Manohar-Dansingani/e/B01M0HPDSY/ref=ntt_dp_epwbk_0
https://www.youtube.com/channel/UCafI20-1v7hv9cCkJVUgHFA

JRRGLVQRWHQRXJK«H[FHOOHQFHLVWKHJRDO

2
 PREFACE

Dear Fellow Student

Thank You for your sincere efforts. The CMA course is both, rigorous & industry oriented.

When you qualify (soon), you will proudly boast of your academic & professional prowess!

This workbook is designed in a Q&A format, covering important concepts which are explained with suitable
illustrations & solved examples. I sincerely hope it will enable you to tackle any type of question in the examinations;
& more important, real-life situations in your professional career.

It is complementary to & not a substitute for your Study Notes. Only important & complex topics have been given
attention in this concise workbook.

May I request you to constantly increase your knowledge & to make your presence felt wherever you are, as a
dedicated professional with impeccable integrity & and unblemished ethics.

Business cycles cannot be avoided: the tragic destruction caused by financial meltdowns can however, be mitigated
with sound financial management. That is where your professional acumen will be vital.

I am grateful to the WIRC of The Institute of Cost Accountants of India & to my students, who have taught me so
much.

Your feedback will be most appreciated. Best Wishes

0DQRKDU9'DQVLQJDQL
B.Com (Hons.), DBF, ACMA, CSSBBP, Chartered MCSI

January 2020

3
SECTION A: INVESTMENT DECISIONS

1. Investment Decisions, Project Planning & Control

4 :+,&+$5(7+(0$,1'(&,6,216,1),1$1&,$/0$1$*(0(17"
:+,&+$5(7+(0$,1'(&,6,216,1),1$1&,$/0$1$*(0(17"

* Investing Decision Where to invest; which project or combination of projects to choose.

* Financing Decision What should be the capital structure? What combination of debt & equity?

* Distributing Decision How should the profits be distributed; how much should be retained?

4 :+$7,6&$3,7$/%8'*(7,1*"
:+$7,6&$3,7$/%8'*(7,1*":+<,6,7,03257$17
":+<,6,7,03257$17"
:+<,6,7,03257$17"

Capital Budget means a list of planned capital expenditures, prepared periodically (usually, annually). Capital
expenditure is that expenditure which is incurred on resource or revenue generating plant, machinery, building etc. It
is of non-recurring nature for each item, & the benefits of this expenditure are evident over time. Capital expenditure
is most important because

a) It has long term effects

b) It is irreversible (once implemented)

c) It usually entails substantial outlays

PLANNING, ANALYSIS, SELECTION, IMPLEMENTATION & REVIEW are the phases of Capital Budgeting.

Each firm would require a thorough PROJECT ANALYSIS before it can allocate funds to any project(s). The
aspects of Project Analysis are:

MARKET ANALYSIS

TECHNICAL ANALYSIS

FINANCIAL ANALYSIS

ECONOMIC ANALYSIS

ECOLOGICAL ANALYSIS

The goal of CAPITAL BUDGETING IS IN CONSONANCE WITH THAT OF FINANCIAL MANAGEMENT:

OPTIMUM UTILIZATION OF RESOURCES & MAXIMIZATION OF VALUE AT ALL LEVELS.

Projects may be classified into:

NEW PRODUCTS OR EXPANSION

REPLACEMENT

RESEARCH & DEVELOPMENT

EXPLORATION

MISCELLANEOUS

4 :+$7$5(
:+$7$5(7+((66(17,$/62)
7+((66(17,$/62)$335$,6,1*&$6+)/2:6)259$/8$7,21
$335$,6,1*&$6+)/2:6)259$/8$7,21"
$335$,6,1*&$6+)/2:6)259$/8$7,21"

Projects can be appraised & compared based on cash flows & keeping in mind some parameters:

4
Use incremental cash flows only

Ignore sunk costs

All cash flows are to be considered post tax

Exclude cost of long term funds

Exclude common allocated overheads

4 :+$7$5(7+(0(7+2'62)(9$/8$7,1*5(78516"
:+$7$5(7+(0(7+2'62)(9$/8$7,1*5(78516"


COMMON METHODS OF APPRAISAL

ASSUMPTIONS

1. The risk or quality of all investment proposals under consideration is the same as that of the existing projects
of the firm.

2. Expected cash flows are realized at the end of each year.

There are four popular methods of capital budgeting

1 AVERAGE RATE OF RETURN

2 PAYBACK PERIOD

3 INTERNAL RATE OF RETURN (IRR)

4 NET PRESENT VALUE (NPV)

1 AVERAGE RATE OF RETURN

The most common formula for this is Average Income After Tax

Average Investment

e.g. post tax income 10 lakhs: Initial outlay 100 lakhs: depreciation 20 lakhs: closing balance of investment: 80
lakhs

ARR = (10/90) * 100 = 11.11%

4 3/($6((;3/$,13$<%$&.3(5,2'
3/($6((;3/$,13$<%$&.3(5,2'
3$<%$&.3(5,2'

2 PAYBACK PERIOD

It is the length of time required to recover the initial cash outlay on the project. Payback Period is easy to understand
& calculate.

It has limited use because:

a) It does not consider time value of money

b) It only concerns itself with return of investment, not return on investment

c) Cash flows after the payback period are ignored

5
d) The threshold is arbitrary & without economic rationale

4 3/($6((;3/$,1',6&2817('3$<%$&.3(5,2'
3/($6((;3/$,1',6&2817('3$<%$&.3(5,2'
',6&2817('3$<%$&.3(5,2'

DISCOUNTED PAY BACK PERIOD is a better measure than pay back period, but it also has limited use because:

a) It only concerns itself with return of investment, not return on investment

b) Cash flows after the payback period are ignored

c) The threshold is arbitrary & without economic rationale

4 3/($6((;3/$,1,55
3/($6((;3/$,1,55:,7+$1(;$03/(
:,7+$1(;$03/(

6
3 INTERNAL RATE OF RETURN

IRR is a discounted cash flow method, wherein the acceptance criterion is to compare the IRR with a required rate of
return. If IRR exceeds required rate (which is usually cost of capital), the project is accepted, if not, it is rejected.
The IRR is the discount rate which makes its NPV = 0

Year Cash Flow P V @ 15% Disc PV @ 16% Disc

0 -100000 -100000 -100000
1 30000 26087 25862
2 30000 22684 22295
3 40000 26301 25626
4 45000 25729 24853
NPV 801.00 -1364.00
IRR = 15+ (801/2165) 15.37 or 15.37%

4 :+$7,6139",6,77+(6$0($6,55"
:+$7,6139",6,77+(6$0($6,55"

4 NET PRESENT VALUE

All cash flows are discounted to their present values, using required rate of return. If the NPV is positive, the project
may be accepted, if negative, and then rejected. In the e g cited above, if the required rate of return (cost of capital
in most cases) is 16%, the NPV is negative & the project is rejected. If however the required rate of return is 15%,
the NPV is positive & the project is accepted.

4 :+$7,6&2672)&$3,7$/"
:+$7,6&2672)&$3,7$/"

Cost of Capital is the weighted average of the cost of the various sources of finance used by the company.

Sources of Finance: DEBENTURES: TERM LOANS: PREFERENCE CAPITAL: EQUITY CAPITAL:

RETAINED EARNINGS

4
 :+$7,67+(&2672)'(%7"
:+$7,67+(&2672)'(%7"

COST OF DEBENTURES

Interest on borrowing is tax-deductible; hence it provides a tax shield to the issuer. The net cost of borrowing, post-
tax is thus lower than the coupon rate: the difference being the tax shield.

Kd = I(1-T) + (F-P)/N
(F+P)/2

• Kd = Post Tax Cost of Debenture Capital

• I = Coupon/Interest per period, per Debenture (could be yearly, half-yearly,

quarterly)

• T = Applicable Tax Rate

• F = Redemption Price per Debenture

• P = Net Amount Realized per Debenture

7
 • N = Number of coupons till maturity

eg FV =100/: Int =14% (payable annually): Amt realized =97/ Tax Rate = 50%: Term 10 yrs.: Redemption at
premium of 5/

I = 14/ T = 50% F = 105/ P = 97/ N = 10

Kd = 7.7%

Note:

If difference between the redemption price & net amount realized can be amortized over the life of the debentures
and this amount is tax deductible, the formula will be modified as follows

Kd = I(1-T) + (F-P)(1-T)/N
(F+P)/2

COST OF TERM LOANS

• Kt = I(1-T)

• Kt = Cost of term loan

• I = Interest

• T = Tax rate applicable

4 3/($6((;3/$,1&2672)35()(5(1&( &2672)(48,7<

3/($6((;3/$,1&2672)35()(5(1&( &2672)(48,7<

Note on Cost of Preference & Equity:

In case of dividend distribution tax, the net dividend outflow for the company will be

Dp * (1 + Tddt) for preference, &

De * (1 + Tddt) for equity

Where Tddt is Dividend Distribution Tax (in percentage)

COST OF PREFERENCE CAPITAL

Kp = Dp + (F-P)/N
(F+P)/2

Kp = Cost of Preference Capital

• Dp = Preference Dividend

• F = Redemption Price

• P = Net amount Realized per share

• N = Maturity Period

Notes:

8
 1. Dividend of any kind is not tax deductible, hence does not come with a tax shield

2. If the preference shares are irredeemable, then Kp = Dp/P0 (where P0 is the current market price per share)

COST OF EQUITY CAPITAL

* DIVIDEND FORECAST APPROACH

• Ke = (D1/P0) + G

• Ke = Cost of Equity Capital

• D1 = Dividend expected at end of year (or at start of next year)

• Po = Current Market Price

• G = Expected Growth Rate in Dividend

* CAPITAL ASSET PRICING MODEL APPROACH

• Ki = Rf + Bi * (Rm-Rf)

• Ki = Required Rate of Return on Security

• Rf = Risk Free Rate of Return

• Bi = Beta of Security

• Rm = Expected Return on Market Portfolio

* BOND YIELD PLUS RISK PREMIUM APPROACH

(subjective method) Yield on Long Term Bonds + Risk Premium

* EARNINGS PRICE RATIO APPROACH (INVERSE OF P/E RATIO)

E1/P0

• E1 = Expected Earnings in the next year (E0 * (1+g))

• P0 = Current Market Price per share

* COST OF EXTERNAL EQUITY

Kx = D1 +G
P0(1-F)

• Kx = Cost of External Equity

• D1 = Dividend Expected at end of year

• G = Expected Growth Rate in Dividend

• P0 = Current Market Price per share

9
 • F = Floatation costs (as a % age of current market price)

Or K x = Ke/(1-F)

e.g. Ke (cost of retained earnings) = 18%

F = 5%

Kx = 18/0.95 = 18.95%

4 3/($6('(6&5,%(:$&& (;3/$,1,76,03257$1&(

3/($6('(6&5,%(:$&& (;3/$,1,76,03257$1&(

Important: Weights should be based on market value

• Ko = Wd*Kd + Wp*Kp + We*Ke + Wx*Kx

• Ko = WACC (WEIGHTED AVERAGE COST OF CAPITAL)

Wd, Wp, We, Wx are the weights of debt, preference capital, existing equity + retained earnings, & external
equity respectively, in the total capital

e.g.

SOURCE COST MV WT COST

Proportion
1 2 3 4=2*3
DEB Kd 7.50% 0.35 0.02625
PREF Kp 14% 0.25 0.035
RET EQ Ke 16% 0.3 0.048
EXT EQ Kx (F =5%) 16.84% 0.1 0.01684
Total 1.00 0.1261
WEIGHTED AVERAGE COST OF CAPITAL 12.61%

4
 021(<+$6$7,0(9$/8(z
021(<+$6$7,0(9$/8(z3/($6((/$%25$7(
3/($6((/$%25$7(

We know that a today is worth more than a tomorrow. The difference can be explained by a discount rate or
hurdle rate (several names, one meaning).

Less clearly understood is the fact that Time Value is a result of three factors:

i) Opportunity Cost (Risk-free rate of return for a comparable time-period)

ii) (Unexpected) Inflation (the decrease in purchasing power of the currency in use)1

iii) Risk (uncertainty; chance of loss)

It follows that the discount rate used for any valuation would be directly related to each of the three
constituents above: viz. higher the risk-free rate of return &/or inflation &/or risk, higher should be the return
required from the investment.

Notes:

1
Deflation would be the reverse
10
* A common misconception is that opportunity cost is the cost of an alternative. It is the benefit foregone by
not investing in the next available alternative.

* Risk is one of the most misunderstood ideas. Consider a bank which lends 1 billion to a
multinational corporation. At the time of the loan, the probability of total default was 1%. This 1% may
seem rather a small figure (expected loss of a mere 10 million) for that scale of operations. The bank would say
“Oh, we can live with that.”

If the company did default (the 1% chance came into play), what the bank stands to lose is 1 billion,
or one hundred times the expected loss of 10 million. That loss could ruin it.

4
 &$6+)/2:6*(1(5$7(9$/8(3/($6((;3/$,1
&$6+)/2:6*(1(5$7(9$/8(3/($6((;3/$,1

Professionals are all too familiar with a situation where a company reports decent profits, but is insolvent. Cash flows
are important: they can be ploughed back for sustained growth. It is essential to bear in mind these guidelines when
appraising a new project:

• Use incremental cash flows only

• Ignore sunk costs
• All cash flows are to be considered post tax
• Exclude cost of long term funds (to avoid double-counting)
• Exclude common allocated overheads
• Remember to include opportunity cost.
Cash flows matter because

Cash Flows show the real picture

They are not so easy to manipulate

Profit may be an illusion, merely on the books

Cash Flows reflect the ability of the company to continue its active existence

The three types of cash flows are

Operating Cash Flows

Investing Cash Flows &

Financing Cash Flows

Operating Cash Flows are of paramount importance. They indicate whether the company can generate sufficient
positive cash flows from its operations. Consider two companies A & B, with identical net positive cash flows of
100 million each.

Company A Company B
( million)

Operating Cash Flow 200 -50

Investing Cash Flow -100 50
Financing Cash Flow 0 100

Net Cash Flow Generated 100 100

11
 It is apparent that Company A has better performance, generating sufficient cash flows from operations to invest for
growth. Company B on the other hand, has to resort to asset sale & additional financing.

4
 :+$7,6)5((&$6+)/2:)25),50)&))
:+$7,6)5((&$6+)/2:)25),50)&))

This is the amount available for meeting debt commitments & for shareholders.

EBIT * (1- tax rate) – (Capital Expenditures – Depreciation) – Change in Working Capital

Depreciation is effectively added back, since it is a non-cash expense.

Capital expenditures & changes in WC are often necessary to continue the business & may be inflows or outflows.

Care must be taken to identify & separate one-time, non-recurring items from regular, recurring flows

Note:

* Operating Profit is not always the same as EBIT. One should be careful to separate one-time,
extraordinary & non-recurring items while calculating sustainable cash flows.

This example illustrates the error:

4
 :+$7,6)5((&$6+)/2:)25(48,7<)&)(
:+$7,6)5((&$6+)/2:)25(48,7<)&)(

The Residual Cash Flow which belongs to equity shareholders.

Net Income – (Capital Expenditures – Depreciation) – (Changes in non-cash Working Capital) – (Principal
Repayments – New Debt Issues) – (Preferred Dividends)

4
 1(735(6(179$/8(352),7$%,/,7<
1(735(6(179$/8(352),7$%,/,7<,
52),7$%,/,7<,1'(;,17(51$/5$7(2)5(785102',),(',17
1'(;,17(51$/5$7(2)5(785102',),(',17(51$/
,17(51$/5$7(2)5(785102',),(',17(51$/
5$7(2)5(7851
5$7(2)5(7851

NPV: Net Present Value of all the cash flow streams of the company, discounted at the appropriate discount
rate or hurdle rate.

Positive NPV implies that wealth is generated for the shareholders (There is a surplus available after meeting all
costs of capital. This surplus belongs to the owners).

12
Profitability Index

Rules:

* PI > 1, accept (NPV is positive)

* PI < 1, reject (NPV is negative)

* PI = 1, indifferent (NPV = 0)

IRR: Is that discount rate at which NPV = 0.

13
Had we considered 27% & 29%, the second part of the formula would have been multiplied by 2 instead of 1.
Interpolation is more accurate when the two discount factors used are closer in value.

Proof:

NPV IRR
* Expressed in currency Percentage return
* Discount rate required Not required
* NPV changes with discount rate IRR remains constant
(for a given cash flow stream)
* Acceptance Criterion
Accept if NPV is positive at a Accept if IRR is in
given discount rate excess of required rate

Disadvantages of IRR

For the cash flow stream above, NPV & IRR are calculated as shown. We know that NPV must be zero when IRR is
15.37%.

1) IRR assumes that all cash flows are reinvested in the same project, at the IRR. This is clearly a false
assumption, since this project generates only positive cash flows after the initial investment at time 0.

It is possible the cash generated could have been:

i) reinvested in another project with a different IRR

14
 ii) used to pay out dividends

iii) used to repay debt or repurchase preference shares, & so on

2) If the cash flow changes signs more than once, & if the amount of cash flow is substantial, there may be
multiple or indeterminate IRRs.

In the example above, there are two IRRs, 10% & 0%. NPV is 0 at both. How would one evaluate these cases?

Whenever there is a dispute between NPV & IRR, go with NPV

At a discount rate (hurdle rate) of 5%, NPV would be positive in this case.

Note:

* Every cash flow after time zero must be discounted, even the negative cash flows.

3) IRR rules must be reversed when we consider financing projects (below), instead of investing projects
(shown above)

This is a financing type project. The firm borrows money at time 0 & at time 1, & repays with interest at end of
period 2.

15
Recollect the IRR rule of acceptance: Accept if IRR is greater than discount rate (or hurdle rate or required rate).

In this case, if the discount rate was 10%, one would be tempted to reject the finance option, since IRR at 6.52% is
LESS THAN the discount rate.

NPV indicates correctly that while the market discount rate is 10%, this financing option has positive NPV, or it costs
us less than 10%, hence it creates value for shareholders.

Put in perspective, an IRR lower than the hurdle rate (in a financing project) indicates acceptance, since we pay less
than the opportunity cost of 10%, on capital borrowed.

4) IRR is biased in favour of shorter duration projects & earlier cash flows.

A Ltd clearly delivers superior value addition to its shareholders (@ 25% discount rate). However, IRR would
indicate a preference for B Ltd.

MIRR

Modified Internal Rate of Return seeks to overcome the reinvestment assumption of IRR.

It considers two rates,

A reinvestment rate at which the positive cash flows generated by the business can be realistically
expected to grow, &

A discount rate (or finance rate) at which the PV of the entire stream of cash flows will be
calculated.

16
Finance rate is 12%, NPV is positive. IRR is 15.49%. Reinvestment Rate is 15%, MIRR is 15.31%.

Finance rate is 15%; NPV is positive (but changed). IRR is 15.49% (unchanged). Reinvestment Rate is 12%, MIRR is
14.19% (changed)

4
 3/($6((;3/$,1(48,9$/(17$118$/,=('139

Projects with unequal lives can be compared using EANPV.

Consider the following example:

Cost of Machine I – 75000, Life 5 years, annual operating cost 12000.

Cost of Machine II – 50000, Life 3 years, annual operating cost 20000.
Cost of Capital 12%

I II
1 Cost -75000 -50000
2 Life 5 3
3 Annual cost -12000 -20000
4 k 12% 12%
5 PVIFA(12%,5) 3.6048 2.4018
6 PV of annual costs -43257.31 6 = 3*5 -48036.63
7 NPV @ 12% -118257.31 7 = 1+6 -98036.63
8 EANPV - 32,805.73 8 = 7/5 - 40,817.45 

17
In this illustration, there are only negative cash flows. Hence, we must choose that project which has lower negative
value. However, the lives are unequal. NPV alone is not enough. Use Equivalent Annualized NPV. In effect, how
much would be the discounted cash flow, annually.

Machine I has the lower EANPV; hence it should be chosen over Machine II.

18
2. Evaluation of Risky Proposals for Investment Decisions
4
 +2:'2(6,1)/$7,21$))(&7&$3,7$/%8'*(7,1*'(&,6,216"
+2:'2(6,1)/$7,21$))(&7&$3,7$/%8'*(7,1*'(&,6,216"

Unexpected inflation is a threat to every project; it is a friend of the borrower, & an enemy of the lender.

One must be extremely careful even of the expected inflation built into financial projections.

* If nominal cash flows are considered, then nominal interest rate should be used for discounting.

* If nominal cash flows & discount rates are considered, then inflation should not be accounted for again.

* If inflation turns out to be higher than initially anticipated, the value of the tax shield on depreciation will be
lower, thus reducing the NPV of the project.

* Lower than expected inflation increases the cost of debt (contracted long-term, upfront) of the company; this
reduces the NPV of the investment.

* Inflation will not equally affect revenues & expenses. If input costs are subject to higher than expected
inflation, in the absence of pricing power, the company cannot pass on these costs to its customers; thus lowering the
NPV.

4
 (;3/$,16(16,7,9,7<$1$/<6,6 6&(1$5,2$1$/<6,6
(;3/$,16(16,7,9,7<$1$/<6,6 6&(1$5,2$1$/<6,6

Sensitivity analysis measures how much the result or decision will change if only one input variable is changed, all
other variables held constant. For example: other things remaining the same, what will be the change in profitability
of a project or investment, given a change in interest rate.

Scenario analysis on the other hand, is a much more complex tool. Suppose there are three expected states of the
economy – good, average & bad. In each of these scenarios, we could have assumptions of interest rate, demand,
wages, availability of raw material, & so on. Scenario analysis would attempt to predict the result in every scenario.

4
 :+$7,67+(&(57$,17<(48,9$/(17$3352$&+"
:+$7,67+(&(57$,17<(48,9$/(17$3352$&+"

For every project, we find the NPV using CFAT or cash flows after tax. However, all these are just projections or best
estimates. Management can assign a certainty equivalent factor; either using judgement, or complex programs, to
each cash flow.

Year CFAT CEF CE CFAT PV @ 8%

0 -500000 1.00 -500000 -500000
1 250000 0.90 225000 208333
2 250000 0.80 200000 171468
3 300000 0.75 225000 178612
4 200000 0.65 130000 95554
5 -450000 0.55 -247500 -168444
CE NPV @ 8% -14477
NPV @ 8% 24709

Notice in the above project appraisal, the more distant the cash flow; the less certain we are about it. Ignoring CEF
would have resulted in a poor decision, since the NPV would be overly optimistic.

4
 3/($6((;3/$,15,6.$'-867('',6&2817('5$7(5$'5
3/($6((;3/$,15,6.$'-867('',6&2817('5$7(5$'5

A company may have different business verticals, each facing varying levels of uncertainty. A new project being
considered may have a distinct risk-return profile from the existing business lines. The value of a risky asset can be
estimated by discounting the expected cash flows from the asset over its life at a risk-adjusted discount rate.

19
4
 5($/237,2160$77(53/($6(',6&866
5($/237,2160$77(53/($6(',6&866

A real option is the right — but not the obligation — to undertake certain business initiatives, such as deferring,
abandoning, expanding, staggering, or contracting a capital investment project. For example, the opportunity to
invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real call or put option, respectively.
Real options are distinct from conventional financial options. They are not traded as securities, and do not usually
involve decisions on an underlying asset that is traded as a financial security.

Please consider the case below, with a decision tree & value of the real option:

Suppose:

20
21
3. Leasing Decisions
4
 6+257127(21/($6(),1$1&(
6+257127(21/($6(),1$1&(

“A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the
right to use an asset for an agreed period of time.

A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset.
Title may or may not eventually be transferred.

An operating lease is a lease other than a finance lease.” Ind AS17(4)

Initial Recognition of Finance Lease (Lessees)

“At the commencement of the lease term, lessees shall recognise finance leases as assets and liabilities in their
balance sheets at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum
lease payments, each determined at the inception of the lease.” Ind AS17(20)

Initial Recognition of Operating Lease (Lessees)

“Lease payments under an operating lease shall be recognised as an expense on a straight-line basis over the lease
term unless another systematic basis is more representative of the time pattern of the user’s benefit.” Ind AS17(33)

NAL

Net advantage to leasing (NAL) is the potential monetary savings of choosing a lease option over outright ownership.

Break-Even Lease Rental

Break-even lease rental (BELR) is the point of indifference between lease financing & buying (with borrowed funds).
BELR has an NAL of zero. If BELR > actual lease rental; accept the lease proposal: else reject it.

22
SECTION B: FINANCIAL MARKETS AND INSTITITUTIONS

4. Institutions in Financial Markets

4
 :+$7$5(7+()81&7,2162)),1$1&,$/0$5.(76"
:+$7$5(7+()81&7,2162)),1$1&,$/0$5.(76"
0$5.(76"

* PRICE RISK MANAGEMENT

* PRICE DISCOVERY PLATFORM

* RESOURCE ALLOCATION

* CONTRACT ENFORCEMENT

4
 :5,7($%5,()127(215%, ,765(63216,%,/,7,(6
:5,7($%5,()127(215%, ,765(63216,%,/,7,(6

PREAMBLE

“to regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and
generally to operate the currency and credit system of the country to its advantage; to have a modern monetary policy
framework to meet the challenge of an increasingly complex economy, to maintain price stability while keeping in
mind the objective of growth.” https://www.rbi.org.in/

Main Functions (https://www.rbi.org.in/Scripts/AboutusDisplay.aspx#MF)

* Monetary Authority

* Regulator and supervisor of the financial system

* Manager of Foreign Exchange

* Issuer of currency

* Developmental role

* Regulator and Supervisor of Payment and Settlement Systems

* Related Functions – Banker to the Government, and Banker to banks

23
5. Instruments in Financial Markets

4
 :+$7$5(7+(&+$5$&7(5,67,&62)%21'6"
:+$7$5(7+(&+$5$&7(5,67,&62)%21'6"

* Interest Bearing Debt Securities

* Price changes inversely with market interest rates (as interest rates increase, price of existing bonds fall; & market
price of existing bonds rise when market interest rates fall)

* Interest is generally paid semi-annually

* Face Value or Par Value is paid out on maturity

4
 :+$7$5(7+(81'(5/<,1*$668037,216:+(1&$/&8/$7,1*<70"
:+$7$5(7+(81'(5/<,1*$668037,216:+(1&$/&8/$7,1*<70"

* No Default

* Bond Held to Maturity

* Coupons Reinvested at the YTM

4
 :+$7$5(7+(7<3(62)5,6.35(6(17,1%21'6"
:+$7$5(7+(7<3(62)5,6.35(6(17,1%21'6"

* Default Risk or Credit Risk

* Interest Rate Risk

* Market Risk

4
 +2:$5(=(52&28321%21'69$/8('"
+2:$5(=(52&28321%21'69$/8('"

Zero coupon bonds are special bonds with no periodic interest payment. They are sold at a discounted price. The
interest rate is implied by the difference between face value (FV) & issue price, given the life of the bond. (Called
Deep Discount Bonds in India)

Please consider residual life. A 10 year bond issued 5 years ago has a residual life of 5 years.

24
4
 3/($6((;3/$,1:,7+,//8675$7,2169$/8$7,212)&283213$<,1*%21'6
3/($6((;3/$,1:,7+,//8675$7,2169$/8$7,212)&283213$<,1*%21'6

Present value of a coupon-paying bond = PV of interest payments + PV of principal

N = residual life (time to maturity)

i = market interest rate

PMT = coupon amount

FV = face value (assuming the bond is redeemed at FV)

Figure 1: Bond Price = Face Value when Coupon Rate = Market Yield

25
Figure 2: Bond Price < Face Value when Coupon Rate < Market Yield

Figure 3: Bond Price > Face Value when Coupon Rate > Market Yield

4
 :+$7$5(+('*()81'6"
:+$7$5(+('*()81'6"

“A hedge fund is an investment fund that pools capital from accredited investors or institutional investors and invests
in a variety of assets, often with complicated portfolio-construction and risk management techniques. It is
administered by a professional investment management firm, and often structured as a limited partnership, limited
liability company, or similar vehicle. Hedge funds are generally distinct from mutual funds and regarded as
alternative investments, as their use of leverage is not capped by regulators, and distinct from private equity funds, as
the majority of hedge funds invest in relatively liquid assets.” https://en.wikipedia.org/wiki/Hedge_fund

Hedge funds are only available to institutional investors & sophisticated, accredited buyers; they cannot be sold to the
general public.

4
 (;3/$,11$9,10878$/)81'6

(https://www.amfiindia.com/investor-corner/knowledge-center/nav-sale-repurchase-price.html#accordion1)

“The performance of a particular scheme of a mutual fund is denoted by Net Asset Value (NAV). In simple words,
NAV is the market value of the securities held by the scheme.

Mutual funds invest the money collected from investors in securities markets. Since market value of securities
changes every day, NAV of a scheme also varies on day to day basis.

The NAV per unit is the market value of securities of a scheme divided by the total number of units of the scheme on
any particular date…

..For example, if the market value of securities of a mutual fund scheme is INR 200 lakh and the mutual fund has
issued 10 lakh units of INR 10 each to the investors, then the NAV per unit of the fund is INR 20 (i.e.200 lakh/10
lakh)”

4
 :+$7,6$75,"
:+$7,6$75,"

“Mutual funds in India have traditionally benchmarked their schemes to a simple Price Return Index (PRI), which
captures only the changes in the prices of the securities that constitute the index. For instance, the popular S&P BSE
26
Sensex is based on the shares of 30 companies and hence, its returns are measured on the price movements of these
constituent stocks.

To enable investors to better assess the performance of a mutual fund scheme versus its chosen benchmark, SEBI has
mandated that fund houses must now benchmark all schemes against a TRI. Unlike a PRI, the TRI captures both the
capital gains as well as the dividend receipts from the index’s constituent securities. It is assumed that the dividend
receipts are reinvested into the index.

Since a mutual funds’ net asset value (NAV) reflects both the capital gains and losses in its portfolio as well as the
dividends received from its portfolio holdings, the TRI is a more appropriate and accurate benchmark of its
performance. Globally, mutual funds are benchmarked against a TRI as best practices. India will now follow suit.
Thus, if a scheme was benchmarked against the S&P BSE Sensex earlier, it will be benchmarked against the S&P
BSE Sensex TRI now as per the SEBI mandate.” https://www.crisil.com/en/home/our-analysis/views-and-
commentaries/2018/04/total-returns-index-a-more-accurate-benchmark-for-mutual-fund-investors.html

4
 3/($6((;3/$,17+(/2$'6758&785(
3/($6((;3/$,17+(/2$'6758&785(
/2$'6758&785(,10878$/)81'6
,10878$/)81'6

Suppose the NAV of a scheme is 10, & there is an entry load of 1%. In this case, an investor buying units today
would pay 10 + 1% of 10, or 10.10.

If the NAV is 10, & there is an exit load of 1%. The investor selling units would receive 10 – 1% of 10, or 9.90

27
6. Capital Markets

4 %5,()127(21),1$1&,$/
%5,()127(21),1$1&,$/
),1$1&,$/0$5.(76
0$5.(76

* Money Market - for financial assets with original maturities of one year or less. Trading is over the
counter and is wholesale.

* Capital Market - for trading in long-term debt or equity-backed securities with maturity exceeding a year.

- Primary Market: securities are issued for the first time to raise funds for the company.

- Secondary Market: securities already issued are traded by owners & prospective owners. No cash
implication for the company.

* Derivatives Market- financial derivatives are traded.

* Commodity Market- market for commodities

* Forex Market - foreign exchange (currency) market

28
7. Commodity Exchanges

4
 6+257127(21&2002',7,(6
6+257127(21&2002',7,(6

A commodity is characterized by its physical properties, the date at which it will be available, and the location at
which it will be available. The price of a commodity is the amount which has to be paid now (spot) or for the future
availability of one unit of that commodity. So, corn in June & corn in December are separate commodities.

Types

EXTRACTIVE which are extracted or drilled like minerals, oil etc. (metals, hydrocarbons)

RENEWABLE agricultural, livestock, dairy and lumber

PRIMARY unprocessed: corn, soya-beans, oil, & gold

SECONDARY processed: petrol, diesel

Costs to be considered

STORAGE COSTS cost of storing the commodity + deterioration

CARRY MARKETS if the forward price compensates the owner for storage costs (net return will be the risk-
free rate)

LEASE RATE the short-seller may have to compensate the owner if Commodity is borrowed for the
transaction

CONVENIENCE YIELD owner of the commodity may receive non-monetary benefits from physical possession

4
 :+$7,6&2002',7<5,6.0$1$*(0(17"
:+$7,6&2002',7<5,6.0$1$*(0(17"

Commodity risk is the risk a business faces due to change in the price and other terms of a commodity. Commodity
risk management involves various strategies like hedging with derivatives, production or purchase contracts, &
liquidity management.

The types of commodity risk are price, quantity, cost, & regulatory risks.

4
 +2:,6&2002',7<5,6.0($685('"
+2:,6&2002',7<5,6.0($685('"

* SENSITIVITY ANALYSIS

* PORTFOLIO APPROACH

* VALUE AT RISK (VaR)

4
 (;3/$,19$/8($75,6.9$5
(;3/$,19$/8($75,6.9$5

You are the CEO of an investment bank, with an investment portfolio of $1 billion. You ask your two risk managers
a simple question: “How much can we lose on any given day?” Their answers:

1 “I don’t know”

2 “99% of the time, on any day, we should not lose more than $38.1618 million”

While the first analyst may actually be telling you the truth, it is not a useful answer, is it? The second answer, VaR
or Value at Risk, may turn out to be totally wrong but at least you have a starting point.

Example:

29
“99% of the time, on any day, we should not lose more than $38.1618 million”

30
SECTION C: SECURITY ANALYSIS & PORTFOLIO MANAGEMENT

8. Security Analysis & Portfolio Management

4
4 $127(217(&+1,&$/$1$/<6,6
$127(217(&+1,&$/$1$/<6,6

Fundamental Analysis studies the macro economy, microeconomics, industry analysis, & the company’s financial

performance to arrive at the intrinsic value of a stock. A judgement call is then made about whether the security is

over or under-valued.

Technical Analysis only considers price & volume as the basic inputs. It focuses on stock charts to identify patterns &

trends, in order to predict future price movements. The principles:

* The Market Discounts Everything

* History Repeats Itself

* Prices Move In Trends

31
 

A trend-line indicates the direction until it reverses. Support line shows an approximate level at which buying

emerges, resistance line is the level at which sellers are more active. Once a support is breached on the downside, it

becomes the resistance for any up-move; likewise, if price breaks above the resistance line, it becomes the support for

any later fall in prices.

Stochastic “Randomly determined; having a random probability distribution or pattern that may be analyzed

statistically but may not be predicted precisely.” https://www.lexico.com/en/definition/stochastic

A stochastic oscillator is a momentum indicator which uses support & resistance levels, based on several calculations

using available data.

4
 :+$7,67+(()),&,(170$5.(7+<327+(6,6"
+$7,67+(()),&,(170$5.(7+<327+(6,6"

Eugene F. Fama was awarded the Nobel Prize for Economic Sciences in 2013. In his (Nobel) Prize Lecture, Fama

mentioned that there were two pillars of asset pricing: efficient markets, & asset pricing models. The original theory

(which is not used anymore) was as follows:

WEAK FORM: stock prices fully reflect all currently available security market information. Past price &

volume data have no bearing on future direction of security prices. Hence, technical analysis is irrelevant.

SEMI-STRONG FORM: stock prices have factored in all available market & non-market public

information. Therefore, fundamental analysis is irrelevant (publicly available information)

STRONG FORM: current stock prices reflect all public & private information. In efficient markets, it

should not be possible for anyone to consistently earn above-market returns.

This theory is strongly disputed by many; the most cited example being of investors like Warren Buffett who have

consistently out-performed the market for several decades.

32
4
 3/($6((;3/$,1'2:7+(25<
3/($6((;3/$,1'2:7+(25<

Charles H. Dow was the founder & first editor of The Wall Street Journal; & co-founder of Dow Jones and Company.

After his death, William Peter Hamilton, Robert Rhea and E. George Schaefer organized and collectively represented

Dow theory, based on Dow's editorials. Dow himself never used the term Dow Theory nor presented it as a trading

system. The six basic tenets of Dow Theory are:

THE AVERAGE DISCOUNTS EVERYTHING

THE MARKET HAS THREE TRENDS, PRIMARY, SECONDARY, MINOR

MARKET TRENDS HAVE THREE PHASES, ACCUMULATION, ABSORPTION, DISTRIBUTION

AVERAGES MUST CONFIRM EACH OTHER

VOLUME MUST CONFIRM THE TREND

A TREND IS IN EFFECT UNTIL IT SHOWS A CONFIRMED REVERSAL

4 :+$7,67+(&$30"
:+$7,67+(&$30"

The CAPM model (1964) earned Professor Sharpe the Nobel Prize in Economic Sciences in 1990. CAPM can be

applied to an individual security or to a portfolio or to projects.

The Capital Asset Pricing Model of Sharpe & Lintner is theoretically a one-period, mean-variance theory of

equilibrium of expected return.

Assumptions of CAPM

* There are many investors; they are all price takers (they behave competitively)

* Markets are efficient & have infinite depth & breadth

* All investors have a uniform time horizon viz. one period & they all have the same information

* All assets are infinitely divisible (any fraction)

* Investors have seamless access to short-selling, unlimited securities are available for

borrowing/lending, unlimited funds are available for borrowing/lending

* Zero taxes, zero transaction costs, zero market imperfection costs

33
* All investors can borrow & lend funds at the risk-free rate

* Investors’ decisions are based on only two variables….expected return & risk: & they all have the

same expectations regarding distribution of returns

* Market portfolio consists of all publicly traded assets

* All investors are rational: they can & will undertake optimal diversification of their investment

portfolios on their own

The key in CAPM is the segregation of risk-components.

Sigma or standard deviation is a measure of total risk. This comprises systematic risk (or market risk, or beta, or

non-diversifiable risk) & unsystematic risk (or unique risk, or company-specific risk, or diversifiable risk)

The CAPM states that investors will be rewarded by the market only for the Beta or systematic risk because they

can & will diversify their portfolios until unsystematic risk is zero (near-zero)

The ex-ante expected returns in equilibrium (which is the same as the required return) on capital assets will be

4
T T ='
T ä
äT ?×
?×β
K H O H K

4
T 
'Z
'ZCPVGGZRGEVGFTGVWTPKPGSWKNKDTKWO4GSWKTGFTGVWTP
QHVJGUGEWTKV[QTRQTVHQNKQ
CPVGGZRGEVGFTGVWTPKPGSWKNKDTKWO4GSWKTGFTGVWTP
QHVJGUGEWTKV[QTRQTVHQNKQ
K

4
H  4KUM
4KUMHTGGTCVGQHTGVWTP 

'
T   'ZRGEVGF4GVWTPQPVJG/CTMGV2QTVHQNKQ
'ZRGEVGF4GVWTPQPVJG/CTMGV2QTVHQNKQ
O

β
+  $GVCQTU[UVGOCVKETKUM
$GVCQTU[UVGOCVKETKUMQHVJGUGEWTKV[QTRQTVHQNKQ
QHVJGUGEWTKV[QTRQTVHQNKQ

='
T ä
äT ? KUVJG4KUM
KUVJG4KUM2TGOKWOKGVJGGZVTCTGVWTPQXGTVJGTKUM
2TGOKWOKGVJGGZVTCTGVWTPQXGTVJGTKUMHTGGTCVGVJCVVJGOCTMGVKUGZRGEVGF
O H

VQFGNKXGTVQEQORGPUCVGHQTVJGOCTMGVTKUM
TKUM
VQFGNKXGTVQEQORGPUCVGHQTVJGOCTMGVTKUM
TKUMHTGGKPXGUVOGPVD[FGHKPKVKQPECTTKGUPQTKUMJGPEGVJGTGKU

PQ
PQTKUM
TKUMRTGOKWOCUUQEKCVGFYKVJKV
RTGOKWOCUUQEKCVGFYKVJKV

34
In other words, CAPM shows that there is a positive, linear relationship between the Beta & the Required

Return of an asset or a portfolio of assets. 2

Investors require a Risk Premium, or a reward for carrying risk (Not all risk, but only Beta)

Beta is the sensitivity of the stock returns, to returns on the market portfolio. Consider these statements:

Zero Risk = Risk-Free Return (Beta = 0)

Market Risk = Market Return (Beta = 1)

It follows logically, that if the systematic risk is higher than the market (Beta >1), required return will be higher,

because no one would like to take a higher risk for a given return, when there exists another investment option,

offering the same return, with lower risk.

e.g. R(f) = 8% Beta = 1.5

E(m) = 10% R(i) = ?

Using the CAPM, the Required Return is

Rf + B (Rm-Rf) = 8 + 1.5(10-8) = 11%

We can understand even intuitively, that when risk is lower, required return is lower & the CAPM substantiates this.

The asset under consideration is required to deliver a return based on its Beta (or systematic risk) vis-à-vis the market

portfolio. Greater the beta, higher would be the required return & vice-versa.

Caution: Nowhere in any rational literature will you see this equation

HIGHER RISK = HIGHER RETURN

Higher Risk does not guarantee higher return3. But any (rational) investor who accepts a higher risk, will do so only

if the returns compensate her/him for the additional risk.

4 :+$7,67+(6(&85,7<0$5.(7/,1(
:+$7,67+(6(&85,7<0$5.(7/,1("
6(&85,7<0$5.(7/,1("

2
While Sharpe, Lintner et al used “expected return”, as we have explained above, this is actually ex-ante, based on equilibrium &
is the “required return”, which is the term we shall use for the rest of this article. Expected Return is usually the sum of the
products of a probability distribution (of various states of nature) & the returns (given those states.)
3
If such was the case, everyone would have bet their life-savings on a lame horse with no chance in a race: & come away with
windfall profits!
35
The SML (Security Market Line) is the graphical representation of the CAPM. It shows the relationship

between beta & required return.

Illustration: Security Market Line

The slope of the SML is the Reward to Risk Ratio: {(Rm-Rf)/ß}

In the illustration above, Rf = 6%. The Market Portfolio (ß =1) is expected to deliver 10%.
Here, Risk-premium is (10-6) = 4%
Hence, an asset or portfolio with ß =1.25 will have a required return of

Rf 6

+ ß * Risk-premium 1.25 *4 = 5
= Rr 11

Illustration : What if Actual Price is Different from the Required Price? (SML)

Consider a security which plots above the SML. In effect, this offers a higher return for the given level of risk: if the

36
returns are higher (think yield also), the price must be lower, hence they are undervalued. Given the assumptions of

efficient markets & rational investors, there will be a greater demand for this security, leading to an increase in price;

& a reduction in its expected return, thus placing it finally on the SML, the market being in equilibrium.

If a security plots below the SML, it obviously delivers lower return for the same risk; ergo, its price is higher than

warranted. Rational investors will sell this investment, bringing the price down & increasing the expected returns:
until

it plots on the SML. This is the simple market mechanism to ensure equilibrium.

&$7,212)5,6.
4  :5,7($6+257127(21',9(56,),&$7,212)
:5,7($6+257127(21',9(56,),&$7,212)5,6.

It is imperative we study risk because it can prove to be the undoing of even the best minds in Security

Analysis.

The CAPM assumes that rational investors diversify the portion of risk which can be diversified & are hence

rewarded

only for Beta or Market Risk. 5LVNLVWKHSUREDELOLW\RIQRWDFKLHYLQJWKHGHVLUHGUHVXOW

Total Risk = Systematic Risk + Unsystematic Risk (Total Risk = Standard Deviation)

Illustration: Total Risk, Systematic (Non-Diversifiable) Risk, Unsystematic (Diversifiable) Risk & Diversification

From the figure four points are apparent

a) Total Risk is highest when there is no diversification

b) Beta (systematic, market, non-diversifiable) risk does not change with number of securities in the portfolio

37
c) Unique (market, diversifiable, unsystematic) risk can be removed with diversification4

d) Benefits of diversification become negligible beyond a point5

4 :+$7,67+(&+$5$&7(5,67,&/,1("
:+$7,67+(&+$5$&7(5,67,&/,1("

Illustration: The Characteristic Line

The Characteristic Line relates the return on the stock (Y- axis) to the return on the market (X- axis). Note that the

stock in the illustration above has a beta <1, hence it’s required return is 8% (less than the expected market return of

10%).

The slope of the characteristic line is BETA (dy/dx)

Recall that Beta of the security is defined as the covariance of the returns on the security with the returns on the

market portfolio, divided by the variance of the market portfolio.

Caution: A fairly common error: Beta of the Market is 16 but the market is not risk-free. We still have to

contend with variance or standard deviation of the market (as measures of total risk)

4 (;3/$,13257)2/,25(78513257)2/,2%(7$ 3257)2/,267$1'$5''(9,$7,21

Portfolio Return: is the sum of the weighted averages of the returns of the individual components in the portfolio

4
Thus making beta = total risk for all practical purposes
5
20 to 30 stocks with low or negative correlation suffice the goal of diversification
6
Sensitivity of returns of the market to sensitivity of returns of the market has to be 1
38
Portfolio Beta: is the sum of the weighted averages of the betas of the individual components.

Portfolio Risk however, is not just a weighted average of the standard deviations of the individual components.

This is a two security portfolio

Positive Correlation means the returns on the assets move in the same direction. Negative Correlation means the

returns on the assets move in opposite directions.

Correlation can be between -1 & +1, the signs signifying positive or negative & the value indicating the strength of

correlation between the returns on the two assets.

Standard Deviation

¦ (R − R )
T T

¦ (Rt − μ )
2 2
t
σ2 = t =1
s2 = t =1
T T −1
σ = σ2 s = s2

population sample

(T-1) in the denominator is to remove the sampling error.

Standard Deviation is a Measure of total risk

Correlation Coefficient

39
OR

Where Covariance is measured as:

OR

Understanding Beta

A high Beta by itself does not guarantee causation. For that, we must take help from:

R2 or Coefficient of Determination: which is the variability in one variable which is explained by the movement of

another

R2 is a more accurate measure of CAUSATION.

R2 = r2 (square of the correlation coefficient)

If r = .9, R2 = .9*.9 =.81

Since coefficient of determination is quite high, we can rely on Beta. In this instance, 81% of the returns on the

security are explained by the index while 19% of the returns on the stock are due to reasons other than the index.

4 +2:'2(6',9(56,),&$7,21+(/3"
+2:'2(6',9(56,),&$7,21+(/3"
(6',9(56,),&$7,21+(/3"

Take a look at this formula for standard deviation of a two-asset portfolio.

40
 When =1, the portfolio SD becomes a simple weighted average.

(This is because, if =1, there is essentially no diversification: exactly a similar stock portfolio)

So long as <1, (even if it is positive), SD of portfolio is less than the weighted average of the
standard deviations of the components of the portfolio

If < 0 (or negative), the benefits of diversification become more pronounced.

This is the risk-mitigating effect of diversification

In theory at least, we can have a RISK-FREE PORTFOLIO, when two securities with = -1 are
combined in a portfolio, in one, unique combination.

4
 :+$7$5(7+(/,0,7$7,2162)7+(&$30
:+$7$5(7+(/,0,7$7,2162)7+(&$30"
/,0,7$7,2162)7+(&$30"

The CAPM is an elegant, parsimonious model which condenses security analysis into a packet of logic that can be

easily understood, but it has its share of potentially fatal dangers & pitfalls.

1) The assumptions are quite impractical

2) The CAPM is based entirely on two factors, expected return & Beta. This is quite simplistic as clearly

acknowledged by Prof. Sharpe himself: “It’s funny how people tend to misunderstand the CAPM’s academic,

theoretical and scientific process. The CAPM was a very simple, very strong set of assumptions that got a nice,

clean, pretty result. And then almost immediately, we all said, let’s bring more complexity into it to try to get closer

to the real world.” (Burton, 2014)

3) Beta used is historical…it changes constantly & rapidly…hence blind reliance on beta is dangerous. Plus,

which measure is being considered...5 years beta, 1 year beta, monthly or weekly beta?

4) As we have seen, beta must be validated by R2

5) Even R2 may not be accurate, since it depends on correlation which is historic & subject to (drastic) change

6) The expected return on the market is an assumption…history has proved that this can be totally, violently

wrong

7) Finally, all the inputs are based on assumptions & the market….in other words, the market is used to

predict the market (neither the market being used, nor that being predicted, is a docile beast)

41
4 (;3/$,13257)2/,27+(25<
(;3/$,13257)2/,27+(25<

Consider this short-list of three available securities. The goal is to maximize portfolio returns, across a two security
portfolio, with lowest risk.

Security E (r ) SD
A 13.00% 15.00%

B 18.00% 25.00%

C 18.00% 20.00%
E (r): Expected Return. SD : Standard Deviation of returns, a measure of total risk.

Greek terms for financial investment:

• = E[R] (expected return)

• 2 = var(R) (variance of returns)
• = SD(R) (standard deviation of returns)
• ij = Corr(Ri, Rj) (correlation between returns of i & j)
• ij = Cov(Ri, Rj) = ij * i* j (covariance between returns of i & j)

n
Variance (σ 2 ) = ¦ [R i - E(R i )]2 Pi
i =1

n
Standard Deviation (σ ) = ¦ [R
i =1
i - E(R i )]2 Pi
Security A has lowest risk (measured by SD), but also, lower expected returns. B & C have identical expected
returns, but B has the highest risk, while C has moderate risk.

When two securities offer the same return, it is logical to choose the security with lower risk.

We can create an equal-weighted portfolio comprising A & C:

Portfolio A & C
Security E (r ) SD Wt

A 13.00% 15.00% 50.00%

C 18.00% 20.00% 50.00%

Portfolio
Return 15.50%
SD 17.50%
The portfolio return is simply the weighted average of the returns on each security.

4 (;3/$,13257)2/,25,6. 5,6.5('8&7,21

(;3/$,13257)2/,25,6. 5,6.5('8&7,21

42
 Riskiness of the portfolio considers not just the risk of each security, but also the covariance, which describes
how two variables move together, relative to their individual mean values, over time.

, or

Variance of the portfolio can also be calculated using correlation, which measures both, the strength of the
relationship, & the direction of movement.

σ p2 = w12σ 12 + w22σ 22 + 2 w1w2 ρ1, 2σ 1σ 2

Cov ij
rij =
σ iσ j
where :
rij = the correlation coefficient of returns
σ i = the standard deviation of R it
σ j = the standard deviation of R jt

Correlation can be between +1 & -1. A correlation of +1 implies that the returns on the two assets move in the same
direction, & change by the same percentage. A correlation of -1 implies that the returns of these two assets move in
opposite directions, but change by the same percentage. (Perfectly positively correlated & perfectly negatively
correlated, respectively)7

Thus, the risk of one asset may be cancelled out by another asset

Recall the portfolio above, 50% each in A & C. The expected portfolio return is 15.50% & expected SD (risk) is
17.50% (correlation between A & C is +1).

However, this is NOT THE OPTIMAL PORTFOLIO!

Consider an equal-weighted portfolio of A & B: (correlation between A & B is -0.25)

Portfolio A & B
Security E (r ) SD Wt

A 13.00% 15.00% 50.00%

B 18.00% 25.00% 50.00%

7
Most correlations observed in life, fall somewhere in between, with a majority of assets of the same class usually showing some
degree of positive correlation.

43
 Portfolio
Return 15.50%
SD 12.87%
The portfolio expected return is the same as a combination of A & C, but the expected SD of the portfolio is
not just lower than that of portfolioAB, but also lower than the SD of security A!

In other words, ADD RISK TO REDUCE RISK !!!8

Magic? No…..MARKOWITZ!

HARRY M. MARKOWITZ won the Nobel Prize in Economic Sciences in 1990, for his seminal contribution
“Portfolio Theory”.9

In general, his findings were

a) Investors prefer higher return to lower return

b) Investors prefer lower risk to higher risk

This gave rise to two path-breaking inferences.

1. For constructing an efficient portfolio, fundamental analysis was not required. The investor should only look
at mean (return), risk (SD) & correlation of the assets being considered

2. The efficient frontier could accommodate every conceivable investment portfolio, no matter what the risk
profile of the investor.

Consider two assets with expected returns & standard deviations as shown below

E(r) SD
Asset 1 8% 12%
Asset 2 13% 20%
The Risk Return trade-off can be calculated for different combinations (with differing correlations)

The following data represents a correlation of -1

Weight 1 Weight 2 E( r)P SD P

1 0 8.00% 12.00%
0.9 0.1 8.50% 8.80%
0.8 0.2 9.00% 5.60%
0.7 0.3 9.50% 2.40%
0.6 0.4 10.00% 0.80%
0.5 0.5 10.50% 4.00%
0.4 0.6 11.00% 7.20%
0.3 0.7 11.50% 10.40%
8
Subject to the securities being added having a negative correlation with existing asset(s).
Given correlation < +1, it is always possible to reduce portfolio risk, below the weighted average of the risk of individual
components.
9
The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1990: Harry M. Markowitz, Merton H.
Miller, William F. Sharpe. Each of them won this award for different research topics
44
 0.2 0.8 12.00% 13.60%
0.1 0.9 12.50% 16.80%
0 1 13.00% 20.00%

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ZĞƚƵƌŶ
ŽƌƌĞůĂƚŝŽŶͲϭ
ϭϱ͘ϬϬй
ϭϬ͘ϬϬй
ZŝƐŬǀƐZĞƚƵƌŶ
ϱ͘ϬϬй ŽƌƌĞůĂƚŝŽŶͲϭ
Ϭ͘ϬϬй
Ϭ͘ϬϬй ϭϬ͘ϬϬй ϮϬ͘ϬϬй ϯϬ͘ϬϬй ZŝƐŬ

4 &$121(+$9($=(52
&$121(+$9($=(525,6.3257)2/,2"
5,6.3257)2/,2"

In theory at least, it is possible to have a zero risk portfolio of two assets (provided their correlation of returns
is -1).

σ p = [ω 2σ 12 + (1 − ω ) 2 σ 22 − 2ω (1 − ω )σ 1σ 2 ]
σp = (ωσ 1 − (1 − ω )σ 2 )2
min risk
σ p = ωσ 1 − (1 − ω )σ 2 = 0
Ÿ ωσ 1 + ωσ 2 − σ 2 = 0
σ2
ω=
σ1 + σ 2
The formula for the zero risk, two asset portfolio, given correlation of -1.

w = weight of Asset 1, (1-w) = weight of Asset 2

From the table above, we can find the zero-risk portfolio as follows (also visible on the graph):

Weight 1 0.625
Weight 2 0.375
Portfolio Return 9.88%
Portfolio SD 0

4 :+$7,)7+(&255(/$7,21%(7:((17:2$66(76,6127
:+$7,)7+(&255(/$7,21%(7:((17:2$66(76,6127"
"

45
 ZŝƐŬǀƐZĞƚƵƌŶŽƌƌĞůĂƚŝŽŶнϭ
ϭϱ͘ϬϬй

ϭϬ͘ϬϬй
ZŝƐŬǀƐZĞƚƵƌŶ
ϱ͘ϬϬй
ŽƌƌĞůĂƚŝŽŶнϭ
Ϭ͘ϬϬй
Ϭ͘ϬϬй ϭϬ͘ϬϬй ϮϬ͘ϬϬй ϯϬ͘ϬϬй

No diversification at all. Correlation of +1 means portfolio SD will be a weighted average of the individual SDs
(+1 correlation is like investing in the same asset)

ZĞƚƵƌŶ ZĞƚƵƌŶǀƐZŝƐŬŽƌƌĞůĂƚŝŽŶϬ
ϭϱ͘ϬϬй

ϭϬ͘ϬϬй
ZĞƚƵƌŶǀƐZŝƐŬ͙
ϱ͘ϬϬй

Ϭ͘ϬϬй
Ϭ͘ϬϬй ϱ͘ϬϬй ϭϬ͘ϬϬйϭϱ͘ϬϬйϮϬ͘ϬϬйϮϱ͘ϬϬй

So long as correlation < +1, diversification will reduce total risk for the same levels of return

4 :+$7 $5( 7+( 0,1,080 9$5,$1&( 3257)2/,2 7+( )($6,%/( 5(*,21  7+( ()),&,(17
)5217,(5"

The straight line represents the risk return possibilities by combining A and B if correlation coefficient is +1.

The curved line (correlation here is -0.2) is always to the left of the straight line (diversification effect).

Portfolio 3 is the Minimum Variance Portfolio (actually, minimum standard deviation portfolio)

Feasible Region

Any investor considering a portfolio combination of A&B faces an opportunity, or feasible set, represented by the
area covered by AB 

46
From 1 to 3, SD decreases even though returns increase. Investors prefer higher returns for same or lower SD.
Hence, 3 dominates 1 & 2.

The Efficient Frontier

The Efficient Frontier is a set of all investment portfolios possible, which offer either

a) Highest returns possible for given amount of risk, or

b) Lowest risk possible for given expected return

Every rational, risk-averse investor will find a suitable investment portfolio, located on this efficient frontier,
combining individual preferences with the efficient frontier

The entire region from A to B is feasible, however investors will only consider segment 3 to B. This is called The
Efficient Set or The Efficient Frontier.

All points on this frontier are efficient portfolios

N-Securities & Efficient Frontier

In a multi-security case, the virtually endless possible portfolios are represented by the broken egg-shaped
region….feasible region.

Of prime importance is the Efficient Frontier, AFX which contains all the efficient portfolios. All portfolios below
the frontier are inefficient, because they are dominated by at least one portfolio on the frontier, which offers either:

a) Higher return for same risk, or

b) Same return for lower risk, or

c) Higher return for lower risk

47
4 :5,7($127(21,1',))(5(1&(&859(6
:5,7($127(21,1',))(5(1&(&859(6
,1',))(5(1&(&859(6

These represent investors’ preferences for risk and return.

Rules:

i) All points (portfolios) on the same indifference curve are equally valuable to the investor

ii) Indifference curves do not intersect

iii) The investor receives greater utility or value, on the indifference curves which are north-west (relative to the
existing one)

Tangency Portfolio

The optimal portfolio for any investor is the Tangency Portfolio, which is the point of tangency, between the
efficient frontier & the risk-return indifference curve

In the chart above, two investors, P & Q have three distinct indifference curves each, & given the efficient frontier
(beyond their control), have optimal portfolios, P* & Q* respectively, on the efficient frontier. They achieve their
highest utility with portfolios P* & Q*.

4 +2:'25,6.
+2:'25,6.
5,6.)5((,19(670(176
)5((,19(670(176),7,1:,7+
),7,1:,7+3257)2/,27+(25<"
3257)2/,27+(25<"

Risk-free investments are available (e.g. T-Bills) & investors have the option of either investing in the risk-free
asset, or borrowing at the risk-free rate, resulting in a new, more flexible, efficient frontier.

Fun Fact: Because of the shape of the curve, it is also called the MARKOWITZ BULLET

48
By definition, the risk-free asset has zero correlation with every risky asset or portfolio in the feasible region, hence
any portfolio comprising Risk-free asset & risky securities in the feasible region, will be represented by a straight
line.10

Risk-free Lending (investing)

Expected Return on the Portfolio

E(Rp) = Rf*wRf + E(Rx)*(1-wRf)

Risk-free = zero risk, hence SDP will be

Risk-free Borrowing

Investors are no longer restricted to their initial wealth when investing in risky assets.

Investors can:

Buy stock on margin

Borrow at the risk-free rate,

thus seeking higher expected returns while assuming more risk

In the chart above, we can clearly see the effect of Risk-free lending/borrowing. The point, Risk-free rate, is 100%
investment in risk-free asset, with zero risk & risk-free return.

The Tangency Portfolio is 100% investment in the market portfolio, with market return & market risk.

However, now one can also borrow (leverage) at the risk free rate, hence the line extends to include short selling (or
borrowing against) risk-free assets & investing in the market portfolio, with higher expected return, but also higher
risk.

This creates a new Efficient Frontier, defined by the borrowing & lending at risk-free rate.

In Reality, Borrowing Costs are higher than Lending Costs.

Rb = Borrowing Cost. The new Efficient Frontier is RFR-F-K-G

Assumptions

10
The line between the risk-free rate and the tangency portfolio is called the capital allocation line. Any investor who likes mean
and dislikes variance will want to hold a portfolio along this line.
49
“My work on portfolio theory considers how an optimizing investor would behave” (Harry. M .Markowitz,
2014)

i) Rational, risk-averse investors, each with the same information, same expectations, and same conclusions
given the available data

ii) Markets in equilibrium (asset markets are clear, supply = demand)

iii) Law of large numbers

iv) Investors prefer higher return to lower return & lower risk to higher risk

v) Investors are aware of their indifference curves (risk-reward)

vi) Investors can borrow & lend at the risk-free rate (unlimited amounts)

vii) Every investor uses portfolio theory to determine demand for & investment in risky assets

viii) Investors have access to & can process immense volumes of data (e.g. a portfolio with “n” variables will
have {n*(n-1)}/2 covariances. 50 assets = 1225 covariances)!

ix) Correlations remain constant. Historical averages are a fair predictor of expected returns

x) Investors are price takers

xi) Risk/volatility is constant & known.

xii) Securities are infinitely divisible

xiii) Asset returns are (jointly) normally distributed

4 :+$7,67+(6+$53(5$7,2"
:+$7,67+(6+$53(5$7,2"

Sharpe Ratio11 Reward-to-variability ratio:

rp − r f
Sharpe Ratio :
σp
(Portfolio return – return on the risk-free investment)/Standard deviation of the portfolio returns

It measures the excess returns per unit of total risk. Higher the Sharpe Ratio better is the performance.

Sharpe Ratio is appropriate when measuring the performance of an entire portfolio, since it considers both, portfolio
return, as well as total portfolio risk. Portfolio risk is based not just on the individual risk & weight of each security
in the portfolio, but also on the correlation between the securities.

Sharpe ratio penalizes undiversified portfolios with a higher denominator (SD), because generally total risk ≈
systematic risk only for relatively well-diversified portfolios. Standard deviation includes both positive & negative
divergences; hence even better than expected performance adversely affects the Sharpe ratio!

4 :+$7,67+(75(<1255$7,2"
:+$7,67+(75(<1255$7,2"

Treynor Ratio 12 Excess return to Beta ratio:

rp − r f
Treynor Ratio :
βp

11
Developed by Nobel Laureate William F. Sharpe in 1966. He called it the “reward-to-variability ratio”
12
Jack L. Treynor, “reward-to-volatility ratio”, 1965.
50
(Portfolio return – return on the risk-free investment)/Beta of the portfolio

It measures the excess returns per unit of market risk. Higher is better.

This ratio is also appropriate when measuring the performance of the parts of a portfolio. It helps to evaluate
securities or portfolios, for possible inclusion into an existing portfolio, using Beta (which is constantly changing)

4
 3/($6((;3/$,1-(16(16$/3+$
3/($6((;3/$,1-(16(16$/3+$
(16$/3+$

Jensen’s Alpha13 It is the measure of out/under performance of a portfolio, based on the CAPM

[
Jensen' s Alpha : α p = rp − rf + β p (rM − rf ) ]
Alpha is the excess return (or negative return) generated by the portfolio, w.r.t. the market portfolio, after considering
the risk premium, using Beta.

Required Return using CAPM or Capital Asset Pricing Model:

R(ri) = rf + [E(rm) – rf] × βi

Positive Alpha is generated when the actual return on the portfolio is in excess of the required return as per CAPM.

(Beta is used as the risk factor, & expected return on the market, less the risk-free rate is “the market risk premium.”)

Jensen’s Alpha is used to compare performance across portfolios or fund managers.

13
Michael Jensen first used Jensen’s Alpha in 1968, to evaluate performance of mutual fund managers.
51
SECTION D: FINANCIAL RISK MANAGEMENT

9. Financial Risks

4 :+$7,67+(',))(5(1&(%(7:((15,6.$1'81&(57$,17<"
:+$7,67+(',))(5(1&(%(7:((15,6.$1'81&(57$,17<"

Risk implies that we know every possible outcome, & the probabilities associated with each. The sum of the
probabilities equals 1 (the entire set of possibilities).

Uncertainty means: “I don’t know!”

We are faced with a conundrum: real life represents uncertainty, which we seek to address with the tools of risk
management.

4 :+$7$5(7+(5,6.6$&203$1<&$1)$&("
:+$7$5(7+(5,6.6$&203$1<&$1)$&("

* OPERATIONAL RISK

* FINANCIAL RISK

* ENVIRONMENTAL RISK

* REPUTATION RISK

4 :+$7$5(7+(0$,1),1$1&,$/5,6.6"
:+$7$5(7+(0$,1),1$1&,$/5,6.6"

* MARKET RISK

* CURRENCY RISK

* COUNTRY RISK

* CREDIT RISK

* LIQUIDITY RISK

* ASSET BACKED RISK

52
10. Financial Derivatives – Instruments for Risk Management

A word of caution: Human beings do not fully understand risk. (Author’s opinion)

Let us consider an example: It’s raining heavily. If I go for a walk, there is a 5% chance that I will slip, fall &
break my leg. Most of us would happily accept this risk & say, “Oh, that’s fine, then. Only 5% chance of
damage”.

God forbid, if I do fall & break my leg, will I break it 5%, or will I break it 100%?

It is imperative for us to understand not just a probability and an expected risk/return, but also, our ability to face this
risk, should the worst happen.

Hence, derivatives ….therefore the need to literally, look before we leap!

_________________________________________________________________

4 :+$7,6$),1$1&,$/'(5,9$7,9("
:+$7,6$),1$1&,$/'(5,9$7,9("

It is a financial instrument which derives its value from the underlying asset.

For e.g. A forward contract on gold is the derivative instrument, while gold is the actual, underlying asset

The price of the derivative contract will be closely linked to the price & changes in price, of the underlying asset; in
this case, gold.

However, the underlying could also be a random event, or a state of nature (like weather)

In fact, exotic, complex, hybrid & customized derivatives, while being instrumental in growth & protection, have
often had terrible consequences, when unchecked for sense & sensibility.

The Net Supply of the Derivative Instrument is ZERO. The supply of the Underlying, or Fundamental Asset, is a
reality.

Consider a future contract on the exchange, on Reliance Industries -

There can only be a derivative contract in existence, if there is a buyer and a seller, and both consent to the price,
executing the trade. Every single contract that exists has both, a buyer and a seller. If both close their positions, then
the net derivative position becomes ZERO.

Contrast this with the actual underlying asset, in this case, shares of Reliance Industries.

The company has issued equity shares and the total outstanding equity is Rs. 6,339 crore. This translates into a total
of 633.91 crore equity shares of Rs. 10/ each, fully paid-up. (Unaudited Financial Results half-year Ended September
30, 2019. https://www.ril.com/InvestorRelations/FinancialReporting.aspx)

These shares exist, even if no fresh buyers or sellers transact. In other words, the market cannot change the
outstanding equity base of Reliance Industries, no matter how many trades there are.

The market can increase or decrease the quantity of derivatives contracts outstanding, depending on number
of trades.

What are the underlying assets?

Most common

Stocks
Bonds
Commodities
Currencies

53
 Interest Rates
Which are the Common Financial Derivatives?

Forwards
Futures
Options
Swaps

4 :+<'(5,9$7,9(6"
:+<'(5,9$7,9(6"

Scenario 1

Consider a farmer, whose fresh crop of corn will be harvested in three months from now. He is unsure about the
price he will receive at that time. Will he get a buyer when he is in the market to sell corn, three months later?
Uncertain again.

A derivative contract will enable him to enter into a firm contract today, to sell a fixed quantity of corn, of an agreed
upon quality, at a mutually agreed price, at the time specified (in his case, three months).

Lo presto, the farmer now knows how much demand there is for his corn for delivery after three months (when he is
ready with his harvest) and he also knows what price he will receive for his produce. Uncertainty removed

Scenario 2

An IT company will receive its payment in US$, a month later. It is unsure about the rupee value of this receipt, at
that time.

Derivatives can enable this company to sell the receivables in US$ today, to lock into the prevailing US$/INR rate for
one month

Once again, the company has mitigated uncertainty. It has an assured buyer for the revenue flow in US$, more
importantly, it is assured of an exchange rate today, to enable sound planning.

Scenario 3

A long-term investor has a blue chip portfolio, which she is unwilling to liquidate. She does feel that the market may
fall in the near future, thus affecting her investments, negatively.

She can use derivatives today, sell now and buy later, amount linked to her portfolio value, to take advantage of any
fall in market values, while at the same time, retaining her portfolio to continue participating in all corporate benefits
therefrom

There are infinite possibilities, for buying or selling (sometimes, a combination of both) using derivatives to hedge
risk

Financial Derivatives are used for:

Speculation: A speculator is one who bets on a price movement, in her/his favor. In effect, speculators use
derivatives as a tool of LEVERAGE to enhance returns (or to lose more money, if they are proved wrong!)

Arbitrage: An arbitrageur takes advantage of a price differential in two markets, for the same asset, at the same
time. Essentially, she/he makes a (theoretically) riskless profit by buying the asset in the market with a lower price,
while simultaneously selling it in the market with a higher price.

Hedging: (Not to be confused with gardens) A hedger either owns the asset, or the right to the asset; or she/he
is a consumer of the asset, or a prospective consumer of the asset. Hedgers use F&O (futures & options) markets to
reduce their risk. (A perfect hedge would be one which eliminates risk, entirely)




54


4 3/($6((;3/$,17+(7<3(62)'(5,9$7,9(6
3/($6((;3/$,17+(7<3(62)'(5,9$7,9(6

FORWARD CONTRACT

A forward contract is

* a contract between two parties

* either on a one-on-one basis, or transacted on an OTC (Over-The Counter) Exchange
* binding on both parties
* completed with one buyer and one seller
* specific in terms of, the price of the underlying to be exchanged, the quality/type of the underlying,
the date of delivery, the quantity, and where applicable, the place and mode of delivery
* a customized contract wherein both parties to the contract must be consensus ad idem

e.g. if “A” agrees to purchase 100 kg of wheat from “B” at Rs. 40/ per kg, after 6 months, it is a forward contract.
Note that the quality, specifications, delivery terms are all clearly specified in the contract)

“A” is assured of a buyer of 100 kg, @ 40/ per kg, 6 months from now
“B” is assured of supply of 100 kg, @ 40/ per kg, 6 months from now

Win-Win situation, right? Uh, oh…..THERE IS COUNTER- PARTY RISK IN FORWARD CONTRACTS

Counter-party risk is the risk of default by one of the parties to the contract. This may not be mala fide, but it
happens. One person’s gain is another person’s loss. When the price of wheat becomes 55/ then “A” has every
incentive to default on a contract to deliver at 40/. The reverse would hold true, if the price of wheat crashed to
25/…in which case, “B” would be better off, not honoring the forward contract, but rather, purchasing the required
quantity in the spot market. With the best of intentions also, it is possible that one party is not able to fulfill her/his
commitment as per the forward contract.

FUTURES CONTRACT

A futures contract is:

* a contract between two parties

* executed thru a stock exchange
* binding on both parties (even though neither has inkling about the identity of the other)
* tantamount to the stock exchange being a counter-party to both, buyer & seller
* theoretically free from counter-party risk (by a process known as NOVATION, the stock exchange
clearing house becomes the buyer for the seller, and the seller for the buyer)
* standardized, as per the exchange regulations
* specific as to price, quantity, specifications, delivery date, terms etc.

4 ',67,1&7,21%(7:((1)25:$5' )8785(6&2175$&76

',67,1&7,21%(7:((1)25:$5' )8785(6 &2175$&76
&2175$&76

55
ŝƐƚŝŶĐƚŝŽŶĞƚǁĞĞŶ&ŽƌǁĂƌĚƐΘ&ƵƚƵƌĞƐ

 &ŽƌǁĂƌĚ     &ƵƚƵƌĞ     

Ύ ƵƐƚŽŵŝnjĞĚ     ^ƚĂŶĚĂƌĚŝnjĞĚ

Ύ WƌŝǀĂƚĞƚƌĂĚŝŶŐŽƌKd    WƵďůŝĐdƌĂĚŝŶŐŽŶdžĐŚĂŶŐĞ

Ύ ĞĨĂƵůƚZŝƐŬĞdžŝƐƚƐ    EŽĞĨĂƵůƚZŝƐŬ

Ύ ŶƚŝƌĞƚƌĂŶƐĂĐƚŝŽŶŝƐƐĞƚƚůĞĚďĞƚǁĞĞŶ  ^ƚŽĐŬdžĐŚĂŶŐĞŝƐƚŚĞŽƵŶƚĞƌͲƉĂƌƚLJ

 ƐĂŵĞƚǁŽƉĂƌƚŝĞƐ    ŚĞŶĐĞ͕ďŽƚŚƉĂƌƚŝĞƐĚĞĂůŽŶůLJǁŝƚŚƚŚĞ

       džĐŚĂŶŐĞ

Ύ ĂŶďĞĐůŽƐĞĚŽƵƚ͕ďƵƚŽŶůLJďLJ   ĂŶďĞĐůŽƐĞĚŽƵƚďLJĂŶLJƉĂƌƚLJ͕ĂŶLJƚŝŵĞ

 ŵƵƚƵĂůĐŽŶƐĞŶƚ    ŽŶƚŚĞĨůŽŽƌŽĨƚŚĞdžĐŚĂŶŐĞ

Ύ EŽůŝƋƵŝĚŝƚLJ     ,ŝŐŚůLJůŝƋƵŝĚ

And, in a futures contract, there is an initial margin collected up-front, plus a daily, MTM (mark-to market)
margin, which both, the buyer and the seller have to deposit with the exchange

4 :+<,6$)25:$5'&2175$&75,6.,(57+$1$)8785(&2175$&7"
:+<,6$)25:$5'&2175$&75,6.,(57+$1$)8785(&2175$&7"
&2175$&7"

The margins (initial & daily MTM) ensure that the maximum loss on a trade going awry is limited to just ONE
DAY’S VOLATILITY.

In all probability, if the risk-margining systems are well formatted, this one-day loss would be easily covered by the
initial margin.

Hence, the risk of default becomes negligible in a Futures Contract.

Contrast this with a Forward Contract, settled only on maturity, with no margining provision. The entire profit of one
party (or loss of the other), is paid out/in only on settlement date.

Some OTC exchanges now collect margins to negate this serious drawback of an otherwise very useful, customized
forward contract.

Nevertheless, it is apparent from the above, that there is higher risk of default in a forward contract, relative to a
futures contract; one part arising from counter-party risk, the other from lack of a robust margining system

4 :5,7($6+257127(2135,&,1*2)$)8785(&2175$&7
:5,7($6+257127(2135,&,1*2)$)8785(&2175$&7

PRICING A FORWARD OR A FUTURE CONTRACT

(In reality, there is a difference in the price of a forward and a future contract of same terms, on the same underlying
asset. Nevertheless, for an initial understanding, this base model is equally applicable in logic, to both)

Pricing a Forward or Future

S = Spot Price of the Underlying

F = Future/Forward Price
Also called
K = Strike Price (price contracted upfront in the contract)

t = Time to Maturity in Years

r = Interest Rate

56
For No-Arbitrage, it follows logically, that

F = S*(1+r)^(t) (discrete compounding)

F = S* e^(r*t) (continuous compounding)

This is the formula for continuous compounding, where ‘e’ is the Euler number with APPROXIMATE value
of 2.71828

Please remember the definition of arbitrage. If this formula does not hold good, then one can buy in the market
where price is lower, sell in the market where price is higher, pay interest on borrowing (whether cash or security)
and still make a riskless profit on expiry.

4
 :+$7,6$5%,75$*("*,9((;$03/(6
:+$7,6$5%,75$*("*,9((;$03/(6

Cash & Carry Arbitrage:

If F > S * (1+r)^(t)

Buy Cash (borrow money), sell Future today.

Sell Cash, buy Future on expiry, pay interest on borrowing and still make money

Example: Cash & Carry Arbitrage

57
^ƵƉƉŽƐĞƚŚĞĐƚƵĂůWƌŝĐĞŽĨƚŚĞ&ƵƚƵƌĞŝƐ ϴϱϰ͘ϳ
&х^Ύ;ϭнƌͿΔ;ŶͿ
dŚĞ/ŶǀĞƐƚŽƌǁŽƵůĚ
ŽŶϴͬϯͬϮϬϭϯ ƵLJŝŶĂƐŚ ϴϱϭ͘ϯ

^ĞůůƚŚĞ&ƵƚƵƌĞ ϴϱϰ͘ϳ

ŽŶϮϴͬϯͬϮϬϭϯ ^ĞůůƚŚĞ^ŚĂƌĞ
^ƵƉƉŽƐĞDĂƌŬĞƚWƌŝĐĞŽŶϮϴͬϯͬϮϬϭϯŝŶĂƐŚŝƐ ϵϬϬ

^ĞůůdŚĞ^ŚĂƌĞŝŶĂƐŚΛϵϬϬͬ
WƌŽĨŝƚ ϵϬϬͲϴϱϭ͘ϯ ϰϴ͘ϳ

WĂLJ/ŶƚĞƌĞƐƚ ϴϱϭ͘ϯΎ͘ϬϲΎ;ϮϬͬϯϲϱͿ ͲϮ͘ϴϬ

ƵLJƚŚĞ&ƵƚƵƌĞΛϵϬϬͬ
>ŽƐƐ ϴϱϰ͘ϳͲϵϬϬ Ͳϰϱ͘ϯ

1(7352),7 

Market Price on Expiry = 900/

58
^ƵƉƉŽƐĞƚŚĞĐƚƵĂůWƌŝĐĞŽĨƚŚĞ&ƵƚƵƌĞŝƐ ϴϱϰ͘ϳ
&х^Ύ;ϭнƌͿΔ;ŶͿ
dŚĞ/ŶǀĞƐƚŽƌǁŽƵůĚ
ŽŶϴͬϯͬϮϬϭϯ ƵLJŝŶĂƐŚ ϴϱϭ͘ϯ

^ĞůůƚŚĞ&ƵƚƵƌĞ ϴϱϰ͘ϳ

ŽŶϮϴͬϯͬϮϬϭϯ ^ĞůůƚŚĞ^ŚĂƌĞ
^ƵƉƉŽƐĞDĂƌŬĞƚWƌŝĐĞŽŶϮϴͬϯͬϮϬϭϯŝŶĂƐŚŝƐ ϴϬϬ

^ĞůůdŚĞ^ŚĂƌĞŝŶĂƐŚΛϴϬϬͬ
>ŽƐƐ ϴϬϬͲϴϱϭ͘ϯ Ͳϱϭ͘ϯ

WĂLJ/ŶƚĞƌĞƐƚ ϴϱϭ͘ϯΎ͘ϬϲΎ;ϮϬͬϯϲϱͿ ͲϮ͘ϴϬ

ƵLJƚŚĞ&ƵƚƵƌĞΛϴϬϬͬ
WƌŽĨŝƚ ϴϱϰ͘ϳͲϴϬϬ ϱϰ͘ϳ

1(7352),7 

Market Price on Expiry = 800/

59
Market Price on Expiry = 1,000/

NET PROFIT IS THE SAME, NO MATTER WHAT THE SPOT PRICE, ON EXPIRY
THAT’S ARBITRAGE

Reverse Cash & Carry Arbitrage:

If F < S * (1+r)^(t)

Buy Future, sell Cash today

Sell Future, buy Cash on expiry

Assumptions behind Arbitrage

No transaction costs
No taxes
Seamless lending and borrowing of both, funds and shares (at same rate)
CONVERGENCE

The assumptions can be modified to meet reality and still have a sound tool for trading, however it is only for those
with deep pockets and minimal costs. The profit we saw in our example, was only 60 ps per share. In perspective,
each contract of Reliance Industries is of 500 shares and those who would venture to execute this trade would
probably execute say, 10,000 contracts. Profit = .60 * 500 * 10000 = 3,000,000 (three million…not small
anymore)


4 :+$7,6&219(5*(1&("
:+$7,6&219(5*(1&("

60
The entire exercise above assumes one major event (normal and logical, but by no means
assured)…..CONVERGENCE

Arbitrage assumes that on expiry the Spot Price & the Futures Price will converge (become one and the same).
Notice that the closing legs of the transactions were executed at identical rates, for the arbitrage to hold true.

During the life-time of the contract, the futures price may be different from the spot (cash) price, but is assumed to
converge to spot price, on expiry

Contango: Futures price above spot price

Backwardation: Spot price above futures price

BASIS: S – F (spot price – futures price). This often gives rise to what is known as basis risk. (If
basis is different at time of executing the contract and different at the time of closing out the contract)

4 (;3/$,17+(&21&(372)3$<
(;3/$,17+(&21&(372)3$<2))
2)),1)8785( )25:$5'&2175$&76
,1)8785( )25:$5'&2175$&76

Long Position: S – F or S - K (S = spot price, F or K = strike price)

Short Position: F – S or K – S

If I have purchased one contract @ 750/ per share (F or K) & the spot price is 780/, payoff is + 30/ per share
For the person who sold the contract to me, has a payoff of -30/ per share

Caution: It is usually stated that both, profits and losses in a derivatives contract, are unlimited. The caveat is
that asset prices cannot go below zero

The person who sold the contract @ 750/ can lose an unlimited amount (sold, hence will lose when price rises and
gain when price falls) but profits are limited to the share price, viz. 750/

In similar vein, I have purchased the contract @ 750/ per share. Theoretically, my profit is unlimited, but my loss is
limited to 750/ being the cost per share
61
The charts above make this point abundantly clear
4 :+$7$5(237,216"
:+$7$5(237,216"

An Option

Gives the Buyer the Right but Not the Obligation, to Buy or Sell a contracted quantity of the Underlying, at
a pre-determined Price, on or before a specified Date.

This is a blatantly, one-sided contract: only one party seems to benefit, hence the Buyer of the Option pays to the
Seller or Writer, an amount upfront, called the Option Premium

The Seller (or Writer) of the Option HAS THE OBLIGATION, (BUT NO RIGHT ) to COMPLY WITH THE
RIGHT OF THE BUYER OR OPTION HOLDER

Call Option:

Gives the buyer the right (without obligation)

To Purchase the Underlying

Put Option

Gives the buyer the right (without obligation)

To Sell the Underlying

There is a buyer & a seller for both, call & put options

The Profit of the Buyer is Unlimited, Loss is limited to the Option Premium paid

The Profit of the Seller is limited to the Option premium paid, the Loss is Unlimited

Options Explained:

European Options: Can be exercised only on maturity

American Options: Can be exercised at any time, on or before maturity

Please Note, this pertains only to exercise. The Options can be bought or sold at any time (an open position can be
closed out at any time)

Expiration date – the date the option matures.

Exercise price - the contracted price at which the option can be exercised

Covered option – an option written against stock held in an investor’s portfolio.

Naked (uncovered) option – an option written without the stock to back it up.

In-the-money call – a call option whose exercise price is less than the current price of the underlying stock. K < S

Out-of-the-money call – a call option whose exercise price exceeds the current stock price.
K>S

At-the-money call – a call option whose exercise price is equal to the current stock price.
K=S

In-the-money put – a put option whose exercise price is more than the current price of the underlying stock. K > S

Out-of-the-money put – a put option whose exercise price is less than the current stock price. K < S

62
At-the-money put – a put option whose exercise price is equal to the current stock price.
K=S

4 (;3/$,1|,1
(;3/$,1|,17+(021(<$7
7+(021(<$7
$77+(021(<
7+(021(< 2872)021(<}
2872)021(<}

Suppose for a Call option: K = 85/. S = 100/.

S > K, hence it is in the money

If this were a put option: it would be out of the money

The logic is simple. You have purchased the call with a strike price of 85/

Today, the market price is 100/. In other words, you have a special right to purchase at 85/, while the rest of the
world can only buy today, at 100/

Should this right (option) have value? Certainly . Hence, the call option is in the money

Suppose this were a put option. You had the right to sell the underlying @ 85/ when the market price is actually
100/. Would you consider this option (right) valuable? Not at all, since you would be better off, ignoring your right
& selling at the current market price.

Hence, the put option is out of the money

4 6+2:+2:352),76 3$<

6+2:+2:352),76 3$<2))6',))(5,1237,216
2))6',))(5,1237,216

Long Call: The buyer of the call has paid a premium. There is no further obligation, hence this is the maximum
loss, irrespective of the price of the underlying, during the life-time of the call option. Once the spot price moves
above the strike price, the option will have a positive payoff for the buyer, but there will still be a loss, since
premium has been paid, which is yet to be recovered. When S = K + p (Spot price = Strike price + premium), the
option is at break-even point.

When S > K, the call option is in-the-money & has a payoff

63
 When S > K + p, the call option shows profit

Short Call: The seller of the call is in a position, which is a reflection (in water) of the buyer

Profit is limited to premium collected, payoff, break-even and loss are the reverse as those of the buyer.

Long Put: The buyer of a put is bearish on the stock (usually, we do not connect buy with bearish). The put gives an
option to sell, which means the buyer of the put expects the price to come down.

Loss is restricted to the premium paid, payoff starts when K > S, break-even occurs when K = S + p, profit begins
after K > S + p

When K > S, the put option is in the money.

Short Put: The seller of the put option is actually bullish or neutral on the underlying

As explained above & visible in the chart, payoff, break-even & loss are the image (in water) of the buyer of the put

4 :+,&+)$&7256'(7(50,1(237,2135,&(6"
:+,&+)$&7256'(7(50,1(237,2135,&(6"

Factor Call Value Put Value

Increase in Stock Price Increases Decreases

Increase in Strike Price Decreases Increases
Increase in variance of underlying asset Increases Increases
Increase in time to expiration Increases Increases
Increase in interest rates Increases Decreases
Increase in dividends paid Decreases Increases

Value of an Option (can never be negative)

Suppose S = 100/ K = 90/

If this is a call option, its intrinsic value is 10/ Max(S-K,0)

If this is a put option, its intrinsic value is 0 : Max(K-S,0)

Suppose the Premium on the Call option shown above is 15/, then the Time Value of the Option is 5/ (Premium –
Intrinsic Value)

For the Put Option above, if the premium was 6/, the entire amount would be the Time Value, since the Intrinsic
Value is zero.

Time Value diminishes constantly, as time elapses & becomes zero on Expiry (also known as time decay)

c = value of an European Call Option

C = value of an American Call Option

p = value of an European Put Option

P = value of an American Put Option

Usually, because of the entitlement to early exercise, C c

64
 P p

4 ',67,1&7,21%(7:((1237,216$1')8785(6
',67,1&7,21%(7:((1237,216$1')8785(6

Options Futures

*Buyer has the right, Both have an obligation

Seller has the obligation

*Premium is the price paid No Premium

by the Buyer

* No Margin for Buyer Both parties pay a Margin

Seller has to pay a Margin

* Can expire, un-exercised Has to be closed either by reversing the trade or by

delivery/purchase

* No MTM Daily MTM

4 '(),1(+('*,1*
'(),1(+('*,1*
+('*,1* ,76
,7652/(,15,6.0$1$*(0(17
52/(,15,6.0$1$*(0(17

HEDGING DOES NOT MAXIMIZE PROFIT.

HEDGING IS A RISK MITIGATION OR RISK ELIMINATION TOOL

OFTEN, IT WILL APPEAR THAT THE HEDGE RESULTED IN SUB-OPTIMAL PROFITS

Hedging With Futures…..Long Hedge

Suppose

Commitment to buy 1000 barrels of crude oil after 3 months at the then prevailing spot price say S

Futures Price for delivery after 3 months = 98.75

Strategy

Go long a 3 months future contract to lock in a price now

At maturity go short futures to close the position

65
Please remember: Assumptions, convergence: no transaction costs: no taxes

Hedging With Futures…..Short Hedge

Suppose

Commitment to sell 1000 barrels of crude oil after 3 months at the then prevailing spot price S

Futures Price for delivery after 3 months = 98.75

Strategy

Go short a 3 months future contract to lock in a price now

At maturity go long a future to close the position

Please remember: Assumptions, convergence: no transaction costs: no taxes

4 :+$7$5(6:$36
:+$7$5(6:$36"(;3/$,17+(&21&(372)
6:$36"(;3/$,17+(&21&(372)|
"(;3/$,17+(&21&(372)|,17(5(675$7(6:$3}
,17(5(675$7(6:$3}

A Swap is an agreement between two counterparties to exchange cash flows on specific dates, based on the terms of
the contract entered into

In an interest rate swap, the Principal amount does not change hands. Interest payments are exchanged, based
on the “NOTIONAL PRINCIPAL”

INTEREST RATE SWAPS DO NOT GENERATE NEW FUNDING: THEY MERELY CONVERT THE PAYMENT OF
INTEREST, FROM FIXED TO FLOATING RATE & VICE VERSA (Plain Vanilla Swap)

Types of Swaps

Currency

Interest Rate

Equity

Commodity

Others

Example “Plain Vanilla” Interest Rate Swap (IRS)

“A” has borrowed US$ 100 million @ 6 month LIBOR for 3 years

66
But “A” has inflows which are of a fixed rate

Hence, there is the risk of a cash flow mismatch & an Interest Rate Risk (if LIBOR increases)

For “A” to enter into an IRS, there must be a counter-party “B”, with a different view on the market, or an opposing
requirement

“A” agrees to receive 6 month LIBOR from “B” & to pay “B” a fixed rate of 5% p.a. (payable HLY) for 3 years (i.e.
6 * HLY interest transactions)

Notional Principal is US$ 100 million

Cash Flows for “A” Million US$ (NOTIONAL PRINCIPAL US$ 100 MN)

Date LIBOR FLOATING FIXED NET CASH FLOW

RATE CASH FLOW CASH FLOW FROM SWAP

5/3/2004 4.2%

5/9/2004 4.8% +2.10 -2.50 -0.40

5/3/2005 5.3% +2.40 -2.50 -0.10

5/9/2005 5.5% +2.65 -2.50 +0.15

5/3/2006 5.6% +2.75 -2.50 +0.25

5/9/2006 5.9% +2.80 -2.50 +0.30

5/3/2007 6.4% +2.95 -2.50 +0.45

(Interest is set every 6 months, in advance)

Let us combine this cash flow with the floating outflow as per “A”’s original contract

Date Floating Cash Flow Cash Flow From Swap Net Cash Flow

Payable US$ million Payable

5/9/2004 -2.10 -0.40 -2.50

5/3/2005 -2.40 -0.10 -2.50

5/9/2005 -2.65 +0.15 -2.50

5/3/2006 -2.75 +0.25 -2.50

5/9/2006 -2.80 +0.30 -2.50

5/3/2007 -2.95 +0.45 -2.50

Voila! “A” now has a guaranteed payable of 2.50% every 6 months, or 5% p.a., irrespective of the LIBOR

High Points for this Swap

If LIBOR > 5%, then fixed payer receives the interest differential.

67
If LIBOR < 5%, then floating payer receives the interest differential.

If LIBOR =5%, then neither party receives nor pays anything.

4
 3/($6((;3/$,1&$36
3/($6((;3/$,1&$36)/2256 &
&$36)/2256 &2//$56
)/2256 &2//$56
2//$56

Cap Buying a cap means buying a call option, or a succession of call options, with interest rates as the
underlying. This is an insurance against excessive interest rates & is used by borrowers who are exposed to interest
rate volatility.

If interest rates rise above the cap rate, the buyer of the call option is protected. The seller (writer) compensates the
buyer. There is as usual, an upfront premium, & a cap agreement could have a single, or multiple exercise dates.

Floor The buyer of a floor purchases a put option on interest rates. If rates fall below the floor, the seller will
compensate the buyer (on payment of an upfront premium).

This is like an insurance plan for the investor or lender who receives floating interest & protects against excessive
volatility. As with caps, there could be one, or many exercise dates.

Collar A simultaneous position in a cap & a floor is called a collar. The agreement could be buying both, a cap & a
floor (excessive volatility expected, direction uncertain); or purchase of a cap while writing a floor (to finance the
cost of the cap, if the FI is a borrower); or write a cap & purchase a floor (to finance the cost of the floor, when the FI
is a lender).

4 '(021675$7(7+(5,6.62)
'(021675$7(7+(5,6.62)/(9(5$*,1*:,7+'(5,9$7,9(6

Consider the following:

Investor “A” buys 500 shares of Reliance @ 1,000/. After 3 months, the price is 1,200/

Investor “B” buys 1 futures contract (lot size, 500 shares) of Reliance with strike price of 1,000/ (upfront margin is
20%)

The comparative statement highlights the lure of derivatives

Investor Investment Profit Profit as % of investment

A 500,000 100,000 20%

B 100,000 100,000 100%

Suppose the price fell to 800/

The following table shows how capital can be severely dented

Investor Investment Profit Profit as % of investment

A 500,000 -100,000 -20%

B 100,000 -100,000 -100%

4
 :+$7,67+(%,120,$/237,2135,&,1*02'(/"

68
The Binomial Option Pricing Model14 is an extremely popular, robust method of calculating option prices. Its

chief advantages are its flexibility to incorporate market realities, and its simplicity.

Assumptions

* Stock price follows a multiplicative binomial process over discrete time periods

* There are two possible outcomes at the end of each time period, up and down (from the current price)

* Investors are risk-neutral

* Markets are efficient

* Transaction costs, taxes, bid-ask spreads and margin requirements are ignored

* Interest rate is constant. Individuals may borrow or lend as much as they wish at this rate.

* No dividends

Explanatory Notes:

We may question the utility of a method which assumes only two possible outcomes, but in reality, security prices

do have a “tick size” for each movement, and the period can be shortened at will. Now it makes sense.

Risk Neutral: (https://cyber.law.harvard.edu/bridge/LawEconomics/risk.htm)

“To illustrate, suppose Mary owes Joe $100. She says to him, "I'd be happy to pay you the $100 right now.

Alternatively, you can flip a coin. If it comes up heads, I will pay you $200 right now. If it comes up tails, I will pay

you nothing. Which do you want?" If Joe answers, "I don't care," he is risk-neutral. If he prefers the first option, he is

risk-averse. If he prefers the second, he likes to gamble”

How it works

A replicating portfolio uses a combination of risk-free borrowing/lending and the underlying asset to create a

portfolio that has the same cash flows as the option being valued. The principles of arbitrage apply here and the value

of the option must be equal to the value of the replicating portfolio.(Ionization et al., n.d.)

Call Option

14
The paper was titled, “Option Pricing: A Simplified Approach”
69
S = 40

K = 45

u = 25%

d = -10%

r = 5%

(Su = 50, call is in the money, value 5.

^ƵϱϬ
K 45 Sd = 36, call is out of the money, value 0)
Ƶϱ
^ϰϬ S = spot price
Đ͍ ^Ěϯϲ
ĚϬ
K = strike price

T=0 T=1 u = % increase in price over 1 period

d = % decrease in price over 1 period

Su= price uptick, at end of 1 period (40*1.25=50)

Sd= price downtick, at end of 1 period (40*0.9=36)

r = risk-free rate of interest15

c = value (premium) of the call option at time 0

Cu = Value of Call at end of 1 period, if spot price is Su

Cd = Value of Call at end of 1 period, if spot price is Sd

The Replicating Portfolio Approach

Buy Δ shares of stock and borrow an amount B. This should have the same value as holding the call (else, there

would be an arbitrage opportunity)

15
For no arbitrage, it is essential that u > r > d
70
(Delta? Δ (Delta) is the riskless hedge ratio; 0 < Δc < 1

It is the number of shares purchased to hedge one call sold. Put differently, it is the sensitivity of the change in price

of the call option, to change in the price of the underlying.)

Replicating Portfolio continued:

The value of this portfolio in the two states would be

Up Δ(1+u)S0 + (1+r)B = Cu

Down Δ(1+d)S0 + (1+r)B = C

d

C u − Cd Cu − Cd
= = Eq. 1
(u − d)S S u − Sd

= (5 – 0)/(50-36) = 5/14 = 0.357143

* This is also called the Hedge Ratio and it is the sensitivity of the change in option price w.r.t. change in price of the

underlying (option Delta)16

(1 + u)C d − (1 + d)C u
B= Eq. 2
(u − d)(1 + r)

= -12.2449 (discrete discounting)

This is the amount borrowed, on which interest must be paid.

Value of the call today, c= ΔS + B = (.357143 * 40) -12.2449 = 2.0408 17

“….all we needed to determine the exact value of the call was its striking price, underlying stock price, range of

movement in the underlying stock price, and the rate of interest. What may seem more incredible is what we do not

need to know: among other things, we do not need to know the probability that the stock price will rise or

fall. Bulls and bears must agree on the value of the call, relative to its underlying stock price!” (Cox et al., 1979)

The Risk Neutral Approach:

We can determine the probability of an up-move

16
The delta changes as the parameters driving it change
17
Discrete discounting is used here, usually, continuous discounting will be used
71
p= r–d Eq. 3

u–d

and the probability of a down-move

1-p, or u – r Eq. 4

u–d

The value of the call is:

c= [pCu + (1-p)Cd] Eq. 5

(1+r)

i.e. expected value of the Call at the end of the period is

probability of up-move * value of call given up-move + probability of down-move * value of call given down-move

This is discounted at the risk-free rate to arrive at the present value of this call option.

It should be exactly the same as the value calculated above. Solving,

Risk Neutral World: all assets are priced such that the return equals “r”, the risk-free rate

Proof:

1) In our example, the spot price today of the stock should be equal to the present value of the discounted

expected value at the end of Period 1.

72
2) The value of the portfolio should replicate holding the call, irrespective of the state of the market.18

3) No Arbitrage: (Options, Futures and Other Derivatives, 9th Edition, 2014, John C. Hull)

Suppose a stock is currently priced at $20

In 3 months, it will be either $22, or $ 18 (either 10% up or 10% down)

Suppose a 3-month call option on this stock has a strike price of 21

Stock Price = $22

Option Price = $1
Stock price = $20
Option Price=?

Stock Price = $18

Option Price = $0

18
A fundamental property of assets & options, is that their price cannot be negative
73
For a portfolio that is long shares and short 1 call option, the values are

When the spot price is 22, the call option (21 strike price) is in the money, with value of 1. Hence, the writer (seller)

of the option has a loss of 1. She also holds shares, hence value of her portfolio is

22 -1

When the spot price is 18, the call option is out of the money, hence value is 0. She also holds shares, hence value

of her portfolio is

18

Please remember, we assumed a risk-neutral world & this was supposed to be a risk-free portfolio. In effect, no

matter what the stock price after 3 months, the portfolio value should be identical, viz.

22 - 1 = 18 or, 4 =1

Solving, we find that = 0.25

Valuing The Portfolio

Risk-free rate 12% (assume)

This (riskless) portfolio is

long 0.25 shares

short 1 call option

a) The value of this portfolio in 3 months is (uptick)

22 - 1 = 22 * .25 -1 = 4.50

74
The value of the portfolio today is 19

4.5e–0.12×0.25 = 4.3670

4.50 is the value after 3 months, this is discounted at the risk free rate (12%) for 3 months (0.25), using continuous

discounting (raised to -.12 because we wish to discount it, not compound it)

In this portfolio, the value of shares today is 20 * .25 = 5

The portfolio is valued at 4.3670,

Hence the value of the call option today (option premium) must be 5 – 4.3670 = 0.633

b) The value of this portfolio in 3 months is (downtick)

18 = 18 * .25 = 4.50

(the portfolio has the same value after three months, whether the stock is up or down)

The value of the portfolio today is

4.5e–0.12×0.25 = 4.3670

In this portfolio, the value of shares today is 20 * .25 = 5

The portfolio is valued at 4.3670,

Hence the value of the call option today (option premium) must be 5 – 4.3670 = 0.633

Value of a Put (One Period)

The Risk Neutral Approach:

Stock prices are volatile. It is universally accepted that rational investors prefer higher returns to lower returns &
lower risk to higher risk. As a result, higher the risk in a stock, higher should be the required return (lower the price,
higher the expected return).

This risk premium is built into the market price of the stock. Given two identical companies with exactly the same
cash flows, the one with higher risk will trade at a lower price, while the company with lower risk will trade at a
higher price in the market.

An option however, derives its value from the underlying, in this case, the stock. Given that risk is already factored in
the spot price; the option price actually reflects a risk-neutral world, where the expected return is the risk-free rate of
interest.

Having understood the risk neutral approach to option pricing, let us move on to the calculations.

19
Continuous compounding/discounting
75
We can determine the probability of an up-move

rT
p= e -d
u-d Eq. 1

and the probability of a down-move

1-p Eq. 2

The value of the put is:

P= e-rT [pPu + (1-p)Pd] Eq. 3

i.e. expected value of the Put at the end of the period is

Probability of up-move * value of put given up-move + probability of down-move * value of put given down-move

This is discounted20 at the risk-free rate to arrive at the present value of the put option.

Put Option

S = 40

K = 45

u = 25%

d = -10%

r = 5%

S = spot price

K = strike price

u = % increase in price over 1 period

d = % decrease in price over 1 period

Su= price uptick, at end of 1 period (40*1.25=50)

Sd= price downtick, at end of 1 period (40*0.9=36)

r = risk-free rate of interest21

T = time in years

p = value (premium) of the put option at time 0

Pu = Value of Put at end of 1 period, if spot price is Su

Pd = Value of Put at end of 1 period, if spot price is Sd

20
Continuous compounding/discounting
21
For no arbitrage, it is essential that u > r > d
76
Given the risk free rate of 5%:

Probability of price going up by 25%


(from 40/ to 50/) is 0.432203
 ^ƵϱϬ
<ϰϱ WƵϬ Probability of price going down by 10%
(from 40/ to 36/) is 0.567797
^ϰϬ
Ɖ͍

^Ěϯϲ
WĚϵ

dсϬ dсϭ

(Su = 50, put with strike price 45 is out of the money, hence value = 0.

Sd = 36, put with strike price 45 is in the money, hence value = 9.)

Valuing a Put (two period)

Assume the stock price today is 50, each time-step is 1 year, & each move is 20%

r = 5% risk-free rate

S = 50 spot price

K = 52 strike price

d = 0.8 down move

u = 1.2 up move

77
p = 0.6282 probability of up move

1-p = 0.3718 probability of down move

Explanation

78
If This was an American Option

However, since the option is American, it can be exercised at any time before maturity.

79
The discerning reader will have noticed that at end of Year 1 (down move), the price is 40. Given that the strike price
is 52, this put option is in the money by an amount of 12 & it makes sense to exercise it early, since 12 is clearly
greater than the no-arbitrage BOPM value of 9.46393.

For this American Put Option, the value today, at node 50 is now 5.089632, HIGHER THAN 4.192654, which
would be the value of the European Option.

4 :+$7,67+(%/$&.6&+2/(60(572102'(/
:+$7,67+(%/$&.6&+2/(60(572102'(/"
%/$&.6&+2/(60(572102'(/"

Scholes & Merton won the Nobel Prize for this seminal work. (Fischer Black unfortunately, died before he could
receive his accolades from the Nobel Committee, though they did break from tradition & make special mention of his
contribution. The Nobel Prize is not awarded posthumously)

Black & Scholes

In their seminal work, The Pricing of Options & Corporate Liabilities22, Fischer Black & Myron Scholes introduced
a revolutionary method of valuing options.

22
The Pricing of Options and Corporate Liabilities Author(s): Fischer Black and Myron Scholes Source: The Journal of Political
Economy, Vol. 81, No. 3 (May - Jun., 1973), pp. 637-654 Published by: The University of Chicago Press
80
Ideal Conditions

The Black-Scholes formula is derived under the assumption of “ideal conditions”, viz.

a) The short-term interest rate is known and is constant through time.

b) The stock price follows a random walk23 in continuous time24 with a variance rate proportional to the
square of the stock price. Thus the distribution of possible stock prices at the end of any finite interval is log-
normal25. The variance rate of the return on the stock is constant.

c) The stock pays no dividends or other distributions.

d) The option is “European,” that is, it can only be exercised at maturity.

e) There are no transaction costs in buying or selling the stock or the option.

f) It is possible to borrow any fraction of the price of a security to buy it or to hold it, at the short-term interest
rate.

g) There are no penalties to short selling. A seller who does not own a security will simply accept the price of
the security from a buyer, and will agree to settle with the buyer on some future date by paying him an amount equal
to the price of the security on that date.

Under these assumptions, the value of the option will depend only on the price of the stock and the time and on
variables that are taken to be known constants.

Thus, it is possible to create a hedged position, consisting of a long position in the stock and a short position in the
option, whose value will not depend on the price of the stock, but will depend only on time and the values of these
known constants.

The risk in the hedged position is zero if the short position in the option is adjusted continuously.

Let us see how this formula works, how the values change & why it must be used with caution.

23
The movements of an object or changes in a variable that follow no discernible pattern or trend.
24
Discrete time views values of variables as occurring at distinct, separate “points in time”, e.g. a digital clock which gives a fixed
reading of 12:00 for a while, then jumping to a new fixed reading of 12:01.
Continuous time views variables as having a particular value for infinitesimally short periods of time. By this definition, between
any two points in time, there exist an infinite number of other points in time. Differential equations are used in continuous time, vs.
difference equations (recurrence relations) in discrete time.
25
A log-normal distribution is a continuous probability distribution of a random variable whose logarithm is normally distributed.
A random variable which is log-normally distributed takes only positive real values.
81
Important:

* Delta of a call or a put is the sensitivity of the option price to change in price of the underlying.

* Risk-Neutral World: It is true that the real world is not risk-neutral, rational investors prefer higher
returns for taking on additional risk. This is reflected in the price of the share (underlying). Higher the risk, lower
the price.

However, when pricing an option in terms of the price of the underlying stock, risk preferences are
unimportant.

This assumption of a risk-neutral world is of immense importance in the valuation of financial derivatives,
which by nature are high-risk instruments.

Comprehension of these daunting expressions:

The price of a call option generally is the difference between the present value of what one expects to receive from
exercise of the option, and the present value of what one expects to pay on account of the exercise.

* S0N(d1) is the present value of the stock that the call holder expects to receive on exercise. Since N(d1) is
the delta of the call option, this term is the value of the stock currently embedded in the call.

* Xe-rTN(d2) is the present value of what the call holder expects to pay upon exercise. N(d2) is the risk-
neutral probability of the option finishing in the money (hence being exercised). If it is in the money, the call
holder will pay X (strike price)at time T. This is discounted to its present value today, at the risk-free rate of
interest.

* Similar logic applies to valuation of a put option. N(-d2) is the probability (in a risk-neutral world) of the
put finishing in the money. N(-d1) is the delta of the put option.

Notes

* The value of a call increases as t, r or v2 increase.

* The value of a put increases as t & v2 increase, & as r decreases.

* In every case, the option can never have a negative value, & it can have a maximum value equal to the
stock price.

* The Option is ALWAYS more volatile than the Underlying.

82
* If no dividends are paid out, the rational investor will not exercise a call option before maturity.
Hence, the value of an American call option (C) = value of a European call option (c).

* If dividend is paid out & there is no equivalent adjustment to the strike price, then the option holder
would prefer to exercise the call option just before the ex-dividend date & C >= c.

* Value of the American put option (P) >= Value of a European put option (p). In some situations, it
would be beneficial to exercise the put before maturity.

Examples of Black-Scholes Valuation (European Calls & Puts)

1. In The Money Call (Out of The Money Put)

Data
Stock Price 20
Duration 0.25
Exercise Price 17
Annual Risk-free
Rate 0.08
Annual Volatility 0.15
Dividend
Percentage 0.00

S0 = 20

K = 17

Duration = 0.25, or 3 months to expiry

Risk Free Rate = 8% p.a.

Annual Volatility = 15%

C S*N(d1) – K*e(-rT)*N(d2)

P K*e(-rT)*N(-d2) – S*N(-d1)

d1 2.4711
83
 d2 2.3961
N(d1) 0.9933
N(-d1) 0.0067
N(d2) 0.9917
N(-d2) 0.0083
SN(d1) 19.8653
SN(-d1) 0.1347
rT 0.0200
Ke(-rT) 16.6634
Call Option 3.3400
Put Option 0.0034
Expected Value of the Call Option 3.3400

Expected Value of the Put Option 0.0034

2. Deep In The Money Call (Deep Out of The Money Put)

Data
Stock Price 25
Duration 0.25
Exercise Price 17
Annual Risk-free Rate 0.08
Annual Volatility 0.15
Dividend Percentage 0.00

d1 5.4463
d2 5.3713
N(d1) 1.0000
N(-d1) 0.0000
N(d2) 1.0000
N(-d2) 0.0000
SN(d1) 25.0000
SN(-d1) 0.0000
rT 0.0200
Ke(-rT) 16.6634
Call Option 8.3366
Put Option 0.0000

3. In The Money Put (Out of The Money Call)

Data
Stock Price 25
Duration 0.5
Exercise Price 30
Annual Risk-free
Rate 0.08
Annual Volatility 0.40
84
 Dividend
Percentage 0.00

d1 -0.3618
d2 -0.6446
N(d1) 0.3588
N(-d1) 0.6412
N(d2) 0.2596
N(-d2) 0.7404
SN(d1) 8.9691
SN(-d1) 16.0309
rT 0.0400

Ke(-rT) 28.8237
Call Option 1.4867
Put Option 5.3104

4. Deep In The Money Put (Deep Out of The Money Call)

Data
Stock Price 15
Duration 0.5
Exercise Price 30
Annual Risk-free Rate 0.08
Annual Volatility 0.40
Dividend Percentage 0.00

d1 -2.1678
d2 -2.4506
N(d1) 0.0151
N(-d1) 0.9849
N(d2) 0.0071
N(-d2) 0.9929
SN(d1) 0.2263
SN(-d1) 14.7737
rT 0.0400
Ke(-rT) 28.8237
Call Option 0.0208
Put Option 13.8445

85
5. At The Money Call (At The Money Put)

Data
Stock Price 20
Duration 0.25
Exercise Price 20
Annual Risk-free Rate 0.08
Annual Volatility 0.15
Dividend Percentage 0.00

d1 0.3042
d2 0.2292
N(d1) 0.6195
N(-d1) 0.3805
N(d2) 0.5906
N(-d2) 0.4094
SN(d1) 12.3900
SN(-d1) 7.6100
rT 0.0200
Ke(-rT) 19.6040
Call Option 0.8113
Put Option 0.4153

6. At The Money Call (At The Money Put)..with lower risk-free rate

Data
Stock Price 20
Duration 0.25
Exercise Price 20
Annual Risk-free Rate 0.05
Annual Volatility 0.15
Dividend Percentage 0.00

d1 0.2042
d2 0.1292
N(d1) 0.5809
N(-d1) 0.4191
N(d2) 0.5514
N(-d2) 0.4486
SN(d1) 11.6178
SN(-d1) 8.3822
rT 0.0125
Ke(-rT) 19.7516
Call Option 0.7270
86
 Put Option 0.4786
As the risk-free rate is reduced, the call loses value while the put becomes more valuable.

7. At The Money Call (At The Money Put)..with higher volatility

Data
Stock Price 20
Duration 0.25
Exercise Price 20
Annual Risk-free Rate 0.08
Annual Volatility 0.25
Dividend Percentage 0.00

d1 0.2225
d2 0.0975
N(d1) 0.5880
N(-d1) 0.4120
N(d2) 0.5388
N(-d2) 0.4612
SN(d1) 11.7608
SN(-d1) 8.2392
rT 0.0200
Ke(-rT) 19.6040
Call Option 1.1974
Put Option 0.8014
An increase in volatility has a positive effect on the value of both, calls & puts.

8. At The Money Call (At The Money Put)..with increased time to expiry

Data
Stock Price 20
Duration 0.5
Exercise Price 20
Annual Risk-free Rate 0.08
Annual Volatility 0.25
Dividend Percentage 0.00

d1 0.3147
d2 0.1379
N(d1) 0.6235
N(-d1) 0.3765

87
 N(d2) 0.5548
N(-d2) 0.4452
SN(d1) 12.4698
SN(-d1) 7.5302
rT 0.0400

Ke(-rT) 19.2158

Call Option 1.8082

Put Option 1.0240

Increase in residual life of the option increases the values of both, calls & puts.

The Black-Scholes formulae are extremely popular & easy to use

* Option prices primarily depend on six variables: S, K, r, T, & dividend.

* Of these, two are contract variables (strike K & maturity T), three are market variables (spot price S,
interest rates r & dividend paid). Only one, volatility is not directly observable.

Caution

The Black-Scholes Equation does not consider tail-risks & its assumptions are extremely rigid. Blind faith in a
formula can prove disastrous.

4 '(6&5,%(620(237,21675$7(*,(6:+,&+$5(%8//,6+
'(6&5,%(620(237,21675$7(*,(6:+,&+$5(%8//,6+

* LONG CALL

Sp Spot Price Today

K Strike Price

c Premium (Paid)

S Settlement Price

88
Figure 1: Long Call

An investor who has a bullish opinion on the market but does not want to pay heavily for being wrong would opt for
purchasing a call. The upside is unlimited (after deducting premium). The maximum loss is limited to the premium
paid to purchase the call.

Break-Even Point: K + Premium Paid (45 + 8 = 53)

* BULL CALL SPREAD

Sp Spot Price Today

K1 Strike Price of Call 1

K2 Strike Price of Call 2

c1 Premium (Paid)

c2 Premium (Received)

S Settlement Price

89
Figure 2: Bull Call Spread

It entails a short position in a call with a higher strike price (OTM: Out-of-the-money) combined with a long position
in a call with a lower strike price (ITM: In-the-money). Both calls have identical expiry dates. It requires an initial
cash outlay.

Break-Even Point: K1 + Net Premium Paid (45 + 4 = 49)

* BULL PUT SPREAD

Sp Spot Price Today

K1 Strike Price of Put 1

K2 Strike Price of Put 2

p1 Premium (Received)

p2 Premium (Paid)

S Settlement Price

90
Figure 3: Bull Put Spread

It involves two puts with the same expiration, but different strike prices. The strike price of the put sold is higher than
the strike price of the purchased put, thus generating positive cash at the outset.

Break-Even Point: K1 - Net Premium Received (55 – 5 = 50)

* COVERED CALL

Sp Spot Price Today

K Strike Price

c Premium (Received)

S Settlement Price

Figure 4: Covered Call

91
* Security Prices cannot be negative hence maximum loss can be substantial, but not unlimited

An investor holds a stock but wishes to:

a) Earn some premium without taking additional risk, &/or

b) Sell at a certain price (which would be the strike price of the call sold + premium received)

As long as the call is not exercised, the investor retains the premium as additional income, which lowers her net
investment. This strategy cushions the downside only marginally, but much of the upside potential is forfeited, as
long as the call option is live.

Break-Even Point: Sp - Premium Received (50 – 8 = 42)

4 (;3/$,1620(%($5,6+675$7(*,(686,1*237,216
(;3/$,1620(%($5,6+675$7(*,(686,1*237,216

* LONG PUT

Sp Spot Price Today

K Strike Price

p Premium (Paid)

S Settlement Price

Figure 1: Long Put

It is a simple strategy to benefit from an expected fall in prices. If the price of the underlying falls below the strike
price, payoff starts. If the prices move up (against expectation), the maximum loss is the premium paid.

Break-Even Point: K - Premium Paid (50 - 3 = 47)

92
* BEAR PUT SPREAD

Sp Spot Price Today

K1 Strike Price of Put 1

K2 Strike Price of Put 2

p1 Premium (Received)

p2 Premium (Paid)

S Settlement Price

Figure 2: Bear Put Spread

A vertical spread where a put is purchased (expecting a decline) & another put with a lower strike price is written
(sold), to offset some of the cost. This strategy requires cash to set up.

Break-Even Point: K2 - Net Premium Paid (57 - 5 = 52)

* BEAR CALL SPREAD

93
Sp Spot Price Today

K1 Strike Price of Call 1

K2 Strike Price of Call 2

c1 Premium (Received)

c2 Premium (Paid)

S Settlement Price

Figure 3: Bear Call Spread

This is a vertical spread: two calls with the same expiration, but different strike prices. The strike price of the short
call (ITM) is below the strike price (OTM) of the long call, hence it generates a cash inflow at the outset.

Break-Even Point: K1 + Net Premium Received (45 + 4 = 49)

4 :+,&+$5(7+(1(875$/675$7(*,(686,1*237,216"
:+,&+$5(7+(1(875$/675$7(*,(686,1*237,216"

COLLAR

Buy Stock

Buy a put K1

Sell a call K2 K2>K1

S 50

Buy Put K1 45 Out of the Money

Sell Call K2 55 Out of the Money

94
 p 3

c 4

S Spot Price Today

K1 Strike Price of Put

K2 Strike Price of Call

p Premium (Paid)

c Premium (Received)

Figure 1: Collar

Upside Limited M ax. Profit K2 - S + Net Premium Received

Downside Limited M ax. Loss S - K1 - Net Premium Received
Break Even Point S - Net Premium Received

An investor writes (sells) a call option & buys a put option. Both the options have the same expiry date. The purpose
is to hedge a long position in the underlying stock. The strike price of the put acts as the exit price (floor) in a
downturn. The strike price of the call represents the upper price (ceiling) at which the investor is prepared to sell.

The stock is “collared” between these two strike prices

95
LONG CALL BUTTERFLY

Sell 2 calls K1 three strike prices

Buy 1 call K2 K2<K1 are equidistant
Buy 1 call K3 K3>K1

S 50
K1 50 (generally, ATM)
K2 46
K3 54

c1 6
c2 11
c3 2

Figure 2: Long Call Butterfly

Upside Limited Max. Profit K3 - K1 - Net Premium Paid High Strike - Middle Strike - Net Premium Paid
Downside Limited Max. Loss Net Premium Paid
Two Break Even Points Upper High Strike - Net Premium Paid
Lower Low Strike + Net Premium Paid

Two calls are written (sold) at a middle price, one call is purchased at the upper strike & yet another call is purchased
at the lower strike price (these three strike prices are equidistant). The short calls (sold at middle price) are generally
ATM (At The Money) The upper & lower strikes are the “wings” The middle strike price is the “body” All these
options expire on the same date.

Maximum Gain: If spot price on expiration = middle strike price, or K1

* SHORT CALL BUTTERLY

A short call butterfly consists of two long calls at a middle strike and short one call each at a lower and upper strike.
The upper and lower strikes (wings) must both be equidistant from the middle strike (body), and all the options must
have the same expiration date.
96
Expectation is to capture a movement outside of the wings.

Figure 3: Short Call Butterfly

^,KZd>>hddZ&>z

Upside Limited M ax. Profit Net Premium Received

Downside Limited M ax. Loss High Strike - M iddle Strike - Net Premium Received
Two Break Even Points Upper High Strike - Net Premium Received
Lower Low Strike + Net Premium Received

4 '(6&5,%($)(:92/$7,/,7<675$7(*,(6
'(6&5,%($)(:92/$7,/,7<675$7(*,(686,1*237,216
86,1*237,216

LON G STR AD D LE

Buy 1 call K1 K 1 =K 2
Buy 1 put K2

S 50
K1 50
K2 50

c1 3
p1 2

Figure 1: Long Straddle

Upside Unlimited M ax. Profit Unlimited

Downside Limited M ax. Loss Net Premium Paid
Two Break Even Points Upper Strike Price of Long Call + Net Premium Paid
Lower Strike Price of Long Put - Net Premium Paid

A Long Straddle is set up when the underlying is expected to be volatile. It entails buying a call & a put, on the same
underlying, at the same strike price, for the same expiry date. If the price moves substantially in either direction, one
of the options will have positive payoff.

97
SHOR T STR AD D LE

Sell 1 call K1 K 1 =K 2
Sell 1 put K2

S 50
K1 50
K2 50

c1 3
p1 2

Figure 2: Short Straddle

Upside Limited M ax. Profit Net Premium Received

Downside Unlimited M ax. Loss Unlimited
Two Break Even Points Upper Strike Price of Short Call + Net Premium Received
Lower Strike Price of Short Put - Net Premium Received

A Short Straddle is set up when the underlying is expected to show little or no volatility. It entails selling a call & a
put, on the same underlying, at the same strike price, for the same expiry date. The lower the actual volatility
experienced, the greater is the premium that the writer (seller) retains.

LONG STRANGLE

Buy 1 call K1
Buy 1 put K2 K1>K2

Figure 3: Long Strangle

Upside Unlimited Max. Profit Unlimited

Downside Limited Max. Loss Net Premium Paid
Two Break Even Points Upper Strike Price of Call + Premium Paid
Lower Strike Price of Put - Premium Paid
Buy a Call & a Put, both OTM (Out of the Money) to reduce cost compared to the Long Straddle. Same underlying &
same expiration date. (Please recall that if the call & put are both OTM, then it follows that the strike price of the call
is higher than the strike price of the put option)

98
SHORT STRANGLE

Sell 1 call K1
Sell 1 put K2 K1>K2

Figure 4: Short Strangle

Upside Limited M ax. Profit Net Premium Received

Downside Unlimited M ax. Loss Unlimited
Two Break Even Points Upper Strike Price of Call + Premium Received
Lower Strike Price of Put - Premium Received

Sell OTM put & call, same underlying, same expiration. (Please recall that if the call & put are both OTM, then it
follows that the strike price of the call is higher than the strike price of the put option)

99
11. Financial Risk Management in International Operations

4 :+$7,6)25(,*1(;&+$1*("
:+$7,6)25(,*1(;&+$1*("

Foreign exchange (forex), is simply the exchange of one country’s currency for another. For example when one
exchanges Indian Rupees for the U.S. Dollar or vice-versa.

When India imports crude oil, most of the contracts will be in U.S.$; hence the buyer must exchange rupees for
dollars & then remit these dollars as payment.

4 (;3/$,1)25(;0$5.(76
(;3/$,1)25(;0$5.(76
$,1)25(;0$5.(76

The global forex market works via phones & Electronic Communication Networks (ECNs). It is an OTC (Over- The-
Counter market), According to the Bank for International Settlements, trading in foreign exchange markets averaged
$6.6 trillion per day in April 2019. This is the largest market in the world.

The participants are governments and central banks, commercial banks, institutional investors, financial institutions,
currency speculators, corporations, and individuals.

The major geographic trading centres are London, New York, Singapore, Hong Kong, & Tokyo. The market
functions 24 hours a day except for weekends. Trading commences in Sydney (Australia), & ends with the New York
session (U.S.A.)

4 :+$7$5(
:+$7$5((;&+$1*(
$5((;&+$1*(5$7(6
(;&+$1*(5$7(6"
5$7(6"

Currencies are not traded in “absolute” values, but in “relative” values. For example, if you ask your banker how
much the U.S. dollar is worth, she will give you a quote in terms of various currencies, called currency pairs.

The “Majors” are the main currency pairs traded globally, comprising 85% of total traded volume. They all relate to
the US$. The Majors are: EUR/USD, USD/JPY, GBP/USD, AUD/USD, USD/CHF, NZD/USD and USD/CAD. The
currency pairs that do not involve USD are called cross currency pairs, such as GBP/JPY. Pairs that involve the euro
are euro crosses, such as EUR/GBP.

A currency pair is the value of one currency quoted against another. The first listed currency is called the base
currency; the other is the quote currency, or counter currency. The convention is to have the USD as the base
currency except w.r.t. the Euro, the Great Britain Pound, the Australian Dollar, & the New Zealand Dollar.

The currency pair quotation represents how much of the quote currency is needed for to purchase one unit of the base
currency.

100
https://www.londonstockexchange.com/exchange/prices-and-markets/international-markets/rates/home.html

From the above, it is clear that one can purchase 1Euro by paying 1.11 USD, or purchase 1 USD by paying 0.90Euro.
Similarly, one would require 1.17Euro to purchase 1GDP.

When we buy a currency pair, we buy the base currency & sell the quote currency. Conversely, when we sell a
currency pair, we sell the base currency & buy the quote or counter currency.

4 +2:$5((;&+$1*(5$7(6'(7(50,1('"
+2:$5((;&+$1*(5$7(6'(7(50,1('"

Exchange rates may be free-floating, pegged (fixed), or hybrid. Every country decides how it wants its currency to be
valued. The factors which affect exchange rates in the market are:

“Balance of payments: When a country has a large international balance of payments deficit or trade deficit, it means
that its foreign exchange earnings are less than foreign exchange expenditures and its demand for foreign exchange
exceeds its supply, so its foreign exchange rate rises, and its currency depreciates.

Interest rate level: Interest rates are the cost and profit of borrowing capital. When a country raises its interest rate or
its domestic interest rate is higher than the foreign interest rate, it will cause capital inflow, thereby increasing the
demand for domestic currency, allowing the currency to appreciate and the foreign exchange depreciate.

Inflation factor: The inflation rate of a country rises, the purchasing power of money declines, the paper currency
depreciates internally, and then the foreign currency appreciates. If both countries have inflation, the currencies of
countries with high inflation will depreciate against those with low inflation. The latter is a relative revaluation of the
former.

Fiscal and monetary policy: Although the influence of monetary policy on the exchange rate changes of a country's
government is indirect, it is also very important. In general, the huge fiscal revenue and expenditure deficit caused by
expansionary fiscal and monetary policies and inflation will devalue the domestic currency. The tightening fiscal and
monetary policies will reduce fiscal expenditures, stabilize the currency, and increase the value of the domestic
currency.

Venture capital: If speculators expect a certain currency to appreciate, they will buy a large amount of that currency,
which will cause the exchange rate of that currency to rise. Conversely, if speculators expect a certain currency to
depreciate, they will sell off a large amount of the currency, resulting in speculation. The currency exchange rate
immediately fell. Speculation is an important factor in the short-term fluctuations in the exchange rate of the foreign
exchange market.

Government market intervention: When exchange rate fluctuations in the foreign exchange market adversely affect a
country's economy, trade, or the government needs to achieve certain policy goals through exchange rate adjustments,
monetary authorities can participate in currency trading, buying or selling local or foreign currencies in large
quantities in the market. The foreign exchange supply and demand has caused the exchange rate to change.

Economic strength of a country: In general, high economic growth rates are not conducive to the local currency's
performance in the foreign exchange market in the short term, but in the long run, they strongly support the strong
momentum of the local currency.”

https://en.wikipedia.org/wiki/Exchange_rate

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Purchasing power parity was originally developed as a theory of exchange rate determination; but is now used
primarily to compare living standards across countries. The bilateral exchange rate must adjust to inflation
differentials over time,

“To compare living standards across countries, PPP exchange rates are constructed by comparing the national prices
for a large basket of goods and services. These rates are used to translate different currencies into a common currency

101
to measure the purchasing power of per capita income in different countries. A PPP exchange rate constructed in this
manner is not, however, an accurate measure of the equilibrium value of the market-determined exchange rate.”

Purchasing-Power Parity: Definition, Measurement, and Interpretation- Robert Lafrance and Lawrence Schembri,
International Department. BANK OF CANADA REVIEW • AUTUMN 2002.

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U.S. economist Irving Fisher proposed this theory. Nominal Interest Rates “R” are a function of real interest rate “a”
& a premium for expected inflation “i”.

R=a+i

If a bank offers 6% interest on a deposit; & inflation is 5%, then the real rate of interest is just 1%.

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If there is no Government interference, this formula should hold true

rh = interest rate in the home country

ih = inflation in the home country

rf = interest rate in the foreign country

if = inflation in the foreign country

* Real rates of return tend to equality everywhere, through arbitrage.

* Countries with higher expected inflation have higher interest rates.

* Spot rate between two currencies adjusts to the interest rate differential between the two countries.

et = exchange rate at time “t”

e0 = exchange rate at time zero

e.g.

If USD/JPY spot is 108

102
Interest Tokyo 6%

Interest New York 12%

What will be the future Spot Rate 2 years later?

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The country with lower interest rates will see lower levels of inflation, and hence an appreciation in the value of the
country’s currency. When interest rates are high, there will be higher levels of inflation, which will result in the
depreciation of the country’s currency.

In our example above, since interest rates in New York were higher relative to those in Tokyo, the Japanese Yen has
appreciated against the USD. (Note that after two years, only 96.74Yen are required to purchase 1USD, vs. 108Yen
today.)

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We shall use a hypothetical example of Yen – US$ carry trade to illustrate the benefits & the pitfalls.

(Taxes, market frictions & market imperfections have been ignored for ease of understanding)

Suppose the current exchange rate is 117 JPY/US$ (117 Japanese Yen for each US Dollar)

* Assume interest rates to be 0.50% in Japan, & 5.25% in U.S.A. An institutional investor would consider
borrowing JPY at 0.50% & converting it into US$ for investment.

* It has two options in mind for a one year investment: US Equity, & US Treasury.

* If US Equity is chosen, there are two expected outcomes, viz. 20% return, or 10% return on investment.

* This gives rise to 3 Scenarios:

Scenario I (Table 1) Invest in US Equity, expected return of 20%

Scenario II (Table 7) Invest in US Equity, expected return of 10%

Scenario III (Table 10) Invest in US Treasury, expected return of 5.25%

* There are two possible outcomes in each scenario: (Table 2)

Case I - Yen depreciates to 120 JPY/US$

Case II - Yen appreciates to 100 JPY/US$

103
Table 1: Scenario I – Invest in Equity (20% return)

Table 2: Two Outcomes: Case I & Case II

The investor has own capital of 10,000 JPY & borrows 90,000 JPY to make a total of 100,000 JPY.

Table 3: Set-up of the Carry Trade

Since interest is 0.5% p.a., total interest on 90,000 JPY will be 450 JPY. When the total amount of 100,000 JPY is
converted at the exchange rate of 117JPY/US$, the investor has 854.7009 US$ to invest. This is expected to grow by
20%, resulting in $1,025.6410 at the end of one year.

Table 4: Investment Performance – Scenario I - Invest in Equity (20% Return)

This amount is converted back into JPY at the then prevailing exchange rates.

Table 5 illustrates Case I wherein the JPY depreciates to 120 JPY/US$, while Table 6 shows the outcome in case of
appreciation (Case II) of the JPY to 100 per US$.

The loan is repaid with interest, leaving a handsome return on investment of either….hold your breath….226.27%, or
21.14%. This astonishing return is due to:

a) Differential rates of return

b) Leverage

c) Depreciation of the currency (JPY) in Case I.

Case II has much lower return because the JPY actually appreciates (though 21% + return is not to be scoffed at)

CASE I

104
Table 5: Scenario I Case I

CASE II

Table 6: Scenario I Case II

Tables 7, 8, & 9 show the projected results in both Case I & Case II of Scenario II (return on shares 10%)

Table 7: Scenario II – Invest in Equity (10% return)

CASE 1

Table 8: Scenario II Case I

CASE 2

Table 9: Scenario II Case II

105
In Case I here, the returns are remarkably lower compared to Scenario I Case I, as expected (10% returns on equity
vs. 20% in Scenario I).

Important Note: In Case II (appreciation of JPY) there is a substantial loss incurred. The negative impacts of
currency appreciation combined with leverage, have more than neutralized the interest (return) differential which
encouraged the carry trade in the first place.

Tables 10, 12, & 13 show the expected results in both Case I & Case II of Scenario III (return from US Treasury
@5.25%)

Table 10: Scenario III – Invest in US Treasury (5.25% return)

CASE 1

Table 11: Scenario III Case I

CASE 2

Table 12: Scenario III Case II

Once again, it is apparent that while Case I promises an extremely gratifying return on own capital employed, Case II
brutally destroys wealth! In fact, the investor is required to make a further contribution, since more than the entire
own capital of 10,000 JPY is wiped out.

Table 13 summarizes our hypothetical case, with a cautionary message. “If something seems too good to be
true…..it probably is!” Imagine the consequence if the actual investment performance had been negative, & was
then mangled by leverage & adverse exchange rate fluctuation!

106
Table 13: Summary of Yen Carry Trade (Hypothetical Illustration)

*********************************************************************************************

Thank You! Best Wishes for Your Examinations & Professional Careers.

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Images courtesy Google search. No copyright infringement intended. All copyrights acknowledged. All rights to
tables, notes & images used are owned by the respective owners &/or originators.

Disclaimer:

e&oe. Without prejudice, without recourse

Some matter included here is from existing publications of the author. The author reserves the right to use the
material in this workbook for his academic & professional activities, without requiring separate permission from the
WIRC of ICMAI. Due credit will be given to the publishers whenever such material is used by the author.

107
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n
 FV = PV*(1+r)

 PV = FV/(1+r)n

If frequency of compounding is more than 1

nm
FV = PV*(1+r/m)

PV = FV/(1+r/m)nm

Rule of 72 (approx)
Doubling Period = 72/r
Doubling Period*r = 72

Rule of 69 (better approx)

Doubling Period = 0.35 + 69/r
(Doubling Period-0.35)*r = 69

n
FV of an Annuity = A[(1+r) -1] Annuity Due = Ordinary * (1+r)
ordinary r

PV of an Annuity = A 1-(1/(1+r)n) Annuity Due = Ordinary * (1+r)

ordinary r

PV of a Perpetuity = A/r

YTM = I + (F-P)/N
(F+P)/2

YTM = I + (F - P)/N
(.4F + .6P)

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108
109