Derivatives - Zell Education 2024

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Contents
Derivative Instrumentand Derivative Market Features................................................................... 1
Forward Commitmentand Contingent Claim Features and Instruments .......................................... 4
Swaps and Options.............................................................................................................................. 7
Derivative Benefits, Risks, and Issuer andInvestor Uses ............................................................... 24
Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives ............................................... 28
Forwards and Futures Valuation ....................................................................................................... 28
Forward Rate Agreements and Swap Valuation ............................................................................... 35
Option Valuation and Put-Call Parity ................................................................................................ 43
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Foreword
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With the aforementioned in context, we bring to you these notes, created by us, for you, to truly help
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Authored by: Mohit Madhiwalla, Aman Milwani, Esha Vora

Illustrated by: Ravi Gupta
Derivative Instrument and Derivative Market Features 1
Derivative Instrument and Derivative Market Features

LOS 72a: Define a derivative and describe basic features of a derivative instrument
LOS 72b: Describe the basic features of derivative markets, and contrast over-the-
counter and exchange-traded derivative markets.
A derivative is a financial contract. But to derive its value is a little more complex than any normal
discounted cash flow or relative valuation technique. A derivative is a financial instrument that
derives its value from the performance of an underlying asset. Complex models with several variables
are required to price a derivative.
Suppose you have an agreement with a shopkeeper to purchase a laptop for Rs. 50,000 next month.
You can call this a contract because both of you have agreed to fulfil an obligation at a fixed price at
a future point in time. The underlying asset of this contract is a laptop. The contract itself is called a
derivative contract and the price of Rs. 50,000 is derived from the value of the laptop.
This is an example of a forward contract. It is an over-the-counter derivative contract because the
agreement is simply between you and the shopkeeper. It is a custom contract that you have specified
with the shopkeeper.
A forward contract is an over-the-counter derivative contract in which the buyer agrees to buy and
a seller agrees to sell an underlying asset at a future date on a specific price that is agreed upon
when the contract is signed.
Over-the-counter markets are unregulated markets and each contract is a with a counterparty,
which may expose the owner of a derivative with a default risk (when the counterparty does not
honour their commitment).
Imagine that you cannot pay the shopkeeper Rs. 50,000 next month. They lose revenue, and now they
have to hold on to that laptop and find another seller. This means that the shopkeeper is subject to
default risk and counterparty risk if you cannot make the payment. SEBI has measures in place to
mitigate these risks.
Default risk: The risk that a party involved in a business transaction will not live up to its business
obligations.
Counterparty risk: Counterparty risk is the probability that the other party in an investment, credit,
or trading transaction may not fulfil its part of the deal and may default on the contractual obligations.
A futures contract is a forward contract that is standardized and exchange-traded. The primary ways
in which forwards and futures differ are that futures are traded in an active secondary market, subject
to greater regulations, backed by a clearing house, and require a daily cash settlement of gains and
losses. Like any other tradeable security, they trade on exchanges like the BSE, NSE, LSE, NYSE, etc.
Difference between Futures and Forward Contracts:

Futures Forwards
Traded on an exchange Traded over-the-counter
Standardized contract terms Customizable contract terms
Marked to market daily No mark to market
Counterparty risk mitigated by exchange Counterparty risk is higher
Can be closed out before expiration Typically, cannot be closed out before expiration
Settled on expiration date Settled on expiration date or periodically during contract
Difference between Over-the-counter derivatives and Exchange traded securities.

Exchange-traded Derivatives (Futures and Over-the-counter Derivatives (Forwards & Swaps)
Options)
Standardized contract terms Customizable contract terms
Marked to market daily No mark to market
Counterparty risk mitigated by exchange Counterparty risk is higher
Can be closed out before expiration Typically, cannot be closed out before expiration
Settled on expiration date Settled on expiration date or periodically during

contract
1. Why is a derivative least likely considered a complex instrument?
A. The payoff of a derivative is based on the value of an underlying asset

B. The payoff of a derivative is delayed
C. The pricing of derivatives is based on complex models
2. Which of these statements is true?

Statement 1: Exchange-traded contracts are standardized
Statement 2: Over-the-counter contracts are Customized
A. One of these statements is correct

B. Neither statement is correct
C. Both of these statements are correct
3. Do customized contracts most likely hold more risk than standardized contracts?
A. No, because there is no counterparty risk

B. Yes, because there is counterparty risk
C. Yes, because there is interest rate risk
4. Which of the following is a key difference between forward commitments and contingent
claims?
A. Contingent claims can be exercised based on a certain event

B. A forward commitment does not have to be fulfilled
C. Contingent claims must be fulfilled at the expiry
5. A credit derivative is most likely a type of:
A. Bond
B. Forward commitment
C. Contingent claim
6. Which of the following are standardized contracts?
A. Forwards and swaps

B. Futures and options
C. Swaps and options
Answers
1. A is correct. The pricing of derivative contracts can be complicated because of their structure.
They derive their value from the value of an underlying asset.
2. C is correct. Both Statements are true. Over-the-counter contracts are customised and do not
trade on exchanges. Whereas, future contracts are standardized as are traded on the
exchange.
3. B is correct. Contracts that do not trade on exchanges hold counterparty risk. This is the risk
that the other party will not fulfill their payments. C is incorrect because both standardized
and customized contracts can be subject to interest rate risk.
4. A is correct. The owner of a contingent claim, like an option contract, has the right to exercise
the contract if a specific event takes place so that the option has value. A forward commitment
has to be fulfilled at expiry, while a contingent claim can be unexercised if the event does not
take place.
5. C is correct. The owner of a credit derivative is protected against rating downgrades of a

company's bonds. The credit derivative's value is derived from the occurrence of a credit
event, and so it is a contingent claim.
6. B is correct. Futures and options are exchange-traded, and so they are standardized contracts.
Forwards and swaps are traded over-the-counter, and so they are customized contracts.
Forward Commitment and Contingent Claim Features and Instruments 4
Forward Commitment and Contingent Claim Features and Instruments
LOS73a: Define forward contracts, futures contracts, options (calls and puts), swaps,
and credit derivatives and compare their basic characteristics.
Forward Contracts
Following the laptop example, we can adequately define a forward contract using financial
terminology. In a forward contract, one party agrees to buy, and the counterparty agrees to sell an
underlying asset at a specified price at a certain point in time. This underlying asset can be a physical
asset or a financial asset like a stock or a bond.
Why would we enter such a contract?

Forward contracts are used either for speculation or to hedge an existing exposure.
1. Speculation: The price of a forward contract is fixed, but its value changes over the time of
the contract. The value of the forward contract is directly related to the price of the underlying
asset. Suppose you enter a forward contract to buy oil. You don't want the physical asset, but
you want to profit from the changes in oil prices. Remember that the price is fixed, but the
value changes. So, if you enter a forward contract of crude oil at USD 72 and if the price of
crude oil increases, then (other things held constant) the value of the forward contract also
increases. You can sell the forward contract at a profit and close the position without taking
physical delivery of the oil.
2. Hedging: Remember that the price of a forward contract is fixed. Today's INR/USD quote is
75.00, and you have a payment of US$1,000 to make one month from now. You have no U.S.
dollars in your bank account right now and you will have to purchase U.S. dollars to make the
payment. You think that the Indian rupee will fall against the dollar in one month and will
become Rs. 76.50 per USD. This will make it more expensive to pay $1,000 one month from
now. You want to hedge your exposure to this event. So, you can enter a forward contract
with a third party to buy USD at a price that is less than Rs. 76.50 per dollar.
Suppose a counterparty agrees to make the trade at Rs. 75.50 per dollar. The price of this
contract is Rs. 75.50 per dollar and will remain fixed throughout the contract's life. Now
suppose that you are correct and that at the end of the month, the INR/USD rate become Rs.
76.50. Instead of paying Rs. 76.50 per dollar to buy USD in the spot market, you are now
paying Rs. 75.50 per dollar to the counterparty and receiving US$1,000.
➢ Note that no payment is made at the initiation of a forward contract. It is simply

an agreement between two parties.
➢ The value at initiation is 0 because neither party have benefited from price changes
yet and so no money has been exchanged yet.
➢ The party that buys the asset is long, and the party that sells or delivers the asset is
short. In this case, since you are buying USD, you are on the long leg of the contract.
Settlement of Forward Contracts

Deliverable Contract
These are settled by the short party delivering the asset at the expiration of the contract. This is more
likely in the case of physical assets like oil. Companies that need oil as an input to their operations or
sell oil to other companies will engage in such contracts.
Cash Settled Contract
These are settled by cash payment, and this is the difference between the agreed-upon forward price
and the spot price (market price) on the day of contract expiry. These are most likely to be used for
index forwards.
• Let's say a farmer who expects to harvest 100 kilograms of wheat in six months. He’s
concerned that the price of wheat might drop in the future, so he wants to lock in a price now.
He finds a buyer who agrees to buy the wheat from him in six months at a price of ₹50 per
kilogram.
However, instead of physically delivering the wheat to the buyer, he agrees to settle the
contract in cash. This means that at the end of the six-month period, you'll receive a payment
from the buyer based on the difference between the price you locked in (₹50 per kilogram)
and the current market price of wheat at that time.
For example, let's say that at the end of the six months, the current market price of wheat is
₹45 per kilogram. In this case, the buyer would owe you ₹5 per kilogram, since the price you
locked in was higher than the current market price. Your total payment would be ₹5,000 (100
kilograms x ₹5 per kilogram).
On the other hand, if the market price of wheat had risen to ₹55 per kilogram, he would owe
the buyer ₹5 per kilogram, since the price you locked in was lower than the current market
price. In this case, you would pay the buyer ₹5,000 (100 kilograms x ₹5 per kilogram).
So, a cash settled forward contract allows you to hedge against price fluctuations by locking
in a price for future delivery while avoiding the logistical hassle of actually delivering the
goods.
Futures Contracts
Futures are standardised on exchanges. This is the main difference between a futures contract and a
forward contract.
Just like forwards, they can be delivered or settled by cash. They also have a value of 0 at initiation
because no money has changed hands at the start of the contract.
The oldest futures exchange that is known is the Dojima Rice Exchange. It was founded in Japan in
1730 for the sole purpose of having a futures market for rice. The Chicago Board of Trade (CBOT)
and the Chicago Mercantile Exchange (CME) are well-known futures exchanges.
What is a clearinghouse?
Clearinghouses were made to ensure that every trader will meet their obligations to make payments.
An over-the-counter contract includes a lot of counterparty risk (as we saw in the example with the
shopkeeper).
Clearinghouses mitigate that risk by taking the other side of the trade so that both parties are
protected. Suppose you buy a futures contract from Company X. This means you are long and
Company X is short. The clearinghouse will split this trade into two legs, the long leg and the short leg.
At the end of the contract, if Company X must make a payment to you but it cannot do so, then the
clearinghouse will fulfil that obligation. There is no counterparty risk anymore because the
clearinghouse will make up for whatever Company X could not pay. Similarly, if Company X’s position
benefits and you have to pay them but fail to do so, then the clearinghouse will make up for this
difference too.
How do futures differ from forwards?

Futures are marked-to-market contracts. Another way to mitigate risk is by marking the value of the
futures contract to the current price of the underlying asset.
This involves an understanding of margin. To enter a futures contract, you must first have an initial
margin in the margin account. This is the amount that must be deposited with the exchange before
entering the contract. Think of it as proof that you have the money to make this trade. It is your ticket
to have a seat at the table and to play the futures game. It is relatively low compared to the total price
of the contract and is usually capped at the maximum allowed price change of the contract.
Suppose the initial margin to enter the contract with Company X is Rs. 10,000. If the value of your
position (i.e., the long leg) reduces by Rs. 500 the next day, then Rs. 500 is transferred from your
margin account to Company X's margin account. Your balance is now Rs. 9,500. Suppose on the second
day, the value of your position increases by Rs. 200. Then Company X transfers that into your account.
Your balance is now Rs. 9,700. This process continues until the end of the contract. Therefore, we say
that futures are daily settled contracts – the margin is deposited or withdrawn daily depending on the
changes in the value of the futures contract.
There is also a maintenance margin. Suppose the maintenance margin for this trade is Rs. 7,500. This
is the minimum amount that must be kept in the margin account so that you can continue to remain
in the game. If the maintenance margin limit is reached, you must add additional funds to bring the
balance back to the initial margin.
Other Terminology
Settlement Price
Suppose it was a very volatile day, and there were large volumes of futures traded. It is not fair to use
the closing price as the daily settlement price. That is why the average price during the closing period
(set by the exchange) is taken to represent the market price in a better way. This price is used to
calculate the daily gain or loss on that day.
Futures contracts can also have price limits. These are limits on how much the settlement price can
change from the previous day's settlement price. This is there to ensure that both legs of the trade do
not have to pay too much money into the margin account at any given time.
Suppose the daily limit that is imposed is Rs. 100. A futures contract settled at Rs. 550 the previous
day, but the next day was very volatile, and traders wanted to make a trade for Rs. 700. The limit is
Rs. 650, and so the settlement price for that day will be Rs. 650. Any orders for trades of Rs. 700 will
not take place. This is called a limit up move because the price has moved higher than the limit price.
There can also be a limit down move for the opposite direction. If traders want to make a trade for
Rs. 400 then no trade will take place because the lower limit is Rs. 450.
In both of these cases, traders are said to have a locked limit. This is because their positions are
"locked," and they cannot make the trade.
Open Interest
Futures contracts have different settlement dates or expiry dates. Each expiry date will have a level
of open interest. Open interest is the number of contracts that are outstanding (or open) for a specific
expiry date. Open interest changes only when traders enter new long positions or close short
positions. So, if you buy a futures contract for a stock, you have created a new contract in the market.
The open interest for that expiry date will increase. If you then close this position by finding a buyer,
then the open interest will decrease.
Open interest measures the open contracts. Note that the open interest does not change if you pass
this contract on to another trader. Suppose you find a buyer of the contract, but they do not take
delivery of the underlying. The contract is still considered open. Therefore, it takes both legs of the
contract to close an open contract. Each buyer must have a seller, and each seller must have a buyer.
Speculators
They provide an essential role in derivatives markets. They are not here to hedge a particular position.
Instead, they are here to profit from the changes in the price of the underlying asset and do not want
delivery of the asset. They provide liquidity to derivatives markets.
Swaps and Options
Swaps
A swap is an agreement to exchange a series of payments with another party on fixed dates over a
period of time. For example, you may enter a plain vanilla interest rate swap. This entails paying a
fixed interest rate and receiving a floating interest rate. The floating interest rate is determined by a
benchmark like the LIBOR (London Interbank Offered Rate) or the SOFR (Secured Overnight
Financing Rate). This is the overnight financing rate and changes every day. It determines the
borrowing costs between banks.
If you are on the other side of the trade, you will pay a floating rate and receive a fixed rate. You will
engage in such a swap based on your beliefs of the floating rate. For example, if you think the floating
rate will increase, you will enter a pay fixed and receive a floating swap.
The value of the swap is taken on a net basis. So, if the interest rate moves against your leg of the
trade, then you will have to pay the difference to the other party
A basis swap is a swap of one floating rate for another floating rate (rather than exchanging floating
rates for fixed rates).
Both of these types of swaps derive their value from the notional principal. This is the basis on which
the swap is valued. It is simply there to calculate the value of the swap payments and is never traded
to the other party.
Swaps are similar to forwards in the following ways:

➢ No money changes hands at the start of the trade.
➢ The value at initiation is 0.
➢ They are over-the-counter contracts.
➢ They are custom contracts.
➢ They are unregulated.
➢ They hold default risk.
➢ Individuals do not take part in swaps; usually large institutions engage in such contracts.
Suppose Party A agrees to pay Party B a fixed rate of 3% per annum on a notional principal of $10
million, while Party B agrees to pay Party A a floating rate based on the 1-year LIBOR rate.
Assuming the current 1-year LIBOR rate is 2%, the payments for the swap contract would be
as follows:
- At the beginning of the contract, Party A would pay Party B:
($10 million x 3%) = $300,000 (fixed rate payment)
- At the end of the year, Party B would pay Party A:
($10 million x 2%) = $200,000 (floating rate payment)
- Therefore, the net payment from Party A to Party B would be:
$300,000 - $200,000 = $100,000
- Note that the notional principal of $10 million is not exchanged between the parties, but
is used only to calculate the payment amounts based on the agreed-upon rates. This is
why it's called a "plain vanilla" swap, as it doesn't involve any additional complexities or
features.
Options
The owner of an options contract has the right but not the obligation to buy or sell an underlying
asset at a particular price before the expiration date. Note that the seller of the option has the
obligation but not the right to sell or buy the underlying asset depending on the type of contract.
There are two types of options:
➢ A call option allows the owner of the option to buy the underlying asset at a specified price
before or on the expiration date.
➢ A put option allows the owner of the option to sell the underlying asset at a specified price
before or on the expiration date.
The seller of the option is also called the option writer. The buyer is said to take the long position, and
the seller is said to take the short position.
Now we have seen that there are two types of options and two different positions that one can take.
So, there are four possible positions that one can take:
1. Long Call: Buyer of a call option (right but not the obligation to buy the underlying)
2. Short Call: Seller of a call option (obligation but not the right to sell the underlying)
3. Long Put: Buyer of a put option (right but not the obligation to sell the underlying)
4. Short Put: Seller of a call option (obligation but not the right to buy the underlying)
The option's price is also called the option premium.
There are various types of options that differ in terms of their exercise styles:
1) American Options: are a type of option contract that can be exercised at any time between the date
of purchase and the expiration date.
2) European Options: are a type of option contract that can only be exercised on the expiration date.
This means that the option holder cannot exercise the option before the expiration date, regardless
of market conditions.
3) Bermuda Options: Bermuda options are a type of option contract that can be exercised on specified
dates between the date of purchase and the expiration date. This gives the option holder some
flexibility in choosing when to exercise the option, but not as much as with American options.
Credit Derivatives
These derivatives give protection to bondholders. Suppose you own a bond of a small-sized company
with irregular cash flows. This is riskier than holding a bond of a large company with regular or certain
cash flows. In case the company defaults on its interest or principal payment, you will lose money on
your investment.
A credit derivative such as a credit default swap (CDS) is like insurance against such an event. You will
pay premiums to the person who sells you a CDS just like you will pay a premium to any insurance
seller. In case the company defaults, then you have the right to claim the insurance.
Credit default swaps are the very financial instruments that saved investors like Michael Burry, Steve
Eisman, Jamie Mae, and Charlie Ledley in the housing crisis (great financial crisis) of 2007/08. The book
and movie The Big Short provide detailed coverage of how these investors (among a handful of others)
spotted the likelihood of widespread default on housing loans. They used this information to bet against
mortgage-backed securities by using credit default swaps.
1. Which of the following contracts most likely require clearinghouses?
A. Futures
B. Forwards
C. Swaps
2. An index forward is most likely:
A. Cash settled
B. Deliverable
C. Neither cash settled nor deliverable
3. A trader enters a derivative contract that is marked-to-market daily. Which of the following is
the most likely contract they have taken?
A. Futures contract on a stock

B. Forward contract on an index
C. Forward contract on oil
4. Is the following statement most likely true?

The value of forwards changes throughout the life of the contract, but the price remains fixed.
A. No, because the price and value both change

B. No, because the price changes and the value does not
C. Yes
5. A maintenance margin is most likely a feature of which of the following contracts?
A. An options contract on a stock

B. A futures contract on oil
C. A forward contract on oil
6. A limit up move is most likely due to:
A. The market price being higher than the upper limit of the settlement price of a futures
trade
B. The market price being lower than the upper limit of the settlement price of a futures
trade
C. The market price being lower than the lower limit of the settlement price of a futures
trade
7. Which of the following is least likely true regarding open interest?
A. The open interest changes when a new position is opened

B. The open interest changes when a position is transferred to another trader
C. The open interest changes when a position is closed
8. What is the utility of the notional principal of a swap?
A. It is the amount that is traded when the swap contract ends

B. It is the value at initiation
C. It is the basis on which the value of the swap is calculated
9. An American-style option most likely allows the holder of the option to:
A. Exercise the option only at expiry

B. Exercise the option at any point before the expiry, including the expiry date
C. Exercise the option at pre-specified dates until the expiration date
10. A credit derivative protects:
A. The bond issuer

B. The shareholder
C. The bondholder
Answers
1. A is correct. Clearinghouses ensure that counterparty risk is mitigated. This is possible for
standardized contracts like futures. B and C are incorrect because forwards and swaps are
customized contracts that do not involve a third party.
2. A is correct. When the underlying asset is a financial instrument, physical delivery is not
possible. These contracts are cash settled, and the value is derived from the difference in the
market price at expiration and the forward price at the initiation. Assets like oil are most likely
deliverable contracts.
3. A is correct. Futures are marked to market daily, and forwards are not.
4. C is correct. The value of forwards is zero at initiation, and the value can change throughout
the life of the contract. The price remains fixed.
5. B is correct. Maintenance margins are a feature of futures contracts. They are daily settled
contracts, and a minimum margin must be maintained in the margin account. This is done to
minimize default risk.
6. A is correct. The price limits of a futures contract define the range in which they will trade. If
a trade is placed above the upper limit of the price limit, it is said to be a limit up move. C is
incorrect because this is the definition of a limit down move.
7. B is correct. The open interest changes when a new position is opened, or an existing position
is delivered.
8. C is correct. The notional principal is never traded and is used only to get the dollar value of
the swap payments. B is incorrect because the value of a swap at initiation is always 0.
9. B is correct. A is a European-style option, and C is called a Bermuda-style option.
10. C is correct. A credit derivative protects a bondholder from rating downgrades. It can also
protect shareholders against a fall in value of the share price after a rating downgrade, but it
is most likely used for bondholder protection.
LOS 73b: Determine the value at expiration and profit from a long or short position
in a call or put option.
Terminology and Notation
S = Spot Price
X = Strike Price
Long Call and Long Put

We will first deal with scenarios where you have purchased an option. Once you have understood the
mechanics of the long side, it will be easier to understand the short side.
Call Options
Suppose a stock is trading at a price of 3,500. You believe that it will reach 3,700 in the next three
months. You search the option chain, and you find a call option that you would like to enter. You find
that the strike price is Rs. 3,600, and the premium is Rs. 80.
This means that you will have to pay Rs. 80 to buy the option contract. Remember that these contracts
are cash settled. At the end of the expiration terms, you will receive the difference between the
market level (spot price) and the strike price.
Remember that we benefit from an increase in the price of an asset if we buy a call option.
The payoff measures the difference between the spot price and the strike price. Remember that you
will exercise a call option only if the spot price is greater than the strike price. So, for any unexercised
option, the payoff is 0.
Therefore, we can make a rule:
If Spot > Strike, Payoff = Spot - Strike
If Spot < Strike, Payoff = 0
The payoff for any given spot price is, therefore, the maximum of (S - X) or 0. We will see this as a table
and as a graph later on.
But we have also paid a premium to enter the trade. This must be factored into the profit and loss that
we make on the position. We put a negative sign on the premium because it is a cash outflow.
So,
Profit = Payoff - Premium
This will make a lot more sense when we see the mathematics behind this.
Let us now look at various scenarios of the spot price and the related payoff and profit.
Spot Price Payoff Premium P/L
3500 0 80 -80
3525 0 80 -80
3550 0 80 -80
3575 0 80 -80
3600 0 80 -80
3625 25 80 -55
3650 50 80 -30
3675 75 80 -5
3700 100 80 20
3725 125 80 45
3750 150 80 70
3775 175 80 95
3800 200 80 120
Let us now derive the chart that we use for call options. We want to see the potential profit and loss
on the y-axis against the various scenarios of spot prices on the x-axis.
First, let us consider only the premium. You may think of this as a fixed cost that we have paid to enter
the option contract. Since it is a cash outflow, we will show it as a loss. It will be negative and below
the x-axis.
Now let us look at the payoff:
When we combine the two charts, we get the following profit and loss chart as a result:
As you can see, even when the payoff is 0, there is a loss because of the price paid to buy the call
option (there is a loss even when the spot price is Rs. 3,600 although the strike price and spot price
are the same). This loss reduces until the price reaches Rs. 3,680 – the breakeven point. Any point
beyond Rs. 3,680 will result in a profit.
What is the logic behind this?

Buying a call option means that you have the right but not the obligation to purchase an asset at a
specified price. Suppose the spot price reaches Rs. 3,700. This means that you can buy the stock at the
strike price of Rs. 3,600 from the other party who sold you the call option. Now you can take these
stocks and sell them in the open market immediately for Rs. 3,700. Your profit is Rs. 100 (the payoff)
- Rs. 80 (the premium).
If the spot price is Rs. 3,575, it does not make sense to exercise the option. Why? If you buy the stock
at the strike price of Rs. 3,600, then you will have to sell it in the open market for Rs. 3,575. The payoff
is negative. You are better off with a payoff of 0 if you do not exercise the option.
Payoff for long call options = Maximum of (S - X) and 0
That is why if the option goes unexercised, then the payoff is 0. But you have still paid the premium.
So the profit is Rs. 0 (payoff) - Rs. 80 (the premium).
Remember the rules we had made earlier:
If Spot > Strike, Payoff = Spot - Strike
If Spot < Strike, Payoff = 0
Now we can make the golden rules for long call options:
Payoff = Max (S - X, 0)
Revisit this entire working once again before progressing to the payoff and profit for put options.
Long Put Options
For simplicity, we will use the same strike price and same premium but a different expectation of the
stock price. The stock is trading at Rs. 3,500 but you believe that the price will fall to Rs. 3,300. You
purchase a put option with the strike price of Rs. 3,400.
Remember that we benefit from a decrease in the price of an asset if we buy a put option.
Following are the rules that you must remember for put options:
If Spot > Strike, Payoff = 0
If Spot < Strike, Payoff = Spot - Strike
We will dive straight into the tabular and graphical representation and use similar logical reasoning
that we used for call options.
Following is the payoff and profit table:
3200 200 80 120
3225 175 80 95
3250 150 80 70
3275 125 80 45
3300 100 80 20
3325 75 80 -5
3350 50 80 -30
3375 25 80 -55
3400 0 80 -80
3425 0 80 -80
3450 0 80 -80
3475 0 80 -80
3500 0 80 -80
The graph for the premium remains the same.

The payoff curve looks like this:
Similarly, the profit curve looks like this:

What is the logic behind this?

Buying a put option means that you have the right but not the obligation to sell an asset at a specified
price. Suppose the spot price reaches Rs. 3,300. This means that you can buy the stock at the spot
price of Rs. 3,300 from the open market. Now you can take these stocks and sell them to the
counterparty of the option for Rs. 3,400. Your profit is Rs. 100 (the payoff) - Rs. 80 (the premium).
If the spot price is Rs. 3,425, then it does not make sense to exercise the option. Why? If you buy the
stock at the spot price of Rs. 3,425, then you will have to sell it to the counterparty for Rs. 3,400. The
payoff is negative. You are better off with a payoff of 0 if you do not exercise the option.
Payoff for long put options = Maximum of (X - S) and 0
That is why if the option goes unexercised, then the payoff is 0. But you have still paid the premium.
So the profit is Rs. 0 (payoff) - Rs. 80 (the premium).
Now we can make the golden rules for long put options:
Payoff = Max(X - S, 0)
These two examples display the beauty of long options – call options have limited downside and
mathematically unlimited upside, put options have limited downside, and the upside is capped when
the share price hits Rs. 0.
Short Call and Short Put

For every long leg, there is a short leg.
Short Call
Now we will switch the perspective from the buyer of the call to the seller of the call.
First, let us understand why we would sell a call option. When you write (sell) a call option, you are
betting against the stock price. Why not buy a put then? When you write a call option, you earn the
premium immediately. This means that you are not spending any money to bet against a stock. In
fact, you are earning money.
The difference is that your upside is limited to the premium that you have collected with a potentially
unlimited downside. We will build up to the profit chart just like we did for a long call option.
Since you are collecting the premium, it is a cash inflow and remains fixed.
3500 0 80 80
3525 0 80 80
3550 0 80 80
3575 0 80 80
3600 0 80 80
3625 -25 80 55
3650 -50 80 30
3675 -75 80 5
3700 -100 80 -20
3725 -125 80 -45
3750 -150 80 -70

3775 -175 80 -95
3800 -200 80 -120
Unlike a put option with potentially unlimited upside when the stock price falls, the payoff graph for
a call option looks like this:
Remember that in this case, you are giving someone else the right to buy an asset from you. Think of
this as the exact inverse logic of buying a call option. You will therefore sell a call option when you
think that the stock price will not go above the strike price. If it does, then you are wrong, and you can
lose significant amounts of money.
The profit chart looks like this:
What is the logic?

The buyer of the call option will exercise their right to buy the stock when the price is at least Rs.
3,680. A positive payoff and a positive profit for the long leg is a negative payoff and negative profit
for the short leg. The seller of the call does not have any right but all the obligation to sell the asset.
Now we can make the golden rules for short call options:
Payoff = -Max(S - X, 0)
Profit = Payoff + Premium
Notice that all we have done here is put a minus sign on the payoff and the plus sign on the premium.
This indicates the opposite side of the trade. It is as simple as saying that a cash inflow for the long
leg is a cash outflow for the short leg and vice versa.
Short Put
First, let us understand why we would sell a put option. When you write (sell) a put option, you are
betting on the stock price. Why not buy a call then? When you write a put option, you earn the
premium immediately. This means that you are not spending any money to bet for a stock. In fact, you
are earning money.
The difference is that your upside is limited to the premium that you have collected.
3200 -200 80 -120
3225 -175 80 -95
3250 -150 80 -70
3275 -125 80 -45
3300 -100 80 -20
3325 -75 80 5
3350 -50 80 30
3375 -25 80 55
3400 0 80 80
3425 0 80 80
3450 0 80 80
3475 0 80 80
3500 0 80 80
The premium graph remains the same as the one for a short call because we are collecting the 80
Rupees that the buyer of the put option had paid to us.
The payoff looks like this:
Similarly, the profit chart looks like this:
What is the logic?

The buyer of the put option will exercise their right to sell the stock when the price is at least Rs. 3,320.
A positive payoff and a positive profit for the long leg is a negative payoff and negative profit for the
short leg. The seller of the put does not have any right but all the obligation to buy the asset.
Now we can make the golden rules for short put options:
Payoff = -Max (X - S, 0)
Profit = Payoff + Premium
What is the motivation to sell options, and what are the dangers?
Long legs of options thrive on volatility. If the stock price does not move enough, then long options
remain unexercised. If the long leg remains unexercised, then the short leg will be happy to collect the
premium. Day traders can use this strategy to collect premiums on days that do not have too much
volatility. If you collect small premiums daily, then these can add up and can provide good returns to
your portfolio. However, you will still need some margin in your account if you are caught on the
wrong side of the trade.
Selling an option would be dangerous if volatility is expected. Imagine you wrote a call option, and a
company announces that its earnings are 30% better than expected. This is a volatility event and will
most likely increase the share price. Refer to the short call profit graph again and see what happens
when the stock price increases by a lot. The holder of the option will exercise the option, and losses
to the short leg can be very steep.
Options on the NSE trade in "lots." The lot size depends on the liquidity and the price of the
underlying asset.
LOS 73c: Contrast forward commitments with contingent claims.

A forward commitment would be something like the agreement you had with the shopkeeper. The
simple way to remember this is that you were obligated to purchase the laptop at the predetermined
price because you agreed to pay a specific sum for an underlying asset at a future period, which
terminated. Futures, forwards, and swap prices are determined using this concept.
If you had made a contingent claim to buy the laptop, then your purchase would have been contingent
or dependent on some event to take place next month.
A contingent claim is a claim (to a payoff) that depends on a particular event. Options are contingent
claims that depend on a stock price at some future date. Contingent claims only require a payment if
a certain threshold price is broken.
Follow this example closely to understand how options work. Suppose the market price of the laptop
today is Rs. 50,000. You think that one month from now the price will increase to Rs. 55,000. You do
not have the funds to buy this laptop today, so you have told the shopkeeper that you would like the
option to purchase the laptop one month from now for Rs. 50,000. The shopkeeper thinks that the
market price will be Rs. 45,000 at the end of the month.
Think about how both parties benefit from their personal opinion of the price if their opinion turns
out to be true. In this case, both parties are satisfied by Rs. 5,000 because of their beliefs about the
price one month from now. But you are not so confident, and so instead of committing the Rs. 50,000
you take the option to buy the laptop at that price.
You have the right to exercise your option. If the price does increase to Rs. 55,000 you will exercise
the option. Why? Because you can now buy something for Rs. 50,000 that is worth Rs. 55,000. But you
do not have an obligation to exercise your option. Why? Because you chose not to buy the laptop in
case you could buy it at a lower price in the market one month from now. So, if the market price falls
to Rs. 45,000, then you do not have to exercise the right to buy at Rs. 50,000. You can simply buy it
from the market.
You can see that the decision to exercise or not exercise is contingent on the market price is at a
certain level at the end of the month.
Credit derivatives are contracts that depend on a "credit event" to occur. A credit event could be a
company defaulting on its bond payments or its ratings being downgraded.
Banks and other lenders use credit derivatives to remove the risk of default from a loan portfolio
Use the following information for questions 1 to 4.
Details Price
Strike Price 750
Premium 90
Assume that the spot price is Rs. 920.
1. Calculate the payoff for a long call option.
A. 0
B. 170
C. 80
2. Calculate the payoff for a long-put option.
A. 0
B. 90
C. -170
3. Calculate the payoff for a short put option.
A. 0
B. 90
C. 170
4. Calculate the payoff for a short call option.
A. -170
B. 0
C. 90
5. If a trader believes that the price of the underlying asset will decrease, then they will least
likely:
A. Take a long call option

B. Take a short call option
C. Take a long put option
6. Which of the following regarding option premiums is most likely true?
A. The option premium increases the profit of a long call and long put option
B. The option premium reduces the profit of a long call and long put option
C. The option premium reduces the profit of a long call but increases the profit of a long put
option
7. Why is it most likely risky to take a short position in an option?
A. The potential for unlimited gains must be compensated by additional risk

B. The writer of the option has the right to exercise the option, but the gains are limited
C. The writer of the option has the potential for unlimited losses, and the upside benefits are
limited
Answers
1. B is correct. Payoff = Max(S - X, 0) = Max (920 – 750, 0) = 170. C is incorrect because this is the
profit = 170 – 90 (premium) = 80.
2. A is correct. Payoff = Max(X - S, 0) = Max (750 – 920, 0) = 0.
3. A is correct. Payoff = -Max(X - S, 0) = -Max (750 – 920, 0) = 0.
4. A is correct. Payoff = -Max(S - X, 0) = -Max (920 – 750, 0) = -170.
5. A is correct. A long call option benefits the option holder when the price of the underlying
asset increases. B and C both satisfy the condition that the option has value when the price
decreases. The difference is that the trader will collect a premium in the short call option and
will not have the right to exercise the option. Whereas if they purchase a long put option, they
will pay a premium and have the right to sell the underlying at a specified price.
6. B is correct. Profit = Payoff – Premium for all long options, Profit = Payoff + Premium for all
short options & Long options pay a premium; short options collect a premium.
7. C is correct. This is one of the reasons that option writers write options for very short
expiration dates. They collect a premium, and there is not enough time for the price to move
too much, so they are safe. Otherwise, the short leg of call and put options can face very steep
losses.
Derivative Benefits, Risks, and Issuer and Investor Uses 24
Derivative Benefits, Risks, and Issuer and Investor Uses

LOS 74a: Describe purposes of, and controversies related to, derivative markets.
Benefits of Derivative Markets
We already mentioned before that derivatives can be used to hedge positions. For example, suppose
you own a portfolio of stocks that is a mirror image of the NIFTY 50 Index. That means any downward
move in the overall index will also mean that your portfolio gets damaged. This damage can be
minimised by buying put options of the NIFTY 50.
Derivatives also allow for price discovery. This works purely on the demand and supply of the asset.
For example, we can know the price that buyers are willing to pay and sellers are willing to receive
when we look at oil futures. We can see how this price changes over different expiry dates and can
gauge the general direction of the demand and supply dynamics using this information.
Because of leverage, transaction costs are significantly reduced. We saw from the Reliance example
that you could have exposure to 250 shares by paying Rs. 12,500 instead of paying Rs. 55,000.
However, this comes with its risks.
Risks of Derivative Markets
While leverage can be extremely beneficial, it can also be evil. With the leverage of 4.4 times, if the
underlying increases by 10%, we can make a profit of 44%, but if the underlying decreases by 10%, we
can make a loss of 44%. If you do not have a trading strategy to minimise your losses, it is as good as
gambling.
Derivatives are complex instruments. We saw how important it is to understand the payoff and profit
or loss dynamics of options. One argument for imposing lot sizes is to restrict the average trader from
making risky bets. Suppose you sold the Reliance call instead of buying it. You collect a premium of Rs.
12,500 and can continue selling options to build this up. But leverage can work against you as well. So
if you were not knowledgeable about the risks of selling a call option, then your losses are potentially
unlimited.
LOS 74b: Compare the use of derivatives among issuers and investors.
Companies that utilize derivative instruments for risk management purposes, referred to as issuers of
derivatives, engage in various strategies to mitigate financial risks. These strategies can involve
changes in asset and liability values, earnings volatility, and exposure to underlying securities or
interest rates. Here are some examples:
1. Currency Risk Management: A company earning income in a foreign currency might use forward
contracts to hedge exchange rate risk. This helps to stabilize earnings reported in its domestic
currency.
2. Interest Rate Risk Management: A corporation with fixed-rate debt that uses fair value reporting
may enter into an interest rate swap as the floating-rate payer. This conversion effectively transforms
the fixed-rate liability into a floating-rate liability with lower duration, reducing sensitivity to interest
rate changes.
3. Commodity Price Risk Management: Companies dealing with commodity-like products may use
forward contracts on underlying assets matching their products. This offsets fluctuations in the
reported value of inventory on the balance sheet due to changes in market prices.
Accounting standards may permit hedge accounting, which enables firms to recognize gains and losses
from qualifying derivative hedges simultaneously with changes in the values of the assets or liabilities
being hedged. Issuer hedges can be classified based on their purpose:
- Cash Flow Hedge: Used to hedge future receipts in a foreign currency using forwards or swaps, or to
convert a floating-rate liability to a fixed-rate liability to manage interest payment cash flows.
- Fair Value Hedge: Designed to offset changes in the values of the firm's assets or liabilities. For
instance, hedges against fluctuations in the balance sheet value of inventory or volatility of debt
values.
- Net Investment Hedge: A hedge reducing the volatility of the value of a foreign subsidiary's equity
reported on the balance sheet, achieved through derivatives like foreign currency forwards or futures
to manage changes in exchange rates.
Investors also employ derivatives for risk management and portfolio optimization:
- Commodity Exposure: Investors can gain exposure to commodities by purchasing forwards, allowing
participation in price movements with low initial funds.
- Interest Rate Positioning: Investors can alter the duration of a bond portfolio through interest rate
swaps, adjusting their risk exposure to changes in interest rates.
- Equity Portfolio Management: Equity portfolio managers can temporarily modify market risk
exposure by buying or selling equity index futures. Alternatively, they can use options to reduce
downside risk while preserving upside potential.
In both corporate and investor contexts, the use of derivatives involves strategic decisions to manage
risk exposure and optimize financial outcomes.
LOS 75a: Explain arbitrage and the role it plays in determining prices and promoting
market efficiency.
Arbitrage is one of the key assumptions of derivatives pricing. It refers to a position where traders can
earn a riskless profit. Understand that this is not the risk-free rate. An arbitrage opportunity arises
when one gets a guaranteed return that is above the risk-free rate after transaction costs have been
paid.
This requires assets to be mispriced. Suppose you have two friends. One lives in India, and the other
lives in the U.K. Let us assume that they cannot communicate with each other, all payments are made
online and there are no transaction costs. The INR/GBP quote is 100.00. Your friend in India tells you
that they want to sell a television for Rs. 40,000 and your friend in the U.K. tells you that they want to
buy that same model for GBP 43,000. There is a glaring arbitrage opportunity here. You can
immediately buy the television for Rs. 40,000, and accounting for the exchange rate, you can sell it for
Rs. 43,000. This is a completely riskless profit.
In reality, there will be transport costs, storage costs, currency conversion costs, timing differences,
and all such costs that you must consider in the profit calculation. These are few of the limits to
arbitrage.
Arbitrage and Law of One Price

One of the foundations for market efficiency is perfect information. Once the news travels that such
an arbitrage opportunity is available, there will be hundreds of people who will take advantage of this
riskless profit and exploit the opportunity.
So the riskless profit cannot continue. People in India will realise that they can sell the television for a
higher price (since the demand is there), and people in the U.K. will realise that they can buy it at a
lower price (since the supply is there). This way, the price will converge to the arbitrage-free price.
This is also called the no-arbitrage condition because, at this price, there is no possible arbitrage
opportunity.
This is the logic behind the law of one price – assets that have similar payoffs will trade at a similar
arbitrage-free price.
Let’s take an example:
Let's say that Stock A is currently trading at ₹100 per share in the spot market. The futures contract
for Stock A, which expires in one month, is trading at ₹105. The risk-free rate is 1% per annum.
Here's how an arbitrageur could execute an arbitrage transaction:
The arbitrageur borrows ₹100 from a lender at the risk-free rate of 1% per annum. This means that
the arbitrageur has to repay ₹100.25 at the end of one month (i.e., ₹100 x (1 + 1%)^(1/12)).
The arbitrageur buys one share of Stock A in the spot market for ₹100, using the borrowed funds.
At the same time, the arbitrageur sells one futures contract for Stock A at the futures price of ₹105.
This means that the arbitrageur has agreed to deliver one share of Stock A in one month's time at
the futures price of ₹105.
At the expiration of the futures contract, the arbitrageur delivers the share of Stock A to the buyer of
the futures contract, and receives ₹105.
The arbitrageur repays the ₹100 loan plus any interest to the lender, which comes to ₹100.25.
However, the arbitrageur has received $105 from the futures contract. This means that the
arbitrageur has a profit of ₹4.75 (₹105 - ₹100.25) from the arbitrage transaction.
At t=0 Cashflows At T=1

Borrow Funds at 1% + 100 Repay borrowed funds + interest -₹100.25
per annum
Buy Futures contract 0 Settle futures contract @₹105 + 105
@₹105
Arbitrage Gain = (105-100.25)
= 4.25
Arbitrageurs will continue to make such trades until the net profit is 0. The price in the spot market
will move towards Rs. 105, and the price in the futures market will move towards Rs. 100. This is the
convergence that happens for the law of one price to hold.
1. What is the most likely explanation of arbitrage?
A. It is a condition where a trader can make a profit that is equal to the risk-free rate
B. It is a condition where a trader can make a riskless profit that does not necessarily equal
the risk-free rate
C. It is a condition where a trader can minimize losses on a position by hedging
2. Which of the following is an assumption of arbitrage?
A. Two assets with similar payoffs must trade at different prices

B. Two assets with similar payoffs must have the same risk profile
C. Two assets with similar payoffs must trade at similar prices
Answers
1. B is correct. A is incorrect because the return of an arbitrage opportunity does not always
equal the risk-free rate even though the trade is riskless. C is incorrect because traders can
hedge a position without having to carry out an arbitrage trade.
2. C is correct. This condition outlines the law of one price. It means that if two assets with
similar payoffs are priced differently, then their prices will converge over a period of time to
the no-arbitrage price.
Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives 28
Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives
Now that you are familiar with the various types of derivatives and the terminology associated with
them, the next step is to understand the basics of derivative pricing.
By the end of this reading, make sure that you are familiar with the concepts of arbitrage, the factors
that affect futures pricing, and the factors that affect options pricing.
Forwards and Futures Valuation
LOS 75a: Explain how the concepts of arbitrage, replication, and risk neutrality are
used in pricing derivatives.
We saw the use of arbitrage pricing in the previous reading while discussing the law of one price and
price convergence. The logic of arbitrage is the foundation of derivatives pricing. We will now explore
this idea mathematically.
Why do we use the risk-free rate?
Whenever we do a discounted cash flow analysis, we discount the cash flows at the risk-free rate plus
a premium for the riskiness of the asset.
Think about the CAPM formula. We use the risk-free rate plus the market risk premium, which is
adjusted for beta. In this case, we are assuming that investors do not like risk, and so to take on a
higher level of risk, they will require a higher return. This is called risk aversion.
However, in arbitrage pricing we assume that there is no premium. We assume that investors are risk-
neutral. Since there is no premium, we are adding 0 to the risk-free rate; hence the risk-free rate is a
good tool for discounting or compounding cash flows.
We use this risk-free rate to reach a no-arbitrage condition.
Traditional securities like stocks or bonds may not have similar assets within the asset class with similar
payoffs that trade for different prices. But this is different for derivatives. The future payoff is certain,
and so we can discount this payoff at a risk-free rate.
Let us now assume that we have a hedged portfolio of the underlying and the derivative. Suppose you
own a stock worth Rs. 500 and you want to sell it in one year. You can then sell a futures contract for
a one year expiry at a pre-determined price. Suppose the price of the futures contract is Rs. 505.
Now you are long the stock and short a futures contract. You will have to deliver the stock one year
from now for a certain cash flow that is the futures price.
We want to make these cash flows comparable to today. So, we must bring back the value of F(T) to
today.
Suppose the risk-free rate is rf. That means F(T) will be discounted at the risk-free rate for one year.
Now we know that F(T) at time 0 - denoted by F(T)0 – will be equal to S0 under the no-arbitrage
condition. We also know that this same F(T)0 will grow to F(T) compounded at the risk-free rate.
Now we can make the futures pricing formula:
F(T) = F(T)0 x (1 + rf)T
and since F(T)0 = S0
F(T) = S0 x (1 + rf)T
The no-arbitrage condition is absolutely necessary for this equality to hold. It is also called risk-neutral
pricing because we are not assuming any additional risk over the risk-free rate and the arbitrage
condition holds.
This entire process is called replication. We have taken an underlying stock of S0 and compared it to
the certain futures price of F(T) one year from now.
We can use this technique for bonds too. Remember the idea of credit default swaps. They give
protection to the bondholder. So, suppose you hold a risky bond that has a high yield to maturity. This
yield to maturity will be a function of the risk-free rate plus a risk premium. If you want to mitigate
the effect of the risk premium, you will hold some form of credit protection like a credit default swap.
Now we can say that:
Risky Bond + Credit Protection = Value of a Bond at the Risk-Free Rate
Credit protection is just another form of a derivative, and so we can use this equality as a foundation
to price a credit derivative at the no-arbitrage price.
1. Why is the risk-free rate most likely an appropriate rate for arbitrage pricing?
A. Arbitrage returns are at the risk-free rate
B. There is no premium that is added to the risk-neutral rate
C. We assume that investors are risk averse
2. What effect does credit protection most likely have if a bondholder holds a risky bond?
A. It increases the value of the portfolio because the bondholder is protected from default
risk to some extent
B. It decreases the value of the portfolio because the bondholder must pay for additional
protection
C. It increases the market value of the bond itself
3. A trader enters a futures contract for a stock. The stock price today is Rs. 560, and the risk-
free rate is an annualised rate of 5.50%. The contract expires in two years. Calculate the no-
arbitrage futures price.
A. 621.60
B. 623.29
C. 590.80
Answers
1. B is correct. A is incorrect because this is not always the case. C is incorrect because we
assume that investors are risk-neutral in arbitrage pricing. There is no premium added to this
level of risk, and so the risk-free rate is a suitable rate.
2. A is correct. C is incorrect because credit protection, like a credit default swap, is an external
factor that the bondholder has purchased. This has no effect on the market value of the
bond.
3. B is correct. F(T) = S0 x (1 + rf)T = 560 x (1 + 5.50%)2 = 623.29. A is incorrect because it takes
560 x [1 + (2 x 5.50%)]. C is incorrect because it does not account for the time factor and
takes 560 x (1 + 5.50%)
Explain how the value and price of a forward contract are determined at expiration,
during the life of the contract, and at the initiation.
Remember that the value of futures and forwards contracts must be 0 at initiation. We can use the
same logic that we used in arbitrage pricing.
Suppose you are provided with the following information:
Spot Price
Risk-Free Rate 5.00%
Time to Expiry (years) 1
Quoted Futures Price 10,600.00
Let us discount the quoted futures price - F(T) - to compare it to the spot price today.
F(T)0 = 10,600/(1 + 5.00%)1
F(T)0 = 10,095.24
We can immediately tell that this futures contract is overpriced since the quoted price is greater than
the spot price. There is now some value to this contract. So now, either one of the two cases is
possible:
1. The underlying price should increase to Rs. 10,095.24.
2. The futures price should decrease to Rs. 10,500.
Let us see how this works. The strategy in this case is to sell the overpriced futures and buy the
underpriced underlying.
This will ensure the no-arbitrage price of 10,000 x (1 + 5.00%)1 = Rs. 10,500.
What is the value of this contract, given the information?

The value is simply the difference between the spot price S0 and the discounted futures price F(T)0.
V(T) = S0 - F(T)0
and since F(T)0 = F(T)/(1 + rf)T
V(T) = S0 - F(T)/(1 + rf)T
The value is negative in this case (by Rs. 95.24) hence proving that the discounted futures price is
overpriced.
The whole point is to make the two values comparable at any point in time. So it is important to
become comfortable with moving these values around.
Describe monetary and nonmonetary benefits and costs associated with holding the
underlying asset and explain how they affect the value and price of a forward
contract.
Monetary Benefits
Suppose you own a futures contract for shares, and this contract expires one year from now. These
shares are going to pay a dividend 3 months from now. This benefit must be included in the futures
price by subtracting them from the futures price.
Why do we subtract benefits from the futures price?
Theoretically speaking, when a company pays dividends, its share price reduces by the dividend per
share amount (adjusted for taxes). Similarly, when a bond pays a coupon, there are fewer coupon
payments to be made, and so the value of the bond reduces. These benefits reduce the value of the
underlying.
Let us continue with the example of the futures with a 12-month expiry with an underlying that pays
dividends in 3 months. Following is the timeline:
We always want to compare all the cash flows at the same point in time. So, when we discount F(T)
to F(T)0, we take a one-year discounting period. Similarly, when we discount the dividend to T = 0,
we must take a 3Imonth discounting period.
F(T) = [S0 - PV (Benefits)] x (1 + rf)T
There may also be non-monetary benefits of holding an asset. This is called a convenience yield. This
is difficult to measure and is prevalent for commodities. Nevertheless, you should know that the
convenience yield is treated as a benefit, and its present value is subtracted from the futures price.
Monetary Costs
Suppose you hold some barrels of oil, and you also have a futures contract to sell these at some
point in the future. There are storage costs for keeping these barrels of oil in the warehouse.
These costs must be included in the futures price by adding them to the futures price.
Why do we add costs to the futures price?
Suppose you are asked to store a large piece of equipment for one month, but you need a warehouse
to do that. You will pay some rent for this warehouse. You will charge the counterparty that same
amount of rent as compensation for storage.
Similarly, when we store any physical asset that has a derivative contract associated with it, we must
add these costs as compensation.
Remember that we always want to compare cash flows at the same point in time that is T = 0.
Therefore, we take the present value of these costs and add them to the futures price.
F(T) = [S0 + PV (Costs)] x (1 + rf)T
We can then make a combined equation to consider the benefits and the costs:
F(T) = [S0 + PV (Costs) - PV(Benefits)] x (1 + rf)T
Let's assume that the current spot price of a particular commodity is $50 per unit, the present value
of costs associated with holding the commodity until the futures contract expiration date is $2 per
unit, the present value of benefits associated with holding the commodity until the expiration date is
$3 per unit, the risk-free interest rate is 5% per year, and the time until the expiration date is 6
months (0.5 years).
Using the formula, we can calculate the futures price at time T as follows:
F(T) = [S0 + PV (Costs) - PV(Benefits)] x (1 + rf)T
F(T) = [$50 + $2 - $3] x (1 + 0.05)^0.5
F(T) = $49.50 x 1.024
F(T) = $50.60
Therefore, the futures price at time T is $50.60 per unit of the commodity.
Use the following information for questions 1 to 3:
A trader wants to obtain the arbitrage-free price of a futures contract. They have compiled the
following information:
Time to Expiration 3 years
Underlying Price 451.20
1. Calculate the futures price.
A. 469.70
B. 509.00
C. 451.23
2. Calculate the futures value at initiation.
A. 509.00
B. 469.70
C. 0
3. If a trader quotes a price of 515, then what is the most likely outcome?
A. Either the trader's quote will reduce, or the futures price will increase
B. Either the trader's quote will increase, or the futures price will decrease
C. Both the trader's quote and futures price will increase
A trader wants to enter a futures contract on stock and has compiled the following information:
Time to Expiration 4 years
Underlying Price 300.00
The stock pays a dividend of Rs. 12 in 2 years.

4. Calculate the no-arbitrage futures price.
A. 343.31
B. 342.13
C. 369.47
5. In 3 years, the price of the underlying is Rs. 370. What is the value of the futures contract at
this point in time?
A. -41.16
B. 41.16
C. 11.10
6. Suppose the dividend of Rs. 12 was instead a cost of holding the underlying. Calculate the
futures price.
A. 370.64
B. 356.39
C. 369.47
Answers
1. B is correct. F(T) = S0 x (1 + rf)T = 451.20 x (1 + 4.10%)3 = 509.00
A does not take the time factor into account. C is the wrong formula because it takes [1 + (rf)3]
instead of (1 + rf)3
2. C is correct. The value at initiation is 0 regardless of the futures price.
3. A is correct. This presents an arbitrage opportunity, and it is likely that the prices will converge
to a point between the quote and the no-arbitrage price. B and C do not allow for any sort of
convergence, and so they are incorrect.
4. A is correct. See the graphic below to understand how this is calculated. B is incorrect because
it does not take the present value of the dividend. C is incorrect because it adds the present
value of the dividend instead of subtracting it.
5. B is correct. See the graphic below to understand how this is calculated. A is incorrect because
it shows the loss to the short party of the trade. C is incorrect because it discounts the spot
price, not the futures price.
6. C is correct. The present value of 11.01 should be added to the spot price.
F(T) = [S0 + PV (Costs)] x (1 + rf)T . A is incorrect because it does not add the present value; it adds the
undiscounted value. B is incorrect because it does not add the cost at all.
Forward Rate Agreements and Swap Valuation
Define a forward rate agreement and describe its uses.

A forward rate agreement (FRA) is a derivative that obtains its value from interest rates. We want to
lock in a specific interest rate at a future date point in time.
Terminology
Suppose a dealer quotes the 6x12 FRA rate as 1.50%. That means you can enter an FRA that starts 6
months from now, and the deposit is valid for a period of 6 months (12 - 6). The annualised fixed rate
on the FRA (for the 6-month deposit period) is 1.50%.
Concept
Suppose you want to borrow some money for 6 months, but you won't need to do so until next year.
You think that interest rates will increase in the future, so you want to hedge your bet. You can
immediately enter a 6-month FRA that starts one year from now.
In terms of months, this would be called a 12x18 FRA. The FRA starts 12 months from now, and it is
valid for a period of 6 months.
The timeline can be expressed in the number of days as follows:
The value of the FRA is the difference between the locked-in rate and the floating rate one year from
now. The floating rate is the LIBOR.
What are its uses?

It is mainly used to hedge interest rate uncertainty.
➢ If you think interest rates will increase, then you will enter a long position in an FRA. This will
allow you to lock in a fixed rate and pay the floating rate.
➢ If you think interest rates will decrease, then you will take the short position. This will allow
you to pay the floating rate and receive a fixed rate.
How is this different from an interest rate swap?

Although the fixed rate is set in advance for both of these instruments, forward rate agreements are
settled at the start of the contract, while interest rate swaps are settled at the very end of the cycle.
What are synthetic FRAs?

A bank can synthetically or artificially make an FRA by using two sets of LIBOR loans. Suppose the bank
wants to replicate the 6-month FRA that starts one year using LIBOR loans instead of forward rate
agreements. The timeline is as below:
The bank has effectively borrowed money today at the 540-day LIBOR and has lent this same amount
today at the 360-day LIBOR. At the end of 360 days, they will receive the loan they made and use these
funds for the remaining 180 days.
The effective interest rate is, therefore, the same rate as they would have to pay if they entered a
fixed-for-floating FRA.
1. Which of the following is the most likely use of a forward rate agreement?
A. It locks in the price of a stock for a given period of time

B. It locks in an interest rate at a future date for a given period of time
C. It locks in an interest rate today for a given period of time
2. The short position of an FRA:
A. Pays a fixed interest rate and receives a floating rate

B. Pays a floating interest rate and receives a fixed rate
C. Pays one floating rate and receives another floating rate
3. A bank wants to make a synthetic FRA that starts in 90 days and lasts for 270 days. Which of
the following combinations will it most likely use?
A. Borrow at the 90-day LIBOR and lend at the 270-day LIBOR

B. Borrow at the 360-day LIBOR and lend at the 90-day LIBOR
C. Borrow at the 270-day LIBOR and lend at the 90-day LIBOR
4. How do FRAs differ from interest rate swaps?
A. FRAs are settled at the very end of the contract

B. Swaps are settled at the very end of the contract
C. The fixed rates for FRAs are priced when the FRA period begins, but the fixed rate for
swaps is priced at initiation
Answers
1. B is correct. Forward rate agreements are used for locking in interest rates. C is incorrect
because the forward rate starts at a future point in time, not today.
2. B is correct. If you think interest rates will fall, then you can enter the short position of an
FRA. This way, you can pay a lower floating rate and receive a higher fixed rate. A is incorrect
because this is the long leg of the FRA. C is incorrect because this is the definition of a basis
swap.
3. B is correct. Following is the timeline:
4. B is correct. C is incorrect because the fixed rates are priced at initiation for both types of
derivatives.
Explain why forward and futures prices differ.

Forwards and futures both provide the same function of hedging or speculation, but they differ in how
they are settled, liquidity, and counterparty risk. Since futures are daily settled, there is a theoretical
difference in the price and value of these two instruments. But in reality, there is no significant
difference.
At most, the following argument can be made. Suppose that the value of your futures contract has
been increasing over the past few days. The counterparty will have to pay a margin every day to reflect
this increase in value. This is cash-in-hand – a realised gain. Some of this cash can be removed from
the margin account (as long as the maintenance margin is kept) and it can be invested in risk-free
securities.
If the interest rates move up along with the value of your long position, you can invest this increase in
the margin at the risk-free rate and earn a higher value on your investment. If interest rates go down,
then you can still invest at the risk-free rate but earn a lower interest, and so you will gain less value
from your investment.
On the other hand, suppose you are on the short leg of the trade. You will have to pay money if the
futures prices go up. This will further reduce the value of your investment because of the opportunity
cost of funds. Imagine that the value had not changed at all. You could have invested that margin at
the risk-free rate. Instead, you have to pay the counterparty. And if interest rates go down, then you
are relatively better off than the counterparty.
What is opportunity cost?
Let’s say a student spends three hours and Rs. 200 at the movies the night before an exam. The
opportunity cost is time spent studying and that money to spend on something else.
To sum up:
➢ For long futures: If interest rates are positively correlated with futures prices, it is an increase
in the value of the investment relative to a similar forward contract
➢ For short futures: If interest rates are positively correlated with futures prices, it is a decrease
in the value of your investment relative to a similar forward contract
If interest rates are constant or just not correlated with futures prices, then there is no difference in
the price of a futures contract and a forward contract.
1. Which of the following is most accurate regarding futures and forwards?
A. Forward contracts are daily settled, and futures contracts are settled at maturity
B. Forward contracts have realised gains, and futures contracts have unrealised gains
C. Futures contracts are settled daily, and forward contracts are settled at maturity
2. A trader has taken a long position in a futures contract. The position's value increases over a
period of time. Which of the following interest rate scenarios would be most beneficial to this
trader?
A. Fall in interest rates

B. Rise in interest rates
C. Flat interest rates
3. A trader has taken a short position in a futures contract. The position's value decreases over
a period of time. Which of the following interest rate scenarios would be most beneficial to
this trader?
A. Fall in interest rates

B. Rise in interest rates
C. Flat interest rates
Answers
1. C is correct. B is incorrect because since futures contracts are settled on a daily basis, one
party will receive immediate cash in the margin account if their position improves.
2. B is correct. The cash-in-hand can be invested at higher interest rates, and so the return to
the investment increases.
3. A is correct. The idea here is that the trader will have to pay the long leg a certain amount of
margin. The opportunity cost of funds is reduced.
Explain how swap contracts are similar to but different from a series of forward
contracts.
We saw earlier that the main difference between an FRA and a swap is in the way that they are settled.
An interest rate swap is nothing but a series of FRAs.
Let us break this down into different pieces.
Assume that you enter the long leg of an interest rate swap. You will pay a fixed rate and receive a
floating rate.
Following are the terms: 1 year swap with quarterly payments.
This means that every 3 months, you will receive the difference between the fixed rate and the floating
rate at that point in time.
The floating rate at each quarter is unknown because we can't predict the future, but we know the
fixed rate. Let us call the fixed-rate Sn and the floating rate Fn where n is the date at which the
difference is calculated.
Note that all the Sn payments are of a fixed amount since we are on the long leg of the contract.
The swap starts 90 days from now, although the fixed rate has already been set. The cash flow will be
+F90 - S, and this net receipt/payment is complete.
Now the timeline looks like this:
The second payment that is 180 days from now, looks similar to an FRA. Think of it as an FRA for 180
days that starts 180 days from now.
The third payment that is 270 days from now, also looks similar to an FRA. Think of it as an FRA for 90
days that starts 270 days from now.
We have now seen that we can see interest rate swaps as a series of forward rate agreements. The
forward contract rate is equal to the swap's fixed rate. Note that the price of a swap, just like any other
derivative, is fixed at initiation and does not change. The value changes over the life of the swap. This
is the fixed rate of the swap.
But the difference is that the value of the swap at initiation would not be equal to 0. The FRAs all have
a fixed rate that is equivalent to the rate of the swap. So, Fn - Sn does not have to be zero at the
initiation.
A forward contract with a non-zero value at initiation is called an off-market forward. So, we can
reconcile the non-zero values with the following logic. The series of FRAs will have some positive
present values and some negative present values at the initiation. It is possible that all of these cancel
each other out to give a swap value of 0 at initiation, but it is not necessarily the case.
We can also use the no-arbitrage principle to find the swap fixed rate that gives the swap value of 0
at the initiation. If we borrow at the fixed rate F and lend at the quarterly LIBOR rate, this will produce
the same cash flows as the swap (pay fixed, receive floating). The payment due every 90 days is Fn, and
the floating rate received is Sn.
When the present value of the fixed rate payments equals the present value of the floating rate leg,
the value will be 0.
The swap value increases:
➢ For the long leg, when floating rates increase.
➢ For the short leg, when floating rates decrease.
The swap value decreases:
➢ For the long leg, when floating rates decrease.

➢ For the short leg, when floating rates increase.
1. Which of the following best describes the relation between swaps and FRAs?
A. Swaps are a series of FRAs with non-zero values at initiation

B. FRAs are a series of swaps with non-zero value at initiation
C. Swaps are a series of FRAs with zero value at initiation
2. A trader holds a long position of an interest rate swap. Which of the following benefits them
the most?
A. A decrease in fixed rates

B. An increase in floating rates
C. A decrease in floating rates
Answers
1. A is correct. C is incorrect because it is possible to have a non-zero value at initiation when we
think about swaps as a series of FRAs.
2. B is correct. The long leg makes fixed payments and receives floating rate payments. If the
floating rate increases, then the cash inflow increases, and this benefits the trader's position.
Option Valuation and Put-Call Parity
Explain the exercise value, time value, and moneyness of an option.

We saw the payoff and profit of options in the previous reading. The moneyness of an option refers
to the payoff of an option.
Moneyness of Call Options
The call option has a positive payoff when the spot price is greater than the strike price. This means
that the option is in-the-money.
The call option has a payoff of exactly 0 when the spot price is equal to the strike price. This means
that the option is at-the-money.
When the spot price is less than the strike price, it means that the option is out-of-the money.
Remember that when the spot price is less than the strike price, we will not exercise a call option. So,
we can say that the payoff of out-of-the money options and at-the-money options is both equal to 0.
Moneyness of Put Options
The put option has a positive payoff when the spot price is less than the strike price. This means that
the option is in-the-money.
The put option has a payoff of exactly 0 when the spot price is equal to the strike price, which means
that the option is at-the-money.
When the spot price is greater than the strike price, it means that the option is out-of-the money.
Remember that when the spot price is greater than the strike price, we will not exercise a put option.
So we can say that the payoff of out-of-the money options and at-the-money options is both equal to
0.
The exercise value or intrinsic value of call and put options can therefore be summarised by the rules
that we had seen in the previous reading:
Payoff for long call options = Maximum of (S - X) and 0
Payoff for long put options = Maximum of (X - S) and 0
In-the-money options have positive exercise value. At-the-money options and out-of-the-money
options have 0 exercise value.
Why are option prices (premiums) for at-the-money and out-of-the-money options positive?
The simple answer is time. Option prices are derived from spot prices of the underlying asset. Suppose
the NIFTY Index is trading at 15,500. It will not remain at this level forever. It can potentially reach
16,000 at some point in time. So a call option with a strike price of 15,800 will have value simply
because of the possibility over a period of time that NIFTY will reach 16,000.
The slightly more complex answer is volatility, but even this traces back to the concept of the time
value of options. Think of it this way: you are more likely to try food from 5 new restaurants in a span
of 5 weeks than you are to try food from 5 new restaurants in a span of one day. More time allows for
more events to take place. More events means more potential for volatility.
Either way, the premium of an option is the function of the exercise value and time value, both.
Premium = Exercise Value + Time Value
In reality, the time value is the unknown variable. Option premiums are available to see on the option
chain, and the exercise value can be calculated as we have learnt in the previous reading.
Time value is most likely to be positive. But as an options trader, you will be more interested in the
change of time value because that will give a good idea of how the options price will change.
Options have 0 time value when they reach expiration. That is because there is no more time for any
more events to take place, and so the price of the underlying asset cannot move to change the options
price.
1. A call option has a strike price of 50, and the underlying price is 57. The option premium is 7.
This option is most likely:
A. Out-of-the-money
B. In-the-money
C. At-the-money
2. A put option has a premium of 10 and a strike price of 100. The current spot price is 98. This
option is most likely:
A. Out-of-the-money
B. In-the-money
C. At-the-money
3. An option has a negative exercise value. This option is most likely
A. Out-of-the-money
B. In-the-money
C. At-the-money
4. The option premium is a function of:
A. Exercise value and payoff

B. Volatility and time value
C. Exercise value and time value
Answers
1. B is correct. The moneyness refers to the payoff, not the profit. Although the profit, in this
case, is 0, the payoff is 7.
2. B is correct. The payoff is 2, and so the option is in the money even though the loss (if
exercised) is 8.
3. A is correct. At-the-money options have 0 exercise value, in-the-money options have
positive exercise value.
4. C is correct. The premium accounts for the exercise value (also called intrinsic value) and
time value. So, even if an option has a negative exercise value, there is still some time
remaining for market conditions to change until expiration.
Identify the factors that determine the value of an option and explain how each
factor affects the value of an option.
There are 6 factors that go into a complex formula called the Black-Scholes pricing model. You do not
need to know the model; you need to understand how these 6 factors will affect the options price for
call options and put options.
We will use a + sign if there is a positive relationship between the factor and the option price and a -
sign if there is a negative relationship between the factor and the option price.
Note that we are assuming that we hold long calls and long puts and that these are all European
options unless specified otherwise.
1. Price of the Underlying Asset
Option prices derive their value primarily from the price of the underlying asset. To be more specific,
the changes in options prices occur primarily from the changes in the price of the underlying asset.
Let us look at the payoffs for long call options and long put options to understand how this works.
Assume the strike price is constant:
Payoff for Long Call = Max(S – X, 0)
Any increase in S (the underlying's price) will increase the payoff. An increase in the payoff will increase
the exercise value. This will increase the option's price.
Payoff for Long Put = Max(X – S, 0)
Any increase in S (the underlying's price) will decrease the payoff. A decrease in the payoff will
decrease the exercise value. This will decrease the options price.
We can denote this relationship in the following table:
Factor Notation Call Option Put Option
Price of Underlying Asset S + -
2. Strike Price
We will use the same logic as before, but we will hold the underlying price constant.
Payoff for Long Call = Max(S – X, 0)
Any increase in X (the strike price) will decrease the payoff. A decrease in the payoff will decrease the
exercise value. This will decrease the option's price.
Payoff for Long Put = Max(X – S, 0)
Any increase in X (the strike price) will increase the payoff. An increase in the payoff will increase the
exercise value. This will increase the options price.
Note that the spot price will keep changing throughout the life of the option contract. We have a
choice of which strike price we want. So we can use this information to assess which strike price will
be most probable to give us a profit depending on our belief of the spot price movement.
Price of Underlying Asset X - +
3. Risk-Free Rate
Call Options
Let us consider the cash flow of exercising a long call option. Suppose you hold a call option with an
expiry of 3 months. So, you have the right to buy a stock 3 months from now. If you exercise the
option, you will have to spend money to buy these stocks. This is a cash outflow. Suppose the amount
is Rs. 100,000.
We want to see the present value of this cash outflow. So, we discount it at the risk-free rate. Suppose
the rate is 5.00% with annual compounding. Rs. 100,000 discounted at 5.00% for 3 months =
98,787.65.
Suppose the risk-free rate increases to 7.00%. Rs. 100,000 discounted at 7.00% for 3 months =
98,322.75.
Remember that these are cash outflows, and so the lower, the better.
Here we have established a relationship between call options and the risk-free rate: an increase in the
risk-free rate will increase the value of a call option, a decrease in the risk-free rate will decrease the
value of a call option.
Put Options
Let us consider the cash flow of exercising a long put option. Suppose you hold a put option with an
expiry of 3 months. So, you have the right to sell a stock 3 months from now. If you exercise the option,
you will earn money by selling these stocks. This is a cash inflow. Suppose the amount is Rs. 100,000.
We want to see the present value of this cash inflow. So, we discount it at the risk-free rate. Suppose
the rate is 5.00% with annual compounding. Rs. 100,000 discounted at 5.00% for 3 months =
98,787.65.
Suppose the risk-free rate increases to 7.00%. Rs. 100,000 discounted at 7.00% for 3 months =
98,322.75.
Remember that these are cash inflows, and so the higher, the better.
Here we have established a relationship between put options and the risk-free rate: an increase in the
risk-free rate will decrease the value of a put option, a decrease in the risk-free rate will increase the
value of a put option.
Risk-Free Rate rf + -
4. Volatility of the Underlying Asset
Remember this statement for the rest of your options trading career: long options love volatility, short
options hate volatility, regardless of a call or a put option.
Remember that when you are long an option, you will want the price of the underlying asset to move
so that there is a higher chance of the option expiring in-the-money. When you are short an option,
you do not want the price of the underlying to move a lot. If the price moves substantially and you are
caught on the wrong side of the trade, then the losses can be very steep.
Volatility σ + +
5. Time to Expiration
We saw earlier that time and volatility go hand in hand. More time allows for more volatility and less
time allows for less volatility.
The time value of options is dependent on the time to expiration.
Option Price = Exercise Value + Time Value
If time value increases, the option price increases, and if time value decreases, then the option price
decreases.
We can look at this from the perspective of the time value of money too. We will use the same
argument as we did for the risk-free rate.
Call Options
Assume the cash outflow is Rs. 100,000 3 months from now at a risk-free rate of 5.00%. The present
value is Rs. 98,787.65.
Let us extend the time to expiration to 6 months. The present value of the outflow is now 97,590.00.
If we change the time to 1 month, the cash outflow is Rs. 99,594.24.
Remember that these are cash outflows, and so the lower, the better.
Put Options
Assume the cash inflow is Rs. 100,000 3 months from now at a risk-free rate of 5.00%. The present
value is Rs. 98,787.65.
Let us extend the time to expiration to 6 months. The present value of the inflow is now 97,590.00.
If we change the time to 1 month, the cash inflow is Rs. 99,594.24.
Remember that these are cash inflows, and so the higher, the better.
Increasing the time to expiration benefits the value of call options and put options, and decreasing the
time to expiration harms the value of call options and put options.
Time T + +
6. Costs and Benefits of Holding the Underlying
We already saw that the net carry cost or net carry benefit must be either added or subtracted,
respectively. But how does it affect calls and puts?
Consider carry benefits like dividends. Dividends reduce the value of the share price. So, this will
reduce the payoff of a call option and increase the payoff of a put option.
Note that an American-style call option on a stock that pays dividend will have more value than a
European-style call option. The holder of a call option does not hold the shares until the option is
exercised. If the call option can be exercised before the ex-dividend date then the holder of the call
can buy the shares on or before that date to earn dividends. Holders of European call options may
only exercise the option on a specific date. They are not entitled to dividends if the exercise date on
the option is after the ex-dividend date.
Consider carry costs like storage costs. These will increase the price of the underlying because the
owner will demand a higher payment. So this will increase the payoff of a call option and reduce the
payoff of a put option.
Net Carry Cost θ (Theta) + -
Net Carry Benefit γ (Gamma) - +
Now we can summarise all of these relationships in one table:
Price of Underlying Asset S + -
Strike Price X - +
Risk-Free Rate rf + -
Volatility σ + +
Time T + +
Net Carry Cost θ (Theta) + -
Net Carry Benefit γ (Gamma) - +

Note that "+" indicates a directly proportional relationship and "-" indicates an inversely
proportional relationship.
1. The spot price of a stock increases. Which of the following is the most likely impact of a long
put position?
A. Improves
B. Worsens
C. Remains the same
2. There is a call option with a stock that pays dividends. Which of the following is the most likely
impact of a long call position once the dividends are paid?
A. Improves
B. Worsens
C. Remains the same
3. A trader makes the following statement: "Volatility is good for long call options but bad for
long put options." Are they most likely correct?
A. Yes, because long options like volatility

B. No, because short options like volatility
C. No regarding calls but yes regarding puts
4. A trader makes the following statement: "Time is good for long call options but bad for long
put options." Are they most likely correct?
A. Yes, because long options like time

B. No, because short options like time
C. No regarding calls but yes regarding puts
5. Two traders hold two put options with significantly different strike prices. Given that the spot
price is constant, which of the two traders are more likely to be out-of-the-money?
A. The one with the higher strike price

B. The one with the lower strike price
C. Cannot say
6. The risk-free rate decreases by 50bps. Which of the following is most likely for the positions
of long call options?
A. Improves
B. Worsens
C. Remains the same
Answers
1. B is correct. The exercise value of a put option is inversely related to the spot price.
2. B is correct. Carry benefits reduce the value of the call option. Dividends reduce the share
price. When the share price decreases, the payoff of a long call option decreases.
3. A is correct. Volatility benefits all long positions and harms all short positions, regardless of
the call or put condition.
4. A is correct. The time value of an option allows for even out-of-the-money options to become
in-the-money. More time allows for a higher probability of market moves.
5. B is correct. Remember that the higher the strike price, the higher the exercise value of a put
option. The question is asking which of the two are more likely to be out-of-the-money and
not in-the-money. So, the option with the lower strike price is more likely to be out-of-the-
money.
6. B is correct. The value of a call option is directly proportional to a change in the risk-free rate.
The value of a put option is inversely proportional to a change in the risk-free rate.
Explain put–call parity for European options.

We can explain this by constructing two different portfolios which will have the same payoff.
Portfolio 1: Call Option "c" with Strike Price "X" and a pure-discount bond that pays "X" at maturity
Scenario 1: At the maturity date, the call option expires out-of-the-money.
Payoff of Call = 0
Payoff of pure-discount bond = X
Total payoff = X
Portfolio 2: Put Option "p" with Strike Price "X" and the underlying asset "S."
Payoff of Put Option = X - S
Payoff of underlying = S
Total payoff = X
Portfolio 1: Call Option "c" with Strike Price "X" and a pure-discount bond that pays "X" at maturity
Scenario 2: At the maturity date, the call option expires in the money.
Payoff of Call = S - X
Payoff of pure-discount bond = X
Total payoff = S
Portfolio 2: Put Option "p" with Strike Price "X" and the underlying asset "S."
Payoff of Put Option = 0
Payoff of underlying = S
Total payoff = S
It is intuitive to understand that if a call option expires in-the-money then the put option has expired
out-of-the-money.
So, we can say that the payoff of Portfolio 1 is equal to the payoff of Portfolio 2 at expiry.
Since the bond pays X at expiry, we must discount this back to today.
Therefore,
c + X/(1 + rf)T = p + S
This is the main formula that can be re-arranged to find the missing variables.
The left-hand side of the equation is called a fiduciary call, and the right hand side is called a protective
put.
Fiduciary Call = c + X/(1 + rf)T
Protective Put = p + S
1. Which of the following is a fiduciary call?
A. p + S
B. c + S/(1 + rf)T
C. c + X/(1 + rf)T
2. The call premium is 5, and the strike price is 3. The put premium for that same expiry date 1
year from now is 4. Which of the following is the price of the underlying asset if the risk-free
rate is 3.00%?
A. 3.85
B. 3.91
C. 4.00
3. A call option has a price of 45, and a put option of the same maturity has a price of 51. The
underlying asset is currently priced at 60. Which of the following is the face value of the bond
for the put-call parity to hold if the risk free rate is 5.00% and the option expires in two years?
A. 66.00
B. 72.77
C. 69.30
Answers
1. C is correct. A fiduciary call is the combination of a call option at price "c" and strike price "X"
and a pure-discount bond with a face value of "X."
2. B is correct. S = c + X/(1 + rf)T - p = 5 + [3/(1 + 3.00%)1] - 4 = 3.91. A is incorrect because it takes
the call price as the strike price.C is incorrect because it does not discount the bond value.
3. B is correct.
X/(1 + rf)T = p + S - c
X/(1 + 5.00%)2 = 51 + 60 - 45
X = (1 + 5.00%)2 x 66 = 72.77
A is incorrect because it does not consider the time value of money (does not discount the
bond). C is incorrect because it does not consider the time to expiry.
Explain put–call forward parity for European options.

The only difference between the put-call parity and put-call forward parity is that the forward price is
used instead of the underlying price.
The logic here is that when we take a long position in a forward contract, we must buy the underlying
at expiry. The payoff from the pure-discount bond that is "X" must be suitable to pay for the purchase
of the underlying asset. So, the face value of the bond must at least be equal to the forward price.
We know that F0(T) = S0 x (1 + rf)T
So, when we solve for S0 we get:
S0 = F0(T)/(1 + rf)T
We can now substitute this in the put-call parity formula.
c + X/(1 + rf)T = p + F0(T)/(1 + rf)T
Notice that since rf and T are both the same, we can re-arrange the formula in the following way:
c + X/(1 + rf)T - F0(T)/(1 + rf)T = p
[X - F0(T)]/(1 + rf)T = p - c
Explain how the value of an option is determined using a one-period binomial model.
A "bi"-nomial model implies that over the next period, the value of an asset will have two possible
outcomes. So, to construct a binomial model, we require:
➢ The asset's value at the beginning of the period
➢ The magnitude of the two possible changes in outcome (for each direction)
➢ The probability of each outcome
We will explain options pricing using the one-period binomial model.
Suppose the following information has been provided for a stock that is currently priced at Rs. 87:
➢ Size of the up-move = 1.31
➢ Size of the down-move = 0.93
➢ Probability of the up-move = 0.57
We can summarise this data in the following table:
Details Notation Value
Size of up-move U 1.31
Size of down-move D 0.93
Probability of up-move πU 0.57
Probability of down-move πD (1 - πU) 1 – 0.57 = 0.43

We can also draw out this data in the following way:
So, there is a 57% chance that the stock price moves to 113.97 in the next year and a 43% chance that
the stock price moves to 80.91 in the next year.
Now let us introduce the strike price of a call option.
Suppose a trader buys a call option for the stock at Rs. 90, and this option expires one year from now.
The risk-free rate is 4.50%.
What is the payoff of the call option for the two possible outcomes, and what is the price of the call
option today?
Now we can see that the payoff of the up-move one year from now is 23.97 (with a probability of
57%), and the payoff of the down-move is 0 (with a probability of 43%).
Now we can see the expected payoff because these payoffs are probability-based.
Therefore,
Expected Payoff = (57% x 23.97) + (43% x 0) = 13.66
But this is one year from now.
And so the final step is to discount this back by one year at the risk-free rate.
Therefore,
Price of the Call Option “c” = 13.66/(1 + 4.50%)1 = 13.07
Risk-Neutral Probabilities
Remember that arbitrage pricing uses risk-neutral rates, and so the same concept can be applied to
probabilities.
This is the probability for each outcome that maintains the risk-neutrality of investors.
So now suppose that the probabilities for the up-move and down-move were not given at all. We
would have the following information:
Details Notation Value
Size of up-move U 1.31
Size of down-move D 0.93
Risk-Free Rate rf 4.50%
The risk-neutral probability of the up-move is calculated as:
πU = (1 + rf - D)/(U - D)
And so, for traders to remain risk-neutral the probability of an up-move is:
(1 + 4.50% - 0.93)/(1.31 - 0.93) = 0.30 or 30%
Therefore, the risk-neutral probability of a down-move is:
1 - 0.3 = 0.7 or 70%
Details Value
Spot Price 76
Strike Price 60
Size of up-move 1.23
Size of down-move 0.91
A trader wants to price a call option for a stock with the information that has been provided using the
binomial model. It is a European-style option with one year to expiry. The up-moves and down-moves
are relevant for a one-year horizon.
1. Calculate the risk-neutral probability of an up-move.
A. 0.45
B. 0.55
C. 0.23
2. Calculate the payoff of the up-move and the payoff of the down-move.
A. Payoff (U) = 9.16, Payoff (D) = 33.48

B. Payoff (U) = 33.48, Payoff (D) = 0
C. Payoff (U) = 33.48, Payoff (D) = 9.16
3. Calculate the expected payoff of the call option one year from now.
A. 20.10
B. 22.46
C. 15.07
4. Calculate the price of the call option.
A. 20.10
B. 19.05
C. 14.28
Details Value
Spot Price 105
Strike Price 80
Size of up-move 1.31
Size of down-move 0.65
A trader wants to price a put option for a stock with the information that has been provided using the
binomial model. It is a European-style option with one year to expiry. The up-moves and down-moves
are relevant for a one-year horizon.
5. Calculate the risk-neutral probability of an up-move.
A. 0.40
B. 0.60
C. 0.20
6. Calculate the payoff of the up-move and the payoff of the down-move.
A. Payoff (U) = 11.75, Payoff (D) = 0

B. Payoff (U) = 137.55, Payoff (D) = 68.25
C. Payoff (U) = 0, Payoff (D) = 11.75
7. Calculate the expected payoff of the option one year from now.
A. 4.52
B. 0
C. 4.70
8. Calculate the price of the option.
A. 4.52
B. 0
C. 4.70
Answers
1. A is correct. πU = (1 + rf - D)/(U - D) = (1 + 5.50% - 0.65)/(1.31 – 0.65) = 0.45. B is incorrect

because this is the probability of a down-move. C is incorrect because it takes "U – 1" which
is not a probability.
2. C is correct. We can draw out the binomial path in the following way:
3. A is correct. Payoff for a Call Option = Max(S – X, 0), The payoff for the up-move is 33.48, and
the payoff for the down-move is 9.16. The expected payoff considers the probability of these
two paths. Expected Payoff = (45% x 33.48) + (55% x 9.16) = 20.10. B is incorrect because it
mixes up the probabilities. It takes 55% for the up-move and 45% for the down move.C is
incorrect because it does not consider the down-move.
4. B is correct. The price of the option is the expected payoff discounted back to today.
Price = 20.10/(1 + 5.50%)1 = 19.05. A is incorrect because that is the expected payoff. C is
incorrect because it does not consider the down-move.
5. B is correct. πU = (1 + rf - D)/(U - D) = (1 + 4.05% - 0.65)/(1.31 – 0.65) = 0.60.

59
6. A is incorrect because this is the probability of a down-move. C is incorrect because it uses "U
+ D" in the denominator instead of "U - D."
7. C is correct. We can draw out the binomial path in the following way:
8. C is correct. Payoff for a Put Option = Max(X – S, 0), The payoff for the up-move is 0 because
X – S < 0 and the payoff for the down-move is 80 – 52 = 28. The expected payoff considers the
probability of these two paths. Expected Payoff = (60% x 0) + (40% x 11.75) = 4.70
9. A is correct. The price of the option is the expected payoff discounted back to today. Price =
4.70/(1 + 4.05%)1 = 4.52
Explain under which circumstances the values of European and American options
differ.
Recall that an American-style option can be exercised at any point up to and including the expiration
date. European-style options must be exercised only on the expiration date.
There will only be a difference in value when the underlying has some cost or benefit attached to it.
Suppose there are two identical European and American call options on a stock that pays a dividend.
The holder of the call option has the right to buy the stock. But they can only receive dividends on the
stock if they have purchased the stock before or on the ex-dividend date.
Now, if the expiry of the European call option is after the ex-dividend date, then the dividend does
not make a difference. But if the expiry of the American call option is after the ex-dividend date, then
the holder of the option can exercise the option early so that they get the shares and get the benefits
of the dividend of the shares too. This is the early exercise value of an American call option.
Put options, however, have no early exercise value because the underlying is sold to the other party.
It is beneficial for holders of put options to wait until the underlying has paid a cash outflow because
this reduces the price of the underlying, and this benefits the long put position.
Formula 60
Formula
Basics of Derivative Pricing and Valuation
• No arbitrage forward price: 𝐹0 (𝑇) = 𝑆0 (1 + 𝑅𝑓)𝑇
• Payoff to long forward at expiration = 𝑆𝑇 − 𝐹0 (𝑇)
𝐹 (𝑇)
• 0
Value of forward at time t: 𝑉𝑡 (𝑇) = 𝑆𝑡 + 𝑃𝑉𝑡 (𝑐𝑜𝑠𝑡) − 𝑃𝑉𝑡 (𝑏𝑒𝑛𝑒𝑓𝑖𝑡) − (1+𝑅𝑓) 𝑇−𝑡
• Exercise value of call = Max[0, S − X]
• Exercise value of put = Max[0, X − S]
• Option value = exercise value + time value
𝑐+𝑋 𝑋
• Put call parity = (1+𝑅𝑓)𝑇+𝑝 = 𝑐0 + (1+𝑅𝑓)𝑇
0
“
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Authored by: Mohit Madhiwalla, Aman Milwani, Esha Vora

Derivative Instrument and Derivative Market Features

Difference between Futures and Forward Contracts:

Traded on an exchange Traded over-the-counter

Standardized contract terms Customizable contract terms

Marked to market daily No mark to market

Counterparty risk mitigated by exchange Counterparty risk is higher

Settled on expiration date Settled on expiration date or periodically during contract

Difference between Over-the-counter derivatives and Exchange traded securities.

Marked to market daily No mark to market

Counterparty risk mitigated by exchange Counterparty risk is higher

Settled on expiration date Settled on expiration date or periodically during

1. Why is a derivative least likely considered a complex instrument?

A. The payoff of a derivative is based on the value of an underlying asset

2. Which of these statements is true?

A. One of these statements is correct

A. No, because there is no counterparty risk

A. Contingent claims can be exercised based on a certain event

5. A credit derivative is most likely a type of:

6. Which of the following are standardized contracts?

A. Forwards and swaps

5. C is correct. The owner of a credit derivative is protected against rating downgrades of a

Forward Commitment and Contingent Claim Features and Instruments

Why would we enter such a contract?

➢ Note that no payment is made at the initiation of a forward contract. It is simply

Settlement of Forward Contracts

How do futures differ from forwards?

Swaps and Options

Swaps are similar to forwards in the following ways:

1. Which of the following contracts most likely require clearinghouses?

2. An index forward is most likely:

A. Futures contract on a stock

4. Is the following statement most likely true?

A. No, because the price and value both change

5. A maintenance margin is most likely a feature of which of the following contracts?

A. An options contract on a stock

6. A limit up move is most likely due to:

7. Which of the following is least likely true regarding open interest?

A. The open interest changes when a new position is opened

8. What is the utility of the notional principal of a swap?

A. It is the amount that is traded when the swap contract ends

A. Exercise the option only at expiry

10. A credit derivative protects:

A. The bond issuer

9. B is correct. A is a European-style option, and C is called a Bermuda-style option.

Long Call and Long Put

Spot Price Payoff Premium P/L

3800 200 80 120

Now let us look at the payoff:

What is the logic behind this?

Following is the payoff and profit table:

Spot Price Payoff Premium P/L

3200 200 80 120

The graph for the premium remains the same.

Similarly, the profit curve looks like this:

What is the logic behind this?

Short Call and Short Put

3750 -150 80 -70

The profit chart looks like this:

What is the logic?

Similarly, the profit chart looks like this:

What is the logic?