UNIT - 1

The derivatives market is the financial market for derivatives, financial instruments like futures
contracts or options, which are derived from other forms of assets.
The market can be divided into two, that for exchange-traded derivatives and that for over-the-
counter derivatives. The legal nature of these products is very different, as well as the way they
are traded, though many market participants are active in both. The derivatives market in Europe
has a notional amount of €660 trillion.
Evolution and Growth of Financial Derivatives:
According to some financial scholars, future trading dates back in India to around 200 B. C. Evolution of
trading methods of futures can be traced in the medieval fairs of France and England as early as the 12th
century. The first futures contracts were reportedly done in respect of rice in Japan in the 17th century
when forward agreements were entered into for the trading of commodities in Japan.
As per the records, rice was traded for future delivery in Osaka in the 1730s. Wheat and corn futures were
reportedly traded in the UK and the USA in the 19th century. The Chicago Board of Trade (CBOT),
established in 1848, was an active exchange for handling commodities, especially corn and wheat.
The history of derivatives has two important milestones. The first was the establishment of stock options
trade in Chicago — initially OTC and subsequently on the CBOT market in equity derivatives in 1987.
The CBOT was set up in 1848 as a meeting place for farmers and merchants. It standardized the quantities
and qualities of the grains that were to be traded. The first future type contract was known as ‘to arrive’
contract.
The CBOT now offers futures contract on various assets like corn, soya bean meal, soya bean oil, wheat,
silver, bonds, treasury notes, stock index, etc.
In 1874, the Chicago Produce Exchange was established to provide a market for poultry products, butter,
and other perishable agricultural products. In 1898, the butter and egg dealers detached themselves from
this exchange and formed Chicago Butter and Egg Board.
In 1919, this was renamed as Chicago Mercantile Exchange and was reorganized for future trading. In
1972, the International Monetary Market (IMM) was constituted as a division of the Chicago Mercantile
Exchange in 1972 for futures trading in foreign currencies.
The first traded financial futures were foreign currency contracts which began trading on the International
Commercial Exchange (ICE) in 1970. However, it failed and had to go out of business. Additional foreign
currency contracts commenced trading on the Chicago Mercantile Exchange in 1974.
In 1975, the commodity futures trading commission (CFTC) officially designated nine currencies as
contract markets on these exchanges, these included British pound, Canadian dollar, Deutschemarks,
Dutch guilders, Japanese Yen, Swiss traces, Italian Lira and Mexican Pesos. Global futures market
currently include metals, grains, petroleum products financial instruments and a whole lot of other
products.
Other futures that trade in futures world over include the Chicago Rice and Cotton Exchange, the New
York Future Exchange, the London International Finance Futures Exchange (LIFFE), the Toronto Futures
Exchange (TFE) and the Singapore International Monetary Exchange (SIMEX), MATIF (France), EOE
(Holland), SOFFEX (Switzerland) and DTB (Germany).
In India, there is no derivative based on interest rate currently. But there is a future market on selected
commodities (Castor seed, hessian, gur, potatoes, turmeric and pepper). The Forward Markets Commission
(FMC) is the controlling body for these markets.
India also has a strong currency forward market. Daily volume in this market is reportedly over US $ 500
million per day. The forward cover is currently available for a maximum of 6 months. Indian users can
also buy derivatives based on foreign currencies on foreign markets for hedging.
Ever since the “Badla” was banned, there has been a crying need for other risk-hedging devices. The
Bombay Stock Exchange has been glamorizing for the return of the “Badla” in its old form. But the
National Stock Exchange has set into motion the process of introducing futures and options.
The L. C. Gupta Committee on derivatives was of the view that there was need for equity-based
derivatives, interest rate derivatives and currency derivatives. But it recommended introduction of equity-
based derivatives in the first instance based on futures only, rather than options or futures/options on
individual stocks which are considered riskier.
The Committee suggested that the other complex type of derivatives should be introduced at a later stage
after the market participants have acquired some degree of comfort and familiarity with the simpler types.
The Securities and Exchange Board of India (SEBI) has, of late, accepted the recommendation of the
Gupta Committee and allowed phased introduction of derivative trading in the country beginning with a
stock index futures.
Amendments to the Securities Contract Act (SCRA) are on the anvil. This will facilitate inclusion of
derivative contracts based on index of prices of securities and other derivative contracts in securities
trading. The SEBI also approved suggestive by-laws proposed by the Committee covering operational
aspects for regulation and control on derivative contracts.
The RBI introduced recently, rupee derivative trading in the country. It formally allowed banks and
corporates from July 6, 1999 to hedge against interest rate risks using interest rate swaps (IRS) and
forward rate agreements (FRA). According to the guidelines, there would be no restriction on the tenure
and size of the IRS and FRA entered by banks.
The IRS would allow corporates to hedge their interest rate risks and provide an opportunity to swap their
old high-cost loans with cheaper ones. However, the RBI has warned that while dealing with corporates,
the participants should ensure that they are undertaking FRAs/IRS only for hedging their own balance
sheet exposures and not for speculative purposes.
Thus, commercial banks, primary dealers, and corporates can now undertake IRS and FRA as a product for
their own balance sheet management and market making purposes.
Features of Financial Derivatives
1. Financial Derivative is a contract.
2. It derives value from underlying assets.
3. It has specified obligation as per the contract which means there are parties involved with
specified conditions.
4. Financial Derivatives are carried off-balance sheets.
5. Trading of underlying assets is not involved.
6. Financial Derivatives are mostly secondary market instruments.
7. Financial Derivatives are exposed to risks such as operational, counter party and legal.
Types of Derivatives in India
There are four different types of derivatives that can easily be traded in the Indian Stock Market. Each
derivative is different from the other and consist of varying contract conditions, risk factor and more.
The four different types of derivatives are as follows:
 Forward Contracts
 Future Contracts
 Options Contracts
 Swap Contracts
Let us have a look and study in-depth detail about these derivatives.
 Forward Contracts
Forward contracts mean two parties come together and enter into an agreement to buy and sell an
underlying asset set at a fixed date and agreed on a price in the future.
In simpler words, it is an agreement formed between both parties to sell their asset on an agreed future
date.
The forward contracts are customized and have a high tendency of counterparty risk. Since it is a
customized contract, the size of the agreement entirely depends on the term of the contract.
Forward contracts do not require any collateral as they are self-regulated. The settlement of the
forward contract gets done on the maturity date, and hence they are reserved by the expiry period.
 Future Contracts
Future contracts are like forward contracts. Future contracts mean an agreement made by the two
parties to buy or sell an underlying instrument at a fixed price on a future date.
Future contracts do not allow the buyer and seller to meet and enter into an agreement. In fact, the deal
gets fixed through exchange mode.
In futures contracts, the counterparty risk is low because it is a standardized contract. In addition, the
clearinghouse plays the role of a counterparty to the parties of the contract, which reduces the credit
risk in the future.
The size of future contracts is fixed, and it is regulated by the stock exchange just because it is known
as a standardized contract.
Since these contracts are standard, the futures contracts listed on the stock exchange cannot be
changed or modified in any possible way.
In simpler words, future contracts have pre-decided size, pre-decided expiry period, pre-decided size.
In futures contracts, an initial margin is required because settlement and collateral are done daily.
 Options Contracts
Options contracts are the third type of derivative contracts in India. Options contracts are way different
than future and format contracts because these contracts do not require any compulsion to discharge
the contract on a specific date. Options contracts provide the right but not the commitment to buy or
sell an underlying instrument.
Option contracts consist of two options:
o Call Option
o Put Option
In call option, the buyer has all the right to purchase an underlying asset at a fixed price while entering
the contracts. While input option, the buyer has all the right but not obligation to sell an underlying
asset at a fixed price while entering the contract.
However, in both call and put option contracts, the buyer chooses to settle all the contracts on or
before the expiry period. Thus, anyone who regularly trades in the option contract can take any of the
four different positions, i.e., short, or long, either in the call or the put option. These options are traded
at the stock exchange and over the counter market.
 Swap Contracts
Out of all three derivatives contracts, swap contracts are one of the most complex contracts. Swap
contracts mean the agreement is done privately between both parties. The parties who enter swap
contracts agree to exchange their cash flow in the future as per the pre-determined formula. Under
swap contracts, the underlying security is the interest rate or currency, as these contracts protect both
parties from several major risks. These contracts are not traded to the Stock Exchange as investment
banker plays the role of a middleman between these contracts.
Forward Market
A forward market is an over-the-counter (OTC) marketplace for foreign exchanges, securities, interest
rates, and commodities, unlike the stock, derivatives, or commodity markets. The term forward market
is most associated with the currency market.
It's a market where forward contracts are bought and sold for hedging (investment protection) or
speculation (maximizing returns). The Forward Markets Commission regulates both forward and
futures markets in India.
Forward Market Meaning
The forward market is the marketplace that sets the price of assets and financial instruments (Bonds,
Swaps, Equity, Cap, Futures, Forward rate agreements, Bills of exchange, and so on) for future
delivery and is used for financial instrument trading. In other words, the forward market is the market
where we can sell and buy financial instruments and assets for future delivery.
The forward market is the market that is used to determine the price of forward contracts, financial
instruments, and assets, as well as to sell and buy them. The trading of instruments takes place on such
a market. The forward market allows contract parties to customize the time, amount, and rate at which
the contract is to be performed.
How Does the Forward Market Work?
Forward contracts are created through forward markets. The forward contracts are designed to be used
for both speculative and hedging purposes. Forward contracts are exchanged among banks and from
banks to their clients.
Forward and futures contracts are accessible in the forward market. Forward contracts could be
customized to the requirements of the holder - whereas futures contracts are more standard and
uniform in terms of maturity and order size.
Types of Forward Market

1) Flexible Forward: The parties might tend to exchange money that is normally on or even before the
maturity date using this strategy.

2) Closed Outright The exchange rate is agreed upon between the two parties as to the prevailing spot rate
Forward: plus the premium in this form of transaction.

3) Non-Deliverable There is no physical delivery with this approach, and the parties agree to merely settle
Forward: the difference between the spot rate and the exchange rate.

4) Long Dated They are comparable to short-dated contracts, but the maturities are normally for a
Forward: longer period.

Forward Market Example

Consider the case of a farmer who harvests a particular crop but is uncertain about its pricing three
months later. In this situation, the farmer can lock in the price at which he will sell his produce in the
next three months by entering into a forward contract with a third party. The forward market is the
name given to the market for such a transaction.
Benefits of the Forward Market
 In the forward market, parties enter and decide the quantity, time, and rate at the time of delivery
according to their own needs, requirements, and specifications. It is extremely adaptable and
practical for both parties.
 It is extremely beneficial to parties who have specific commodities that they will need to exchange
in the future. The forward market provides a complete hedge and attempts to eliminate various
risks so that parties can protect their commitments.
 The products in the forward market are usually traded over the counter. Rather than engaging in
future contracts, most institutional investors prefer to deal with them. Over-the-counter goods
provide them the freedom to customize the duration, contract size, and approach to meet their
specific needs.
 The parties can now match their exposure to the period in which they can enter the contract. They
may adapt it to fit any party and change the time based on this.
What Is a Forward Contract?
A forwards contract is a specific agreement by two parties to purchase or sell an asset at a particular price
on a future date. The two parties agree to conduct the said transaction in the future, hence the term
‘forward’. The value of the forward contract is derived from the underlying asset’s value, such as stocks,
commodities, currencies, etc. This is why a forward contract acts as a derivative. However, unlike an
options contract, the two parties involved in a forwards derivative contract are obligated to fulfil the
specified transaction and take the delivery of the underlying asset.
Forward contracts are not traded on a centralised exchange, which is why they are essentially considered
over-the-counter or OTC derivatives. Furthermore, since forward contracts are negotiated privately and
without an intermediary, they are more customisable than standard derivative contracts.
How Is Forward Trading Done?
The two parties typically enter a forward contract because of their opposing views on a particular asset’s
future price. One party believes that the price of a particular asset is set to rise in the future and therefore
wishes to purchase it at a lower, predetermined price to make profits based on the price difference. Hence,
this party offers to be the buyer. On the other hand, the other party believes that the asset’s price will fall
soon and therefore wishes to cut their losses by locking in a predetermined price. This party, therefore,
offers to be the seller.
Based on how the market performs and the price of the asset changes, the actual result of the forward
contract can typically go in three different ways:
1. The Price of The Asset Rises in The Future
In this scenario, the buyer’s prediction comes true, and they can sell the asset at a higher price. They take
the delivery of the asset by paying the lower predetermined price of the forwards’ contract and sell it on
the open market. The profit made by the buyer in this scenario is the difference between the actual current
price of the asset and the locked-in price at which the buyer bought it.
2.The Price of The Asset Falls in The Future
In this scenario, the seller’s prediction is correct, providing benefits from the sale made through the
forward contract. Even though the price of the asset has fallen, the seller gets to sell it at a price higher than
its current value. The profit made by the seller in this scenario is the difference between the price at which
the seller sells the asset and the actual current price of the asset.
3.The Price of The Asset Remains Unchanged in The Future
In this scenario, the prediction of neither the buyer nor the seller is proven correct. Therefore, the
transaction results in no profit made or loss incurred by either party.
Example Of a Forwards Contract
To understand the concept better, let us take a forward contract example. Let’s say a farmer is on track to
harvest 20 tonnes of maize by next year. To make a profit on his harvest, he must sell it at a price of at
least Rs 10,000 per tonne. If the farmer chooses to wait till next year to sell his maize harvest, he may or
may not be able to make a profit on the transaction. This is because there is no saying what the price per
tonne will be next year.
However, if the farmer chooses to enter into a forward contract with a food manufacturing company that
guarantees to pay him his desired price in exchange for his harvest next year, his risk is minimised.
Therefore, even if the price of maize falls next year, he will be protected by the obligation of the forward
contract and the fact that he will receive a higher price based on the lock-n price.
Features Of a Forwards Contract
Some of the most essential features of a Forwards contract includes:
Unlike futures contracts, forwards contracts are not standardised and are not traded on exchanges. As a
result, they are also more customisable and allow for specific changes in the agreements with regards to the
asset traded, amount and date of delivery.
The parties can settle forward derivatives in one of the two ways. One is where the seller makes physical
delivery of the assets and receives the agreed-upon payment by the buyer. The other is where cash
settlement occurs, and there is no actual physical delivery of the asset in question. Instead, one of the two
parties settles the contract by paying the other an appropriate differential in cash.
Forward contracts are some of the most employed tools for corporations to minimise and hedge interest
rate related risks. By entering into a forwards contract, they won’t have to purchase an asset at a higher
price in the future.
Forward trading typically requires no margin amount and is unregulated by the Securities and Exchange
Board of India, i.e., SEBI, making it customisable and easier to trade.
Conclusion
Whether you are a headgear who wants to lock in a predetermined price to cut future losses or a speculator
who wants to make profits based on the price fluctuation, a forwards contract is an ideal investment tool.
However, since the process can seem complex, it is wise to consult a financial advisor such as IIFL before
you start Forwards trading.
Hedging with Forwards
Forward Trades
Before explaining how a forward trade works, it’s helpful to give an example of how a business that trades
in a foreign currency can be affected by changes in the exchange rate. Later on, we can use the same
example to show how a forward trade would help the same company to prevent itself from suffering a loss.
An Example
A UK-based brewery that has expanded into the US market may take an order for $100,000 worth of its
product from a US-based buyer. If the exchange rate at the time the sale is agreed is 0.745 USD/GBP this
is equal to £74,500. The company may agree to the sale and send the goods to the buyer, expecting to
receive $100,000 from the buyer which will convert into £74,500 of their domestic currency.
However, the buyer may not have to make the payment immediately. They may have a period of, say, three
months before they have to make the payment. The amount of time that can elapse varies from deal to deal,
but three months is a good example. This is where things become risky. If the US dollar weakens in the
meantime, then when the company receives their payment in dollars this will convert to less money in their
domestic currency (the British pound) than they expected.
If, for example, when the payment is made the exchange rate is 0.730, this will convert to £73,000 and the
company will receive £1,500 less than it anticipated.
How Forward Trades are Used
Forward trades are used to eliminate the risk of this happening. What happens when a company hedges
their FX exposure with a forward trade, is that they enter into an agreement with a third party.
Traditionally, these agreements have been provided by either brokers or banks and many companies still
use brokers and banks to make these agreements. Bound is not a bank or a broker but is a company that
provides the same agreement.
Under a forward trade agreement, a company will agree to exchange an amount of currency at a set rate at
a future date with the third party. What this means is that when the company receives their future payment
in the foreign currency, they will be able to exchange it back into their domestic currency through the third
party at the rate agreed to in the forward trade. Even if exchange rates have changed in the real world, they
will be able to exchange their money at the rate set in the forward trade agreement.
Revisiting Our Example
Going back to the brewery, when they received their order for $100,000 of their product from the US, they
could approach Bound to create a forward trade. Under the forward trade, Bound may agree to exchange
$100,000 at a rate of 0.745 USD/GBP in three months’ time. This exchange rate is locked and both parties
will agree to settle the deal by a particular date.
Even if the dollar weakens, when the company receives their payment of $100,000 from the buyer in the
US, they can take this payment to Bound who will convert it into British pounds at the original rate. So, if
the buyer pays three months after the sale is agreed and the exchange rate at that time has changed to 0.730
USD/GBP, this will not matter to them. Bound has already agreed to exchange this payment back into
British pounds at a rate of 0.745 USD/GBP.
As a result, no loss is incurred from exchange rate changes and they receive £74,500, as they originally
expected. Without the forward trade, the company would be forced to exchange the money through the
usual channels and the change in the exchange rate would cause them to lose money.

UNIT – 2
Features of Forward Contract
The following are the essential features of a forward contract –
 These are not standardized and are not traded on a stock exchange. Also, the parties
can make changes in the agreement with regard to the underlying assets, amount and
delivery date. Thus, they are customizable.
 The parties can settle these contracts in one of the ways. One is where the seller
makes the physical delivery of assets and receives the agreed payment from the buyer.
The other is cash settlement, where there is no physical delivery of the asset. It is one
of the parties paying to settle the contract with the appropriate differential cash.
 Corporations mostly use these contracts to minimize and hedge interest rate risk. This
prevents them from purchasing an asset at a higher price in future.
  Forward trading requires no margin as SEBI does not regulate it. Thus, it is easy to
trade and customizable.
How Does a Forward Contract Work?
Let us understand how a forward contract works with the help of an example. A farmer has
1000 kgs of wheat to sell at Rs.30/kg to make profits. If the farmer waits till next year, he
may or may not be able to profit from the transaction. This is because no one can predict the
wheat price next year.
Thus, the farmer decides to enter into a forward contract with a manufacturing company that
promises to pay him a specific price (Rs.30/kg) in exchange for wheat next year. So even if
the wheat price falls the next year, the farmer is protected by the obligation of a forward
contract. Also, he will receive a higher price compared to the market.
Generally, the two parties enter into a forward contract because of their opposing views on a
future price of a particular asset. One party believes the price will rise in the future, and the
other believes the price will fall in the future. So, at the time of execution, one party makes a
profit while another party incurs a loss. Based on the market conditions and the price of an
asset, the forward contract result can go in three ways –
Asset Price Increases in Future
The buyer feels that the future price of wheat might increase in future. Thus, the buyer enters
a contract at a forward price which is lower than the expected price in future. If the
predictions come true, the buyer can buy the wheat at a lower price and then sell it at a higher
price in the open market to make a profit.
Asset Price Falls in Future
The seller (farmer) feels that the price of wheat may fall in future. For security, the seller
locks them at a higher price to sell the wheat (asset). If the seller’s predictions come true and
the price falls, the seller would not make a loss as he fixed it at a higher price while entering
the forward contract.
Asset Price Remains Unchanged in Future
The prediction of the buyer and seller is not correct. Therefore, the transaction results in no
loss and no profit by either of the parties.
What are Forward Contracts Used For?
The forward contract is primarily used to hedge against potential losses. It enables the
participants to lock the asset price in future. This future price is very important, especially in
industries that experience significant volatility in prices. For instance, in the oil industry,
entering into a forward contract to sell a specific number of oil barrels can be used to protect
against the potential downward swings in oil prices. Moreover, these contracts are mainly
used to hedge against the changes in currency exchange rates while making international
transactions.
Alternatively, forward contracts can also be used for speculative purposes. This is not very
common because these contacts are created by two parties and are not available for trading on
stock exchanges. If the speculator believes that the future spot price of the asset will be
higher than the forward price today, they may enter into a long forward position. Also, if the
future spot price exceeds the agreed contract price, they will profit.
Advantages and Risks of a Forward Contract
Advantages
The following are the advantages of a forward contract –
 Hedging: The preset specifications in the agreement made by the parties allow them
to manage risks and protect themselves from market fluctuations that can affect the
asset price.
 Customization: The parties involved in the agreement make specific requirements,
including expiry date, lot size and pricing.
 Simplicity: These are simpler to understand the price protection and enable proximity
among traders with less regulation.
Risks
The following are the risks involved in a forward contract –
 Regulatory Risk: These are executed with the mutual consent of both parties
involved. Also, they are not governed by any specific regulatory authority. Because
there is no regulatory authority, it increases the risk ability of either of the parties to
default.
 Liquidity Risk: The trading decision is impacted in these contracts due to low
liquidity. Even though the trader has a strong trading view, they may not be able to
execute the strategy because of low liquidity.
 Default Risk: The institution that drafted the agreement is exposed to a high level of
risk in the event of default or non-settlement by the client. Thus, these are risky for
both parties as it is over the counter investments.
futures contracts
A futures contract is a right and an obligation to buy or to sell an asset. Remember when we talk of
types of futures contracts, there are futures across asset classes. The different types of futures
contracts include equity futures, index futures, commodity futures, currency futures, interest rate
futures, VIX futures, etc. The concept across all the types of futures is the same. They are all a
contract between a buyer and seller for delivery at a future date.
What is the Difference of futures contracts
Let us take a quick look at the different types of futures contracts available in India. Remember, these
futures options are different from options because an option is a right to the buyer without an
obligation; and an obligation to the seller without the right. For now, let us stick to futures.
Equity stock futures: If you expect Reliance to go up and want to buy 1000 shares but don’t have the
money, then what do you do? You can buy Reliance Futures. Similarly, if you expect the Reliance
price to go down, you can also sell the Reliance futures. Either way, you make profits if the price
movement is in your favour, otherwise, you make a loss. Equity futures in the organized format is less
than 20 years old in India. Equity futures give you leverage. You deposit an initial margin like say
20% with the broker and you can trade 5 times the money you have. Futures are only available on a
selected list of stocks.
Equity Index Futures: If you do not want to take the risk of stocks, you can buy or sell index futures.
In India, the Nifty futures and the Bank Nifty futures are not only popular but also extremely liquid.
Index futures can be used to speculate on the movements of broad-based indices with lower risk than
stock futures. Index futures can be used for hedging and arbitrage but we will not get into all that now.
Currency Futures: This organized currency futures market came into India in 2008 and has become
extremely popular. You can bet on currencies and protect your currency payment or receipt risk. For
example, if you expect the dollar to strengthen, you buy USDINR futures and if you expect the rupee
to strengthen then you sell USDINR futures. You can trade futures on dollars, pounds, euros, and yen.
Commodity Futures: have been very popular but CTT has taken some sheen off commodity futures.
Like the other futures, commodity futures also allow hedging against price changes in the various
commodities including agricultural products, precious metals like gold and silver, hydrocarbons like
oil and natural gas as well as industrial metals like aluminium, zinc, nickel, and copper. Initial
margins are low in commodities so it attracts a lot of speculators. Commodity futures happen
principally in MCX and NCDEX in India.
Interest rate futures: Interest rate futures represent a contract to buy or sell government security or T-
Bill at a specified price on a predetermined date. The interest yield is implied in the bond prices and
you can bet on rates rising or rates falling and also hedge your interest rate risk.
VIX Futures: The VIX is the volatility index and you can bet on whether market volatility will go up
or go down. It has nothing to do with the market direction. VIX is called the Fear Index and is a
barometer of investor panic. Normally sharp market corrections are accompanied by a spurt in VIX.
What are futures?
As the name suggests, the future is a contract that pertains to the future. In finance parlance, futures
are a contract that is legal and standardized. It is an agreement to buy or sell an underlying asset at a
predetermined price at a specified time in the future. Normally, this deal is between two parties not
known to each other. Futures are different from forwards in the sense that forwards are customized
OTC products but futures are standardized exchange-traded products. On NSE and BSE, all futures
contracts have the counter-guarantee of the clearing corporation.
Features Of Future Contracts
Here are some amazing features of futures contracts:
 Commodity futures markets in India are regulated by the FMC — Forward Markets Commission.
This governing body regulates aspects such as withdrawing or granting recognition of any
commodity markets engaged in forward dealings.
 Available for many different types of asset classes, a future contract can work across exchanges,
commodities or currencies, and indices.
 Unlike a forward contract, a futures contract is standardised. As an example, once a contract states
that it applies to 1000 barrels of oil, one will have to lock in their price as per that unit or in
multiples of it. If one wants to lock in a price, they would need to sell or purchase a hundred
separate contracts. To lock in the price of a million barrels of oil, one would need to buy or sell a
thousand such contracts. Traders also get an efficient idea of what the futures price of a stock or
the value of its index is likely to become.
 Future contracts can mainly aid in determining the future supply and demand of shares, which is
based on their current future price.
 Since futures are traded on margin trading, they allow those without sufficient funds to carry out
and participate in trades. One can do so by paying a smaller margin rather than the entire value of
the physical holdings.
 Future contracts are employed by two types of market participants: speculators and hedgers. Those
who produce or purchase an underlying asset hedge are known as producers or hedgers. These
individuals also guarantee the price at which the commodity will be purchased or sold.
Alternatively, those who bet on the price movements of the underlying asset through the use of
futures are known as speculators.
Futures Contract Example
Here is an example of a futures contract for a better understanding:
Suppose an oil producer wants to sell oil but fears that the oil prices may fall in the future. To ensure the
oil producer gets a predetermined price and not incur a loss, a futures contract can be used. With the aid of
future contracts, the oil producer can lock in the price at which the oil will sell thereby delivering the oil to
the buyer, once the future contract expires.
On the other hand, a manufacturing company may require oil to use for making widgets. Since this
company prepares well by planning ahead and prefers to have oil coming in each month, they may also
employ the use of a future contract. This way the company knows the price at which they will receive oil,
based on the price set in their future contract. They know that they will be taking up the delivery of that oil
once their contract expires.
Pricing of Futures
We know the futures instrument derives its value from its respective underlying. We also
know that the futures instrument moves in sync with its underlying. If the underlying price
falls, so would the futures price and vice versa. However, the underlying price and the futures
price differ and they are not really the same. Say for example, Nifty Spot is at 17586 whereas
the corresponding current month contract is trading at 17597. This difference in price
between the futures price and the spot price is called the “basis” or spread. The basis is 9
points in our example.

Pricing of a futures contract depends on the characteristics of the underlying asset. There is
no single way to price futures contracts because different assets have different demand and
supply patterns, different characteristics and cash flow patterns. Market participants use
different models for pricing futures. The two popular models of futures pricing:

 Cash and Carry model

 Expectancy model

Cash and Carry Model

Let us understand this concept with an example.

There are two people - Ram & Arjun. Ram decides to buy a particular stock TCS in the spot

market paying total amount and takes delivery of the share. On the other hand, Arjun decides

to buy TCS in futures paying just the margin.

What happens with Ram’s Position?

TCS shares are credited in his demat account. Now if TCS announces a dividend, Ram is

entitled to that dividend, but simultaneously he loses out on the opportunity cost of the funds

involved in buying those TCS shares in the spot market. He is basically forgoing the interest

on those funds.
On the other hand, Arjun deploying just a small margin is holding a similar position in TCS.

When dividend is announced Arjun is not entitled to this dividend as his demat account

doesn’t have TCS shares.

We see that both Ram and Arjun are long on TCS but still their situation has few differences

on account of opportunity cost of funds involved as well as dividends received. This is known

as cost of carry!

The Cash & Carry Model assumes that markets are perfectly efficient. This means there are

no differences in the cash and futures price. No opportunity for arbitrage exists and investors

are indifferent to the spot and futures market prices while they trade in the underlying asset.

The model also assumes, that the contract is held till maturity, the price of a futures contract

will be equal to the spot price plus the net cost incurred in carrying the asset till the maturity

date of the futures contract.

Futures Price = Spot Price + (Carry Cost – Carry Return)

Here, Carry Cost refers to the cost of holding the asset till the futures contract matures. This

could include storage cost, in case of commodities, interest paid to acquire and hold the asset,

financing costs etc.

Carry Return refers to any income derived from the asset while holding it like dividends,

bonuses etc. A net of these two is called the net cost of carry.
The cost of carry model used for pricing futures is given by:

Where,

S- Spot price

r- cost of financing (using continuously compounded interest rate)

T- Time to expiry

e- 2.71828

Expectancy Model

According to the expectancy model, it is not the relationship between spot and futures prices

but that of expected spot and futures prices, which moves the market. This is why market
participants would enter futures contract and price the futures based upon their estimates of

the future spot prices of the underlying assets.

According to this model,

 Futures can trade at a premium or discount to the spot price of the underlying asset.

 Futures price give market participants an indication of the expected direction of movement of
the spot price in the future.

For instance, if the futures price is higher than the spot price of an underlying asset, market

participants may expect the spot price to go up in the near future. This expectedly rising

market is called “Contango market”.

Similarly, if the futures price is lower than the spot price of an asset, market participants may

expect the spot price to come down in future. This expectedly falling market is called

“Backwardation market”

The difference between the spot and the futures price is known as Basis.

So, now that we have understood how futures contracts are priced. Next, let us discuss the

different market participants in this futures market.

Currency Futures
Every country has a currency, and the value of that currency changes all the time in relation

to other currencies. The value of a country's currency is determined by a variety of factors,

including the status of the economy, foreign exchange reserves, supply and demand, and

central bank policy. Investors are attracted to a currency that is stable and

strong. NSE Currency futures can be used to do this.

Currency futures are a forex futures trading instrument with a currency future exchange rate

as the underlying asset, such as the euro to US dollar exchange rate or the British Pound to

US dollar exchange rate. Currency futures are fundamentally the same as all other futures

markets (index and commodity futures markets) and are traded in the same manner.

What are Currency Futures?

Currency futures are based on two different currencies' exchange rates. The euro and the

dollar (EUR/USD) are an example of a currency pair with an exchange rate. The first

currency indicated in the pair is the governing currency.

Futures dealers are concerned about the euro price in this situation. Traders purchase a

contract for a specific amount, and the contract's value fluctuates with the value of the euro.

Currency futures only trade in one contract size, so traders must trade in multiples of that.

Features of Currency Futures

Mentioned below are the key attributes of currency futures prices:

 Underlying Asset: This is the currency exchange rate that has been specified.

 Expiration Date: This is the final settlement for cash-settled futures. It is the date on

which the currencies are exchanged for physically delivered futures.

 Size: The sizes of contracts are all the same.

 Margin Requirement: An initial margin is necessary to enter into a futures contract. A

maintenance margin will be established, and if the original margin goes lower than

this level - a margin call will occur, requiring the trader or investor to deposit money

in order to raise the initial margin over the maintenance margin.

Importance of Investing in Currency Futures

Like other futures - foreign exchange futures can be utilized for hedging or speculative
objectives. FX futures are purchased by a party who knows they will require foreign currency

in the future but does not want to buy it now.

This will function as a hedge against any potential exchange rate volatility. They will be

assured of the FX futures contract's exchange rate when the contract expires, and they need to

acquire the currency.

Similarly - if a party anticipates receiving a cash flow in a foreign currency in the future, they

might use futures to hedge their position.

Speculators frequently use currency futures as well. If a trader believes a currency would

appreciate against another. He or she might buy the FX futures contracts to profit from the

fluctuating exchange rate. Because the initial margin retained is typically a fraction of the
contract size, these contracts can be beneficial to speculators. This effectively allows them to

leverage up their position and increase their exposure to the exchange rate.

Interest rate parity can also be checked using currency futures. If interest rate parity does not

hold - a trader may be able to earn solely on borrowed funds and the utilization of futures

contracts by employing an arbitrage technique.

Due to the opportunity to modify these over-the-counter contracts, currency forwards is

frequently used by investors wishing to hedge a position. Currency futures are popular among

speculators because of their high liquidity and ability to leverage their positions.

Settlements of Currency Futures

A currency futures contract can be settled in one of two ways. The vast majority of the time,

buyers and sellers will take an opposing position to offset the original positions before the

last day of trading (which varies depending on the contract). The profit/loss is credited to or

debited from the investor's account when an opposite position closes the trade before the last

day of trading.

Contracts are typically held until the maturity date, after which they are either cash-settled or

physically delivered, depending on the contract and exchange. The physical delivery of most

currency futures takes place four times a year, on the third Wednesday of March, June,

September, and December.

Only a small percentage of currency futures transactions are completed by a buyer and seller

physically delivering foreign money. When a currency futures contract is kept until it expires

and is physically settled, both the applicable exchange and the participant are responsible for

completing the delivery.

Hedging with Foreign Currency Futures

Exchange rates are quite volatile and unpredictable, it is possible that anticipated profit in

foreign investment may be eliminated, rather even may incur loss. Thus, in order to hedge

this foreign currency risk, the traders’ often use the currency futures. For example, a long

hedge (i.e., buying currency futures contracts) will protect against a rise in a foreign
currency value whereas a short hedge (i.e., selling currency futures contracts) will protect

against a decline in a foreign currency’s value.

It is noted that corporate profits are exposed to exchange rate risk in many situation. For

example, if a trader is exporting or importing any particular product from other countries then

he is exposed to foreign exchange risk. Similarly, if the firm is borrowing or lending or

investing for short or long period from foreign countries, in all these situations, the firm’s

profit will be affected by change in foreign exchange rates. In all these situations, the firm

can take long or short position in futures currency market as per requirement.

The general rule for determining whether a long or short futures position will hedge a

potential foreign exchange loss is:

 Loss from appreciating in Indian rupee= Short hedge

 Loss from depreciating in Indian rupee= Long hedge

Short Hedge

A short hedge involves taking a short position in the futures market. In a currency market,

short hedge is taken by someone who already owns the base currency or is expecting a future

receipt of the base currency.

Short Hedge Strategy Through an Example.

An exporter is expecting a payment of USD 1,000,000 after 3 months. Suppose, the spot
exchange rate is INR 57.0000: 1 USD. If the spot exchange rate after 3-months remains

unchanged, then exporter will get INR 57,000,000 by converting the USD received from the

export contract. If the exchange rate rises to INR 58.0000: 1 USD, then exporter will get INR

58,000,000 after 3 months. However, if the exchange rate falls to INR 56.0000: 1 USD, then

exporter will get INR 56,000,000 thereby losing INR 1,000,000. Thus, exporter is exposed to

an exchange rate risk, which it can hedge by taking an exposure in the futures market .By

taking a short position in the futures market, exporter can lock-in the exchange rate after 3-

months at INR 57.0000 per USD (suppose the 3 month futures price is Rs. 57). Since a USD-

INR futures contract size is of 1000 USD, exporter has to take a short position in 1000

contracts. Whatever may be the exchange rate after 3-months, exporter will be sure of getting
INR 57,000,000. A loss in the spot market will be compensated by the profit in the futures

contract and vice versa.

An exporting firm can thus hedge itself from currency risk, by taking a short position in the

futures market. Irrespective, of the movement in the exchange rate, the exporter is certain of

the cash flow.

Long Hedge

A long hedge involves holding a long position in the futures market. A Long position holder

agrees to buy the base currency at the expiry date by paying the agreed exchange rate. This

strategy is used by those who will need to acquire base currency in the future to pay any

liability in the future.

Long Hedge Strategy Through an Example.

An importer, has ordered certain computer hardware from abroad and has to make a payment

of USD 1,000,000 after 3 months. The spot exchange rate as well as the 3- month’s future

rate is INR 57.0000: 1 USD. If the spot exchange rate after 3-months remains unchanged then

importer will have to pay INR 57,000,000 to buy USD to pay for the import contract. If the

exchange rate rises to INR 58.0000 : 1 USD, then importer will have to pay more – INR

58,000,000 after 3 months to acquire USD. However, if the exchange rate falls to INR

56.0000: 1 USD, then importer will have to pay INR 56,000,000 (INR 1,000,000 less).
Importer wants to remain immune to the volatile currency markets and wants to lock-in the

future payment in terms of INR. Importer is exposed to currency risk, which it can hedge by

taking a long position in the futures market. By taking long position in 1000 future contracts,

importer can lock-in the exchange rate after 3-months at INR 57.0000 per USD. Whatever

may be the exchange rate after 3-months, importer will be sure of getting the 1 million USD

by paying a net amount of INR 57,000,000. A loss in the spot market will be compensated by

the profit in the futures contract and vice versa.

An importer can thus hedge itself from currency risk, by taking a long position in the futures

market. The importer becomes immune from exchange rate movement.

Understanding Currency Arbitrage

Currency arbitrage involves the exploitation of the differences in quotes rather than

movements in the exchange rates of the currencies in the currency pair. Forex

traders typically practice two-currency arbitrage, in which the differences between the

spreads of two currencies are exploited. Traders can also practice three-currency arbitrage,

also known as triangular arbitrage, which is a more complex strategy. Due to the use of

computers and high-speed trading systems, large traders often catch differences in currency

pair quotes and close the gap quickly.

The most important risk that forex traders must deal with while arbitraging currencies is

execution risk. This risk refers to the possibility that the desired currency quote may be lost

due to the fast-moving nature of forex markets.

Example of Currency Arbitrage

For example, two different banks (Bank A and Bank B) offer quotes for the US/EUR

currency pair. Bank A sets the rate at 3/2 dollars per euro, and Bank B sets its rate at 4/3

dollars per euro. In currency arbitrage, the trader would take one euro, convert that into

dollars with Bank A and then back into euros with Bank B. The result is that the trader who

started with one euro now has 9/8 euros. The trader has made a 1/8 euro profit if trading fees

are not taken into account.

Currency arbitrage requires the buying and selling of the two or more currencies to happen
instantaneously, because an arbitrage is supposed to be risk free. With the advent of online

portals and algorithmic trading, arbitrage has become much less common. With price

discovery high, the ability to benefit from arbitrage falls.

What is Cost of Carry

The charges of storing a physical product or retaining a financial instrument are known as the

cost of carry. Interest on long holdings, local short rates, and insurance and storage charges

associated with a physical item are all examples of carry costs.

Definition of Cost of Carry

Simply put, carry costs are any additional funds required to maintain a specific position. If

you want to trade stocks, you must have a thorough understanding of the term. Cost of carry
is a component to consider in the financial markets because it changes depending on any

charges associated with keeping a given position or stock.

Cost of carry futures, for example, can be confusing across markets. This has a significant

impact on trade demand and may even provide arbitrage possibilities. When trading stocks,

you may be charged a cost of carry because you are trading per share.

What is the Cost of Carry Model?

Before taking a position, every investor should carefully consider all of the potential costs.

Cost of carry may not always imply a large sum of money or excessive liabilities. The degree

of the financial cost is usually determined by the techniques implemented in managing the

possible expenses associated with an asset of position. Depending on the context, the term

cost of carry has several connotations.

In the financial markets, for example - the costs of entering a position and maintaining it

differ from the expenses of carrying it. In the commodity markets, cost of carry refers to the

costs of retaining an asset, as well as storage, insurance, and other fees.

To grasp the concept of cost of carry, you must first learn about the cost of carry model. The

model will assume that the arbitrage spread between the spot and futures prices effectively

eliminates all pricing flaws, both clear and not-so-obvious. After all of these other factors are

taken into account, the cost of carry is the only item that justifies the difference between the
spot and futures prices.

It is the expense of holding a futures position in your books, as the name implies. The

assumption in the cost of carry model is that such futures contracts are kept to maturity and

not squared off in the interim.

What is Cost of Carry Futures?

In the futures market of derivatives, the cost of carry is defined as a component of the

computation for a stock's future cost. If the cost of carry is tied to a physically held

commodity, storage rates, inventory pricing, and insurance may be included in an investor's

cost of carry. Furthermore, each investor is unique, and their specific cost of carry

considerations may influence their decision to invest in futures markets at different prices.

Cost of Carry Formula

The 'convenience yield' is factored into the price calculation of the futures market. This is an

advantage of having the commodity in question in terms of value. The cost of carry formula

is as follows:

"F =Se^(r+s-c)*t)"

Explanation of the Cost of Carry Formula:

F = it is the price of the commodity in the future.

S = it is the commodity's spot price.

e = it is the natural log base.

r = it is the rate of interest without risk.

s = it is the cost of storage that is shown as a spot price per cent.

c = it is the yield of convenience.

t = it is the time until the contract is delivered, and it is a fraction of a year.

How to Calculate Cost of Carry?

CoC is frequently used by traders to gauge the market mood. A big drop in CoC is interpreted

by analysts as an indication that the underlying is about to fall. CoC of the benchmark index

Nifty futures, for example, fell nearly half a fortnight ago and served as a signal of the index's

subsequent correction. When the CoC for a stock's future rises, it indicates that traders are

willing to pay more to keep the position and hence expect the underlying to rise. CoC is
stated as a percentage of an annualized value. You could utilize the formula mentioned above

to do the calculation.

What is Cost of Carry in Derivatives?

Since derivatives prices are generated from the underlying spot price, they move in lockstep

with it. It could also happen differently - as changes in futures prices widen the arbitrage

difference and make futures buying more appealing, driving up spot prices.

Stock Market Index

Stock market indexes indicate a specific collection of shares chosen based on specific

characteristics such as trading frequency, share size, and so on. The sampling technique is

used in the stock market to depict market direction and change through an index.
Meaning of Stock Market Index

A stock market index - it is a statistical source that measures financial market fluctuations.

The indices are performance indicators that indicate the performance of a certain market

segment or the market as a whole.

A stock market index is constructed by choosing equities from similar companies or those

that match a predetermined set of criteria. These shares are already listed on the exchange and

traded. Share market indexes can be built using a range of variables, including industry,

segment, or market capitalization.

Each stock market index tracks the price movement and performance of the stocks that

comprise the index. This simply means that the success of any stock market index is precisely

proportionate to the performance of the index's constituent stocks. In layman's words, if the

prices of the stocks in an index rise, the index as a whole rises as well.

Types of Stock Market Indices

a) Sectoral Index

Both the BSE and the NSE have some strong indicators that gauge companies in a given

sector. Indices like the S&P BSE Healthcare and NSE Pharma are known to be good

indicators of changes in the pharmaceutical sector. Another notable example is the S&P BSE

PSU and Nifty PSU Bank Indices, which are indices of all listed public sector banks.
However, neither exchange is required to have equivalent indexes for all industries, yet this is

a key cause in general.

b) Benchmark Index

The Nifty 50 index, which consists of the top 50 best-performing equities, and the BSE

Sensex index, which consists of the top 30 best-performing stocks, are indicators of the NSE

and the Bombay Stock Exchange, respectively. This group of equities is known as a

benchmark index since they employ the best standards to regulate the companies they select.

As a result, they are regarded as the most reliable source of information about how markets

work in general.

c) Market Cap Index

Few indices select companies on the basis of their market capitalization. Market

capitalization refers to the stock exchange market value of any publicly traded corporation.

Indices such as the S&P BSE and NSE small cap 50 are companies with a lower market

capitalization as defined by the Securities Exchange Board of India (SEBI).

d) Other Kinds of Indices

Several additional indices, such as the S&P BSE 500, NSE 100, and S&P BSE 100, are

slightly larger and have a greater number of stocks listed on them. You may have a low-risk

appetite, but Sensex stocks may have a high-risk appetite. Investment portfolios are not

designed to fulfil all demands. As a result, investors must remain focused and invest in areas

where they feel secure.

Formation of an Index

A stock market index is formed by combining equities with similar market capitalizations,

business sizes, or industries. The index is thereafter computed based on the stock pick.

However, each stock will have a distinct price, and the price range in one stock will not be

the same as the price range in another. As a result, the index value cannot be determined by

simply adding the prices of all the stocks.

As a result, allocating weights to stocks enters the picture. Each stock in the index is given a

certain weightage depending on its current market price or market capitalization. The weight
defines the impact of stock price fluctuations on the index value. The two most widely used

stock market indices are:

a) Market Cap Weightage

Market capitalization refers to a company's overall market value on the stock exchange. It is

computed by multiplying the total number of outstanding stocks issued by the corporation by

the stock price. However, for a market-cap-weighted index, the stocks are chosen based on

their market capitalization relative to the overall market capitalization of the index.

Assume a stock has a market capitalization of Rs. 100,000, and the underlying index has a

total market capitalization of Rs. 2,000,000.

As a result, the stock will be given a weightage of 50%. An investor should keep in mind that

the market capitalization of a company changes every day with the change in its price, and as
a result, the weightage of the stock changes daily. In India, several indices use free-float

market capitalization. The total number of shares listed by corporations is not used to

determine market capitalization in this case. Instead, they use the number of publicly traded

shares.

b) Price Weightage

The index value is calculated utilizing market capitalization rather than the company's stock

price in this technique. As a result, equities with higher prices receive more substantial

weightage in the index than stocks with lower prices.

What are Index Futures?

Index futures are contracts that allow a trader to purchase or sell a financial index today and

have it resolved at a later date. Traders speculate on the price direction of an index, such as

the S&P 500, using index futures. Index futures are also used by investors and investment

managers to protect their stock investments from losses.

How do Index Futures Work?

Index futures, like all futures contracts, provide the trader or investor the power and

responsibility to deliver the contract's cash value based on an underlying index at a future

date. The trader is bound to provide the cash value on expiry unless the contract is unwound
before expiration by an offsetting deal.

An index is a measurement of the price of a single item or a collection of assets. Index futures

are derivatives, which means they are based on an underlying asset (the index). Traders

utilize these products to trade a wide range of assets, including stocks, commodities, and

currencies. To bet on the index's appreciation or depreciation, an investor could buy or sell

index futures on the S&P 500.

How to Trade Index Futures?

In index futures investing or trading, the buyer and seller lock purchase and sell bids. Both

parties agree to close their holdings lawfully at a specific price and on a specific date.

Traders' buy and sell orders are placed by a futures broker on their behalf. The next step is to

create a long and short position for buy and sell orders, with initial and maintenance margins.
The payment of futures contracts is entirely based on cash. On the expiration date, the seller

and buyer can also pay and receive the difference in the agreed-upon contract price in cash.

Simply said, a higher price results in a profit for the buyer, while a lower price results in a

loss for the seller.

Types of Index Futures

Index futures are of several types, and they are mentioned below:

Nifty 50: 50 underlying securities make up the BSE's Sensitive Index or Sensex.

Nifty IT: Shares of information technology make up the underlying assets. The fortunes of

these futures would depend on the performance of the overall sector.

S&P BSE Sensex: 30 underlying securities make up the BSE's Sensitive Index or Sensex.

Nifty Bank: Bank shares make up the index, so how the Nifty Bank futures would perform

would depend on how well the banks are doing.

S&P BSE Bankex: The futures have banking stocks listed on the Sensex.

S&P BSE Sensex 50: This index is inclusive of 50 stocks instead of the 30 that make up the

Sensex.

S&P BSE Bharat 22 Index: This index is made up of 22 central public sector enterprises.

Others: You could also trade in these futures from foreign stock exchanges.

Importance of the Index Futures

Due to a lack of cash to make large stock purchases, futures contracts are one of the most

effective trading options. It's a derivative-based investment that allows traders to spend less

while earning more. Furthermore, there are two methods for using equities or stock index

futures:

Experienced traders can use futures contracts to bet on the future direction of an underlying

asset or index. Simply put, it means that instead of buying or selling futures contracts,

investors can wager on a group of assets by speculating on a bullish or bearish market.

Traders must stay current with market developments in order to lock in successful positions

when speculating.

Many traders utilize futures contracts to hedge against losses incurred as a result of excessive

stock price swings. When stock prices fall, investors with a stock portfolio or equity index
options sell futures contracts to reduce their risk of losing money. Futures contracts gain

value in this case, as opposed to stock prices falling.

Introduction to Derivatives

Derivatives are financial instruments whose value depend upon or is derived from some

underlying assets. The underlying assets can be real assets such as commodities, gold etc. or

financial assets such as index, interest rate etc. A derivative does not have its own physical

existence. It emerges out of the contract between the buyer and seller of the derivative

instrument. Its value depends upon the value of the underlying asset. Hence returns from

derivative instruments are linked to the returns from underlying assets. The most common

underlying assets include stocks, bonds, commodities currencies, interest rates and market

indexes. Stock futures are derivative contracts based on individual stocks in the securities

market. Stock index futures are derivative contracts where the underlying asset is an index. In

case of wheat futures, the underlying asset is wheat. In case of gold futures the underlying

asset is gold. Similarly we have derivatives based on various real as well as financial assets.

Now a days we also find derivatives which are based on other derivatives. The derivative

itself is merely a contract between two or more parties.

Securities Contracts (Regulation) Act, 1956 defines derivative as under:

“Derivative” includes—

(A) a security derived from a debt instrument, share, loan, whether secured or unsecured,

risk instrument or contract for differences or any other form of security,

(B) a contract which derives its value from the prices, or index of prices, of underlying

securities.

2. Classification of Derivatives

Derivatives can be classified into broad categories depending upon the type of underlying

asset, the nature of derivative contract or the trading of derivative contract.

2.1 Commodity derivatives and Financial derivatives

Derivatives can be classified into Commodity derivatives and Financial derivatives on the

basis of the type of underlying asset. In case of Commodity derivatives the underlying asset is
a physical or real asset such as wheat, rice, jute, pulses, or even metals such as gold, silver,

copper, aluminium, oil etc. In case of financial derivatives the underlying asset is a financial

asset such as equity shares, bonds, debentures, interest rate, stock index, current, exchange

rate etc. Financial derivatives are more popular the world over. Commodity derivatives are

traded on Multi Commodity Exchange (MCX) and National Commodities and Derivatives

Exchange (NCDEX) in India. Commodity derivatives based on agricultural commodities are

more popular than those based on metals. It must be noted that the derivatives were

developed to hedge the price risk in case of agricultural commodities. Hence initially

commodity derivatives were developed. Financial derivatives were developed later in the

decade of 1980s. Financial derivatives are traded on BSE, NSE, United stock exchange

(USE) and MCX-SX in India.

2.2 Elementary derivatives and Complex derivatives

Elementary or basic derivatives are those derivatives which are simple and easily

understandable. Such derivatives are futures and options. Complex derivatives have complex

provisions and features which make them difficult to understand by an investor. Complex

derivatives include exotic options, synthetic futures and options and so on.

2.3 Exchange traded derivatives and Over The Counter (OTC) derivatives

Derivatives may be traded on an exchange or they may be privately traded over the counter
(OTC). Exchange traded derivatives are standardised derivative product traded as per the

rules and regulations of the exchange. For example Stock index futures, stock index options

and Stock futures and options in India are exchange traded derivatives. OTC derivatives are

private bilateral contracts between two parties and are non standardised. These derivatives are

specific to the needs of the parties involved. For example forward contracts in foreign

exchange market are OTC derivatives.

3. Participants (Or Traders) In Derivatives Market

Different types of parties participate in derivatives market and make it a liquid and smooth

market. Derivatives were initially developed to provide hedging against price risk. However

now a days these instruments are also widely used for the purpose of speculation. Further, if

there is any mispricing then arbitrage opportunities arise which can be exploited to restore
equilibrium. Three categories of traders in derivative market are- Hedgers, Speculators and

Arbitrageurs.

Hedgers: Investors having long position in assets are exposed to price risk i.e. the risk that

asset prices will go down. On the other hand investors having short position in assets are also

exposed to price risk i.e. the price of the asset may go up. Hence they want to hedge their

position to be immune to price risk. Hedgers use financial derivatives to reduce or eliminate

the risk associated with price of an asset. Futures contracts enable both the parties (having

long or short position) to hedge or eliminate their risk. In case of hedging, risk is actually

transferred from the hedger to the speculator. Options are widely used by hedgers to reduce

their risk exposure.

Speculators use derivatives to get extra leverage and earn quick and large potential gains on

the basis of future movements in the price of an asset. They can increase both the potential

gains and potential losses by usage of derivatives in a speculative venture. Speculators take

position on the basis of their assessment of future price movements. Futures are widely used

by speculators. If a speculator expects that the stock price will go up, he buys futures and vice

versa.

Arbitrageurs are those traders who take advantage of any discrepancy in pricing and exploit

it to bring in equilibrium. Arbitrageurs are in business to take advantage of a discrepancy

between prices in two different markets. Arbitrage is possible over space as well over time.

Derivatives allow arbitrageurs to exploit arbitrage opportunities over time as well. If, for

example, they see the futures price of an asset getting out of line with the cash price, they will

take offsetting positions in the two markets (overtime) to lock in a profit.

3.1 Types of Financial derivatives

The subject matter of this chapter is financial derivatives. Financial derivatives are those

derivatives where the underlying asset is the financial asset or instrument such as index,

stocks, bonds, currency, interest rates etc. Financial Derivatives are generally classified as

Forwards, Futures, Options and Swaps depending upon their nature and features. In this book

we focus only on the first three categories i.e. Forwards, Futures and Options. They are

explained below:
4. Forwards

A forward contract is a private bilateral agreement between two parties to buy and sell a

specified asset at a specified price on a specified future date.

Consider a farmer in Punjab, Mr Singh, plans to grow 5000 Kgs of wheat this year. He can

sell his wheat for whatever the price is when he harvests it, or he could lock in a price now by

selling a forward contract that obligates him to sell 5000 kgs of wheat to Pillsbury after the

harvest for a fixed or specified price. By locking in the price now, he can actually eliminate

the risk of falling wheat prices. On the down side, if prices rise later, he is foreclosing the

opportunity of super profits. But then, he must have played safe and insured himself against

the possibility of prices falling down eventually. The transaction that Mr. Singh has entered

into is known as Forward transaction and the contract covering such transaction is known as

Forward Contract.

Hence a forward is a contract between two parties to buy or sell a specified asset at a pre-

determined price on a specified future date.

A financial forward contract is that forward contract where the underlying is a financial asset

such as currency. For example assume that an Indian company XYZ Ltd. has to pay its

import bills in 20000 US dollars after three months. However the company faces the risk of

rupee depreciation, i.e. the price of the US dollar may go up. To guard against this exchange
rate risk, the company may enter into a forward agreement with some other company to buy

20000 US dollars at a specified price after 3 months. This way it has hedged its position. If

after three months the exchange rate is higher, the company `stands to gain. If on the other

hand the rupee appreciates and US dollars are available at a lower price, the company stands

to lose. In any case the company’s position is certain in the sense that it will get 20000 US

dollars at the pre-specified price after 3 months.

4.1 Features

Forward contract has following features:

Customised – Each contract is custom designed and parties may agree upon the contract size,

expiration date, the asset type, quality, etc.

Underlying asset – The underlying asset can be a stock, bond, commodity, foreign currency,

interest rate or any combination thereof.

Symmetrical rights and obligations – Both the parties to a forward contract have equal

rights and obligations. The buyer is obliged to buy and the seller is obliged to sell at maturity.

They can also enforce each other to perform the contract.

Non-regulated market – Forward contracts are private and are largely non-regulated,

consisting of banks, government, corporations and investment banks. It is not regulated by

any exchange.

Counter-party Risk or default risk – This is a risk of non-performance of obligation by

either party as regards to payment (buyer) or delivery (seller). Being a private contract, there

are chances of default or counter party risk.

Held till maturity – The contracts are generally held till maturity. A forward contract cannot

be squared up at the wish of one party. It can be cancelled only with the consent of the other

party.

Liquidity – Liquidation is low, as contracts are customised catering to the needs of parties

involved. They are not traded on an exchange.

Settlement of Contract – Settlement of a derivative contract can be in two ways – through

delivery or through cash settlement. Most of the forward contracts are settled through
delivery. In this case the buyer pays the price and seller gives the delivery of the specified

asset at maturity. Some of the forward contracts are also cash settled. In case of cash

settlement, the parties only pay/receive the price differential so as to settle the contract. No

physical delivery of asset takes place and hence no full payment is made for the contract.

5. Futures

A Futures contract is a refined or modified forward contract. A futures contract is a contract

to buy or sell a specified asset (physical or financial asset) at a specified price on a specified

future date. It is traded on an exchange and is a standardised contract. A financial futures

contract is a contract wherein two parties agree to buy or sell a specified financial asset at a

specified price on a specified future date. Futures contracts are generally traded on an

exchange which sets the basic standardized rules for trading in the futures contracts.
5.1 Features

Standardised Contract – Terms and conditions of future contracts are standardized. They

are specified by the exchange where they are traded.

Exchange based Trading – Trading takes place on a formal exchange which provides a

place to engage in these transactions and sets a mechanism for the parties to trade these

contracts.

No default risk – Futures contract has virtually no default risk because the exchange acts as a

counterparty and guarantees delivery and payment with the help of a clearing house.

Clearing house – The clearing house protects the parties from default by requiring the parties

to deposit margin and settle gains and losses (or mark to market their positions) on a daily

basis.

Liquidity – Futures contracts are highly liquid contracts as they are continuously traded on

the exchange. Any party can square up his position any time.

Before maturity settlement possible – An investor can offset his future position by

engaging in an opposite transaction before the stipulated maturity of the contract.

Margin requirement – All futures contracts have margin requirements. Margin money is

required to be deposited with the exchange by both the buyer as well as seller at the time of

entering into the contract. Margin is important to safeguard the interest of the other party.
There are two types of margins – initial margin and maintenance margin. Initial margin is the

margin amount to be deposited initially with the exchange. If contract value is ` 100000,

initial margin requirement is 5% and maintenance margin is 2%, then the buyer of the

contract has to deposit ` 5000 with the exchange in his margin account. Now margin account

is settled on daily basis i.e. mark to market settlement. If margin amount in the account on

any day falls below the maintenance margin of ` 2000, then a variable call is made to

replenish the margin amount to the level of initial margin.

Settlement mechanism – Settlement of a derivative contract can be in two ways- through

delivery or through cash settlement. Very few of the futures contracts are settled through

delivery. In this case the buyer pays the price and seller gives the delivery of the specified

asset at maturity. Most of the futures contracts are cash settled. In case of cash settlement, the
parties only pay/receive the price differential so as to settle the contract. No physical delivery

of asset takes place and hence no full payment is made for the contract. In case of Index

futures the settlement is done only through cash as an Index cannot be delivered.

5.2 Futures Contract Terminology

Spot price – The price at which an underlying asset trades in the spot market.

Futures price – The price that is agreed upon at the time of the futures contract for the

delivery of an asset at a specific future date.

Contract cycle – It is the period over which a contract trades on the exchange. Every month

on Friday following the last Thursday; a new contract having a three-month expiry is

introduced for trading, on NSE and BSE.

Expiry date – Is the date on which the final settlement of the contract takes place. Last

Thursday of every month is expiry date for futures contracts. If that happens to be a trading

holiday then previous working day.

Contract Size or Lot size – The quantity of the underlying asset that has to be delivered

under one contract.

Price steps – The minimum difference between two price quotes. The price step in respect of

CNX Nifty futures contracts is ` 0.05.

Price bands – The minimum and maximum price change allowed in a day is termed as price
bands. It is generally +- 10%. There are no day minimum/maximum price ranges applicable

for CNX Nifty futures contracts. However, in order to prevent erroneous order entry by

trading members, operating ranges are kept at +/- 10%.

5.3 Comparison between Forwards and Futures

Though both forwards and futures share common characteristics, they differ on the following

grounds:

BASIS FORWARDS FUTURES

Standardisation of Forward contracts are private Futures contracts are

contract agreements between two exchange traded and

BASIS FORWARDS FUTURES

parties and are non- standardised contracts as

standardised. terms and conditions are

set in advance.

Trading & Regulation Forwards are not traded on Futures are traded on stock

stock exchange. They are not exchange and are

regulated. regulated.

Counter party default There is always a possibility Clearing houses guarantee

risk that a party may default. the transaction, thus

minimising the default

risk.

Liquidity Liquidity is low, as contracts Liquidity is high, as

are tailor-made contracts contracts are standardised

catering to the needs of parties exchange-traded contracts.

involved. Further, they are not

easily accessible to other

market participants.

Price Discovery Price discovery is not efficient, Price discovery is efficient,

as markets are scattered. as markets are centralised.

Settlement Settlement of the Forward Futures contracts are mar-

contract occurs at the end of ked-to market on daily

the contract, i.e. Settlement basis which means that

date only. they are settled day by day

until the end of the

 BASIS FORWARDS FUTURES

contract.

Hedging/speculation Forward contracts are popular Futures are popular among

among hedgers. speculators.

Margin Requirements There is no requirement for Both the buyer and seller

depositing margin money by have to deposit margin

either party. money with the exchange.

Examples Foreign Currency market in Commodities futures,

India Index futures and

Individual Stock futures in

India.

5.4 Types of Financial Futures Contracts

Financial futures contracts can be – index futures, stock futures, currency futures, interest rate

futures depending upon the underlying asset. In case of index futures, the underlying asset is

an Index. In this chapter we deal with only two types of financial futures viz – Index futures
and Stock Futures.

a. Index Futures

In case of Index futures the underlying asset is a stock index say NIFTY or SENSEX. A stock

index is constructed by selecting a number of stocks and is used to measure changes in the

prices of that group of stocks over a period of time. Futures contracts are also available on

these indices. This helps investors make money on the performance of the index.

Contract size : Index futures contracts are dealt in lots. The stock indices points – the value

of the index – are converted into rupees.

For example, suppose the BSE Sensex value was 6000 points. The exchange stipulates that
each point is equivalent to ` 1, Further each contract has a lot size of 100. Then the value of

one contract will be 100 times the index value – ` 6,00,000 i.e. 1×6,000×100.

Expiry : An open position in index futures can be settled by conducting an opposing

transaction on or before the day of expiry.

Duration: Index futures have three contract series open for trading at any point in time – the

near-month (1 month), middle-month (2 months) and far-month (3 months) index futures

contracts.

Example : If the index stands at 3550 points in the cash market today and an investor decide

to purchase one Nifty 50 July future, he would have to purchase it at the price prevailing in

the futures market.

The price of one July futures contract could be anywhere above, below or at ` 3.55 lakh (i.e.,

3550×100), depending on the prevailing market conditions. Investors and traders try to profit

from the opportunity arising from this difference in prices.

b. Stock Futures

Stock futures are futures contracts where the underlying is an individual stock. For example

SBI stock futures have SBI stock as the underlying asset.

Lot/Contract size : In the financial derivatives market, the contracts are not traded for a

single share. Instead, every stock futures contract consists of a fixed lot of the underlying
share. The size of this lot is determined by the exchange and it differs from stock to stock.

For instance, a Reliance Industries Ltd. (RIL) futures contract has a lot of 250 RIL shares,

i.e., when you buy one futures contract of RIL, you are actually trading 250 shares of RIL.

Similarly, the lot size for Infosys is 125 shares.

Duration: Stock Futures contracts are also available in durations of 1 month, 2 months and 3

months. These are called near month, middle month and far month, respectively. The month

in which it expires is called the contract month and new future contracts are issued on the day

after expiry of the last contract.

Expiry: All three maturities contracts are traded simultaneously on the exchange and expire

on the last Thursday of their respective contract months. If the last Thursday of the month is a

holiday, they expire on the previous business day. In this system, as near-month contracts
expire, the middle-month (2 month) contracts become near-month (1 month) contracts and

the far-month (3 month) contracts become middle-month contracts.

Example: If an investor purchased a single June futures contract of XYZ Ltd., he has to buy

at price at which the June futures contracts are currently available in the derivatives market.

Let’s say these futures are trading at ` 1,000 per share. This implies, the investor agrees to

buy/sell at a fixed price of ` 1,000 per share on the last Thursday in June. However, it is not

necessary that the price of the stock in the cash market (or spot market) on last Thursday has

to be ` 1,000. It could be ` 992 or ` 1,005 or anything else, depending on the prevailing

market conditions. This difference in prices lead to profit or loss.

6. Options

An options is a contract that gives its buyer (holder) a right (but not obligation) to buy or sell

a specified asset at a specified price (exercise price) on or before a specified future date. An

options is a contract sold by one party (option-writer) to another party (option holder). The

holder of the options can exercise the option at specified price or may allow it to lapse. The

specified price is also termed as strike price or exercise price.

The options contract gives a right to the buyer. The seller has the obligation but no right. If

the option holder exercises the option, then the writer or seller of the option will be obliged to

perform. Hence when the option holder has a right to buy, the option writer has the obligation
to sell. When option holder has a right to sell, then the option writer has the obligation to buy.

Hence in case of options, the buyer and sellers are not on equal footing. The buyer has a

privileged position. Since the buyer has a right but no obligation, he has to pay some price,

known as options premium to the seller (or writer) of the option. NO RIGHT COMES FREE

OF COST. Hence the buyer pays options premium to the seller to buy the right to buy or sell.

The seller receives this options premium as a compensation for the obligation he undertakes.

Hence options contracts are asymmetrical w.r.t. rights and obligations. The buyer of the

options contract has a right but no obligation. The seller or writer of the options has an

obligation but no right. Since the holder of the option has a right, he may not exercise his

right if the conditions are unfavourable. Hence it is possible that the options contract is not

exercised at all.
This clearly differentiate options contract from futures contract discussed above. In case of

futures contracts, both the buyer as well as seller has equal rights and obligations. They can

enforce each other to perform the contract. At the same time they are obliged to perform the

contract.

Comparison Between Futures and Options

BASIS FUTURES OPTIONS

Rights Both the parties have right to ask Only the buyer (or holder) of the

for the performance of the options has the right to buy or

contract. sell. Seller does not have any

right.

Obligations Both the parties are obliged to Only the seller is obliged to

perform the contract. perform the contract.

Premium No premium is paid by either The buyer pays the options

payment party. premium to seller.

Margin Both the parties have to deposit Only the option writer has to
requirement some initial margin as per the deposit initial margin with the

requirements of the exchange. exchange as only the seller is

exposed to price risk. No margin

is to be deposited by the option

holder, as he has a right but no

obligation.

Profit and loss The buyer as well as the seller of The option holder’s loss is

potential the futures contract are exposed limited (to the extent of

to all the downside risk and has premium paid), but has potential

potential for all upside profits. for all upside profits. The
BASIS FUTURES OPTIONS

The gain to the buyer is loss to seller’s gain is limited to the

the seller and the loss to the amount of options premium but

buyer is gain to the seller. There he is exposed to all the downside

is unlimited gain and loss risk (i.e. potential loss is

possibility for both the parties. unlimited).

Realisation of Profit or loss on futures are The gain on option can be

profits/losses ‘marked to market’ daily, realized in the following ways:

meaning the change in the value a. Exercising the option at

of the positions is attributed to expiry

the accounts of the parties at the b. Going to the market and

end of every trading day – but a taking the opposite position, or

futures holder can realize c. Waiting until expiry and

profits/losses by going to the collecting the difference

market and taking the opposite between the asset price and the

position. strike price.

Execution of Futures contract are settled Buyer may or may not exercise

contract through cash or delivery but the option and therefore the

they are always executed. option contract may lapse

without being exercised or

become a waste.

Purpose Futures are used to hedge and Usually used as a hedge

speculate. instrument. Options are a better

hedging instrument than futures.

This is because here the hedger

 BASIS FUTURES OPTIONS

keeps all the potential for upside

gain but his loss is limited.

6.1 Types of Options

a. Call options – An options contract that gives its holder the ‘right to buy’ a specified asset

at a specified price on or before a specified future date, is termed as call option. The seller

has the obligation to sell. A call option is bought when the buyer of the call option fears a rise

in underlying asset’s price. A call option is exercised when the stock price is greater than the

exercise price. In such a case the holder of the call options can buy the stock or asset at the

exercise price which is lower than the prevailing market price.

For example: Let us assume that the current price of SBI shares is ` 119. Mr. A expects that

the price of SBI share will go up, hence he buys a call option on SBI shares at the exercise

price of ` 120. The expiration date is after 1 month. Further assume that the option can be

exercised only on the expiry date and not before that. Now if on the expiry date, the

prevailing market price of SBI share is more than 120, say ` 125, then Mr. A will exercise the

option. He will buy a share of SBI by exercising his call option at the price of ` 120. He can

sell it at the market price of 125 in spot market and make a gain of ` 5. If on the other hand
the market price is ` 115 on the date of expiry, then Mr. A will not exercise this call option.

His loss in this case will be the amount of option premium that he must have paid at the time

of buying this call option.

b. Put options – A put option provides a right to sell. An options contract that gives its

holder the ‘right to sell’ a specified asset at a specified price on or before a specified future

date, is termed as put option. The seller has the obligation to buy. A put option is bought

when the buyer of the put option fears a decline in underlying asset’s price. A put option is

exercised when the stock price (or the underlying asset’s price) is lower than the exercise

price. In such a case the holder of the put option can sell the stock (or asset) at the exercise

price which is higher than the prevailing market price.

For example: Let us assume that the current price of SBI shares is ` 119. Mr. A expects that

the price of SBI share will go down, hence he buys a put option on SBI shares at the exercise

price of ` 120. The expiration date is after 1 month. Further assume that the option can be

exercised only on the expiry date and not before that. Now if on the expiry date, the

prevailing market price of SBI share is less than 120, say ` 116, then Mr. A will exercise the

option. He will sell a share of SBI by exercising his put option at the price of ` 120, and make

a gain of ` 4. If on the other hand the market price is ` 123 on the date of expiry, then Mr. A

will not exercise this put option. His loss in this case will be the amount of option premium

that he must have paid at the time of buying this put option.

6.2 Styles of Options

a. European options – A European style options contract can be exercised only on the

expiration date. In the above examples the call options as well as put options were of

European style as it is given that they can be exercised only on the expiration date and not

before that.

b. American options – An American style options contract can be exercised at any time

before the expiration or on the expiration date. American options provide more flexibility to

the holder of the options, as he may exercise the options anytime till maturity. Therefore,

American style of options have higher options premium than the European style of options.
6.3 Covered Options and Naked options

There are two ways to write options – Covered option writing and Naked option writing.

a. Covered option – Covered option means an option for which the seller owns the

underlying securities. When the option writer has the underlying stock and writes (or sells)

the option to buy that stock (i.e. writes the call option), then such a call option is known as

Covered Option. If the option is exercised then the writer supplies the stock that he holds or

has previously purchased. In this case the option is covered with the stock that the option

writer is holding. Covered option writing is a less risky strategy.

b. Naked option – Naked option means an option for which the seller does not own the

underlying security. When the option writer does not have the underlying stock but writes (or

sells) the option to buy that stock (i.e. writes the call option), then such a call option is known
as Naked option. If the price of the stock rises and the call option is exercised, the option

writer must buy the stock at the higher market price in order to supply it to the buyer. With

naked option the potential for loss is considerably greater than with covered option.

6.4 Index, stock, currency and interest rate options

Options can be classified on the basis of the underlying assets as well. Here we have – index

options, stock options, currency options and interest rate options.

a. Index options : In case of Index options, the underlying security is a stock index such as

NIFTY or SENSEX. Hence the value of an index option is derived from the value of the

underlying index. In India Options are available on NIFTY and SENSEX.

b. Stock options : In case of stock options, the underlying security is a stock such as TCS

ICICI BANK etc. Hence the value of a stock option is derived from the value of the

underlying stock. In India Options are available on more than 100 stocks listed on NSE and

BSE.

c. Currency options : In case of currency options, the underlying security is a foreign

currency such as US Dollar, EURO etc. Hence the value of a currency option is derived from

the value of the underlying foreign currency.

d. Interest Rate options : In case of interest rate options, the underlying security is a

particular interest rate such as Repo rate or MIBOR. Hence the value of an interest rate
option is derived from the value of the underlying interest rate.

6.5 Basic Terminology Used in Case of Options

 Exercise price (or strike price) – It is the specified price at which an option

can be exercised. It is also known as strike price. The exercise price for a call

option is the price at which the security can be bought (on or before the

expiration date) and the exercise price for a put option is the price at which the

security can be sold (on or before the expiration date).

 Expiration date – The date, on or before which, the option may be exercised

is termed as expiration date. Beyond this date the right of the options holder

ceases to exist. On or before the expiration date, the option may be exercised if
 conditions are favourable to the buyer. If conditions are not favourable then

the option is not exercised and is left to lapse.

 Option premium – In options contract, the option holder (or the buyer of the

options) has to pay some amount known as options premium to the option

writer (or seller of the options) for availing the right. It is required because the

buyer of the options has a right while seller of the options has obligation to

buy or sell at the specified price. Hence there is a transfer of risk from the

holder to the writer of the options. Hence the holder of the options must pay

some amount to the writer to buy the options. The amount of option premium

depends upon strike price, time to expiry, risk free rate of return and volatility

of the underlying asset.

6.6 Payoffs From Basic Option Positions

6.6.1 Call Option

As you already know by now, a Call option gives the option holder a right to purchase a

security at the exercise price. In stock market a long position means buying and a short

position means selling.

1(a) Long Call (Buying a call option)

Let us suppose an investor buys a call option of ABC Ltd. share with exercise price (or strike
price) of ` 250 at a premium of ` 10. The option holder will exercise his option to buy the

share when the actual market price of the share on the expiration date is more than ` 250. In

that case the holder of the call option can buy the stock at exercise price of ` 250 and can

immediately sell it at a higher market price in the market. At price below ` 250, the option

holder shall choose not to exercise the call option. He can buy the share from the market at a

lower price if he so desires. Hence, payoff of a call option at expiration will be as under. It is

also termed as the value of the call option at expiry.

Payoff of a Long Call (i.e. call option buyer or = S1 – X if S1 > X

call option holder)

=0 if S1 ≤ X
Where S1= Stock Price at expiration and X = Exercise Price.

One of the noteworthy points about option is that payoffs to the buyer or holder cannot be

negative. This is because, the option is exercised only if S1> X. If S1 < X, option holder

won’t exercise the call option and the call option expires with zero value. The loss to the

option holder shall be limited to the premium paid by him originally. Profit to the option

holder is the value of the option at expiration minus the premium paid.

It must be noted that the option holder must pay an amount called Option premium to the

option writer so as to buy the call option. If the amount of call option premium is C, the Net

payoff (or profit and loss) of a Long Call (i.e. of a buyer of a call option) is determined as

under

Net Payoff (profit or loss) to Long call (call holder) = S1 – X – C if

= 0-C = – C if

The investor would break-even if market price is equal to exercise price plus the option

premium already paid. When market price is higher than this break-even point then the call

option holder makes profits. On the other hand if market price is lower than the break-even

point then the call option holder incurs a loss, maximum of the amount of option premium.

In our example the buyer of a call option would break-even if the market price is ` 260. The
net payoff of the call with the exercise price ` 250 can be given as under for different stock

prices at expiration.

Share price on exercise date (S1) 240 250 260 270 280

Exercise price (E) 250 250 250 250 250

Exercise option No No Yes Yes Yes

Buyer’s Inflow 0 0 260 270 280

Buyer’s outflow 0 0` -250 -250 -250

 Premium Paid -10 -10 -10 -10 -10

Net Payoff Or Loss/Profit -10 -10 0 10 20

Figure 1: Net Pay-off to Buyer of Call Option (Long Call)

In the Figure 1 above, it could be observed that if the share price is less than the exercise

price, the loss of the option holder is constant and is limited to the option premium paid.

However, as the share price increases beyond the exercise price, his loss reduces and breaks

even when the share price equals exercise price plus premium. When the share price is

beyond this break-even point then the option holder makes profit or gains. The potential for
the gains is unlimited. The higher the share price the greater is the gain. Hence the loss to a

long call (or call option holder) is limited to the amount of option premium paid, but gains are

unlimited.

1(b) Selling a call option (Short Call or call option writer)

The position of a call option writer is exactly opposite of call option holder.

Payoff of a Short call (or call option writer) = –(S1 –X) if

=0 if

The seller of a call option receives option premium for writing the call option but bears all the

downside risk. A short call (i.e. seller of call option) incurs losses if the share price is higher
than the exercise price. In that case, the option holder will exercise the call option and the

writer or seller has to fulfil his obligation deliver the share worth S1 (stock price at

expiration) for only X (exercise price) amount:

Where S1= Stock Price at expiration and X = Exercise Price.

Since the seller of the call options receives a premium of C irrespective of the outcome of the

call option, the net payoff (or profit and loss) to a short call (or to call option seller) is given

below:

Net Payoff (profit or loss) to Short call(or call writer) = –(S1 – X)+C if

= 0+C = C if

Where C = call option premium amount.

It must be noted that the net gain to a short call is limited to C while his potential loss is

unlimited. The higher the stock price at expiration the greater will be the loss to a short call.

Please note that the net payoff of a seller of a call option is exactly the opposite of the net

payoff of the holder of a call option. Hence gains to the option holder is loss to the option

seller and loss of the option holder is the gain to the option seller. The break-even point of

call option seller is same as the break-even point of call option holder.

The call writer is exposed to losses if the share price increases: In our example the net payoff
to a seller of the call option will be as under for different stock prices.

Share price at expiration (S1) 240 250 260 270 280

Exercise price 250 250 250 250 250

Whether option is Exercised by the holder No No Yes Yes Yes

Seller’s Inflow 0 0` 250 250 250

Seller’s Outflow 0 0 -260 -270 -280

 Premium received 10 10 10 10 10

Net payoff (Loss/Profit) 10 10 0 -10 -20

The position of call option seller or option writer can be depicted in Figure 2 as follows:

It can be observed that Figure 2 is just the reverse of Figure 1. This is because net payoff to a

short call is exactly opposite of the net payoff to a long call. In Figure 2, the option seller

makes the profit when the share price is less than the exercise price plus premium. However,

the profit reduces when the share price increases beyond 250. So the profit potential of a call

seller is limited to 10 only i.e. the premium received. But chances of losses are unlimited and

are dependent upon the market price of share. The higher the market price the greater will be

the potential loss.

Figure 2: Net Payoff of a Short Call (Or Call Option Writer/Seller)

6.6.2 Put Option

A Put option provides the holder of the option, the right to sell, a security at the exercise price

2(a) Long Put (i.e. Buying a Put option or Put option holder)

Let us suppose an investor buys a put option of ABC Ltd. share with exercise price (or strike

price) of ` 250 at a premium of ` 10. The option holder will exercise his put option to sell the
share when the actual market price of the share on the expiration date is less than ` 250. In

that case the holder of the put option can buy the share at a lower price from market and sell

the share at exercise price of ` 250 by exercising his put option. At share price equal to or

above ` 250, the option holder will choose not to exercise the put option. He can sell the share

in the market at a higher price if he so desires.

To generalise, a put option is exercised by the holder only when the stock price at expiration

(S1) is lower than the exercise price (X). In such a case the put option holder will sell his

stock at exercise price to the seller of the option rather than selling it in the market where he

will get a lower price for his stock. The option holder will not exercise his option if the stock

price at expiration is equal to or higher than the exercise price. Hence the payoff from a put

option is given below. It is also termed as the value of a put option at expiry.

Pay-off to a Long Put (Put option buyer or Put option holder) =0 i

= X-S1 i

It must be noted that the option holder must pay an amount called put Option premium to the

option writer so as to buy the put option. If the amount of option premium is P, the Net

payoff of a Long Put (i.e. of a buyer of a put option) is determined as under

Net Payoff to Long Put (Put option buyer or Put option holder) = 0-P = -P i

= X-S1 -P i

The investor would break-even if stock price is equal to exercise price minus the option

premium already paid. When stock price is lower than this break-even point then the put

option holder makes profits. On the other hand if stock price is higher than the break-even

point then the put option holder incurs a loss, maximum to the amount of option premium.

Continuing our example, the position of a put option buyer or holder could be summarised as

follows:

Share price at expiration 220 230 240 250 260 270

 Exercise option Yes Yes Yes No No No

Buyer’s cash inflow 250 250 250 0 0 0

Buyer’s cost or cash outflow 220 230 240 0 0 0

Premium Paid -10 -10 -10 -10 -10 -10

Net Payoff (Loss/Profit) 20 10 0 -10 -10 -10

The Net Payoff diagram of a Long Put or buyer of a put option is provided in Figure 3.

Figure 3: Net Pay Off of a Put Option Holder (Buyer)

As it could be observed, the option holder of a put option exercises his option as long as the

stock price is lower than the exercise price. But he will not make profit unless the difference

between exercise price and stock price is more than the amount of put option premium

already paid by the option holder. His profit is equal to the exercise price less the sum of

stock price and premium. Further, the option holder would like his option to lapse in case the

stock price is more than the exercise price. In that case the loss to the option holder is equal to

the amount of option premium already paid. The option holder’s maximum loss is limited to

the amount of premium paid i.e. ` 10. The maximum gain to the put option holder will be
when stock price is zero (which is a hypothetical condition). In such a case the gain to the put

option holder will be equal to exercise price minus the amount of premium paid. In our

example it would be ` 250-10 = ` 240.

2(b) Short Put (or Selling a Put Option or Put Option writer)

The position of a put option writer is exactly opposite of the put option holder.

As seen above, the option holder will not exercise his option unless the stock price is lower

than the exercise price. Hence when stock price is higher than the exercise price, the put

option will lapse and its value will be zero. But if stock price is lower than the exercise price

then put option is exercised and the loss to the put option seller will be equal to the difference

between exercise price and stock price. The payoff from a short put option or for a seller of a

put option is given below:

Payoff to Short Put (or Put option Writer) =0

= -(X-S1)

Since the seller of the put option receives a premium of P irrespective of the outcome of the

put option, the net payoff to a short put (or to option seller) is given below:

Net Payoff to Short Put (or Put option Writer) =0+P=P if

= -(X-S1) + P if

It must be noted that the net gain to a put option writer is limited to P while his potential loss

is unlimited. The lower the stock price at expiration the greater will be the loss to a short put

(or put writer). Please note that the net payoff of a seller of a put option is exactly the

opposite of the net payoff of the holder of a put option. Hence gains to the option holder is

loss to the option seller and loss of the option holder is the gain to the option seller. The

break-even point of put option seller is same as the break-even point of put option holder.

The put option writer is exposed to losses if the stock price decreases. In our example the net

payoff to a seller of the put option will be as under.

 Share price 220 230 240 250 260 270

Whether put option is exercised by its Yes Yes Yes No No No

holder

Seller’s cost or cash outflow -250 -250 -250 0 0 0

Seller’s benefit or cash outflow 220 230 240 – – –

Premium Received 10 10 10 10 10 10

Net Payoff (Loss/Profit) -20 -10 0 10 10 10

The Net payoff matrix for writer of a put option looks like the Figure 4.

Figure 4: Net Payoff of a Short Put (i.e. Put Option Writer)

The net payoff for the put option writer is negative if stock price is less than (X–P). His loss

potential is substantial and dependent upon the share price. The lower the share price the

greater will be the loss. However as the share price cannot fall below zero, the maximum loss

will be equal to exercise price less premium. Hence in our example the maximum loss to a

put option writer will be ` 240 (i.e. 250-10). Please note that in our example the maximum
gain to a put option holder was ` 240. Further, the profit to a put option writer is limited to the

option premium received.

Break even position of Option parties

The above discussion shows net payoffs to a call option holder, call option writer, put option

holder and put option writer. In the discussion we have also specified the break-even level or

position in each case. It must be noted that the buyer and seller of options (whether call or

put) have completely opposite net payoffs. Hence their break-even level is also same. No gain

or loss to buyer also means no gain or loss to the seller.

In case of a call option, it will be exercised when stock price at expiration (S1) is higher than

the exercise price (X). But the buyer of a call option will be break even, having no gain or

loss, only when the stock price at expiration(S1) is equal to exercise price (X) plus call option

premium (C). This is because the call option premium is also a cost which is already incurred

by the call option holder. Hence the break-even point for a call option holder is when stock

price is equal to X+C. The same is the break even position for the writer of a call option.

UNIT – 3
What Is a Currency Option?

A currency option (also known as a forex option) is a contract that gives the buyer the right,

but not the obligation, to buy or sell a certain currency at a specified exchange rate on or

before a specified date. For this right, a premium is paid to the seller.
Currency options are one of the most common ways for corporations, individuals or financial

institutions to hedge against adverse movements in exchange rates.

Currency Option

The Basics of Currency Options

Investors can hedge against foreign currency risk by purchasing a currency put or

call. Currency options are derivatives based on underlying currency pairs. Trading currency

options involves a wide variety of strategies available for use in forex markets. The strategy a

trader may employ depends largely on the kind of option they choose and the broker or

platform through which it is offered. The characteristics of options in decentralized forex

markets vary much more widely than options in the more centralized exchanges of stock and

futures markets.

Traders like to use currency options trading for several reasons. They have a limit to their

downside risk and may lose only the premium they paid to buy the options, but they have

unlimited upside potential. Some traders will use FX options trading to hedge open positions

they may hold in the forex cash market. As opposed to a futures market, the cash market, also

called the physical and spot market, has the immediate settlement of transactions involving

commodities and securities. Traders also like forex options trading because it gives them a

chance to trade and profit on the prediction of the market's direction based on economic,
political, or other news.1

However, the premium charged on currency options trading contracts can be quite high. The

premium depends on the strike price and expiration date. Also, once you buy an option

contract, they cannot be re-traded or sold. Forex options trading is complex and has many

moving parts making it difficult to determine their value. Risk include interest rate

differentials (IRD), market volatility, the time horizon for expiration, and the current price of

the currency pair.

Vanilla Options Basics

There are two main types of options, calls and puts.

 Call options provide the holder the right (but not the obligation) to purchase an

underlying asset at a specified price (the strike price), for a certain period of time. If
 the stock fails to meet the strike price before the expiration date, the option expires

and becomes worthless. Investors buy calls when they think the share price of the

underlying security will rise or sell a call if they think it will fall. Selling an option is

also referred to as ''writing'' an option.

 Put options give the holder the right to sell an underlying asset at a specified price (the

strike price). The seller (or writer) of the put option is obligated to buy the stock at the

strike price. Put options can be exercised at any time before the option expires.

Investors buy puts if they think the share price of the underlying stock will fall, or sell

one if they think it will rise. Put buyers - those who hold a "long" - put are either

speculative buyers looking for leverage or "insurance" buyers who want to protect

their long positions in a stock for the period of time covered by the option. Put sellers

hold a "short" expecting the market to move upward (or at least stay stable) A worst-

case scenario for a put seller is a downward market turn. The maximum profit is

limited to the put premium received and is achieved when the price of the underlying

is at or above the option's strike price at expiration. The maximum loss is unlimited

for an uncovered put writer.

The trade will still involve being long one currency and short another currency pair. In

essence, the buyer will state how much they would like to buy, the price they want to buy at,
and the date for expiration. A seller will then respond with a quoted premium for the trade.

Traditional options may have American or European style expirations. Both the put and call

options give traders a right, but there is no obligation. If the current exchange rate puts the

options out of the money (OTM), then they will expire worthlessly.

SPOT Options

An exotic option used to trade currencies include single payment options trading (SPOT)

contracts. Spot options have a higher premium cost compared to traditional options, but they

are easier to set and execute. A currency trader buys a SPOT option by inputting a desired

scenario (e.g. "I think EUR/USD will have an exchange rate above 1.5205 15 days from

now") and is quoted a premium. If the buyer purchases this option, the SPOT will
automatically pay out if the scenario occurs. Essentially, the option is automatically

converted to cash.

The SPOT is a financial product that has a more flexible contract structure than the traditional

options. This strategy is an all-or-nothing type of trade, and they are also known as binary or

digital options. The buyer will offer a scenario, such as EUR/USD will break 1.3000 in 12

days. They will receive premium quotes representing a payout based on the probability of the

event taking place. If this event takes place, the buyer gets a profit. If the situation does not

occur, the buyer will lose the premium they paid. SPOT contracts require a higher premium

than traditional options contracts do. Also, SPOT contracts may be written to pay out if they

reach a specific point, several specific points, or if it does not reach a particular point at all.

Of course, premium requirements will be higher with specialized options structures.

Additional types of exotic options may attach the payoff to more than the value of the

underlying instrument at maturity, including but not limited to characteristics such as at its

value on specific moments in time such as an Asian option, a barrier option, a binary option,

a digital option, or a lookback option.

Example of a Currency Option

Let's say an investor is bullish on the euro and believes it will increase against the U.S. dollar.

The investor purchases a currency call option on the euro with a strike price of $115, since
currency prices are quoted as 100 times the exchange rate. When the investor purchases the

contract, the spot rate of the euro is equivalent to $110. Assume the euro's spot price at the

expiration date is $118. Consequently, the currency option is said to have expired in the

money. Therefore, the investor's profit is $300, or (100 * ($118 - $115)), less the premium

paid for the currency call option.

Speculation is the position a trader takes in the market betting that the price of a security or

asset will increase or decrease. Speculators seek large profits and often use options, or

derivatives, that provide sufficient leverage.

Options in Operation
Options provide a source of leverage because they can be cheaper to purchase in comparison

to buying the actual stock. This allows a trader to control a larger position in options,

compared with owning the underlying stock.

For example, suppose a trader has $2,000 to invest. A share of XYZ stock costs $50 and an

XYZ call option (with a strike price of $60 that expires in one month) costs $0.20 per share.

The premium for one contract, then, would be $20, since each options contract is based on

100 shares of stock.

If the trader chooses only to buy stock, there will be a long position of 40 shares

($2,000/$50). However, by using options, the trader could control 10,000 shares with the

same $2,000 investment ($2,000/$0.20), hence, the power of leverage.

In this case, gains and losses are magnified by the leverage gained from using options. If the

XYZ stock rises to $70 in one month ($10 over the $60 options strike price), in the all-stock

scenario, the trader's position is worth $2,800 (a gain of $800). In the all-options situation, the

total gain would be $100,000 (10,000 shares x $10). Conversely, if XYZ closed above $50,

but below $60, the stock-only transaction would still show a profit, however, the options-only

transaction would produce a $2,000 loss, demonstrating the cost of options contracts.

The speculator's anticipation of the asset's future direction will determine which options

strategy is taken. If the speculator believes that an asset will increase in value, they should
purchase call options that have a strike price that is lower than the anticipated or

targeted price level. If the speculator is correct and the asset's price increases substantially,

they will be able to close out of the position and realize a gain. The gain would be equal to

the difference between the strike price and the market value, plus any remaining time

value remaining on the option.

If the speculator believes that an asset will decrease in value, they would instead purchase put

options with a strike price that is higher than the anticipated price level. If the price of the

asset does fall below the put option's strike price, the speculator can sell the put options for a

price that is equal to the difference between the strike price and the market price, plus any

remaining time value, to realize a gain.

Options arbitrage is a trading strategy using arbitrage in the options market to earn small

profits with very little or zero risk.

Traders perform conversions when options are relatively overpriced by purchasing stock and

selling the equivalent options position. When the options are relatively underpriced, traders

will do reverse conversions or reversals. In practice, actionable option arbitrage opportunities

have decreased with the advent of automated trading strategies.

What Is Option Pricing Theory?

Option pricing theory estimates a value of an options contract by assigning a price, known as

a premium, based on the calculated probability that the contract will finish in the

money (ITM) at expiration. Essentially, option pricing theory provides an evaluation of an

option's fair value, which traders incorporate into their strategies.

Models used to price options account for variables such as current market price, strike price,

volatility, interest rate, and time to expiration to theoretically value an option. Some

commonly used models to value options are Black-Scholes, binomial option pricing, and

Monte-Carlo simulation.

Understanding Option Pricing Theory

The primary goal of option pricing theory is to calculate the probability that an option will
be exercised, or be ITM, at expiration and assign a dollar value to it. The underlying

asset price (e.g., a stock price), exercise price, volatility, interest rate, and time to expiration,

which is the number of days between the calculation date and the option's exercise date, are

commonly-employed variables that input into mathematical models to derive an option's

theoretical fair value.

Options pricing theory also derives various risk factors or sensitivities based on those inputs,

which are known as an option's "Greeks". Since market conditions are constantly changing,

the Greeks provide traders with a means of determining how sensitive a specific trade is to

price fluctuations, volatility fluctuations, and the passage of time.

The greater the chances that the option will finish ITM and be profitable, the greater the value

of the option, and vice-versa.

The longer that an investor has to exercise the option, the greater the likelihood that it will be

ITM and profitable at expiration. This means, all else equal, longer-dated options are more

valuable. Similarly, the more volatile the underlying asset, the greater the odds that it will

expire ITM. Higher interest rates, too, should translate into higher option prices.

Special Considerations

Marketable options require different valuation methods than non-marketable options. Real

traded options prices are determined in the open market and, as with all assets, the value can

differ from a theoretical value. However, having the theoretical value allows traders to assess

the likelihood of profiting from trading those options.

The evolution of the modern-day options market is attributed to the 1973 pricing model

published by Fischer Black and Myron Scholes. The Black-Scholes formula is used to derive

a theoretical price for financial instruments with a known expiration date. However, this is

not the only model. The Cox, Ross, and Rubinstein binomial option pricing

model and Monte-Carlo simulation are also widely used.

Using the Black-Scholes Option Pricing Theory

The original Black-Scholes model required five input variables—the strike price of an option,
the current price of the stock, time to expiration, the risk-free rate of return, and volatility.

Direct observation of future volatility is impossible, so it must be estimated or

implied. Thus, implied volatility is not the same as historical or realized volatility.

For many options on stocks, dividends are often used as a sixth input.

The Black-Scholes model, one of the most highly regarded pricing models, assumes stock

prices follow a log-normal distribution because asset prices cannot be negative. Other

assumptions made by the model are that there are no transaction costs or taxes, that the risk-

free interest rate is constant for all maturities, that short selling of securities with the use of

proceeds is permitted, and that there are no arbitrage opportunities without risk.

Clearly, some of these assumptions do not hold true all or even most of the time. For

example, the model also assumes volatility remains constant over the option's lifespan. This
is unrealistic, and normally not the case, because volatility fluctuates with the level of supply

and demand.

Modifications to options pricing models will therefore include volatility skew, which refers to

the shape of implied volatilities for options graphed across the range of strike prices for

options with the same expiration date. The resulting shape often shows a skew or "smile"

where the implied volatility values for options further out of the money (OTM) are higher

than for those at the strike price closer to the price of the underlying instrument.

Additionally, Black-Scholes assumes that the options being priced are European style,

executable only at maturity. The model does not take into account the execution of American

style options, which can be exercised at any time before, and including the day of, expiration.

On the other hand, the binomial or trinomial models can handle both styles of options

because they can check for the option's value at every point in time during its life.

What Is the Black-Scholes Model?

The Black-Scholes model, also known as the Black-Scholes-Merton (BSM) model, is one of

the most important concepts in modern financial theory. This mathematical equation

estimates the theoretical value of derivatives based on other investment instruments, taking

into account the impact of time and other risk factors. Developed in 1973, it is still regarded

as one of the best ways for pricing an options contract.

Black-Scholes Model

History of the Black-Scholes Model

Developed in 1973 by Fischer Black, Robert Merton, and Myron Scholes, the Black-Scholes

model was the first widely used mathematical method to calculate the theoretical value of an

option contract, using current stock prices, expected dividends, the option's strike price,

expected interest rates, time to expiration, and expected volatility.

The initial equation was introduced in Black and Scholes' 1973 paper, "The Pricing of

Options and Corporate Liabilities," published in the Journal of Political Economy.1 Robert

C. Merton helped edit that paper. Later that year, he published his own article, "Theory of

Rational Option Pricing," in The Bell Journal of Economics and Management

Science, expanding the mathematical understanding and applications of the model, and

coining the term "Black–Scholes theory of options pricing."2

In 1997, Scholes and Merton were awarded the Nobel Memorial Prize in Economic Sciences

for their work in finding "a new method to determine the value of derivatives." Black had

passed away two years earlier, and so could not be a recipient, as Nobel Prizes are not given

posthumously; however, the Nobel committee acknowledged his role in the Black-Scholes

model.

How the Black-Scholes Model Works

Black-Scholes posits that instruments, such as stock shares or futures contracts, will have a

lognormal distribution of prices following a random walk with constant drift and volatility.

Using this assumption and factoring in other important variables, the equation derives the

price of a European-style call option.

The Black-Scholes equation requires five variables. These inputs are volatility, the price of

the underlying asset, the strike price of the option, the time until expiration of the option, and

the risk-free interest rate. With these variables, it is theoretically possible for options sellers

to set rational prices for the options that they are selling.

Furthermore, the model predicts that the price of heavily traded assets follows a geometric

Brownian motion with constant drift and volatility. When applied to a stock option, the model
incorporates the constant price variation of the stock, the time value of money, the option's

strike price, and the time to the option's expiry.

Black-Scholes Assumptions

The Black-Scholes model makes certain assumptions:

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

 Markets are random (i.e., market movements cannot be predicted).

 There are no transaction costs in buying the option.

 The risk-free rate and volatility of the underlying asset are known and constant.

 The returns of the underlying asset are normally distributed.

 The option is European and can only be exercised at expiration.

While the original Black-Scholes model didn't consider the effects of dividends paid during

the life of the option, the model is frequently adapted to account for dividends by determining

the ex-dividend date value of the underlying stock. The model is also modified by many

option-selling market makers to account for the effect of options that can be exercised before

expiration.

Alternatively, for the pricing of the more commonly traded American-style options, firms

will use a binomial or trinomial model or the Bjerksund-Stensland model.

The Black-Scholes Model Formula

The mathematics involved in the formula are complicated and can be intimidating.

Fortunately, you don't need to know or even understand the math to use Black-Scholes

modeling in your own strategies. Options traders have access to a variety of online options

calculators, and many of today's trading platforms boast robust options analysis tools,

including indicators and spreadsheets that perform the calculations and output the options

pricing values.

The Black-Scholes call option formula is calculated by multiplying the stock price by the

cumulative standard normal probability distribution function. Thereafter, the net present

value (NPV) of the strike price multiplied by the cumulative standard normal distribution is

subtracted from the resulting value of the previous calculation.

In mathematical notation:
Volatility Skew

Black-Scholes assumes stock prices follow a lognormal distribution because asset prices

cannot be negative (they are bounded by zero).

Often, asset prices are observed to have significant right skewness and some degree
of kurtosis (fat tails). This means high-risk downward moves often happen more often in the

market than a normal distribution predicts.

The assumption of lognormal underlying asset prices should show that implied volatilities are

similar for each strike price according to the Black-Scholes model. However, since the

market crash of 1987, implied volatilities for at-the-money options have been lower than

those further out of the money or far in the money. The reason for this phenomenon is the

market is pricing in a greater likelihood of a high volatility move to the downside in the

markets.

This has led to the presence of the volatility skew. When the implied volatilities for options

with the same expiration date are mapped out on a graph, a smile or skew shape can be seen.

Thus, the Black-Scholes model is not efficient for calculating implied volatility.
Drawbacks of the Black-Scholes Model

As stated previously, the Black-Scholes model is only used to price European options and

does not take into account that U.S. options could be exercised before the expiration date.

Moreover, the model assumes dividends and risk-free rates are constant, but this may not be

true in reality.

The model also assumes volatility remains constant over the option's life, which is not the

case because volatility fluctuates with the level of supply and demand.

Additionally, the other assumptions—that there are no transaction costs or taxes; that the risk-

free interest rate is constant for all maturities; that short selling of securities with use of

proceeds is permitted; and that there are no risk-less arbitrage opportunities—can lead to

prices that deviate from the real world's.

What Does the Black-Scholes Model Do?

The Black-Scholes model, also known as Black-Scholes-Merton (BSM), was the first widely

used model for option pricing. Based on certain assumptions about the behavior of asset

prices, the equation calculates the price of a European-style call option based on known

variables like the current price, maturity date, and strike price. It does so by subtracting the

net present value (NPV) of the strike price multiplied by the cumulative standard normal

distribution from the product of the stock price and the cumulative standard normal
probability distribution function.

What Are the Inputs for Black-Scholes Model?

The inputs for the Black-Scholes equation are volatility, the price of the underlying asset, the

strike price of the option, the time until expiration of the option, and the risk-free interest rate.

With these variables, it is theoretically possible for options sellers to set rational prices for the

options that they are selling.

What Assumptions Does Black-Scholes Model Make?

The original Black-Scholes model assumes that the option is a European-style option and can

only be exercised at expiration. It also assumes that no dividends are paid out during the life

of the option; that market movements cannot be predicted; that there are no transaction costs
in buying the option; that the risk-free rate and volatility of the underlying are known and

constant; and that the prices of the underlying asset follow a log-normal distribution.

What Are the Limitations of the Black-Scholes Model?

The Black-Scholes model is only used to price European options and does not take into

account that American options could be exercised before the expiration date. Moreover, the

model assumes dividends, volatility, and risk-free rates remain constant over the option's life.

Not considering taxes, commissions or trading costs or taxes can also lead to valuations that

deviate from real-world results.

What are Index Options and its Types?

In the Indian options market, it is the index options that are a lot more popular and liquid. Just

as a stock is an option on a stock, the index option is an option on a well-accepted index like

the Nifty, Sensex, Bank Nifty, etc. What are index options and how do they work? Apart

from the index options definition, let us also look at what is index options conceptually. Here

is a quick take on what are index options, the types of index options, and how and when to

apply the same.

Index Options and its Types

Index Options are the derivative instrument, which means their value is derived from the
movements in the underlying index. In India, there are popular indexes like the Sensex, Nifty,

Bank Nifty, Nifty Financial Services. Supposed you want to take a view on these indices

rather than on individual stocks, you can use index options. You can also use index options to

protect your portfolio by using contrary index options as a hedge.

Normally, index options are available where the futures are already available so there is a

benchmark for option pricing. Then the lot sizes, strike prices, and different expiry periods

are determined for the index options and once they are standardized, they are ready and all set

to trade. Unlike futures which is a kind of discrete product where either the buyer gains or the

seller gains, the trader in index options is a lot more asymmetric in nature. That means; the

buyer of the index options only pays the premium and that also represents their maximum

possible loss.
Understanding Nifty options with an example

Data Source: NSE

The above is the Nifty call options contract on a strike price of Rs.15,800 when the nifty spot

value is at 15,772 in the NSE. This is a right to buy Nifty at an exercise price of Rs.15,800

without the obligation to buy. However, to get this right without the obligation is a privilege

you need to pay a price. Currently, the price you need to pay for this right is Rs.54 and the

price keeps constantly changing depending on the view on the Nifty future movement.

What happens if you buy the Nifty 15,800 call option at Rs.54? Nifty has a minimum lot of

75 shares of Nifty so that is the bare minimum you need to buy. So, buying one lot of Nifty

15,800 call option (right to buy at 15,800) will cost you Rs.4,050. Remember that the options

contract will expire on the last Thursday of June which is 24 June. So, you have just 2 days

left to close the position at a profit. In the meanwhile, if the Nifty falls sharply, you may not
get anything and lose the entire Rs.4,050.

If the Nifty goes up to 15,810 on Wednesday and the Nifty option goes up to Rs.70, then you

book a profit of Rs.1,200 (75x16) on the trade and walk out with a profit. Either way, your

maximum loss on this index options trade can never be more than Rs.4,050. Of course, when

you add up the brokerage and statutory charges, you would find that the minimum loss is

higher than that but that is the whole idea.

Types of index options

Let us quickly go one step ahead and look at the types of index options. The index options

classification can be done in 3 ways as under.

  Among the index options, an index call option is a right to buy the index and an index

put option is a right to sell the index. The former is a bullish view while the latter is a

bearish view.

 You can also classify index options as being ITM / OTM / ATM options. In the

money or ITM options are the index options that are profitable if exercised. OTM

options are not profitable if exercised. To simplify, if You are holding the Nifty

15,800 call option, the option is ITM if Nifty is at 15,810 but it is OTM if Nifty is at

15,790.

 Currently, Indian markets permit the trading of index options on the Nifty and Bank

Nifty on a monthly and weekly options basis. The monthly options expire on the last

Thursday of the month while the weekly options expire every Thursday.

How to do arbitrage using stock and index options

When we talk about arbitrage there are two thoughts that immediately come to mind. First is

the age old practice of arbitraging the price differences between the NSE and the BSE. The

second is the arbitrage between the spot and the future market, which is used quite popularly

across most asset classes. But did you know that it is also possible to arbitrage the mispricing

in options. So what are the arbitrage strategies using options and how to do arbitrage in
options? Let us understand risk arbitrage using options in greater detail.

There are broadly 2 common situations wherein you can do arbitrage in options and earn

riskless profit.

1. When there are discrepancies in the put / call parity

The concept of put call parity states that for given strike price on an underlying asset and the

same strike price, the put and the call must have a static sustainable relationship. If this

relationship is violated then it gives an arbitrage opportunity. Let us understand this concept

by comparing a long call option with a protective put option..

ParticularsPay OffParticularsPay offStrategyLong on CallStrategyProtective put

strategyCMP of RelianceRs.950CMP of RelianceRs.950Buy 950 CallRs.20Buy RIL Futures

Buy RIL 950 putRs.950

Rs.16

Let us assume that in the above case the parity is when the 950 call is available at 20 and the

RIL 950 put is available at Rs.16. You can argue that the cost of buying the call is higher at

Rs.20 but you need to remember that in the protective put we are combining a long future and

a long put option. The difference of Rs.4 is accounted for by the cost of margin that you need

to put for the long futures position. At this level of put call parity there is no arbitrage

opportunity. But arbitrage could arise in 2 situations..

The markets may expect that the upside of the stock is limited. That will make the price of

the 950 call come down from Rs.20 to Rs.14. This creates an arbitrage opportunity. You can

buy the relatively underpriced call option and sell the combination of futures and put option.

This is almost riskless arbitrage for you.

Alternatively, the imputed cost of futures may drop from Rs.4 to Rs.2 due to sharply lower

cost of funds. This could result in an arbitrage where the combination of futures and put can

be bought and the call option can be sold.

2. Strike arbitrage in options

Strike arbitrage in options is available between two options on the same underlying but of

different strikes. Normally, these price discrepancies do not last for too long as arbitrageurs
come in and wipe away these differences. But this is how the strike arbitrage in options will

typically work..

ParticularsOptionParticularsOptionSBI CMPRs.255SBI CMPRs.255SBI 255 CallRs.5SBI

250 call13Intrinsic Value0Intrinsic Value5Time Value5Time Value8Nature of

OptionATMNature of OptionITMOption pricingRelatively UnderpricedOption

PricingRelatively Overpriced Arbitrage by buying 1 lot of 255 SBI call and selling 1 lot of

250 SBI call Buy 1 lot 255 SBI Call-5Sell 1 lot 250 SBI Call+13If, SBI expires at 270+10

(Leg Profit)If SBI expires at Rs.270-7 (Leg Loss)The net profit on the above arbitrage will be

Rs.3 if SBI expires at Rs.270/-If SBI expires at 220-5 (loss on option)If SBI expires at

220+13 (Let profit)The net profit on the above arbitrage will be Rs.8 if SBI expires at

Rs.220/-
The above asymmetric options arbitrage is set up in such a way that irrespective of the price

at which the underlying stock finally expires, the profit on the arbitrage will range between

Rs.3 and Rs.8. That is profit range that you will lock in.

There are many more options arbitrage strategies

Actually, there are many more complex options strategies that you can use to create options

arbitrage. There are strategies like Boxes, Conversions and Dividend arbitrage but the above-

mentioned strike arbitrage and Put Call Parity arbitrage are the most common.
 UNIT – 4
Commodity trading is the buying and selling of commodities such as metals, energy, agricultural

products and livestock and meat. The modern commodity market finds its roots in the trading of

agricultural products. This article traces the evolution of the commodity trading in India.

India has a long-standing, enriching history in commodity markets. In fact, many would

argue that commodity trading started in India, long before it started in other countries.

However, years of foreign rule, droughts, famines, and poor government policies reduced the

importance and popularity of commodity markets in India.

But with India becoming stronger in the global economy, the Indian commodity markets have

witnessed substantial growth. Commodity derivatives trading began in India way before

financial derivatives trading. Commodity derivatives trading began around the same time as

that of the U.K and U.S.A.

In India, commodity trading began with the set-up of the first organised commodity trading

centre, i.e the Bombay Cotton Trade Association in 1875 which laid the foundation of futures

trading in India.

Gradually, derivatives were developed for a broad basket of commodities. After the

establishment of the Bombay Cotton trade association, many cotton merchants and mill

owners were not happy with the functioning of the association.

This led to the establishment of the Bombay Cotton Exchange ltd in 1893 by a group of

unsatisfied cotton merchants and mill owners. This was later followed by the establishment of

futures markets in edible oilseeds complex, raw jute and jute products and bullion.

The Gujarati Vyapari Mandli was created in 1900 to conduct futures trading in groundnut,

castor seed and cotton.

Calcutta Hessian Exchange was created in 1919 for futures trading in raw jute and jute

products. However, organised trading in jute started only with the set-up of East India Jute

Association Ltd in 1927. These two associations merged to establish East Indian Jute and

Hessian Ltd in 1945.

However, futures trading in Raw Jute was suspended in 1964 by the insistence of the West

Bengal government.
In 1920, futures trading began in gold and silver in Bombay, and later it spread to Kanpur,

Jaipur, etc.

The Bombay commodity exchange was established and registered on October 12, 1938 for

trading in oil seed complex

Before the second world war broke in 1939, there were several future markets trading oil

seeds in Gujarat and Punjab. The most exemplary of them was the Chamber of Commerce at

Hapur, established in 1913.

In 1939, the government banned the trading of cotton derivatives. Further, Forward trading

was disallowed or prohibited in oilseed, and many other commodities including foodgrains,

spices, vegetable oils, sugar and cloth in 1943.

However, commodities trading again picked up steam, after India’s independence in the early

1960s. But future trading was limited only to minor commodities such as pepper and

turmeric.

The commodity future market remained dismantled, and dormant for almost four decades.

With the turn of the new millennium, the Government started actively encouraging

commodities markets in India.

In 1992, futures trading in hessian was allowed. In April 1999, future trading in various

edible oilseed complexes was permitted. In May 2001, futures trading in sugar was allowed.
Since April 2003, future trading has been allowed in all commodities by the Government of

India.

With exchanges like MCX and NCDEX eliminating counterparty risks, commodity trading is

an attractive investment option for both hedgers and speculators.

Commodities are the resources or raw materials that are used to manufacture refined goods.

Unlike finished goods, commodities are standardised, meaning that two separate units of a

commodity in equal measure are identical irrespective of their origin or production. Thus,

they are also interchangeable. Much like stock trading, wherein you can buy and

sell shares of companies, with commodity trading you can do the same with commodity

products. This trading happens on certain exchanges, and the aim is to generate profit from
the changes in the commodity market through purchase and sale of the commodities. Trading

commodities has evolved as a practice over the years. Moreover, the range of commodities in

the market today is incredibly diverse. Let us look at the commodity exchanges in India and

the different types of commodities traded in the commodity derivatives market.

Major Commodity Exchanges in India:

 Multi Commodity Exchange of India

 National Multi Commodity Exchange of India

 Indian Commodity Exchange

 National Commodity and Derivatives Exchange

Types of Commodity Market:

Typically, commodity trading occurs either in derivatives markets or spot markets.

1. Spot markets are also known as “cash markets” or “physical markets” where traders

exchange physical commodities, and that too for immediate delivery.

2. Derivatives markets involve two types of commodity derivatives: futures and

forwards; these derivatives contracts use the spot market as the underlying asset and

give the owner control of the same at a point in the future for a price that is agreed

upon in the present. When the contracts expire, the commodity or asset is delivered

physically. The main difference between forwards and futures is that forwards can be
customized and traded over the counter, whereas futures are traded on exchanges and

are standardized.

The most traded commodities:

On the exchanges, you can trade in hard as well as soft commodities. Hard commodities

include crude oil, metals, etc. and soft commodities generally have a shelf life and include

agricultural commodities like wheat, soybean, corn, cotton, etc.

Globally, the most-traded commodities include gold, silver, crude oil, Brent oil, natural gas,

soybean, cotton, wheat, corn, and coffee. Here is some insight into a few of these

commodities

1. Crude oil
Crude oil is one of the most sought-after commodities. With several byproducts such as

petroleum and diesel, the demand for crude oil is increasing every day, especially due to the

boom in demand for automobiles. The high demand has even led to the eruption of

geopolitical tensions all over the world. OPEC is a consortium of the nations that produce oil,

and some of the top oil-producing countries are Saudi Arabia, USA and Russia.

2. Gold

Gold has always been an anchor for most people. When we see the price value of the US

dollar fall, we start buying more gold for security and when the price value of the dollar goes

up, gold prices tend to fall; they share an inverse relationship.

3. Soybeans

Soybean is also one of the top commodities, but is often impacted by factors like weather,

demand for dollars and demand for biodiesel.

Types of commodities traded in India (Multi Commodity Exchange of India – MCX):

 Bullion: Gold, Silver

 Agricultural commodities: Black pepper, castor seed, crude palm oil, cardamom,

cotton, mentha oil, rubber, Palmolein

 Energy: Natural gas, Crude oil

 Base Metals: Brass, Aluminum, Lead, Copper, Zinc, Nickel

Types of commodities traded in India (National Commodity and Derivatives Exchange

– NCDEX):

 Cereals and pulses: Maize Kharif/south, Maize rabi, Barley, Wheat, Chana, Moong,

Paddy (basmati)

 Soft: Sugar

 Fibres: Kappa’s, Cotton, Guar seed, Guar gum

 Spices: Pepper, Jeera, Turmeric, Coriander

 Oil and Oil seeds: Castor seed, Soybean, Mustard seed, Cottonseed oil cake, Refined

soy oil, Crude palm oil

Participants of commodity market:

1. Speculators:
Speculators drive the commodity market, along with hedgers. By constantly analyzing the

prices of commodities they are able to forecast future price movements. For instance, if the

prediction is that the prices will move higher, they will buy commodity futures contracts and

when the prices do actually seem to move higher, they can sell the aforementioned contracts

at a higher price than what they bought it for. Similarly, if the predictions indicate a fall in

prices, they sell the contracts and buy them back at an even lower price, thus making profits.

2. Hedgers:

Manufacturers and producers typically hedge their risk with the help of the commodity

futures market. For example, if prices fluctuate and fall during harvest, farmers will have to

face a loss. To hedge the risk of this happening, farmers can take up a futures contract. So,

when the prices fall in the local market, the farmers can compensate for the loss by making

profits in the futures market. Inversely, if there is a loss in the futures market, it can be

compensated for by making gains in the local market.

What are the benefits of trading in commodities?

1. Transparency in trading transactions:

Since commodity trading takes place on the exchanges, there is no price manipulation by

either buyers or sellers; there is total transparency. If the prices quoted by either party match,

an exchange is executed. Price discovery of the commodities happens without manipulation,

and this is one of the major plus points of online trading platforms. The lower margins in

commodity futures are an incentive for small trades to utilise this sector for hedging risks and

finding higher leverage.

2. Risk Management:

Trading happens on exchanges with total transparency, therefore there is little to no danger of

counterparty risk. The exchanges enforce proper risk management protocol in order to protect

the investors.

Participants in the Commodity Derivatives Market

1. Producers and Consumers: Producers and consumers of physical commodities are the

largest participants in the Commodity Derivatives Market. They use futures and
 options contracts to hedge against price risks associated with their physical

commodities. Producers can use these contracts to lock in a selling price for their

products, while consumers can use them to lock in a buying price for their raw

materials.

Producers, also known as hedgers, use commodity derivatives to lock in prices for their future

production. This allows them to manage the risk associated with volatile commodity prices.

For example, if a farmer is growing a crop that is expected to be in high demand in the future,

they can sell futures contracts to lock in a favorable price for their harvest. This protects the

farmer from price changes in the market and provides them with a stable source of income.

Consumers, also known as end-users, use commodity derivatives to manage the price risk

associated with purchasing commodities. For example, an airline may use fuel hedging to

protect itself against fluctuations in the price of jet fuel. By entering into a futures contract,

the airline can lock in a set price for fuel, which helps it budget for its future operations and

manage its financial risk.

2. Speculators: Speculators are financial institutions and investors who trade in futures

and options contracts with the aim of making a profit from price movements. They do

not have a direct interest in the underlying commodities and are not using these

contracts to hedge against price risks. Speculators are individuals or organizations that
invest in commodity derivatives for the purpose of profiting from price movements.

They do not have an underlying exposure to the commodity and enter into the market

solely for the purpose of generating returns. Speculators play a critical role in the

commodity markets as they provide liquidity and help to smooth out price

movements.

3. Intermediaries, such as banks and brokers, play a critical role in facilitating

transactions in the commodity derivatives market. They help participants enter into

contracts, provide market information and price quotes, and manage the settlement

and delivery of contracts. Intermediaries also play a key role in reducing the risk

associated with commodity derivatives by providing hedging and risk management

services to their clients.

Commodity Index

There were many investors or traders who wanted to access the commodities market without

having to take care of the physical delivery of the commodity and the costs associated with it.

The launch of the first-ever tradable commodity index, MCX iCOMDEX in 2019 acted as a

blessing in disguise for them. This is because it allows investors to trade in the commodity

market through indices rather than futures contracts. Before we move any further, you must

know that commodities can be traded in 3 ways – indices, futures and options but in this

article, we will discuss only indices. Now, let’s understand what is a commodity index and

how it helps investors and traders seeking entry into the commodity market.

Understanding commodity index

A commodity index is an investment tool that tracks prices and returns on a basket of

underlying commodities (consists of a single commodity or combination of commodities).

These indices would track various groups of commodities such as energy, precious metals,

agriculture, industrial metals, and more. You must know that the value of each index would

fluctuate on the basis of the price movement of its underlying assets.

The major difference between commodity index and NIFTY or SENSEX is the constituents.

While the constituents of NIFTY or SENSEX are prices of underlying stocks, MCX
iCOMDEX consists of commodity futures.

Now let’s take a look at the salient features of MCX iCOMDEX before we understand its

various indices.

1. It consists of the following:

a. The composite index which is composed of futures contracts across various

segments

b. Two sectoral indices namely, Bullion Index and Base Metals Index

2. The underlying constituents under this index are liquid futures contracts traded on

MCX

types of commodity indices on MCX and NCDEX

 The below table will give you a better understanding of all the commodity indices on MCX

and NCDEX.

Commodity Index Exchange Constituents

 Gold
MCX iCOMDEX Bullion Index MCX
 Silver

 Aluminum

 Copper

MCX iCOMDEX Base Metal Index MCX  Lead

 Nickel

 Zinc

 Crude Oil
MCX iCOMDEX Energy Index MCX
 Natural Gas

 Guargram
NCDEX Guarex NCDEX
 Guarseed

What is Commodity Futures?

A commodity futures contract is the agreement to purchase or sell a predetermined amount of

a commodity at a particular price on a specific date in the future. Commodity futures could be

utilized to hedge or protect an investment position or to bet on the directional move of the

underlying asset.

How Do Commodity Futures Work?

Most commodity futures contracts are closed out or netted at the expiration date. The

difference in price between the original trade and the closing trade is cash-settled.

Commodity futures are usually used in taking a position in the underlying asset. The typical

kind of assets are:

 Silver

 Gold

 Crude Oil
  Wheat

 Natural Gas

 Corn

They are contracts that are called by the name of their expiration month, which means a

contract ending in the month of September is a September futures contract. Some

commodities could have a significant amount of price volatility or price fluctuations.

As the outcome of this, there is the potential for large gains but large losses too.

Objective of Commodity Futures

A motive to invest in the futures market is to protect a commodity's price. Futures are used by

businesses to lock in the prices of the commodities they sell or utilize in their manufacturing.

Instead of speculating, the purpose of hedging is to prevent losses from potentially

unfavourable price movements. Many hedgers employ or manufacture the underlying asset of

a futures contract. Farmers, oil producers, livestock breeders, and manufacturers are just a

few examples.

As commodities futures trade on an open market, they correctly determine the price of raw

resources. They also predict the future worth of the commodity. Traders and their experts

decide the prices. They investigate their particular commodities all day and every day. Each

day's news and information are promptly included in forecasts. If Iran threatens to completely
close the Strait of Hormuz - for example, commodity prices will fluctuate substantially based

on that news.

Commodity futures could sometimes reflect the trader's or market's emotions rather than

supply and demand. Speculators buy up prices in anticipation of a shortage in the event of a

crisis. When other traders notice that a commodity's price amount is soaring, they start a

bidding battle. As a result of this, the price goes up even more. The fundamentals of the

supply and demand chain, however, have not changed. The prices will fall back to earth after

the crisis is gone.

Benefits of Commodity Futures

Here are some advantages of trading commodity futures.

  Price discovery is the result of trading in these futures. Prices are transparent, and

liquidity guarantees that the proper prices are offered.

 Since these contracts are regulated, it is easy to compare pricing in different

marketplaces around the world.

 These futures allow producers, traders, and end-users to hedge against price swings,

removing uncertainty.

 Investors profit from trading (in these futures) because it allows them to diversify

their holdings. Gold futures, for example, can be used to hedge bets and safeguard

portfolios because gold prices move in the opposite direction of many other assets.

How to Trade Commodity Futures?

Commodity funds are the safest way to invest in commodities futures. Commodities

exchange-traded funds and commodity mutual funds are also options. These funds do invest

in a wide range of commodity futures that are available at any given time.

Commodity futures and options trading is both difficult and dangerous. The price of

commodities is quite volatile. Fraudulent practices abound in the market. You can lose more

than your investment in the beginning if you aren't sure what you're doing.

Below mentioned is a step-by-step guide on how to trade commodity futures online in a

straightforward procedure.
Here are a few steps to take in getting started:

Step 1: Choose an online commodity brokerage firm that suits you.

Step 2: Complete the KYC that is asked for account opening.

Step 3: Find the account.

Step 4: Develop a trading plan that suits your personal risks and returns goals.

Step 5: You can begin trading commodity futures.

Commodity Options

In a historic decision for the Indian commodity derivative market, in 2017, after a lot of

demand from trading members, market regulator SEBI (Securities and Exchange Board of

India) approved options trading in commodities (futures). In October 2017, options trading on
gold (1 kg lots) futures were allowed, making it the first commodity option to be traded on

Indian bourses.

What are Commodity Options?

Commodity trade options contracts are rights to buy (call option) or sell (put option)

underlying commodity futures at predetermined prices on the date of contract expiry. It is

important to note that, unlike in equity options where options involve rights to sell or

buy shares of companies at pre-set prices, it works a bit differently for the commodity

trading space.

In India, market regulators mostly exclusively allow options trading in the commodity futures

market and not the commodity spot market because in India the spot or cash market in

commodities is regulated by state governments while the SEBI only regulates the commodity

derivatives market.

What is a call option on trading commodities?

A call option gives the owner a right to buy the underlying commodity futures at a fixed price

or the strike price on the date of the expiry of the contract. The buyer of an option is said to

go long on an option. If the buyer chooses to exercise his right to buy, then on the date of

expiry, the options contract devolves into the futures contract.

A buyer of a call option will only execute his right when there is intrinsic value; that is, the
strike price is lower than the prevailing price of the commodity futures contract.

Commodity Option Pricing: How does a commodity call option work?

Let us understand commodity option pricing, especially a call option with an example.

Suppose trader G is bearish on the prices of one-month gold futures currently trading at

Rs.1500 per lot, expecting the prices of underlier to fall. He enters into a one-month Gold

Call Option at a mutually agreed strike price of Rs.1150. He pays a premium of Rs. 50 to the

underwriter for the options contract.

Now on the date of contract expiry, trader G finds his bets have gone right. Because G would

like to buy low, if the current price of the 1-month gold futures trades anywhere higher than

Rs.1150, at say Rs.1350 per lot, trader G will go ahead and exercise his buying rights and

convert the options to a one-month futures contract at the strike price, while making a neat
profit of Rs.200. The buyer of the option is said to be In The Money (ITM) when the strike

price is lower than current market prices. The underwriter of the option in this event will be

obliged to honour the contract.

In another market scenario, if the market price of one-month gold futures is trading even

lower than the strike price of Rs.1150, at say, Rs. 1000, then the buyer of the option can

choose not to exercise his right to buy at the strike price. The contract would expire worthless

without being exercised. The only loss for trader G would be the premium he paid to the

underwriter.

What is a commodity put option

A commodity put option gives the owner the right to sell underlying commodity futures at a

preset price once the contract expires on a fixed date, which is last Thursday of the month.

One can also sell or underwrite a put option on commodity futures, which could expose

him/her to pricing risks because if the buyer chooses to exercise his right to purchase the

underlying contract, the underwriter will have to honour his side of the deal. But the

underwriters’ reward lies in the premium they receive on such put option commodity trades

since the belief is, most options contracts will go worthless on the date of expiry when the

strike price is higher than current prices.

Commodity Option Pricing: How does a put option on commodity trades work?
Let us assume trader H is bullish on the prices of one-month gold futures and he expects

prices to further rise from the current levels of Rs.1500 per lot. He could buy a one-month

gold put option at a strike price of say Rs.1700 after paying a premium to the underwriter.

The buyer of the option would always look at booking the option contract at a strike price

that is on the higher end of his market expectations.

Now, much to trader H’s joy, one month after the contract was entered into, the trader finds

that current prices of one-month futures are trading at Rs.1650. Then he would exercise his

right to sell the underlying one-month gold futures at the strike price of Rs.1700 and pocket a

gain of Rs. 50, which is the intrinsic value, over the prevailing market price of the futures.

The trader is said to be In The Money on the put option when the strike price is higher than

the current usual price, and the intrinsic value is greater than zero.
But what if the markets turn aggressively bullish and trader H finds on the date of options

expiry, one-month gold futures trading at prices even higher than the strike price, at say

Rs.1750? In that case, trader H can choose not to exercise his put option or the right to sell

the underlying one-month gold futures at the strike price of Rs.1700 where he stands to make

a notional loss of Rs.50. This way, by not exercising his right to sell, the owner minimized

his losses. He only loses the premium amount.

What are the advantages of commodity trade options contracts?

 Since commodity option contract buyers pay a premium for these contracts, they are

not required to maintain mark to market margins.

 Buying put options in commodity trades are a great way of taking a short position in

the futures while minimizing risk. One can choose not to exercise the right to sell if

current prices of the futures contracts are higher than the strike price. The stakes are

much higher in the futures as they involve compulsory delivery.

 Options work out cheaper than futures contracts in terms of returns and risk

mitigation as one has only to pay the premium if the rights to buy or sell the

underlying asset at pre-set prices are not exercised.

 Experts term options as a type of price insurance in a somewhat volatile

commodity derivatives market where one can take advantage of the price volatility on
both the directions to hedge one’s pricing risks.
 UNIT – 5
What are Swaps in Finance?

The financial market is ever-expanding and evolving. Newer ways to invest via different

schemes and instruments have cropped up, expanding the scope for diversification of your

portfolio. Apart from equity, derivatives are also a great way to invest and make profits. One

such derivative is called a ‘swap contract’.

Let us see how various players in the market use swap contracts.

What are swaps?

Swaps are derivative contracts made for a financial exchange between two parties. The two

said parties agree to exchange the earnings on two separate financial instruments. Moreover,

only the cash flows are exchanged, whereas the principal amount invested remains with the

original parties. Every cash flow exchange is known as a ‘leg’.

Swap contracts involve an underlying asset, which can be any legal commodity or financial

instrument of value. It is usually the big businesses and financial institutions that enter into

such contracts. However, swap transactions are not prevalent among retail investors.

Unlike shares traded on a stock exchange in a dematerialised format, swaps are over-the-

counter transactions.

How does a swap take place?

For a swap contract, there is no standardised format that is followed. Each contract is unique

and tailor-made. After negotiating, the parties enter into a contract based on the conditions

that they both agree to.

A swap contract is based on a notional principal amount. The cash flows earned on it are

exchanged between the parties. Moreover, the swap contract specifies a start and end date.

The exchange of cash flows takes place during this period at specified frequencies.

Since these are traded over the counter, there is no mechanism to oversee these deals. This

increases the chances of counterparty defaults, making them risky contracts to enter into.

Different kinds of swap deals operate differently. Moreover, each kind of swap has a

particular purpose.

What are the types of swaps?

Interest rate swaps

This is the most common type of swap contract, wherein, the fixed exchange rate is swapped

for a floating exchange rate. For instance, X and Y enter into an interest rate swap. Here, X

agrees to pay Y an interest at a predetermined fixed rate. In exchange, Y pays X interest at a

floating rate. These interest payments are made at specified intervals throughout the

contract’s duration. It allows the parties to hedge against the risk that arises from interest rate

fluctuations. This is also known as a plain vanilla swap.

Commodity swaps

In most cases, producers enter into a swap with buyers and fix a selling price for the

commodity. This helps them mitigate the losses that may arise from fluctuations in price. The

underlying asset in such a swap can be any commodity, including grains, crude oil, and

metals. The value of such commodities is determined at a spot price, which can be highly

volatile.

Credit-default swaps

This type of swap works like insurance for a lender against the risk of default by the

borrower. Here, a third-party guarantee to pay the principal as well as the interest to the

lender if the borrower is unable to repay. It reduces the risk undertaken by the lender and

allows the borrower to avail of loans more easily. However, the swap contract only comes
into action if the borrower defaults.

Debt-equity swaps

This swap is used to exchange debt for equity or vice versa. It is a method employed to

restructure the capital of a company. In many cases, companies do so when they are unable to

pay their dues on the debt they have undertaken. Shifting to equity allows them to push the

repayment.

Total return swaps

Total return swaps involve one party providing interest at a fixed rate to the other party. For

example, A owns shares that are exposed to price fluctuations and other benefits such as

dividends. He enters into a swap contract with B. B agrees to provide A a fixed interest. This
reduces A’s risk as he gets a stable return. In exchange, B benefits from the price

fluctuations, dividends, and appreciation of the share’s value.

Currency swaps

Currency swaps involve a loan amount, interest on which is exchanged by the two parties.

This amount is in separate currencies. Many businesses use this to avoid foreign exchange

taxes and get easy loans in a local currency. Governments also enter into such contracts to

stabilize exchange rate fluctuations.

Another example of such a swap is the dollar-rupee swap auction announced by the RBI

recently.

RBI’s dollar-rupee swap auction

The RBI used a dollar-rupee swap as a tool to manage the forex market’s liquidity and

stabilize the value of the rupee. The Central Bank announced a six-month swap window to

conduct this activity.

RBI announced that it would give $2 billion (in return for the Indian rupee) to banks that

wish to enter the swap. This would infuse dollars into the market and improve its liquidity.

Moreover, banks that had a major outflow of dollars would be able to replenish their

reserves.

However, it was a sell-buy swap deal. This means that at the same time, the two parties also
entered into a deal where this transaction would be reversed after six months. The banks

would have to sell the US dollars for INR to the RBI, who promised to buy it from them.

This move was taken in an effort to normalize the effects of global turmoil and to minimize

its impact on the Indian financial markets.

What are the benefits of swaps?

 Helps hedge risk

Swaps can help the party reduce the risk that comes with fluctuations in the market.

Moreover, a commodity swap reduces the risk for the producer as it ensures a specified

amount to them, even if the prices go down.

 Access to new markets

Swaps allow the market players to venture into markets they previously could not access. It

can be utilized to approach new financial markets as hedging allows you to reduce your risk.

The takeaway

Swaps are financial derivatives that are generally used by big businesses and financial

institutions. A swap contract involves the exchange of cash flows from an underlying asset.

The major benefit of swaps is that it allows investors to hedge their risk while also allowing

them to explore new markets.

Different Types of Swaps

Swaps are derivative instruments that represent an agreement between two parties to

exchange a series of cash flows over a specific period of time. Swaps offer great flexibility

in designing and structuring contracts based on mutual agreement. This flexibility

generates many swap variations, with each serving a specific purpose.

There are multiple reasons why parties agree to such an exchange:

 Investment objectives or repayment scenarios may have changed.

 There may be increased financial benefit in switching to newly available or

alternative cash flow streams.

 The need may arise to hedge or mitigate risk associated with a floating rate loan

repayment.
Interest Rate Swaps

The most popular types of swaps are plain vanilla interest rate swaps. They allow two parties

to exchange fixed and floating cash flows on an interest-bearing investment or loan.

Businesses or individuals attempt to secure cost-effective loans but their selected

markets may not offer preferred loan solutions. For instance, an investor may get a cheaper

loan in a floating rate market, but they prefer a fixed rate. Interest rate swaps enable the

investor to switch the cash flows, as desired.

Assume Paul prefers a fixed rate loan and has loans available at a floating rate

(LIBOR+0.5%) or at a fixed rate (10.75%). Mary prefers a floating rate loan and has loans

available at a floating rate (LIBOR+0.25%) or at a fixed rate (10%). Due to a better credit

rating, Mary has the advantage over Paul in both the floating rate market (by 0.25%) and in
the fixed rate market (by 0.75%). Her advantage is greater in the fixed rate market so she

picks up the fixed rate loan. However, since she prefers the floating rate, she gets into a swap

contract with a bank to pay LIBOR and receive a 10% fixed rate.

Paul borrows at floating (LIBOR+0.5%), but since he prefers fixed, he enters into a swap

contract with the bank to pay fixed 10.10% and receive the floating rate.

Benefits: Paul pays (LIBOR+0.5%) to the lender and 10.10% to the bank, and receives

LIBOR from the bank. His net payment is 10.6% (fixed). The swap effectively converted his

original floating payment to a fixed rate, getting him the most economical rate. Similarly,

Mary pays 10% to the lender and LIBOR to the bank and receives 10% from the bank. Her

net payment is LIBOR (floating). The swap effectively converted her original fixed payment

to the desired floating, getting her the most economical rate. The bank takes a cut of 0.10%

from what it receives from Paul and pays to Mary.

Currency Swaps

The transactional value of capital that changes hands in currency markets surpasses that of all

other markets. Currency swaps offer efficient ways to hedge forex risk.

Assume an Australian company is setting up a business in the UK and needs GBP 10 million.

Assuming the AUD/GBP exchange rate is at 0.5, the total comes to AUD 20 million.

Similarly, a UK-based company wants to set up a plant in Australia and needs AUD 20
million. The cost of a loan in the UK is 10% for foreigners and 6% for locals, while in

Australia it's 9% for foreigners and 5% for locals. Apart from the high loan cost for foreign

companies, it might be difficult to get the loan easily due to procedural difficulties. Both

companies have a competitive advantage in their domestic loan markets. The Australian firm

can take a low-cost loan of AUD 20 million in Australia, while the English firm can take a

low-cost loan of GBP 10 million in the UK. Assume both loans need six monthly

repayments.

Both companies then execute a currency swap agreement. At the start, the Australian firm

gives AUD 20 million to the English firm and receives GBP 10 million, enabling both firms

to start a business in their respective foreign lands. Every six months, the Australian firm

pays the English firm the interest payment for the English loan = (notional GBP amount *
interest rate * period) = (10 million * 6% * 0.5) = GBP 300,000 while the English firm pays

the Australian firm the interest payment for the Australian loan = (notional AUD amount *

interest rate * period) = (20 million * 5% * 0.5) = AUD 500,000. Interest payments continue

until the end of the swap agreement, at which time the original notional forex amounts will be

exchanged back to each other.

Benefits: By getting into a swap, both firms were able to secure low-cost loans and hedge

against interest rate fluctuations. Variations also exist in currency swaps, including fixed vs.

floating and floating vs. floating. In sum, parties are able to hedge against volatility in forex

rates, secure improved lending rates, and receive foreign capital.

Commodity Swaps

Commodity swaps are common among individuals or companies that use raw materials to

produce goods or finished products. Profit from a finished product may suffer if commodity

prices vary, as output prices may not change in sync with commodity prices. A commodity

swap allows receipt of payment linked to the commodity price against a fixed rate.

Assume two parties get into a commodity swap over one million barrels of crude oil. One

party agrees to make six-monthly payments at a fixed price of $60 per barrel and receive the

existing (floating) price. The other party will receive the fixed rate and pay the floating.

If crude oil rises to $62 at the end of six months, the first party will be liable to pay the fixed
($60 *1 million) = $60 million and receive the variable ($62 * 1 million) = $62 million from

the second party. Net cash flow in this scenario will be $2 million transferred from the second

party to the first. Alternatively, if crude oil drops to $57 in the next six months, the first party

will pay $3 million to the second party.

Benefits: The first party has locked in the price of the commodity by using a currency swap,

achieving a price hedge. Commodity swaps are effective hedging tools against variations in

commodity prices or against variation in spreads between the final product and raw material

prices.

Credit Default Swaps

The credit default swap offers insurance in case of default by a third-party borrower. Assume

Peter bought a 15-year long bond issued by ABC, Inc. The bond is worth $1,000 and pays
annual interest of $50 (i.e., 5% coupon rate). Peter worries that ABC, Inc. may default so he

executes a credit default swap contract with Paul. Under the swap agreement, Peter (CDS

buyer) agrees to pay $15 per year to Paul (CDS seller). Paul trusts ABC, Inc. and is ready to

take the default risk on its behalf. For the $15 receipt per year, Paul will offer insurance to

Peter for his investment and returns. If ABC, Inc. defaults, Paul will pay Peter $1,000 plus

any remaining interest payments. If ABC, Inc. does not default during the 15-year long bond

duration, Paul benefits by keeping the $15 per year without any payables to Peter.

Benefits: The CDS works as insurance to protect lenders and bondholders from borrowers’

default risk.

Zero Coupon Swaps

Similar to the interest rate swap, the zero coupon swap offers flexibility to one of the parties

in the swap transaction. In a fixed-to-floating zero coupon swap, the fixed rate cash flows are

not paid periodically, but just once at the end of the maturity of the swap contract. The other

party who pays floating rate keeps making regular periodic payments following the standard

swap payment schedule.

A fixed-fixed zero coupon swap is also available, wherein one party does not make any

interim payments, but the other party keeps paying fixed payments as per the schedule.

Benefits: The zero coupon swap (ZCS) is primarily used by businesses to hedge a loan in
which interest is paid at maturity or by banks that issue bonds with end-of-maturity interest

payments.

Total Return Swaps

A total return swap gives an investor the benefits of owning securities, without

actual ownership. A TRS is a contract between a total return payer and total return receiver.

The payer usually pays the total return of agreed security to the receiver and receives a

fixed/floating rate payment in exchange. The agreed (or referenced) security can be a bond,

index, equity, loan, or commodity. The total return will include all generated income

and capital appreciation.

Assume Paul (the payer) and Mary (the receiver) enter into a TRS agreement on a bond

issued by ABC Inc. If ABC Inc.’s share price rises (capital appreciation) and pays a dividend
(income generation) during the swap's duration, Paul will pay Mary those benefits. In return,

Mary has to pay Paul a pre-determined fixed/floating rate during the duration.

Benefits: Mary receives a total rate of return (in absolute terms) without owning the security

and has the advantage of leverage. She represents a hedge fund or a bank that benefits from

the leverage and additional income without owning the security. Paul transfers the credit risk

and market risk to Mary, in exchange for a fixed/floating stream of payments. He represents a

trader whose long positions can be converted to a short-hedged position while also deferring

the loss or gain to the end of swap maturity.

Derivatives vs. Swaps: An Overview

Derivatives are contracts involving two or more parties with a value based on an underlying

financial asset. Often, derivatives are a means of risk management. Originally, international

trade relied on derivatives to address fluctuating exchange rates, but the use of derivatives has

expanded to include many different types of transactions.

Swaps are a type of derivative that has a value based on cash flows. Typically, one party's

cash flow is fixed while the other's is variable in some way.

Derivatives

A derivative denotes a contract between two parties, with its value generally determined by

an underlying asset's price. Common derivatives include futures contracts, options, forward
contracts, and swaps.

The value of derivatives generally is derived from the performance of an asset, index, interest

rate, commodity, or currency. For example, an equity option, which is a derivative, derives its

value from the underlying stock price. In other words, the value of the equity option

fluctuates as the price of the underlying stock fluctuates.

A buyer and a supplier, for example, might enter into a contract to lock in a price for a

particular commodity for a set period of time. The contract provides stability for both parties.

The supplier is guaranteed a revenue stream, and the buyer is guaranteed supply of the

commodity in question.

However, the value of the contract can change if the market price of the commodity changes.

If the market price goes up during the contract period, the derivative value goes up for the
buyer because he is getting the commodity at a price lower than market value. In that case,

the derivative value would go down for the supplier. The opposite would be true if the market

price dropped during the time period covered by the contract.

Swaps

Swaps comprise one type of derivative, but its value isn't derived from an underlying security

or asset.

Swaps are agreements between two parties, where each party agrees to exchange future cash

flows, such as interest rate payments.

The most basic type of swap is a plain vanilla interest rate swap. In this type of swap, parties

agree to exchange interest payments. For example, assume Bank A agrees to make payments

to Bank B based on a fixed interest rate while Bank B agrees to make payments to Bank A

based on a floating interest rate.

Assume Bank A owns a $10 million investment that pays the London Interbank Offered Rate

(LIBOR) plus 1% each month. Therefore, as LIBOR fluctuates, the payment the bank

receives will fluctuate. Now assume Bank B owns a $10 million investment that pays a fixed

rate of 2.5% each month.

Assume Bank A would rather lock in a constant payment while Bank B decides it would

rather take a chance on receiving higher payments. To accomplish their goals, the banks enter
into an interest rate swap agreement. In this swap, the banks simply exchange payments and

the value of the swap is not derived from any underlying asset.

Both parties have interest rate risk because interest rates do not always move as expected.

The holder of the fixed-rate risks the floating interest rate going higher, thereby losing

interest that it otherwise would have received. The holder of the floating rate risks interest

rates going lower, which results in a loss of cash flow since the fixed-rate holder still has to

make streams of payments to the counterparty.

The other main risk associated with swaps is counterparty risk. This is the risk that the

counterparty to a swap will default and be unable to meet its obligations under the terms of

the swap agreement. If the holder of the floating rate is unable to make payments under the
swap agreement, the holder of the fixed-rate has credit exposure to changes in the interest rate

agreement. This is the risk the holder of the fixed-rate was seeking to avoid.

Legislation passed after the 2008 economic crisis requires most swaps to trade through swap

execution facilities as opposed to over the counter and also requires public dissemination of

information.1 This market structure is intended to prevent a ripple effect impacting the larger

economy in case of a counterparty default.

Managing Interest Rate Risk

Interest rate risk exists in an interest-bearing asset, such as a loan or a bond, due to the

possibility of a change in the asset's value resulting from the variability of interest rates.

Interest rate risk management has become very important, and assorted instruments have

been developed to deal with interest rate risk.

This article looks at several ways that both businesses and consumers manage interest rate

risk using various interest rate derivative instruments.

Managing Interest Rate Risk

Which Investors are Susceptible to Interest Rate Risk?

Interest rate risk is the risk that arises when the absolute level of interest rates fluctuates.

Interest rate risk directly affects the values of fixed-income securities. Since interest rates and

bond prices are inversely related, the risk associated with a rise in interest rates causes bond
prices to fall, and vice versa. Bond investors, specifically those who invest in long-term

fixed-rate bonds, are more directly susceptible to interest rate risk.

Suppose an individual purchases a 3% fixed-rate 30-year bond for $10,000. This bond pays

$300 per year through maturity. If during this time, interest rates rise to 3.5%, new bonds

issued pay $350 per year through maturity, assuming a $10,000 investment. If the 3%

bondholder continues to hold their bond through maturity, they lose out on the opportunity to

earn a higher interest rate.

Alternatively, they could sell their 3% bond in the market and buy the bond with the higher

interest rate; however, doing so results in the investor getting a lower price on their sale of

3% bonds as they are no longer as attractive to investors since the newly issued 3.5% bonds

are also available.

In contrast, changes in interest rates also affect equity investors but less directly than bond

investors. This is because, for example, when interest rates rise, the corporation's cost of

borrowing money also increases.

This could result in the corporation postponing borrowing, which may result in less spending.

This decrease in spending may slow down corporate growth and result in decreased profit and

ultimately lower stock prices for investors.

Interest Rate Risk Should Not Be Ignored

As with any risk-management assessment, there is always the option to do nothing, and that

is what many people do; however, in circumstances of unpredictability, sometimes

not hedging is disastrous. Yes, there is a cost to hedging, but what is the cost of a major move

in the wrong direction?

One need only look to Orange County, California, in 1994 to see evidence of the pitfalls of

ignoring the threat of interest rate risk. In a nutshell, Orange County Treasurer Robert Citron

borrowed money at lower short-term rates and lent money at higher long-term rates. The

strategy was initially great as short-term rates fell and the normal yield curve was

maintained.1

But when the curve began to turn and approach inverted yield curve status, things changed.

Losses to Orange County and the almost 200 public entities for which Citron managed money
were estimated at nearly $1.7 billion and resulted in the municipality's bankruptcy. That's a

hefty price to pay for ignoring interest rate risk.1

Investment Products

Those who want to hedge their investments against interest rate risk have many products to

choose from

Forwards: A forward contract is the most basic interest rate management product. The idea

is simple, and many other products discussed in this article are based on this idea of an

agreement today for an exchange of something at a specific future date.

Forward Rate Agreements (FRAs): An FRA is based on the idea of a forward contract,

where the determinant of gain or loss is an interest rate. Under this agreement, one party pays

a fixed interest rate and receives a floating interest rate equal to a reference rate. The actual
payments are calculated based on a notional principal amount and paid at intervals

determined by the parties. Only a net payment is made—the loser pays the winner, so to

speak. FRAs are always settled in cash.

FRA users are typically borrowers or lenders with a single future date on which they are

exposed to interest rate risk. A series of FRAs is similar to a swap (discussed below);

however, in a swap, all payments are at the same rate. Each FRA in a series is priced at a

different rate unless the term structure is flat.

Futures: A futures contract is similar to a forward, but it provides the counterparties with

less risk than a forward contract—namely, a lessening of default and liquidity risk due to the

inclusion of an intermediary.

Swaps: Just like it sounds, a swap is an exchange. More specifically, an interest rate

swap looks a lot like a combination of FRAs and involves an agreement between

counterparties to exchange sets of future cash flows. The most common type of interest rate

swap is a plain vanilla swap, which involves one party paying a fixed interest rate and

receiving a floating rate, and the other party paying a floating rate and receiving a fixed rate.

Diversification is one method to hedge against interest rate risk.

Options: Interest rate management options are option contracts for which the underlying

security is a debt obligation. These instruments are useful in protecting the parties involved in
a floating-rate loan, such as adjustable-rate mortgages (ARMs). A grouping of interest rate

call options is referred to as an interest rate cap; a combination of interest rate put options is

referred to as an interest rate floor. In general, a cap is like a call, and a floor is like a put.

Swaptions: A swaption, or swap option, is simply an option to enter into a swap.

Embedded Options: Many investors encounter interest management derivative instruments

via embedded options. If you have ever bought a bond with a call provision, you too are in

the club. The issuer of your callable bond is insuring that if interest rates decline, they can

call in your bond and issue new bonds with a lower coupon.

Caps: A cap, also called a ceiling, is a call option on an interest rate. An example of its

application would be a borrower going long, or paying a premium to buy a cap and receiving

cash payments from the cap seller (the short) when the reference interest rate exceeds the
cap's strike rate. The payments are designed to offset interest rate increases on a floating-rate

loan.

If the actual interest rate exceeds the strike rate, the seller pays the difference between the

strike and the interest rate multiplied by the notional principal. This option will "cap," or

place an upper limit, on the holder's interest expense.

The interest rate cap is a series of component options, or "caplets," for each period the cap

agreement exists. A caplet is designed to provide a hedge against a rise in

the benchmark interest rate, such as the London Interbank Offered Rate (LIBOR), for a stated

period.

Floors: Just as a put option is considered the mirror image of a call option, the floor is the

mirror image of the cap. The interest rate floor, like the cap, is a series of component options,

except that they are put options and the series components are referred to as "floorlets."

Whoever is long, the floor is paid upon maturity of the floorlets if the reference rate is below

the floor's strike price. A lender uses this to protect against falling rates on an outstanding

floating-rate loan.

Collars: A protective collar can also help manage interest rate risk. Collaring is

accomplished by simultaneously buying a cap and selling a floor (or vice versa), just like a

collar protects an investor who is long on a stock. A zero-cost collar can also be established
to lower the cost of hedging, but this lessens the potential profit that would be enjoyed by an

interest rate movement in your favor as you have placed a ceiling on your potential profit.

What Causes Interest Rate Risk?

Interest rate risk is the decline in the interest rate of an asset, which would return less to an

investor and is primarily a concern with fixed-income products. Declining interest rates cause

interest rate risk and are a larger concern for products with longer maturities.

Is Interest Rate Risk a Market Risk?

Yes, interest rate risk is a market risk. Interest rates in an economy can change and thereby

impact the interest rate on fixed-income securities. The risk is that the interest paid on a

fixed-income security will decrease and the payout to the investor will be smaller.

What Happens When Interest Rates Rise?

When interest rates rise, the cost of borrowing money becomes more expensive. This causes

consumers to buy less as the cost of goods, such as a home or car, becomes more costly.

When consumers buy less, demand has decreased, when demand decreases, companies

eventually decrease the supply of goods and services, which means producing less, which

means hiring fewer people or even letting go of some employees, which causes consumers to

spend even less, further strengthening the cycle. The overall increase of interest rates results

in a slow down of the economy.

The Bottom Line

Each of the products discussed above provides a way to hedge interest rate risk, with different

products more appropriate for different scenarios. There is, however, no free lunch. With any

of these alternatives, one gives up something—either money, like premiums paid-for options,

or opportunity cost, which is the profit one would have made without hedging.

What is Interest Rate Swap?

An interest rate swap (IRS) is a type of derivative contract where the two counterparties agree

to exchange one stream of future interest payments for another based on the specific principal

amount. Generally, these contracts involve the exchange of a fixed interest rate for a floating

interest rate or vice versa. This helps to reduce the exposure to interest rate fluctuations or
obtain a marginally lower interest rate with the help of a swap. Moreover, interest rate swaps

are also called plain vanilla swaps.

These contracts are traded over the counter (OTC), which can be customised in different

ways according to the parties’ desired specifications.

Read more about Fixed vs Floating Interest Rate

How Do Interest Rate Swaps Work?

The interest rate swap occurs between two parties, where they exchange a series of interest

payments. One party receives fixed-rate payments, and the other receives floating-rate

payments. The party enters into a contract with the expectation that the interest rate may rise

or fall and which situation could benefit them. They create a customized agreement that

includes the frequency of payments, loan tenure, and principal amount. The principal amount
is the notional amount, which remains the same in the contract. The only thing that gets

swapped is the interest rate.

Under this contract, one party may reap the financial reward while another may incur a

financial loss. If interest rates rise, the party receiving the floating rate will profit, and the

party receiving the fixed rate will incur a loss. In contrast, if the interest rate falls, the party

getting paid the fixed return will benefit, while the party receiving the floating rate will see

that the interest payments will go down.

Example

For instance, party A has an investment of INR 10 lakhs for 3 years with an interest rate of

7%. Party B has an investment with an interest rate of MIBOR (currently 6%) +1% on INR

10 lakhs for 3 years. Both parties receive the same amount monthly as long as MIBOR is 6%.

However, party A believes that rates will rise and would want a floating rate. In contrast,

party B assumes that rates are falling and would want a fixed rate.

The two parties enter into an interest rate swap agreement in which party B will make

monthly payments to party A of MIBOR+1% on the notional principal amount of INR 10

lakhs for 3 years. At the same time, party A will make monthly payments to party B of 7%

every month on the same notional amount for 3 years. This is a standard interest rate swap,

where the notional principal amount of INR 10 lakhs remains the same.
Assume that in the following month, the MIBOR rises to 6.5%. In this case, party B will

receive a fixed payment of 7%. However, party A will receive the new MIBOR +1%, i.e.

7.5% on the principal amount. This way, party A will benefit if the interest rate rises.

Types of Interest Rate Swaps

There are three different types of interest rate swaps –

Fixed to Floating

Under this type of swap, the party enters into an agreement that receives cash flow through

a fixed interest rate but pays out a floating interest rate. The interest amount is based on the

notional principal amount. Moreover, the floating rates are referenced through the MIBOR

benchmark, which is set daily.

For instance, a company can issue its investors a bond at an attractive fixed interest rate.
Later, the company feels it can get better cash flow from a floating interest rate. Thus, the

company enters into a swap with a counterparty bank where the company receives a fixed

rate and pays a floating interest rate.

*MIBOR – The Mumbai Inter-Bank Offered rate is the overnight lending offered rate for

Indian commercial banks. It is the benchmark interest rate at which bonds borrow funds from

other Indian banks. Also, it is calculated based on the input panel of 30 banks and primary

dealers. MIBOR is modelled from the famous London Inter-Bank Offered Rate (LIBOR).

Floating to Fixed

Under this type of swap, the party enters into an agreement that receives cash flow through

a floating interest rate but pays out a fixed interest rate. Also, the interest is calculated based

on the principal amount.

For instance, a company that does not have access to a fixed-rate loan may borrow at a

floating rate and enter into a swap to achieve the fixed rate. The contract specifications like

tenor, frequency and dates of floating rate are mirrored on the swap contract. Thus, the fixed

rate becomes the company’s borrowing rate.

Float to Float

Under this type of swap, companies enter into an agreement to change the type or tenor of the

floating rate index to get attractive rates. In other words, the companies exchange receipts on
a specific principal amount based on floating rates referenced at two separate benchmarks.

This is also known as a basis swap.

For instance, a company may sway from a three-month MIBOR to a six-month MIBOR

either because the rate is attractive or it matches other payment flows. Also, the company

may switch to a different index like government bonds rate, treasury bill rate, etc.

Explore: Treasury Bills

Advantages and Risks of Interest Rate Swaps

The following are the advantages of interest rate swaps –

 Hedging Risk: The significant advantage of these swaps is minimizing the interest

rate risks. By swapping, the parties can make profitable deals while making optimal

cash flows per their requirements.

  Comparative Advantage: Sometimes, companies can receive an interest rate better

than the borrower rate. However, this is different from the financing that the

companies look for. For instance, a company may want to swap the floating interest

with a fixed interest rate from another company which can fulfil their requirements.

The following are the risks of interest rate swaps –

 Interest Rate Risk: The movement of interest rates is unpredictable, which can add

inherent risk to both parties in the agreement. It means that the receiver will profit

only if the floating interest rate falls, while the payer will profit only if the floating

interest rate increases.

 Credit Risk: These contracts are generally prone to the credit risk of the

counterparty. This happens when one party in the contract tends to default and will

not be able to make the payments. It becomes difficult for the other party to collect.

What Is a Currency Swap?

A currency swap, sometimes referred to as a cross-currency swap, involves the exchange of

interest—and sometimes of principal—in one currency for the same in another currency.

Interest payments are exchanged at fixed dates through the life of the contract. It is

considered to be a foreign exchange transaction and is not required by law to be shown on

a company's balance sheet.

The Basics of Currency Swaps

Currency swaps were originally done to get around exchange controls, governmental

limitations on the purchase and/or sale of currencies. Although nations with weak and/or

developing economies generally use foreign exchange controls to limit speculation against

their currencies, most developed economies have eliminated controls nowadays.

So swaps are now done most commonly to hedge long-term investments and to change the

interest rate exposure of the two parties. Companies doing business abroad often use currency

swaps to get more favorable loan rates in the local currency than they could if they borrowed

money from a bank in that country.

Currency swaps are important financial instruments used by banks, investors, and

multinational corporations.

How a Currency Swap Works

In a currency swap, the parties agree in advance whether or not they will exchange the

principal amounts of the two currencies at the beginning of the transaction. The two principal

amounts create an implied exchange rate. For example, if a swap involves exchanging €10

million versus $12.5 million, that creates an implied EUR/USD exchange rate of 1.25. At

maturity, the same two principal amounts must be exchanged, which creates exchange rate

risk as the market may have moved far from 1.25 in the intervening years.

Pricing is usually expressed as London Interbank Offered Rate (LIBOR), plus or minus a

certain number of points, based on interest rate curves at inception and the credit risk of the

two parties.

Due to recent scandals and questions around its validity as a benchmark rate, LIBOR is being

phased out. According to the Federal Reserve and regulators in the UK, LIBOR will be

phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing

Rate (SOFR). As part of this phase-out, LIBOR one-week and two-month USD LIBOR rates

will no longer be published after December 31, 2021.1

A currency swap can be done in several ways. Many swaps use simply notional principal
amounts, which means that the principal amounts are used to calculate the interest due and

payable each period but is not exchanged.

If there is a full exchange of principal when the deal is initiated, the exchange is reversed at

the maturity date. Currency swap maturities are negotiable for at least 10 years, making them

a very flexible method of foreign exchange. Interest rates can be fixed or floating.

India and Japan signed a bilateral currency swap agreement worth $75 billion in October

2018 to bring stability to forex and capital markets in India.

Exchange of Interest Rates in Currency Swaps

There are three variations on the exchange of interest rates: fixed rate to fixed rate; floating

rate to floating rate; or fixed rate to floating rate. This means that in a swap between euros

and dollars, a party that has an initial obligation to pay a fixed interest rate on a euro loan can
exchange that for a fixed interest rate in dollars or for a floating rate in dollars. Alternatively,

a party whose euro loan is at a floating interest rate can exchange that for either a floating or

a fixed rate in dollars. A swap of two floating rates is sometimes called a basis swap.

Interest rate payments are usually calculated quarterly and exchanged semi-annually,

although swaps can be structured as needed. Interest payments are generally not netted

because they are in different currencies.

What Is a Forward Rate Agreement (FRA)?

A forward rate agreement (FRA) is an over-the-counter (OTC) contract between parties that

determines the rate of interest to be paid on an agreed-upon date in the future. In other words,

an FRA is an agreement to exchange an interest rate commitment on a notional amount.

The forward rate agreement determines the rates to be used along with the termination

date and notional value. FRAs are cash-settled. The payment is based on the net difference

between the interest rate of the contract and the floating rate in the market—the reference

rate. The notional amount is not exchanged. It is a cash amount based on the rate differentials

and the notional value of the contract.

KEY TAKEAWAYS

 Forward rate agreements (FRAs) are over-the-counter (OTC) contracts between

parties that determine the rate of interest to be paid on an agreed-upon date in the

future.

 The notional amount is not exchanged, but is a cash amount based on the rate

differentials and the notional value of the contract.

 A borrower might want to fix their borrowing costs today by entering into an FRA.

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Forward Rate Agreement

Formula and Calculation for a Forward Rate Agreement (FRA)

where: FRAP=FRA payment

FRA=Forward rate agreement rate, or fixed interestrate that will be paid

R=Reference, or floating interest rate used inthe contract

NP=Notional principal, or amount of the loan thatinterest is applied to

P=Period, or number of days in the contract period

Y=Number of days in the year based on the correctday-count convention for the contract

1. Calculate the difference between the forward rate and the floating rate or reference

rate.

2. Multiply the rate differential by the notional amount of the contract and by the

number of days in the contract. Divide the result by 360 (days).

3. In the second part of the formula, divide the number of days in the contract by 360

and multiply the result by 1 + the reference rate. Then divide the value into 1.

4. Multiply the result from the right side of the formula by the left side of the formula.

Forward rate agreements typically involve two parties exchanging a fixed interest rate for a

variable one. The party paying the fixed rate is referred to as the borrower, while the party
paying the variable rate is referred to as the lender. The forward rate agreement could have

the maturity as long as five years.

A borrower might enter into a forward rate agreement with the goal of locking in an interest

rate if the borrower believes rates might rise in the future. In other words, a borrower might

want to fix their borrowing costs today by entering into an FRA. The cash difference between

the FRA and the reference rate or floating rate is settled on the value date or settlement date.

For example, if the Federal Reserve Bank is in the process of hiking U.S. interest rates, called

a monetary tightening cycle, corporations would likely want to fix their borrowing costs

before rates rise too dramatically. Also, FRAs are very flexible, and the settlement dates can

be tailored to the needs of those involved in the transaction.

Forward Rate Agreement (FRA) vs. Forward Contract (FWD)

A forward rate agreement is different from a forward contract (FWD). A currency forward is

a binding contract in the foreign exchange market that locks in the exchange rate for the

purchase or sale of a currency on a future date. A currency forward is a hedging tool that does

not involve any up-front payment. The other major benefit of a currency forward is that it can

be tailored to a particular amount and delivery period, unlike standardized currency futures.

The FWD can result in the currency exchange being settled, which would include a wire

transfer or a settling of the funds into an account. There are times when an offsetting contract

is entered, which would be at the prevailing exchange rate. However, offsetting the forward

contract results in settling the net difference between the two exchange rates of the contracts.

An FRA results in settling the cash difference between the interest rate differentials of the

two contracts.

A currency forward settlement can be on either a cash or delivery basis, provided that the

option is mutually acceptable and has been specified beforehand in the contract.

Limitations of Forward Rate Agreements

There is a risk to the borrower if they had to unwind the FRA and the rate in the market had

moved adversely so that the borrower would take a loss on the cash settlement. FRAs are

very liquid and can be unwound in the market, but there will be a cash difference settled

between the FRA rate and the prevailing rate in the market.
Example of a Forward Rate Agreement

Company A enters into an FRA with Company B in which Company A will receive a fixed

(reference) rate of 4% on a principal amount of $5 million in half a year, and the FRA rate

will be set at 50 basis points less than that rate. In return, Company B will receive the one-

year London Interbank Offered Rate (LIBOR), determined in three years’ time, on the

principal amount. The agreement will be settled in cash in a payment made at the beginning

of the forward period, discounted by an amount calculated using the contract rate and the

contract period.

The formula for the FRA payment takes into account five variables:

 FRA = the FRA rate

 R = the reference rate

  NP = the notional principal

 P = the period, which is the number of days in the contract period

 Y = the number of days in the year based on the correct day-count convention for the

contract

Assume the following data, and plugging it into the formula above:

 FRA = 3.5%

 R = 4%

 NP = $5 million

 P = 181 days

 Y = 360 days

The FRA payment (FRAP) is thus calculated as:

If the payment amount is positive, then the FRA seller pays this amount to the buyer.

Otherwise, the buyer pays the seller. Remember, the day-count convention is typically 360

days in a year. Note also that the notional amount of $5 million is not exchanged. Instead, the

two companies involved in this transaction are using that figure to calculate the interest rate

differential.

What happens if you sell a forward rate agreement (FRA)?

The seller of a forward rate agreement (FRA), or the lender in the transaction, agrees to

accept a fixed interest rate at a predetermined future date. If there has been a decrease in the

floating market interest rate, then the FRA seller benefits from having locked in the higher

rate.
Why would you buy a forward rate agreement?

The main reason to buy a forward rate agreement (FRA) is to hedge against future increases

in interest rates. By locking in an interest rate to be paid at a specified date in the future, FRA

purchasers provide themselves with a measure of protection should market rates rise.

What are the risks of a forward rate agreement?

A forward rate agreement (FRA) is an over-the-counter (OTC) contract, meaning that there

are lower levels of regulation and oversight related to the transaction compared with futures

contracts. It can sometimes be difficult for a party to close an FRA before the maturity date,

and the agreements are also subject to counterparty risk, as there is a potential that a

participant in the contract could default on its obligations.

The Bottom Line

A forward rate agreement (FRA) is an over-the-counter (OTC) contract that establishes an

interest rate to be paid at a predetermined future date. The parties in the FRA do not exchange

the notional amount. Instead, they settle the contract in cash based on the rate differential and

the contract’s notional value.

Parties can enter into an FRA to hedge against or benefit from future interest rate movements.

Borrowers can use an FRA to fix their borrowing costs, while lenders can benefit from

locking in a predetermined rate if market rates fall.