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Indian Derivative markets

INTRODUCTION
Foreign exchange (FX) options are contracts that give the buyer the right, but

not the obligation, to buy or sell one currency against the other, at a predetermined price and on or before a predetermined date.
The buyer of a call (put) FX option has the right to buy (sell) a currency

against another at a specified rate.


European Option: If the right can only be exercised on a specific date American Option: If the option can be exercised on any date till a specific

date

Use of Option
Protection against downside risk (buying simple puts and calls to hedge

existing FX positions)
Earn from covered option writing (e.g. a Japanese exporter who is long

US$, selling a US$ call/ JPY put option)


Hedge against event driven violent moves, by buying cheap out of money

calls and puts


Take directional views on spot and volatility

Pre Liberalization
Insular economic environment shielded from

global competition

Limited number of financial products


Strict regulatory regime Corporate depended primarily on term lending Commercial banks didnt pay heed to risks from mismatched interest

rate re-pricing of assets and liabilities

Post Liberalization
Rapidly globalizing and deregulating Indian economy Financial risks came into focus Treasury became a hub of action for corporate Freeing the conventional forward contract Introduction of cross currency forward contracts

Derivative Products Available in India


Product traded in overseas markets
A cross currency option is an option in which currency of exercise price is different from currency of underlying asset An over-the-counter contract between parties that determines the currency exchange rate to be paid or received on an obligation beginning at a future start date One stream of future interest payments is exchanged for another based on a specified principal amount

Cross Currency options

Forward Rate Agreements

Interest Rate Swaps

Commodity futures/ Options

An agreement to buy or sell a set amount of a commodity at a predetermined price and date

Derivative Products Available in India (Contd.)


Equity Derivatives

Rupee Derivatives

Commodity Futures

Rupee Interest Rate Swaps

Need For Derivatives in India


Commercial banks are providing the main impetus

Increased awareness among banks and financial institutions of the balance sheet mismatches and resulting risks Offering customized solutions tailored to specific needs of Corporate Clients Innovative products and sophisticated solutions to optimize the financing and treasury management function

FC-INR options
Hedge for currency exposures to protect the downside while retaining the upside, by paying a premium upfront Big advantage for importers, exporters (of both goods and services) as well as businesses with exposures to international prices Enable Indian industry and businesses to compete better in international markets by hedging currency risk

FC-INR options (Contd.)


Non-linear payoff of the product enables its use as hedge for various special cases and possible exposures The nature of the instrument again makes its use possible as a hedge against uncertainty of the cash flows Attract further forex investment due to the availability of another mechanism for hedging forex risk Complement the spot and forwards FX market to provide the complete universe of hedging instruments for corporate customers

Put Call Parity


K C P S0 t (1 r )
C P S0 S1 K r t = call premium = put premium current stock price stock price at option expiration option striking price riskless interest rate time until option expiration

= = = = =

Black Scholes Model

Assumptions
The stock price is determined by the following stochastic equation dS = (mdt+sdBt), where m and s are constant and Bt is the standard Brownian motion The short selling of securities with full use of proceeds is permitted

There are no transaction costs or taxes and securities are perfectly divisible
There are no dividends during the life of the derivative There are no riskless arbitrage opportunities Security trading is continuous The risk free rate r is constant and same for all maturities Log returns are independent, stationary and normally distributed

Black Scholes Model / Kolmogrov Equation

MIFOR = Mumbai Interbank Forward Offer Rate

Ex1: Consider a 1 month call option on USD/INR in which the spot USD/INR is 48.735 (S), the exercise price is 48.90 (X), MIFOR rate is 6.04% (r) for the period of 30 days (T= 0.083), and the risk-free interest rate on the foreign currency LIBOR is 1.84% (rf) Solution: = 0.01892 = 0.01462

N(d1) = 0.507548 N(d2) = 0.505832 = Rs. 0.081738 Equivalent to Rs. 81,738 for a notional of USD 1 million

Binomial Model
The binomial model breaks down the time to

expiration into potentially a very large number of time intervals, or steps. A tree of stock prices is initially produced working forward from the present to expiration The tree represents all the possible paths that the stock price could take during the life of the option Next the option prices at each step of the tree are calculated working back from expiration to the present The option prices at each step are used to derive the option prices at the next step of the tree using risk neutral valuation based on the probabilities of the stock prices moving up or down, the risk

Step 1
If S is current price, then in next period price will

be either:
Sup = S*u or Sdown = S*d

Variance =

Nu = the number of up ticks Nd = the number of down ticks

Step 2
Max [ (Sn K), 0 ], for a call option Max [ (K Sn ), 0 ], for a put option

K is the strike price and Sn is the spot price of the underlying asset at the nth period

Step 3
Once the above step is complete, the option

value is then found for each node, starting at the penultimate time step, and working back to the first node of the tree