DERIVATIVES

DERIVATIVES
As per SCRA,derivative instruments means

(i)A security derived from a debt instrument, share,secured/unsecured loan, risk

instrument/contract for differences or any other form of security

(ii)A contract that derives its value from prices/index of prices of underlying securities.

Usefulness:

(i) The prices of derivatives converge with the prices of the underlying at the expiration of
the contract. This helps in discovery of future & current prices.

(ii) Facilitates transfer of risk from those who carry them (but do not like to carry them) to
those with risk appetite.

(iii) Derivatives, by their very nature, are linked to the underlying cash markets.They
therefore facilitate higher trading volumes as more players take part due to available facility
for risk transfer.

(iv)Speculative trades shift to more controlled environment of derivatives market, otherwise

speculators would trade in underlying cash markets where margining ,monitoring &
surveillance of players would be very difficult.

(v)It energises enterpreneurial activity.

(vi) It helps savings & investment in the long run.

 EVOLUTION OF DERIVATIVES MARKET

In the 12th century, European traders offered futures contracts promising future delivery of
items .

In the 13th century, English Cistercian monasteries sold wool 20 years in advance to foreign
parties.

1634-37: Period of “Tulip Mania” in which huge speculative bets were placed on Tulip
flower & fortunes were lost.

17th Century: Rice futures market was developed in Japan, near Osaka.

1848 ; Central Board of Trade (CBOT) developed forward contracts on several commodities.
In 1865, CBOT extended these contracts to exchanges called “Exchange Traded
Contracts”thereby introducing future contracts in the US.

Thereafter CBOT was “spun off “ into a separate Chicago Butter & Egg Board .
This was reorganized for futures trading & name changed to Chicago Mercantile Exchange.
(CME)

In 1972, the CME constituted the International Monetary Market (IMM) for trading in
currency futures.
In 1973, the Chicago Board Options Exchange (CBOE) was formed & became the first
market place for trading in listed options.

In 1975, CBOT introduced interest rate futures using treasury bills derivative contracts, the
first pure interest rate futures market.

In 1977, CBOT introduced treasury Bond futures.

In 1982, CME introduced Eurodollar bond futures.

In 1982, Kansas City Board of Trade introduced stock index futures.

In 1983, Chicago Board Options Exchange (CBOE) introduced options on index contracts
using S & P 100 & S & P 500 indices.
 TULIP MANIA

Tulip Mania, a speculative frenzy in 17th-century Holland over the sale of tulip bulbs.

Tulips were introduced into Europe from Turkey shortly after 1550.

These delicately formed, vividly coloured flowers became a popular if costly item.

The demand for differently coloured varieties of tulips soon exceeded the supply.

Prices for individual bulbs of rare types began to rise to unwarranted heights in northern
Europe.

By about 1610 a single bulb of a new variety was acceptable as dowry for a bride, and a
flourishing brewery in France was exchanged for one bulb of the variety Tulipe Brasserie.

The craze reached its height in Holland during 1633–37.

Before 1633 Holland’s tulip trade had been restricted to professional growers and
experts.

But the steadily rising prices tempted many ordinary middle-class and poor families
to speculate in the tulip market.

Homes, estates, and industries were mortgaged so that bulbs could be bought for
resale at higher prices.

Sales and resales were made many times over without the bulbs ever leaving the
ground.

Rare varieties of bulbs sold for the equivalent of hundreds of dollars each.

The crash came early in 1637, when doubts arose as to whether prices would
continue to increase.

Almost overnight the price structure for tulips collapsed, sweeping away fortunes and
leaving behind financial ruin for many ordinary Dutch families.
 DERIVATIVE MARKETS IN INDIA

In 1999, the Securities Contract Regulations Act (SCRA) was amended to include
“derivatives” within the domain of “securities”. Regulatory framework was developed
for governing derivatives trading.

In March 2000, a three decade old notification ,which prohibited forward trading in
securities, was repealed.

In June 2000, SEBI pemitted both BSE & NSE to introduce derivatives trading.
First , index futures was introduced based on BSE Sensex & CNX Nifty .

In June 2001, index options was introduced.

In July 2001, stock options was introduced .

In November 2001, stock futures was implemented.

In February 2013, MCX (renamed MSEI) started trading in all these products.
MSEI index derivatives was based on the index of that exchange SX-40 .
 FORWARD CONTRACTS

It is an agreement to buy or sell an asset on a specified date for a

specified price.

One of the parties assumes a long position i.e. he agrees to buy the asset
o a specified future date for a certain specified price.

The other party assumes a short position i.e. he agrees to sell the asset
on the same date for the same price.

Other contract details like delivery date,price & quantity are negotiated
bilaterally between the parties.

Forward contracts are traded outside the stock exchanges.

They are popular on the OTC (Over the Counter) market.

 SALIENT FEATURES OF FORWARD CONTRACTS

(i) They are bilateral contracts & hence exposed to counterparty risk.

(ii) Each contract is customer designed & hence unique in terms of contract
size,expiration date & asset type & quality.

(iii) Contract price is generally not available on public domain.

(iv) On expiration of contract,settlement to be done by delivery of asset.

(v) If a party wants to reverse the contract,it has to necessarily approach the
counterparty which results in charging of higher price.

(vi) They are used in hedging & speculation.(Exporter can sell expected forex forward &
importer can buy forex forward.

(vii) Useful for a speculator who uses forward market instead of a cash market –he would
go long,wait for the prices to rise & reverse the transaction (sell) to make quick
profits.

(viii) No margin requirement.

 LIMITATIONS OF FORWARD CONTRACTS

(i) Lack of centralisation of trading.

(ii) Counterparty risk-default by one of the parties to the transaction.

(iii) Liquidity
 FUTURES

Very much like a forward contract-two parties agree to buy/sell an asset to each other
at a future date at a predetermined price.

Standardised & traded only on stock exchanges.

Exchange specifies certain standard features for the contract to facilitate liquidity.

It is a standardised contract with a standard underlying instrument ,a standard quantity

& quality of underlying instrument that can be delivered & a standard settlement
cycle.

A futures contract can be offset prior to maturity by entering into an equal & opposite
transaction.

Requires margin payment.

 Important Terms-Futures Contract

(i) Futures price: The price at which futures contract trades in market.

(ii) Contract Cycle: Period over which the contract trades.Eg.index futures typically have one
month,two month & three months expiry cycles that expire on the last Thursday of the
month.

(iii) Expiry Date: The date specified in the futures contract. The last day of trading of this
contract which will ceast to exist at the end of the day.

(iv) Contract size: Size of asset to be delivered under one contract. (contract size of NIFTY
futures is 50).

(v) Basis : Futures price minus spot price.For each contract,there will be a different basis for
each delivery month.In normal markets,basis will be +ve indicating future prices normally
> spot prices.

(vi) Cost of Carry:Measures storage cost plus interest cost for financing the asset minus
income earned on the asset.

(vii)Initial Margin: Amount to be deposited first in the margin a/c .

MTM Margin:At the end of trading each day,the margin account is adjusted to
reflect the investor’s gain/loss depending upon the futures price.

Maintenance Margin :Lower than the initial margin.It is to ensure that the balance
in the margin a/c does not become –ve.If the balance in the margin a/c falls below
the maintenance margin,investor receives a margin call & is expected to top up the
margin account to the initial margin level before trading commences the next day.

Pay Offs :It is the likely profit/loss that would accrue to the market participant with
the change in price of underlying asset.

Linear payoff: Profits/losses to the buyer/seller of future contracts are unlimited.

Pay off for BUYER : Pay off for buyer of future contract is akin to pay off for a
person holding the asset. He a potential unlimited upside/downside.

Eg: A person who buys a NIFTY futures contract when nifty is 22300. underlying
asset in this case is the NIFTY portfolio. When the NIFTY moves up,the long futures
starts making profit & when it moves down, it starts making losses .

Pay off for SELLER : Pay off for seller of future contract is akin to pay off for a
person shorting the asset. He a potential unlimited upside/downside.

Eg: In the above example,in this case,the position is opposite. When the NIFTY
moves down,short futures starts making profit & when it moves up, losses start.
 MARGIN ACCOUNT CALCULATIONS

day price gain/loss cum gain/loss margin a/c balance margin call IM 12000

0 1750 0 0 12000 MM 9000

1 1751 200 200 12200 LOT 200

2 1735 -3200 -3000 9000

3 1740.5 1100 -1900 10100

4 1755.7 3040 1140 13140

5 1739.3 -3280 -2140 9860

6 1743.1 760 -1380 10620

7 1730.2 -2580 -3960 8040 3960

8 1739.9 1940 -2020 13940

9 1745.8 1180 -840 15120

10 1725.4 -4080 -4920 11040

LOSS -4920 -4920

 PRICING OF FUTURES

It can be discussed w.r.t.

(i) The Cost-of-Carry model

(ii) Pricing Equity Index Futures
(iii) Pricing Stock Futures

(i) COST OF CARRY MODEL: It explains the dynamics of pricing that constitute
estimation of fair vale of futures.
(ii) Fair value calculation is used to decide the no arbitrage limits on the price of futures.
(iii) Using discrete compounding,where interest rates are compounded at discrete
intervals(e.g. semi annually/annually),price of contract is defined as :

F=S + C
where F=futures price,S=spot price & C= carry or holding cost.

Also expressed as F=S(1+r) ^T

Where r=cost of financing ,T=time til expiration

If F<S(1+r)^T or F>S(1+r) ^T ,arbitrage opportunities would exist i.e.whenever futures

price move away from fair value,there is chance for arbitrage.
In case of commodity futures, the holding cost is the cost of financing the storage ,insurance
purchased etc.

In case of equity,the holding cost is the cost of financing minus dividend income.

Using continuous compounding, equation can be rewritten as

F=Se ^rT

r= interest rate continuously compounded,e=2.71828,T=time till expiry

 PRICING INDEX FUTURES

Stock index Futures are cash settled ,there is no delivery of underlying stocks.

(i) No cost of storage involved in holding equity

(ii) Equity comes with a dividend stream,which is a negative cost if you are long on the stock
& positive if you are short on the stock.

Cost of Carry =Financing Cost- Dividends

Thus crucial aspect of dealing with equity futures is the accurate forecasting of dividends.

The better the forecast of dividend offered by a stock, the better is the estimate of
its futures price.

Pricing of equity index can be done w.r.t. (i) Expected dividend amount
(ii) Expected dividend yield.
 PRICING OF FUTURES GIVEN EXPECTED DIVIDEND AMOUNT

It is also based on cost carry model where the carrying cost =

the cost of financing the financing the portfolio underlying the index minus present value
of the dividends obtained from the stocks comprising the portfolio.

=S(1+r) ^T-d(1+r)^T/index multiplier

PRICING OF FUTURES GIVEN EXPECTED DIVIDEND YIELD

If the dividend flow throughout the year is generally uniform (there are few cases of
clustering of dividend in any particular month) ,it is used to calculate the annual dividend
yield

F=S(1+r-q)^T
OR
S*e^[(r-q)*t)
,where
F=Futures price
S=spot index value
r=Cost of financing
q=expected dividend yield
T=holding period
 PRICING STOCK FUTURES

Pricing of stock futures is based on the cost carry model.

PRICING STOCK FUTURES-NO DIVIDENDS EXPECTED

If no dividends are expected during life of stock ,pricing futures on the stock simply involves
multiplying the spot price by cost of carry

F =S(1+r)^T or F= S*e(rt)

PRICING STOCK FUTURES- DIVIDENDS EXPECTED

F=S(1+r)^T-d(1+r)^T OR F=S*e^(rt) – D* e^(rt)

NUMERICAL

1.On Nov 1st, X bought one month January Nifty futures for Rs.5,38,000. Initial margin
of Rs. 43040 was paid to broker. (1 NIFTY contract or lot=200 NIFTY futures). In
February , NIFTY closed at Rs.2720 on expiry. What was his pay off?

2.If NIFTY closed at 2520, what was the pay off?

1.Purchase cost per Nifty = value of the contract/ lot = 538000/200 = Rs.2690

Nifty closed at 2720

Pay off per NIFTY option =( 2720-2690) *200 = 6000 Profit

2. If NIFTY closed at 2520, pay off = (2520-2690) * 200 = (34000) loss

X sold January one month NIFTY future contract for Rs.2,69,000 in January (lot=200).
He paid initial margin of Rs 21,520. In february index closed at 1390. What is his pay
off?
His selling price per NIFTY future = 269000/200 = 1345

Nifty expired at 1390

His pay off = (1345 -1390) * 200 = (9000) loss

 F = S * (1+r)^t + C ,
where F= futures price , S= spot price , r= interest rate, t= time in years,
C= transaction cost

OR

F= S*e^(rt) + C

Where e = continuous compounding factor

If the spot price of silver=Rs.50,000/kg & cost of financing =15% , find out the
price of three months’ silver futures contract of 100 gms
F= S* e^rt = 50000 * e^ (0.15*0.25) = 51910 for 1kg or 1000 gms

Price of 100 gms = 51910 *100/1000 = 5191

If the spot price of TCS is Rs.3000 & the risk free rate=6%, find out the price of
two months’ TCS futures. Assume no transaction cost.
F = S* e(rt) = 3000 * e^ (.06*2/12) = 3030.15
If spot price SBI share is Rs.390 , , find out the value of the 3 months’ SBI futures contract
if the interest rate is 8% p.a.& if it declares a dividend of Rs,30 during the contract
period.

F = S* e^(rt) – D* e^(rt)
F = S* e^(rt) – D * e(rt) = 390* e^(.08*0.25 ) – 30 * e^(.08*.25) = 367.17
If share of ABC Ltd has a spot price of Rs700 & if it declares a dividend of 3% , the
interest rate being 7% p.a., find out the value of 4 months’ futures of ABC Ltd
F = S*e^ (r-D) * t = 700 * e^[(.07-.03) * 4/12] = 709.39
Spot price of XYZ Ltd is Rs. 900 . An investor buys a 3 months’ future contract on
XYZ Ltd. If the company declares a dividend of 80 two months after the
purchase of the contract, find out the price of the three month futures. Interest
rate is 7.5%.

Here t will change while discounting dividend since it is carried forward only for
one month during the contract.

F = S* e^(rt1) – D* e^(rt2)
F = S*e^(rt) – D * e^ (rt) = 900 * e^ (.075
* 3/12) – 80* e^ (.075* 1/12)

= 837.20
1.On January 1st, an investor buys 10,000 shares of Rs.1000 each.He hedged with stock
futures on the same date . Risk free rate=6%. The company expects to pay a dividend of
Rs.90 per share on January 31st.The contract expires on March 28th & the company’s
closing price on that date is 976. If the investor sells the share on March 28 th, what will be
his pay off?

2.Suppose the company had not paid dividend, calculate his pay off.
Spot price =1000 , dividend =6% p.a.
no of days of contract= 31+28+27 =86
No of days of dividend= 1+28 +27 =56

Futures price on January 1st when it was hedged F = Se^(rt) –D*e^(rt)

= 1014-90.83 = 923.17

In the cash segment, he bought at 1000 & sold at 976 . He received dividend of Rs.90
-1000+ 976 +90 =+66

He short sold the futures at 923.17 & squared off on the expiry at 976

His loss in futures = -976+923 =53

His net pay off =66-53 =13 per share

On 10,000 shares = 13X 10000 =1,30,000

WITHOUT DIVIDEND

Futures price quoted on Jan1 without dividend = F = S*e^(rt)

= 1000 * e^ (.06 * 86/365) = 1014.23

Expiry price of futures = 976

Gain= 38

Loss in cash = 1000 -976 =24

Net gain/share = 38 – 24 = 14

Gain on 10,000 shares = 14 X 10000 =1,40,000

 PRICING OF INDEX FUTURES

Spot price of Nifty contract @ Rs.1200 (lot =200) .

A company X Ltd carries a weight of 7% in the Nifty basket. An investor buys 60 day
Nifty contract & X Ltd declares a dividend of Rs 10 share fifteen days after the
purchase of the contract. Risk free rate =15%. The current price of X Ltd is Rs.140 .

Calculate the ex dividend futures price of NIFTY.

 Value of spot NIFTY = 1200
NIFTY lot = 200
Value of spot Nifty contract = 1200* 200 = 240000
Weight of X Ltd in NIFTY = 7%
Value of Xltd in NIFTY = 7% of 240000 =16800
CMP of X Ltd = 140
No. of shares of X Ltd in NIFTY basket = 16800/140 = 120
Dividend declared =Rs. 10 /share
Total dividend = 120* 10 = 1200
F = S*e^rt - D* e^rt

F = 1200* e^(0.15* 60/365) – (1200 * e^ (0.15* 45/365))/200 = 1223

(We are dividing by 200 because we are the calculating the dividend value per NIFTY )
NUMERICAL

A bank enters into a 3 monthUSD-INR purchase contract @ Rs.75.25 for USD10,000.At

the end of two months,when the customer visits the bank & sees the following
quotations:

SPOT 75.30 / 75.40

IM forward 75.45 / 75.52

The customer requested for cancellation of the contract & the bank agreed.

What will be the pay off to the customer on cancellation?

If initially, the bank had entered into forward sale contract instead,what would have
been the pay off to customer?
NUMERICAL

You borrow $2,00,000 for 3 months from a bank at the US rate of interest of 5%
. Tthe Indian rate of interest is 9%. If the spot $/INR rate is Rs.75 , calculate

(i) The fair forward rate of $/INR for 3 months.

(ii) If the market 3 month $/INR forward rate is Rs.75.50, explore if there
is any arbitrage profit to be made .
(iii)What is the $/INR 3 month forward rate for which there is zero
arbitrage ?
SOLUTION:
Formula for 3 month INR/$ fair forward rate =
spot rate*[ (1+ rd)/(1+rf) ]
=75*(1+.09*3/12) (1+.05*3/12)
=75*1.0225/1.0125
=75.74

Total amount to be paid to the banker with interest = 2,00,00 *

Interest rate for 1 year =5%

Interest rate for 3 months = 5% *3/12 =1.25%= 0.0125

Total amount to be paid to banker after 3 months =2,00,000*(1+.0125) =

2,02,500
Today, convert the $ 2,00,00 into INR @ spot rate of Rs.75.00 = 2,00,000*75
=1,50,00,000

Invest thuis amount in a bank for 3 months @ rupee interest rate of 9%.p.a.
3 month INR interest rate= 9%*3/12 = 2.25% =0.0225

Total INR amount received with interest after 3 months= 1,50,00,000

*(1.0225)
= 1,53,37,500
Convert this back to dollar @ the 3 month market forward rate of 75.50for
$/INR =1,53,37,500/75.50
= $ 2,03,145

Payment to banker = 2,02,500

Arbitrage profit = $ 203145 – 202500 = $645

No arbitrage three months INR/$ forward rate = the fair forward rate of
Rs.75.74
 OPTIMAL HEDGE RATIO
It shows the strength of relationship between two assets which can be exploited to
achieve the minimum portfolio variance.

It quantifies systematic co movement between two assets . It is called optimal since a

position on futures contracts based on “h” minimises the portfolio variance most. It is
based on the standard deviation of the spot & future prices of the assets & their
correlation.
No of contracts = h * exposure value (to be hedged)/ contract value of hedge

Optimal hedge ratio h (Minimum Variance Ratio)= σ s/ σ f * ρ.

It shows how the variance value of the hedger’s position depends on the hedge ratio
chosen. The optimal hedge ratio is a risk management ratio that helps you work
out the percentage of a hedging instrument, or in other words, the percentage of
your portfolio that you should hedge.

Hedge effectiveness: Defined as the proportion of variance that is eliminated by

hedging = h^2* σ f^2/ σ s^2

CROSS HEDGE:It is used to manage price risk of an asset by hedging it with derivative
product of another asset ,both of which are positively correlated. Investor takes
opposite position in the derivative position for reducing the price risk of the asset held.
An airlines intends to buy 1 m gallons jet fuel. . It desires to hedge using jet fuel
futures.But this product is not available on the exchanges. So it chooses heating oil
futures to hedge as it has a strong correlation in price with jet fuel. This is called Cross
hedge . 1 contract of heating oil futures =42000 gallons.
Jet fuel Heating oil
SD 2.83% 3.38%

Correlation coeff 81.4%

MV ratio/opt.
hedge ratio

1. Calculate optimum hegde ratio (MVR)

2. No of contracts of heating oil futures required for hedging
3. Loss or gain in the transaction (assume expected price rise of $1/gallon)
4. Hedge effectivenss
MVR = Optimal hedge ratio h = σ s/ σ f * ρ

=0.814* 0.0283/0.0338
= 0.6815

No of contracts of heating oil futures (N)= h * size of the exposure/ size of hedging
instrument

N = 0.6815 * 1,000,000/42000 =16.25 or 16 contracts

If spot price of jet fuel rises by $1 per gallon, gain in futures price = 1/ ρ^2
= 1/ (0.814)^2 = 1.51

Gain in oil futures contract = 42000 * 1.51 * 16 = $ 1,014,720

Loss in jet fuel due to price rise = 1,000,000 * $1 = $ 1,000,000

Net gain = $ 14,720

Hedge effectiveness = σ f^2/ σ s^2 * h^2

= 0.0338^2/0.0283^2*0.6815^2

=0.6625 or 66.25%
A Cocoa merchant has inventory of cocoa of $ 10m @ $1250 /metric ton. He considers
miminisation of risk strategy using cocoa futures contracts on the cocoa exchange.

SD of cocoa = 27% , SD of cocoa futures = 33%, contract size cocoa futures =10 metric
tons

Correlation between cocoa & cocoa futures = 85%

Estimate:

1. Optimum hedge ratio

2. Should the merchant go long or short
3. No of contracts of cocoa futures
Optimal hedge ratio = σ s/ σ f * ρ

h = 0.27/0.33* 0.85 = 0.6955

Since the merchant is holding cocoa inventory, he will hedge to mitigate the price
fall.So he will go short on cocoa futures.

No of contracts = Value of exposure/value of hedging instrument* h

= 10m / 10* 1250 * 0.6955 =556 contracts

A stock portfolio of $100 m has a β of 1.08 measuring S & P futures which stands at 350.
How many contracts are required to hedge ? (market lot =250)
Since the stock portfolio is held, there is an apprehension of price fall.So he will short with
index futures.

No of contracts = 100 m / (350 * 250) * 1.08 = 1234 contracts

 OPTION CONTRACTS

An option contract gives its holder an option i.e.a right but not an obligation to buy or sell
an asset at a predetermined price on a specified future date.

Thus the holder of an option contract does not have to necessarily exercise this right.

OPTION TERMINOLOGY

INDEX OPTION:

Index is the underlying in this option.

Two types of option: American options can be exercised anytime upto the expiration
date.

European Options can be exercised only on the expiry date .

Like index Futures contracts, index option contracts are cash settled.
 STOCK OPTIONS:
They are options on individual stocks.

The stock option contract gives the holder the right to buy or sell shares at a specified price
on a predetermined date.

BUYER OF OPTION

He buys the right but not the obligation to exercise his option to buy/sell the asset on the
seller/writer of the option by payment of an option premium.

WRITER OF AN OPTION

He is the seller of the option & is obliged to buy/sell the asset if the buyer of the option
exercises his right by receipt of an option premium.

CALL OPTION

It gives the holder of the option the right but not the obligation to buy an asset on a
certain date for a certain price.

PUT OPTION

It gives the holder of the option the right but not the obligation to buy an asset on a
certain date for a certain price.
 OPTION PRICE/PREMIUM

Option price is the price that the option buyer pays to the option seller.Also referred to as
Option premium.

EXPIRATION DATE

The date specified in the option contract is called the Expiration Date.

STRIKE PRICE

The price specified in the options contract is called the Strike Price or the Exercise price.

In the Money Option(ITM)

It is an option which would lead to a positive cash flow if the option was exercised
immediately.

A call option on the index is said to be in the money when the current index stands at a
higher level than the strike price.i.e spot price> strike price.

If the index is much higher than the strike price,the call is said to be deep ITM.

In the case of a put option, the put is ITM if the index is below the strike price.
 At the Money Option (ATM)

It is the option that would lead to zero cash flow if exercised immediately.

An option on the index is at the money when the current index=strike ot price. i.e the spot
price=strike price.

Out of the Money Option (OTM)

It is the option that would lead to a negative cash flow if exercised immediately.

A call option on the index is out the money when the current index < strike ot price. i.e the
spot price < strike price.

PRICING OPTIONS

An option buyer has the right but not the obligation to exercise his right on the seller.

The worst thing that can happen to the option buyer is the loss of premium paid by him.

His downside is limited to premium but the upside is unlimited.

This optionality has a value expressed in terms of option price.

It is the supply & demand in the secondary markets that decides option price.
CALL OPTION BUYER

100 110
120
BE

Strike price=100 , option premium =10, expiry =120

 CALL OPTION SELLER OR
WRITER

90 100
0 70 B
E

Strike price =100 , option premium =90 , expiry = 70

 PUT OPTION SELLER

70
0 90 100

Strike = 100, option premium =10 , expiry =70

 CALL OPTION SELLER

BE
100 110 120

Strike = 100 , option premium = 10 , expiry = 120

Maximum gain to the option buyer = UNLIMITED

Maximum loss to the option buyer = LIMITED

Maximum gain to the option seller = LIMITED

Maximum loss to the option seller = UNLIMITED

Spot price of ABC Ltd = 1025 , strike =1050 . Investor purchases two I month call
options (1 contract =100 options) , Premium =10 , expiry = 1080. What is the pay off ?
Profit = E – X – Pr = 1080 – 1050 – 10 = 20
.
Profit on 1 contract = 20*100 = 2000

Profit on 2 contracts =2* 20*100 = 4000

Investor buys 3 month index put option contract . Strike =1340 , expiry = 1350 , Pr =5
(I contract = 200 index options)

Profit = Expiry – Strike – Premium = 1350 – 1340 -5 = 5

Profit on 1 contract = 200* 5 =1000

 CASH V/S OPTIONS

Invstor buys 200 three month call option contracts (I contract – 100 options) , premium
= Rs. 8 per option & X =200 . Compute pay off to the investor for both cash & option if
(i) expiry price = 210 (ii) 180

COMPUTE THE SAME RESULTS FOR PUT OPTION

Scenario 1

At Price 210 , profit = S – X -- Pr = 210 – 200 – 8 =2

Pr0fit for 1 contract = 100 * 2 = 200

Profit for 200 contracts = 200 * 200 = 40,000

At price=180, option not exercised . Loss = option premium on 200 contracts

= 200 * 100 * 8 = 1,60,000

Scenario 2

In CASH, the investor had cash equal to the option premium = 1,60,000

Price at which he is willing to buy = 200 ( refer to the strike)

No of shares bought in cash segment = 1,60,000/200 = 800 shares

When price is at 210, profit = 210 -200 = 10

Profit on 800 shares = 800 * 10 =8000

CASH SEGMENT CONTINUED

When price =180 , loss = 180 -200 = -20

On 800 shares, loss = 800 * -20 = -16,000

On PUT OPTIONS

When expiry is 210, put not exercised

Loss = option premium =1,60,000

When price =180 , profit = X – S –Pr = 200 -180 – 8 = 12

Profit on 200 contracts = 200* 100 * 12 = 2,40,000

CASH PROFITS HAVE BEEN CALCULATED ALREADY.