Derivatives

MODULE 1
 MODULE 1

LEARNING OBJECTIVE :

INTRODUCTION TO DERIVATIVES

REFERENCE : CHAPTER 1 OF JOHN C HULL’S BOOK ON

OPTIONS, FUTURES AND OTHER DERIVATIVES
 INTRODUCTION

What are the various types of Financial Derivative

Instruments you have known?
 Futures/Forwards
 Options
 swaps
 Introduction

• How would you define Financial Derivatives?

 Instruments which derive their value from
price/level of an underlying entity
 Introduction

Who are the market participants? How can they be

categorized based on their motivations to transact in
financial derivatives?
 All financial market participants including
retail investors, HNIs and Institutions
participate in the derivatives market
 Depending upon their outlook / intent, they
can be categorized as
 Hedgers
 Speculators
 Arbitragers
 Introduction

List the benefits of transacting in Derivatives.

Elaborate on the benefits as below.
 Offer a mechanism for redistribution of risk
 Enhance liquidity of the market for the underlying assets
 Enhance price discovery
 Lower transaction costs
 Built-in leverage
 Introduction

What are the risks specific to the derivatives?

 High leverage leading enhanced levels of
financial risk , risks get multiplied using
derivatives
 Introduction

Name the market places where various derivative

instruments are traded. Find out which is the biggest
market place globally
 OTC as well as all major global exchanges
 CME Group is the largest derivatives
exchange globally
 Introduction
Concept builders

State whether True or False

Derivatives
are usually securities but not legal contracts.
may not always increase risk
usually do not have end date/expiry date
have ISIN distinct from that of the underlying
equity index is a derivative product
weather derivatives trade with temperature or rainfall or such weather entities as the
underlying
get their values solely from the price of the underlying
(note : derivatives get values from the prices of the underlying as well as from other factors such as interest rates, storage
costs, dividends etc)
get their price from the price of the underlying ( get their value from the price of the underlying)
need not be actively settled
necessitate payment of funds as well as payment of stocks ( only margins are paid upon entry , in
case of options and futures only the difference amount with the benchmark is paid/received at the time of exit)
 Introduction
Concept builders

State whether True or False

Derivative instrument can be created from just about
any physical entity
The bid ask spreads of the underlying assets are
usually based on the prices of their derivative
contracts
If price of a derivative contract is 100 and its value is
102, the contract would be bought.
 Introduction
Concept builders

State whether True or False

Arbitrager takes more risk than the hedger ( arbitrage, by definition; is opportunity
to earn without taking any risk)
Speculators do not carry out risk management processes
( speculators such as organized hedge funds may have fairly evolved and advanced risk
management processes. It is just that speculators assume higher levels of risk and expect
higher returns for assuming higher levels of risk.)
If a person requires US dollars for travelling abroad 3 months from
now and buys US dollars today; he is getting into an arbitrage ( this is
example of hedging)
If a company buys forward contract on US dollars and simultaneously
sells US dollars in the spot market, the company is likely to be getting
into an arbitrage
Return expectation of an arbitrager would be higher than that of a
hedger ( as arbitrager takes less risk, the return expectations would also be less)
 Introduction
Concept builders

State whether True or False

If a person holding export orders sells forward US
dollars with the help of a commercial bank; the
market risk in USD is transferred to the person by
the bank. ( risk is transferred to the bank by the person)
If a person holding 1000 shares of Infosys buys an
option whose value increases when the price of
Infosys goes down; the person effectively is
transferring out the market risk on Infosys shares
 Introduction
Concept builders

State whether True or False

• If an investor goes long on a future contract at Rs
100 and pays margin of Rs 20 for entering into this
contract, the leverage of the investor is 5x.

• A mutual fund invested into a diversified range of

stocks would find it cost effective to sell futures than
to sell stocks if markets are expected to go down.
 Introduction
Concept builders

State whether True or False

A position in futures by an investor is shown as underlying
assets on one side and the margin as loan on the other side of
the investor’s balance sheet.
Arbitrage leads to more chaos in the market.
The largest derivatives exchange in the world is London Metal
Exchange
Non deliverable forward contracts on USDINR trade on BSE
( Future contracts trade on BSE, Forward contracts usually require physical delivery
at the time of settlement)
Hedgers take nil risk if they are completely hedged. ( They take nil
market risk when completely hedged. However, their risk on counterparty / exchange
and operational risks remain)
 Introduction
Concept builders

State whether True or False

If subsequent value of an option contract is -5 and initial
premium paid is 2 then option would get exercised. (Option is exercised
only if value is positive for the participant.)
If subsequent value of an option contract is +1 and initial
premium paid is 2 then option would get exercised.
Given that
 Price of underlying asset is Rs 100
 Price of its forward contract is 102. Forward contract expires after one month.

 Physical asset is needed 1 month from now.

 Opportunity cost of funds is 1.5% p. m.

In this case, better option is to buy now the physical asset in the spot market
than to buy the forward contract. ( Forward contract costs 2% but the cost of blocking
funds while buying the physical asset is lower at 1.5%)
 Forwards

Compute funds outflow for a company X on 10th July

2017 for the transaction given the background as
below:
 Company X is a regular importer of chemicals
 CFO of X is worried about falling INR vs USD
 On 11th June 2017, X buys 1 month forward USD 100mn @ 26
paise premium over the spot rate of INR64.575 to be settled on
10th July 2017
 The spot rate on 10th July 2017 was INR64.625

INR 100mn * ( 64.5750+0.2600) = INR 6483.5mn

 Forwards

In case of the example in the previous slide, would X

have been better off not buying the forward? What
was the motivation of X for entering into the
contract?
Yes, he would have been better off not buying the
forward.
Motivation of X was to lock the price of USD so that
there is no uncertainty.
 Forwards

Did company X get possession of physical

USD100mn? When?
Yes
On the settlement day.
 Forwards

Was this forwards contract transacted on an

exchange? What would be the most likely counter-
party in this transaction?

No. It was OTC. Bank may be a counterparty.

 Forwards

Supposing the transaction in the earlier slide

involving Company X was in the form of futures
contract and not forwards contract, what would be
the net funds flow for X on 10th July 2017?

INR 100mn * ( 64.625-64.835) => outflow of INR 2.1

cr
 Forwards vs Futures

Can a Forward contract be “customized”? Illustrate

with examples and compare with a standard Futures
contract.
 Yes, it can be customized along the following:
 Quantity
 Time
 Price
 Forwards

What would be the motivation of the bank which

acted as counterparty to X in the Forward
transaction?
Bank runs a book ( speculator) and makes spread on
bid vs ask (arbitrager)
 Forwards

Where would you get to see the USDINR forward

rates?
 Find LTP for 3month forward USDINR
 Compute premium in terms of % p.a.

 https://in.investing.com/currencies/usd-inr-forward-rates
 Forwards

Where would you get to see the USDINR forward

rates?
 Find LTP for 3month forward USDINR
 Compute premium in terms of % p.a.
FUTURES
 Futures

Show how this

number is
computed.
r*t), where t = 17/365 ie 27th July –
n years, r is the cost of carry in % p.a.
r=365*ln(1628.1/1615.25)/17=17.01%
 Equity Futures
Expected future price formula using continuous compounding

In case of equities with present value of dividend income I, stock price
S, risk free interest rate r, time to maturity T->
The expected future price Fe = ( S-I) * exp(r*T) ( using continuous
compounding)

The expected future price Fe = (S-I)*(1+r)^T ( using discrete compounding)

The expected future price Fe = (S-I)*(1+r *T) (using simple interest method)

If actual Future price is Fa then..

the value of the contract is |Fa – Fe|*exp(-r*T)
Positive value may lead to arbitrage
 Equity Futures

Given
 Current date : 10th July
 Expiry : 27th July
 Fa = 1628.1
 S = 1615.25
 Case 1:
 I = 0 (no dividend income expected between 10th July and 27th July)
 Case 2:
 I = ___ ( dividend of Rs 10 expected on 20 th July )
 r = 5% p.a.
Compute in both cases
 Expected value of the future contract
 Value of the future contract to the seller
 Equity Futures

Given
 Current date : 10th July
 Expiry : 27th July
 Fa = 1628.1
 S = 1615.25
 Case 1:
 I = 0 (no dividend income expected between 10 th July and 27th July)
 Case 2:
 I = ___ ( dividend of Rs 10 expected on 20 th July )
 r = 5% p.a.
Expected value of the future contract
 Continuous compounding
 Case 1 : 1615.25*exp(.05*17/365)=1619.02

 Case 2 : (1615.25-10*exp(-.05*10/365))*exp(.05*17/365)=1609.01

 Discrete compounding
 Case 1: 1615.25*(1+5%)^(17/365)=1618.92

 Case 2 : (1615.25-10/((1+5%)^(10/365)))*(1+5%)^(17/365)=1608.92

 Simple interest method

 Case 1 : 1615.25*(1+5%*17/365)=1619.01

 Case 2 : (1615.25-10)*(1+5%*17/365)=1608.99

Note that the differences in the values is not much.

Simple interest method would be acceptable for the purposes of this course, unless other method is
mentioned explicitly in the question.
 Equity Futures

Given
 Current date : 10th July
 Expiry : 27th July
 Fa = 1628.1
 S = 1615.25
 Case 1:
 I = 0 (no dividend income expected between 10th July and 27th July)
 Case 2:
 I = ___ ( dividend of Rs 10 expected on 20 th July )
 r = 5% p.a.
 Value of the future contract to the seller
 Simple interest method
 Case 1 : 1628.1 - 1619.01 = 9.09

 Case 2 : 1628.1 - 1608.99 = 19.11

 Equity Futures

Given
 On the current date : 10th July
 Fa = 1628.1
 S = 1615.25
 A buys underlying stock from B
 A sells future contract to C
 On the expiry date : 27th July
 S = 1650.20
 A sells underlying stock to D
 Future contracts of A and C expire
 r = 5% p.a.
 I=0
 Transaction costs : delivery – 0.2%, futures – 0.01%, nil cost on expired contracts
Compute net profit to A
Net profit = Fa – S – transaction costs = 1628.1 – 1615.25 – transaction costs = 12.85 –
transaction costs
Transaction cost for purchasing stock : 0.2% of 1615.25 = 3.23
Transaction cost for selling stock on the date of expiry : 0.2% of 1650.2 = 3.30
Transaction cost on future contract sold : 0.01% of 1628.1 = 0.16
Transaction cost on future contract at the time of expiry : 0 ( as the contract expired, not
actively traded. Hence no transaction cost)
Net profit = 12.85 – 3.23- 3.30 – 0.16 = 6.16
 Equity Futures

Given
 On the current date : 10th July
 Fa = 1628.1
 S = 1615.25
 A buys underlying stock from B
 A sells future contract to C
 On the expiry date : 27th July
 S = 1650.20
 A sells underlying stock to D
 Future contracts of A and C expire
 r = 5% p.a.
 I=0
 Transaction costs : delivery – 0.2%, futures – 0.01%, nil cost on expired contracts

Comment on
 Whether A,B,C and D are arbitragers, speculators or hedgers?
 A : arbitrager, cannot say anything about B,C and D given the information here.
 How does the risk transfer among A,B,C and D?
 B sells the stock to A. Hence firstly , the market risk transferred from B to A.
 A sells future contract to C. Hence A , in turn; transfers the risk to C
 On the expiry day, A and C also get out of their positions. Risk is assumed by D.
 Equity Futures
Given
 On the current date : 10th July
 Fa = 1628.1
 S = 1615.25
 A buys underlying stock from B
 A sells future contract to C
 On the expiry date : 27th July
 S = 1650.20
 A sells underlying stock to D
 Future contracts of A and C expire
 r = 5% p.a.
 I=0
 Transaction costs : delivery – 0.2%, futures – 0.01%, nil cost on expired contracts

Illustratethe arbitrage involved in this transaction.

Irrespective of the stock price at the time of expiry, net gain to A would be 12.85 less transaction
costs. Hence no market risk after the positions are taken by A. Hence it is an arbitrage.
Explain using this example how the arbitrage actions would improve market efficiency
As more market players go for arbitrage, there would be more buying of the stock and more selling of the future. More buying
would lift the stock price and more selling would lead to dip in future’s price. Hence the difference between the two prices would
narrow. This would continue till equilibrium is achieved wherein the difference between the future price and the stock price would be
equivalent to risk free interest rate. Hence arbitrage makes market more efficient.
Explain using this example the “cost of carry” approach to calculating the expected price of a future contract.
In the cost of carry formula, we used risk free interest rate to calculate expected future price. This is based on the equilibrium
situation described above.
Compute net profit to C.
1650.2 – 1628.1 – 0.16 = 21.94. This is fairly high compared to the net profit to the arbitrager. This is because speculator assumes much
higher risk and expects higher gain.
 Equity Futures – Hedging

A diversified equity fund with corpus of INR 1000 cr

has 5% exposure to TCS. Fund manager expects
short term drag on the portfolio due to expected TCS
price performance ( next 1 month to 1.5 months) and
wishes to hedge against this risk without getting out
of fund’s position in TCS.
Illustrate how the fund manager would carry out
hedging.
 Equity Futures – Hedging

A diversified equity fund with corpus of INR 1000 cr has 5% exposure to TCS.
Fund manager expects short term drag on the portfolio due to expected TCS price
performance ( next 1 month to 1.5 months) and wishes to hedge against this risk
without getting out of fund’s position in TCS.
Illustrate how the fund manager would carry out hedging.

TCS31Aug2017 : 2409
Market lot : 250 units
# of units to be sold : 1000 * 5% * 10000000 / 2409
= 207555 units
# of lots : 830

What are the pros and cons of selling July futures instead of August futures?
August futures have low liquidity, but July Futures do not cover the
full hedge period.
 Equity Futures – Hedging

Fund manager of a diversified equity fund with

corpus of INR 8500 cr ( Beta of 1.2) wishes to cover
the short term risk on the portfolio due to adverse
announcement of monetary policy in the first week
of August.
Illustrate how the fund manager would carry out
hedging.
 Equity Futures – Cross Hedging

Fund manager of a diversified equity fund with corpus of INR 8500 cr ( Beta
of 1.2) wishes to cover the short term risk on the portfolio due to adverse
announcement of monetary policy in the first week of August.
Illustrate how the fund manager would carry out hedging.
Notional value of Nifty : 1.2 * 8500 cr = INR 10200 cr
31Aug2017 Nifty : 9967
Lot size : 75
# of Nifty units to be sold = 10200*10000000/9967
= 10233771
# of lots to be sold : 10233771 / 75 = 136450
What are the challenges in executing this hedge?
July as well Aug futures do not have sufficient liquidity. Fund will
have to resort to cross hedging (eg interest rate futures) or do
combination of reducing Beta and part hedging
 Currency Futures

Cost of carry for currency futures is based on “interest rate parity”

Illustration
 Step 1 : USD 100 borrowed @ 1.2% p.a. for 1 year
 Step 2A : Convert 100 USD into INR @ 64.528 to receive INR 6452.80 ie sell spot USD @ 64.528
 Step 2B : Buy 1 year forward USD@ 67.8437
 Step 3 : Invest INR 6452.80 @ 6.4% p.a. for 1 year
 Step 4 : Receive 6452.80 + 6.4% of 6452.80 = INR 6865.80
 Step 5 : Convert INR 6865.80 into USD 101.2 at the forward rate of 67.8437
 Step 6: Pay back the borrowed USD100 and interest of USD 1.2 on the same for 1 year

 67.8439 is the “break-even” forward rate, no profit- no loss

67.8437 = 64.5280 * (1 + 6.4%) / (1+ 1.2%) ie 64.528 * 1.0514 or premium of 5.14%

Actual premium in case of USDINR hovers around this number

Forward priced higher or lower may lead to arbitrage

 Currency Futures – simplified formula

Fe = S * ( 1 + rlocal – rforeign)

= 64.528 * ( 1+6.4%-1.2%)
= 67.8835

Note : the formula in the earlier slide was

Fe = S * ( 1 + rlocal )/ ( 1+ rforeign)
= 64.528 * (1.064/1.012)
= 67.8437
 Commodity Futures

Expected future price = S * (1+ T*( r + s – y))

Where S : spot price, T : time till expiry
r : risk free interest rate
s : storage cost p.a.
y : convenience yield
When preference is for holding physical asset, hence the price of
future contract is lower ; to the extent of the “convenience” of
holding physical asset.

Physical asset is preferred

to keep the production process going and/or
to take advantage of market shortages
 Commodity future – an example

31AUG2017 Aluminium on MCX traded at 122.5 on

12th July 2017.
If at that instant, spot price of Aluminium was
121.15; risk free rate is 6.20% p.a. cc then compute
storage cost net of convenience yield.
Use the formula
Ans : 1.89% p.a.
 Commodity futures

Compare Aluminium futures with cardamom futures

in terms of their month wise progression on the
MCX
 Contango vs Backwardation

Contango : Actual price of forward / future contract

is higher than the expected price
Backwardation : Actual price of forward /future
contract is lower than the expected price

Commodities with high convenience yields are in

backwardation
 Selling vs shorting
Short vs long
Taking a position

When a physical entity is sold without giving delivery

of any physical asset , it is “shorting”
Forwards and futures are sold but physical delivery
of the underlying is not required.
 Hence it is common to state that a per son is short on Infosys
future when the person has sold Infosys futures
 Likewise a person who buys Infosys futures is “long” on Infosys
futures
When a person either goes long or goes short on a
future contract, he/she assumes fresh risk
the person is said to have taken a “position”
 Concept of margin

Unlike delivery based transaction,

 Buyer of a future contract is not required to give funds
 Seller of a future contract is not required to give physical asset
At the time of expiry, atleast one of the two parties will make
loss and the other party will make profit
If the loss making party reneges from its payment obligation at
the time of expiry, this would pose a risk to the system ( ie the
broker and the exchange and in turn the party making profit)
It is not possible to know in advance which party will make
profit and which party will make loss
 PRACTICE IS TO COLLECT MARGINS FROM BOTH BUYER AND
SELLER, AT THE TIME OF THEIR ENTERING INTO THE POSITION
 Margin Illustrated

27Jul2017 Infosys is trading at 974

One new contract is created ( lot size : 500)
 “notional value” = 974 * 500 = INR 487,000
A is on the “long” side and B is on the “short” side.
Initial margin is 20%
Both A and B pay 20% of 487000 ie INR 97,400 to
their respective brokers prior to entering into their
positions.
 Initial margin

How is initial margin of 20% in the previous slide

determined?
 SPAN margin, plus
 CME GROUP proprietary methodology which is adopted by
exchanges worldwide
 Exposure margin
 To cover extreme loss situations
 Computed client wise by exchange and sent to broker
 Broker debits individual client accounts
 Broker may add additional risk margin based on the prior
knowledge about the client
 “Mark to market”

Now, (say) Infosys future closes at 980 on the day

this position is taken
 A has “mark to market” profit of 500 * ( 980 – 974) = INR
3000
 B has “mark to market” loss of INR 3000
A and B start with margin account credit balance of
INR 97,400 on day 0
On day 1, A has margin account balance of INR
100,400 and B has margin account balance of INR
94,400
 Maintenance level

If the margin credit balance drops to a certain

level ,”maintenance level”; then “margin call” is given
 Let us say broker and client agree on maintenance level of 12%
 If price of the Infosys future drops to INR 895 at any time before
the expiry, the balance in the margin account of A would be
97,400 + 500 * ( 895 – 974) = INR 57,900
 Maintenance level credit balance is 0.12 * 500 * 974 = INR 58,440
 In this A has two options
 Pay INR 39,500 , or
 Sell the future contract, book the loss and get out of the long position.
A would receive INR 57,900 from the broker and book the loss of INR
39,500
 Open Interest

When A and B enter into a new contract , open

interest increases by 1. A takes long position and B
takes short position.
 A enters into 9 more contracts with B , making total
interest = 10.
A sells 6 contracts to C, open interest remains at 10
A sells 2 contracts to B , open interest reduces to 8.
In case 0f Futures, Open interest is a better indicator
of trading activity and trader interest than the daily
trading volumes.
COMMODITY FUTURES
 How does commodity futures market compare with equity futures
market

Underlying
 Equities – Underlying as well as futures get traded on the same exchanges
 Underlying stocks get traded on the NSE and the BSE
 Futures on these stocks also get traded on the NSE and the BSE
 Commodities get traded in various market places/ “mandis” across India.
Commodity futures get traded on the exchanges( which are NCDEX and
MCX)
Trading process
 Both equity futures as well as commodity futures get traded on exchanges
through the process of electronic order matching
Settlement
 Equity futures get “cash” settled only
 In case of commodity futures, both modes of settlement ( ie “cash” and
“physical”) are applicable
What types of commodities are amenable for futures trading ?

Commodities
 having large market
 for which no single entity / group of entities can influence the
market price
 which are not perishable
 For which quality can be standardized and “graded”
What are the categories of commodities for which future contracts
are traded ?

Agricultural products
Bullion (ie gold and silver)
Metals
Energy products
 What are the types of the market participants ?

Entities wishing to reduce future commodity price

risk eg.
 Growers
 Millers/processors
 Jewelers
Speculators
Arbitragers
 How are spot prices determined ?

Exchanges conduct polling of “mandis” twice a day ,

validate those prices and publish the average price,
which gets taken as the benchmark spot price
 What are the types of contracts ?

Compulsory delivery contract

 Both buyer and seller opt for compulsory physical settlement
Exchanges match buyers and sellers using the
warehouse locations indicated
 Warehouses can only be exchange-approved warehouses
 Receipts from the warehouses get dematerialized and
electronically tracked and transferred from seller to the buyer
For the unmatched quantities, buyer takes delivery
wherever seller gives
 What are the types of contracts ?

Sellers right contract

 seller has the right to select warehouse
 buyer of such contract accepts the warehouse option offered by
the seller
 While matching, exchange meets buyer’s preferences to the
extent possible and thereafter buyer needs to accept delivery
wherever the “matched” seller offers the same
 What are the types of contracts ?

Intention matching contract

 Both buyer and seller give their warehouse preferences
 Matched preferences get settled through physical delivery
 Unmatched quantities get cash settled
When are the delivery intentions required to be intimated to the exchange ?

Within 3 days prior to the expiry

In case , buyer/seller does not wish to effect delivery;
position should be closed out more than 3 days prior
to the expiry
 What happens if seller does not adhere to the delivery intentions
indicated ?

Exchange levies penalty on the seller

Part of the penalty goes to the buyer and the rest
goes to the investor protection fund
 How is quality verified before physical delivery ?

Exchange nominates “assayer” on behalf of every

buyer
Assayer verifies the quality in the warehouse where
the commodity is stored
After verification, assayer either rejects the
commodity or accepts it and grades it
Appropriate grading discounts ( as pre-specified by
the exchange) are applied to the purchase price at
the time of settlement
 Regulation

Forward Market Commission (FMC) was the

regulator for the commodity futures market in India
FMC has merged with SEBI
Now, SEBI is the regulator for the commodity
futures markets
 Global perspective

CME group – the leading and most diverse market

place, has 4 exchanges viz.
 CME (Chicago Mercantile Exchange)
 CBOT (Chicago Board of Trade)
 NYMEX ( New York Metal Exchange)
 COMEX (Commodity and Metal Exchange)
London Metal Exchange
Shanghai Metal Exchange
 Product range on the CME group

Agricultural commodities
Energy
Bullion
Metals
Equity indices
Currency pairs
Interest rates
Real estate
Weather
 Designated contracts for futures and options
 Swap execution facility
INTEREST RATE FUTURES
 Interest rates
Recap

Real, nominal
Risk premium
Term structure

 Compounding
 Illustrate continuous compounding
 Bond yields and prices
 Day count convention ( A/A, 30/360, A/360)
 “Advance”/ ”Arrears”
 Fixed vs floating
What is term structure of interest rates ? ( also called yield
curve )

Market levels of interest rates vary for different

tenors
The curve charting “risk free” interest rates at
various tenors is called term structure or yield curve
 Interest rates on government securities of various tenors are
taken as “risk free” interest rates
Term structure
 How are coupon bearing instruments converted into zero coupon
instruments ?

By separating each coupon payment into a separate

security , a coupon bearing instrument is converted
into zero coupon security
RBI carries out this process for dated securities
Each separated coupon trades as a separate security
Term structure is usually created using zero coupon
securities so as to get clear picture of interest rate for
each tenor
 Examples

3 year interest rate 2 years from now is 7.9% p.a.; 2

year spot rate is 7.6% p.a. and 3 year spot rate is
7.7% p.a. Compute the following:
 5 year spot rate
 2 year rate 3 years from now
 Examples

3 year interest rate 2 years from now is 7.9% p.a.; 2

year spot rate is 7.6% p.a. and 3 year spot rate is
7.7% p.a. Compute the following:
 5 year spot rate :
 ((1.076^2)*(1.079^3))^(1/5)-1= 7.78% p.a.
 2 year rate 3 years from now
 ((1.0778^5)/(1.077^3))^(1/2)-1 = 7.90% p.a.
 Examples

Compute the expected forward rate 1 year from

now for a period of 3 years if the term structure is
as follows -
 1 year – 7.23% p.a.
 2 year – 7.54% p.a.
 3 year – 7.67% p.a.

 4 year – 7.72% p.a.

 What are Forward Rate Agreements (FRA)

“B” buys FRA at 7.3% p.a. from “S”

3 month MIBOR on the reference date is 7.5% p.a.
B makes gain of 0.2% p.a. and S makes loss of 0.2%
p.a.
If notional was Rs 100 cr; “B” receives Rs 4,89,477
from “S”
 {100,00,00,000 * (7.5%-7.3%)* 91/365} / (1 + 7.5% * 91/365)
If MIBOR was 7.2% p.a.; “B” loses 0.1% p.a. and “S”
gains 0.1% p.a.
Bilaterally settled
 Example

What is the settlement value to the seller of an FRA

of 91d MIBOR one month from now @ 7.15%, if the
MIBOR on the settlement day is 7.1%? Take notional
at Rs 100 cr.
{1000000000 * (7.15%-7.1%) * 91/365} / (1 + 7.1% *
91/365) = INR 122489.30
 FRA

Which derivative instrument in the fixed income

segment is popular in India? FRA
In a Forward Rate Agreement (FRA), buyer
notionally buys interest rate. T/F? True
If interest rate goes up, buyer (gains/loses) and
seller ( loses/gains)
What is the typical underlying financial instrument
in case of FRA? 3 month MIBOR
 FRA

What are the typical terms of an FRA?

Bilaterally settled,
quoted based on expected future value of 3 month
MIBOR,
settlement value is 3 month MIBOR on that day,
notional can be any amount bilaterally defined,
A/A
Can FRA be settled on any date in future?
Yes, not a standard contract. Bilaterally defined.
Is FRA bilaterally negotiated? Yes
 FRA

What types of market participants transact in FRAs?

Banks, money market funds, NBFCs

What are the typical motives of the FRA buyers/sellers?

Speculation on interest rate movement or hedging of existing bond
portfolio against possible interest rate movements in the fixed
income markets.

• If “B” buys FRA at 6.3% p.a. on 10 th August 2016

• to be settled on 5th October 2016 and
• the 3 month MIBOR on 5th October 2016 is 6.6%;
• What is the gain/loss to “B”?
• Assume notional of Rs 100 cr and underlying of 3 month MIBOR.
100 * (0.3%) * (91/365) / (1 + 6.6% * 91/365) = INR 7,35,837 lacs
 FRA

If Rs 100 cr worth of loans on the books of the

NBFC, as on 10th August; are yielding MIBOR + 50
and the NBFC sells FRA to be settled on 1st
September at 6.9% p.a.; what would be the total gain
for NBFC for the period of 1st Sep to 30th Nov?
 FRA

If Rs 100 cr worth of loans on the books of the NBFC, as on

10th August; are yielding MIBOR + 50 and the NBFC sells FRA
to be settled on 1st September at 6.9% p.a.; what would be the
total gain for NBFC for the period of 1st Sep to 30th Nov?
If there is any drop is 3 month MIBOR as on 1st Sep,
interest revenue for the NBFC from the loans would
reduce . However the FRAs which are sold would give
positive gain if interest rates go down. If the notional
value of the FRA is same as the value of the loans,
NBFC remains neutral on net basis.
Effectively, NBFC locks its interest rate and hedges its
revenue. The effective rate locked is 7.4%.
 FRA

If a bank has, in the net terms; Rs 1000 cr worth

floating rate liabilities on its books; bank would
typically (buy/sell) FRAs with outlook of hedging.
 FRA

If a bank has, in the net terms; Rs 1000 cr worth

floating rate liabilities on its books; bank would
typically (buy/sell) FRAs with outlook of hedging.
Buy FRAs.
 FRA

An NBFC has lent Rs 100 cr on floating rate basis

(MIBOR + 500) B
Borrowed Rs 75 cr at fixed rate of 9% p.a.
Borrowed Rs 10 cr at floating rate of MIBOR plus 150.
Balance owned funds
FRA with settlement date of 1 st Sep is taken up by the
NBFC at 6.8%
Operating costs are 100 bps
FRAs used for hedging, including owned funds
 Assume current levels of 3 month MIBOR at 6.5% p.a.
 FRA

An NBFC has lent Rs 100 cr on floating rate basis (MIBOR + 500) B
Borrowed Rs 75 cr at fixed rate of 9% p.a.
Borrowed Rs 10 cr at floating rate of MIBOR plus 150.
Balance owned funds
FRA with settlement date of 1st Sep is taken up by the NBFC at 6.8%
Operating costs are 100 bps
FRAs used for hedging, including owned funds
 Assume current levels of 3 month MIBOR at 6.5% p.a.
 Unmatched portion of lending book : INR 100 cr minus INR 10 cr
( floating rate borrowing) ie INR 90 cr
 FRAs worth INR 90 cr are sold
 FRA

For the 75 cr worth of FRA

 Case 1 : MIBOR is 6.50%
 Lending rate M+500 ie 11.5% p.a.
 Borrowing cost : (9% p.a.)
 Gain on FRA sold : 6.8% - 6.5% = 0.3% p.a.
 Net margin : 2.8% p.a.
 Case 2 : MIBOR is 6.00%
 Lending rate M+500 ie 11.0% p.a.
 Borrowing cost : (9% p.a.)
 Gain on FRA sold : 6.8% - 6.0% = 0.8% p.a.
 Net margin : 2.8% p.a.
 Case 3 : MIBOR is 7%%
 Lending rate M+500 ie 12.0% p.a.
 Borrowing cost : (9% p.a.)
 Gain on FRA sold : 6.8% - 7.0% = (0.2% p.a.)
 Net margin : 2.8% p.a.
Effectively margin locked at 2.8% p.a.
 FRA

For the 15 cr worth FRA

 Case 1 : MIBOR is 6.50%
 Lending rate M+500 ie 11.5% p.a.
 Borrowing cost : (0% p.a.)
 Gain on FRA sold : 6.8% - 6.5% = 0.3% p.a.
 Net margin : 11.8% p.a.
 Case 2 : MIBOR is 6.00%
 Lending rate M+500 ie 11.0% p.a.
 Borrowing cost : (0% p.a.)
 Gain on FRA sold : 6.8% - 6.0% = 0.8% p.a.
 Net margin : 11.8% p.a.
 Case 3 : MIBOR is 7%%
 Lending rate M+500 ie 12.0% p.a.
 Borrowing cost : (0% p.a.)
 Gain on FRA sold : 6.8% - 7.0% = (0.2% p.a.)
 Net margin : 11.8% p.a.
Effectively margin blocked at 11.8% p.a.
 FRA

For the 10 cr worth of lending at M + 500, borrowing

was at M + 150
 Hence margin locked at 3.5% p.a.
Summing up
 75 cr 2.8%
 15 cr 11.8%
 10 cr 3.5%
Weighted average margin 4.22% p.a. ie 4.22
cr
 FRA

If a bank treasury borrows at MIBOR plus 50 and

has fixed rate of 8% p.a. on its lending book, what
price FRA (termination date of 1st Sep 2016) needs to
be (purchased/sold) by the bank to lock the margin
of 0.75% p.a.
 FRA

If a bank treasury borrows at MIBOR plus 50 and

has fixed rate of 8% p.a. on its lending book, what
price FRA (termination date of 1st Sep 2016) needs to
be (purchased/sold) by the bank to lock the margin
of 0.75% p.a. Buy FRA @ 6.75% p.a.
 FRA

If 15 month spot rate is 7.1%, 12 month spot rate is

7.3% p.a. and FRA settling 1 year from now is
available for 7.4%; would you advice buying or
selling of the FRA (with speculation as outlook)?
 FRA

If 15 month spot rate is 7.1%, 12 month spot rate is

7.3% p.a. and FRA settling 1 year from now is
available for 7.4%; would you advice buying or
selling of the FRA (with speculation as outlook)?
Expected forward rate : ((1.071)^(1.25)/
(1.073))^4-1 = 6.31% p.a. Hence sell FRA
 FRA

If 24 month rate 3 months from now is 6.8% p.a. and

3 month MIBOR is 7.3% p.a.; what would be the
estimated price of FRA settling 24 months from now
if 24 month spot is 6.75%?
 FRA

If 24 month rate 3 months from now is 6.8% p.a. and

3 month MIBOR is 7.3% p.a.; what would be the
estimated price of FRA settling 24 months from now
if 24 month spot is 6.75%? 27 month spot rate =
((1.073)^(0.25) * (1.068^2))^(1/2.25) -1 =
6.86%. Expected 3 month rate 24 months
from now =( (1.0686^2.25)/(1.0675^2) ^4)-
1= 7.74% p.a.
 FRA

A portfolio of Rs 100 cr consisting of fixed income

securities
with average duration of 3
needs to be hedged from 1st Sep to 31st Dec 2017
 using FRA settling on 1st Sep , which is available at
6.8% p.a.

Should the FRA be purchased or sold?

What should be the notional of the FRA?
Assume that the duration of FRA is 0.25.
 FRA

A portfolio of Rs 100 cr consisting of fixed income

securities with average duration of 3 needs to be
hedged from 1st Sep to 31st Dec 2016 using FRA
settling on 1st Sep (with 3 month MIBOR as
underlying) available at 6.8% p.a. Should the FRA be
purchased or sold? What should be the notional of
the FRA? Assume that the duration of FRA is 0.25.
FRA to be bought. Notional = 100*3/0.25 =
1200 cr
 Eurodollar futures

What is the most popular type of interest rate futures

contract globally? Eurodollar futures
 On which exchange does it get traded? CME
 What is the typical underlying financial instrument
for the Eurodollar futures? 3 month LIBOR
 Settlement price for Eurodollar contract

If a 3 month Eurodollar futures contract settles on 15th

September and the LIBOR quotes on that day are as follows:
a. 1 day LIBOR – 0.5%
b. 1 month LIBOR – 0.75%
c. 2 month LIBOR – 0.8%
d. 3 month LIBOR – 0.9%
e. 6 month LIBOR – 1%
What would be the settlement price of the Eurodollar futures
contract?
100 - 0.9 = 99.10
 Features of Eurodollar contract

Describe a typical 3 month Eurodollar futures

contract.
 Based on 3 month LIBOR
 Settlement price= 100 – LIBOR;
 Notional: based on 10000 units;
 Daily settlement
 …Features

What are the typical maturities for Eurodollar

futures?
March, June, September and December for up
to 10 years in future.
Short maturity contracts for other months also
available.
 Notional value

What is the notional value of 1 contract? Price Quote = 99.1 , 99.09

10,000 * (100 – 0.25*(100-quote)).

Eg If quote is 99.1 then..

Notional contract value
=10000 * (100 – 0.25*(100-99.1))
=10000 * (100-0.25*0.9)
=USD 997,750

Eg If quote is 99.09 then..

Notional contract value
=10000 * (100 – 0.25*(100-99.09))
=10000 * (100-0.25*0.91)
=USD 997,725

1 bps upmove in interest rate corresponds to

USD 25 decline in the value of 1 contract
 Eurodollar futures - example

If a 3 month Eurodollar futures contract settling on

15th Sep is quoting at 99.26;
what is the expected 3 month LIBOR on 15th Sep?
0.74% p.a.
 If “B” buys 100 contracts of the futures contract as
in above and
 then finds 3 month LIBOR at 0.63% on 15th Sep,
what is his gain/loss?
Gain = 100 * 25 * 11 = USD 27500
 Eurodollar future - illustration

“A” has a loan book of USD 100m yielding floating rate of interest (3 month LIBOR plus 100).
“A”, now in August, wants to lock his lending rate to a fixed rate from 15th Sep to 15th Dec. A
buys 100 contracts of Eurodollar future with settlement date on 15th Sep @ 97.8.
3 month LIBOR on 15th Sep is 1.8%.
Compute the fixed rate which gets locked between Sep and Dec.

 A would gain effectively 0.4% p.a. on the Eurodollar furure,

 But earn a lower interest rate of 1.8% p.a. for the 3 month period from Sep to
Dec;

 Total earning of 2.2% p.a.

 This is the rate at which Eurodollar future was bought

and hence the rate locked is 2.2% p.a.

 Eurodollar future - illustration

“A” has a loan book of USD 100m yielding floating rate of interest (3 month LIBOR plus
100). “A”, now in August, wants to lock his lending rate to a fixed rate from 15th Sep to 15th
Dec. A buys 100 contracts of Eurodollar future with settlement date on 15th Sep @ 97.8.
3 month LIBOR on 15th Sep is 1.8%.
Compute in USD interest income and gain/loss in the futures contract for “A” between 15th
Sep and 15th Dec.

In USD terms, gain in Eurodollar futures contract

= 100 * 25 * 40 = USD 100,000
Interest earned for 3 month period on USD 100 m @ 1.8% p.a. = USD 100m *
0.25 * 1.8% = USD 450,000
Total of USD 550,000

This is equivalent to earning interest @ 2.2 % p.a. for the 3 month period =
USD 100 m * 0.25 * 2.2% = USD 550,000
 Options on equities

Call option
 Option to “buy”
 ? Will the option buyer exercise the call option , if
 Market price is 105 at the time of expiry and “strike” is 100 .

 Market price is 98 and strike 100

 Payoff
 What would be the payoff to the buyer in each of the two cases
above?
 If buyer paid initially Re 1 to purchase this option
 What would be the net gain/loss to the buyer in each of the two
cases above?
 Options on equities

Call option
 What are the obligations of the seller of this option
 Market price is 105 at the time of expiry and “strike” is 100 .
 Market price is 98 and strike 100

 Payoff
 What would be the payoff to the seller in each of the two cases
above?
 If seller received initially Re 1 as a consideration for offering
this option
 What would be the net gain/loss to the seller in each of the two
cases above?
 Options vs futures

Options
 Buyer has the right ( to purchase, in case of call options)
 Seller has the obligation to settle the contract
Futures
 Both buyer and seller have the obligation
 Call options –payoffs to buyer on expiry

On day 0
 “B” buys call option on stock X
 Quantity –1000 units
 Strike price 100
 Expiry date –day 30
 Premium of Rs 4 per unit
 B pays _______ to buy this call option
 “S” sells call option on stock X
 Quantity –1000 units
 Strike price 100
 Expiry date –day 30
 Premium of Rs 4 per unit
 S receives _____ by selling this call option
 Call options –payoffs to buyer on expiry

B holds the call option till expiry ie till day 30

 On day 30, the settlement price is the closing price of the underlying
 If the closing price of the underlying on the expiry date is Rs 105

 Payoff to the buyer on the expiry day = max ( 0,settlement price –exercise price)

 = max(0, Rs 105 –Rs 100)

 = Rs 5 per unit

 Net gain to the buyer = payoff on the expiry day –option premium

 Rs 5 per unit –Rs 4 per unit

 Re 1 per unit

What is the worst case for the buyer ?

What is the best case for the buyer ?

What is the best case for the seller ?

What is the worst case for the seller ?
 net gain for call option seller on expiry
6

0
91 93 95 97 99 101 103 105 107 109

-2

-4

-6

-8
 Examples of call options - Set I

“A” buys 1000 units of call option on stock X at exercise

price of Rs 102 and pays premium of Rs 2 per unit. What
is the net gain/ loss to “A” , if the stock closes @ Rs 108
on the day of expiry ?
 1000 *{ max ( 108 -102, 0) – 2} = 1000 * {6 – 2} = Rs 4000
“B” sells 100 units of call option on stock Y at exercise
price of Rs 103 and receives premium of Rs 4 per unit. If
the stock closes@ Rs 110 on the day of expiry, what is
the net gain / loss to “B” ?
 100 * { min (0, 103 – 110) + 4} = 100 *{-7+4} = net loss of
Rs 300
 Examples of call options - Set I

“A” buys
 10 lots of
 NIFTY24SEP15 call option with strike of Rs 7900
 By paying option premium of Rs 210 per unit
 If Nifty closes @ 8000 on 24th Sep, what is the net gain / loss
to “A” ?
 10 * 25 * {max(0, 8000 – 7900) – 210}= 10*25*{100-
210}=net loss of Rs 27,500.
 Examples of call options - Set I

“B” sells 20 lots of NIFTY24SEP call options with

strike price 8200 @ 74 per unit. If nifty closes @
8150 on 24th Sep , what is the net gain / loss to B?
 20 * 25 * {min(0, 8200 -8150) + 74} = net gain of Rs
37,000
Snap shot of option chain on Nifty as underlying

As strike price increases, call premium

reduces
Example of bull spread
 Gain/loss diagram bull spread
6

-Higher gain at higher prices, hence called Bull spread

-Cap on the gain
-Floor4 on the loss
-Such a trade is entered into when there is a bullish view on the underlying
-Max loss is restricted to the floor value even if the underlying moves down significantly
2

0
90 95 100 105 110

-2

-4

-6
 Example of bear spread

Buy 104 call @ 3 and sell 97 call @ 6

Prepare the payoff and the gain/loss table on a
spreadsheet
Chart the gain/loss vs market price on the expiry.
Example of bear spread
 gain/loss diagram bear spread
4

0
90 95 100 105 110
-1

-2

-3

-4

-5
 Put option

Option to “sell” with Obligation with the

the buyer seller
Positive payoff when Negative payoff when
market price goes market price goes
below strike price below strike price
Pays premium initially Receives premium
to buy this option initially in consideraion
for selling the option
 Put option example

Evaluate
 B100P@2 when market price = 104
 Net loss of 2
 S100P@2 when market price = 104
 Net gain of 2
 B100C@1 and S101P@1.5 when market price = 102
 Net gain of 1 on call, net gain of 1.5 on put; total net gain of 2.5
 Example-1

 100 units of short future@ 101

 500 units of long call @ strike 105, premium 0.5

 600 units of short put @ strike 110, premium 6

 Average margin : 20%

 Time till expiry : 15 days

 Consider price range from 90 to 130

 Find range(s) for the market price on expiry wherein the trade is profitable
 Greater than 105 ( as per the table shown below)

Market price Total short future@101 buy call105@0.5 sell put110@6

qty : 100 units qty : 500 units qty : 600 units
90 -7550 1100 -250 -8400
95 -5050 600 -250 -5400
100 -2550 100 -250 -2400
105 -50 -400 -250 600
110 4950 -900 2250 3600
115 6950 -1400 4750 3600
120 8950 -1900 7250 3600
125 10950 -2400 9750 3600
130 12950 -2900 12250 3600
 Example-1

 100 units of short future@ 101

 500 units of long call @ strike 105, premium 0.5
 600 units of short put @ strike 110, premium 6
 Average margin : 20%
 Time till expiry : 15 days
 Consider price range from 90 to 130
Sketch the gain/loss vs market price chart

Chart Title
15000
10000
5000
0
90 95 100 105 110 115 120 125 130
-5000
-10000
 Example-1

 100 units of short future@ 101

 500 units of long call @ strike 105, premium 0.5
 600 units of short put @ strike 110, premium 6
 Average margin : 20%
 Time till expiry : 15 days
 Consider price range from 90 to 130
Compute RoI if the market price on expiry was 120
 Net profit : 8950
 Net investment : (100*20%*101 + 500*0.5 + 600 *( 20% * 110
-6) = 11870
 RoI = 8950/11870 = 75.4%
 Example-2

Construct
 Bear spread using call options and
 Bull spread using put options
 Making use of the following option contracts
 31AUG2017Nifty 10,000C@190.8

 31AUG2017Nifty 10,000P@78.3

 31AUG2017Nifty 10,100C@127.5

 31AUG2017Nifty 10,100P@112.1
 Example-2

Construct
 Bear spread using call options
 Making use of the following option contracts
 Sell 31AUG2017Nifty 10,000C@190.8

 Buy 31AUG2017Nifty 10,100C@127.5

At market price of 10,000 or below

Net gain = 190.8 – 127.5 = 63.3
At market price of 10,100 or above
Net gain = 127.5 – 190.8 + 100 = 36.7

Higher gain at lower strike  Bear spread

 Example-2

Construct
 Bull spread using Put options
 Making use of the following option contracts
 Buy 31AUG2017Nifty 10,000P@78.3

 Sell 31AUG2017Nifty 10,100P@112.1

At market price of 10,000 or below

Net gain = 112.1 – 78.3 - 100 = -66.2
At market price of 10,100 or above
Net gain = 112.1 – 78.3 = 33.8

Higher gain at higher strike  Bull spread

 Example 2

Note
 Bull spread is constructed by buying lower strike and selling
higher strike
 Irrespective of whether options are call or put
 Likewise, Bear spread is constructed selling lower strike and
buying higher strike
 Irrespective of whether options are call or put
 Example - 3

Evaluate return on maturity

 Current month future
 Current month at the money call
 Bull spread using current month call options, strike at-the-money
to buy and strike at-the-money+2.5% to sell
 Basket of underlying
 Taking two scenarios for the price of the underlying at the maturity
 + 2%

 -2 %

 Use probability range of 20% to 80% to construct the scenario matrix

 State your conclusions based on the relative returns across the 4
options
Refer to the Excel file evaluating RoI on spread.xlsx
 Example -3

Compute max arbitrage gain possible using the following:

stock 100
future 101.5
call, strike 98 7
call, strike 100 6.1
call, strike 102 5.4
call, strike 104 5.3
put, strike 98 5
put, strike 100 6.2
put, strike 102 7.3
put, strike 104 8
 Example -3

Compute max arbitrage gain possible using the following:

stock 100
S future 101.5
call, strike 98 7
B call, strike 100 6.1
call, strike 102 5.4
call, strike 104 5.3
put, strike 98 5
S put, strike 100 6.2
put, strike 102 7.3
put, strike 104 8
 Constructing “Synthetic” future contract using options

Buying call and selling put at the same strike has the
same profit/loss outcome as going long on a future
contract
Likewise selling call and buying put at the same
strike has the same profit/loss outcome as going
short on a future contract
 Price of Synthetic future

Buy 100 call @ 2 and sell 100 put @ 3

 Creating synthetic long future
 The effective price of this future is 100 + 2 -3 = 99 ie
 The profit/loss outcome would be same as buying future contract at 99, eg
 Market price of 103  profit of 4

 Market price of 98  loss of 1

Sell 100 call @ 2 and buy 100 put @ 3

 Creating synthetic short future
 The effective price of this future is 100 + 2 -3 = 99 ie
 The profit/loss outcome would be same as selling future contract at 99, eg
 Market price of 103  loss of 4

 Market price of 98  profit of 1

 Example-4

A managed account portfolio is as follows:

 INR 50 cr of diversified equity stocks with aggregate beta of 1.1
 Arbitrage position in Infosys stock and futures with notional of
INR 10 cr
 INR 200 cr of GOI securities with duration of 7.2
 INR 75 cr of AA- debentures of NBFCs with average 3 year tenor
and duration of 2.3
 USD 5m in S&P500 index ETF

Identify various risks involved in this portfolio

Indicate methods to hedge these risks from now till 1st October
2017.
 Example-4

A managed account portfolio is as follows:

 INR 50 cr of diversified equity stocks with aggregate beta of 1.1
 Equity market risk, sell Nifty futures with notional of 55 cr
 Arbitrage position in Infosys stock and futures with notional of INR 10 cr
 No risk as it is arbitrage; hence no need to hedge
 INR 200 cr of GOI securities with duration of 7.2
 Interest rate risk, hedge by buying FRAs with notional of 29 (ie 7.2/ 0.25) times the
portfolio value ie 5800 cr
 INR 75 cr of AA- debentures of NBFCs with average 3 year tenor and duration of 2.3
 Credit rsik cannot be hedged easily, interest rate risk by buying FRAs worth 690 cr
 USD 5m in S&P500 index ETF
 Sell S&P500 index futures worth USD5m and sell USDINR forward worth USD 5m

Identify various risks involved in this portfolio

Indicate methods to hedge these risks from now till 1 st October 2017.
 Example-5

Compute the aggregate time value in the following

portfolio, market price of the underlying at 100.8
 100C@2
 102P@3
 99C@3.5
 103p@4.2
 Future contract trading at 103
Classify each of the above contracts into “in-the-
money” or “out-of-the-money” contract
 Example-5

Compute the aggregate time value in the following portfolio, market

price of the underlying at 100.8
 100C@2
 Time value 1.2
 102P@3
 Time value 1.8
 99C@3.5
 Time value 1.7
 103p@4.2
 Time value 2
 Future contract trading at 103
 Time value 0
 Total = 6.7
Classify each of the above contracts into “in-the-money” or “out-of-
the-money” contract, all option contracts here are in-the-money
Intrinsic and time values plotted for call option
Put option premium boundaries
 Example 6

Compare and contrast

 protective put vs covered call
 Protective Put

Current market price of Infosys stock is 967

Buying Infy960 Aug put @ Rs 16 per unit would
protect loss below 944
 Max loss of 23
This is equivalent of buying a call with strike price of
960 @ Rs 23
 Covered call

“B” is holding 1,00,000 shares of Infosys.

Current market price of Infosys stock is 967
Selling Infy1060 Sep call @ Rs 3.5 per unit would
give premium income of Rs 350,000 to “B”
Assumption is that
 Infosys price is unlikely to go higher than 1060
 In case the price goes higher than 1060; the shares held will
also increase in value.
 A part of the share holding can be liquidated to cover the loss
on the call option in case price goes above 1060.
 Hence this is called covered call.
 Example 6

Illustrate “put call parity”

 Put call parity

In previous example,

 Holding stock and a put option was similar to holding a call option

Theoretically, (if S is stock price on expiry, S0 is initial stock price, X is strike, c is call
option premium and p is put option premium)
 Scenario 1 : S > X
 1 unit of call option would give payoff of (S-X)
 risk free bond worth the discounted value of strike would give payoff of X
 Combining the two would give payoff of (S-X) + X = S
 Initial investment = c + discounted value of X
 1 unit of stock would give payoff of S
 1 unit of put option would give nil payoff
 Hence combining the two would give payoff of X
 Initial investment = p + S0
 Hence, c + discounted value of X is equivalent to p + S0
 Prices of call and put options are not independent of each other

Class assignment : prove the same when scenario is S < X

 Example 7

Illustrate straddle, strangle, butterfly and condor

 Long Straddle
Long straddle = long call 100 @ 2 + long put 100 @ 3

Purchase of 1:1 call and put at the same strike price and same expiration
date
Such positions are usually taken prior to an event after which market
may move strongly in either direction
 Short straddle
Short straddle = short call 100 @ 2 + short put 100 @ 3

Sale of 1:1 call and put at the same strike price and same expiration date
Such positions are usually taken prior to an event after which market
may not move strongly in either direction, in view of the seller
 Strangle

Long Strangle = long call 102 @ 1 + long put 98 @ 2

Purchase of 1:1 call and put at the different strike price and same
expiration date, put at a lower strike than call
Such positions are usually taken prior to an event after which market
may move strongly in either direction
 Box

 Buy 1 call and sell 1 put at exercise price K1 -synthetic long

 Buy 1 put and sell 1 call at exercise price K2 – synthetic short
 All at same expiration dates
 Combination of these 4 options leads to a fixed amount payoff and net
gain/loss

 Can a box with locking of positive net gain be constructed using the
example in the slide one before this ?
 Other types of combinations

Butterfly spread 4
3

 Buy 1 call at K1 2
1
 Sell 2 calls at K2 (K2>K1) 0
90 95 100 105 110
-1
 Buy 1 call at K3 (K3>K2) -2

Condor 3.5
3
2.5
 Buy 1 call at K1 2
1.5
 Sell 1 call at K2 (K2>K1) 1
0.5
 Sell 1 call at K3 ( K3>K2) 0
-0.5 90 95 100 105 110
 Buy 1 call at K4 (K4>K3) -1
-1.5
 Example 8

Show that it is never optimal to exercise American

call prior to expiry for a non-dividend paying stock
 American option – option which can be exercised any time
prior to expiry
 European option – option which can be exercised only on
expiry
 In the US markets as well as European markets; both the options
are prevalent. This nomenclature has nothing to do with the
geographical markets
 In India, we have only European options
 Americal
Call , Buy Scenario
100C@ 4 Scenario 1 2 Scenario 3
Market price Market price
Market price on on maturity : on maturity :
maturity : 180 125 80
Market price is 150, prior to
maturity

Alternative 1 : Exercise
Americal call
Profit on
exercise 50

Borrow 100 -101 ( interest of Re 1) -101 -101

Invest in stock 150 180 125 80

In all scenarios, not
exercising is better
alternative for
Net 75 (net of initial premium of 4) 20 -25
American call
options on non-
dividend paying
underlying
Alternative 2 : Do not exercise Americal call and wait
till expiry

Net 76 21 -4
 Practice question - 1

entry
strike price ( in case of entry
Sr no # of units long/sh type of instrument exit price
option) price
ort

1 100 L call 110 8

2 150 S call 120 4
3 225 S put 110 1
4 75 S future 128 125
5 200 S call 130 2

 Exit at the time of expiry , 30 days from entry

 Same underlying for all
 Practice question - 2

Show all arbitrage pairs and compute the max gain possible using
the following:
stock 100
future 102
call, strike 99 6.4
call, strike 100 6.0
call, strike 102 5.4
call, strike 104 5.3
put, strike 98 5
put, strike 100 6.0
put, strike 102 3.1
put, strike 104 8
 Practice question - 3

Discuss bull spread vs long call when

 potential upside/downside expected : +/- 7%,
 Probability of upside ranges from 40% to 60% ( steps of 5%)
 Valuing options

Risk-neutral equation
 S0 * ( 1+rf) = p * S0 * u + (1-p) * S0 * d
where rf : risk free return
p = probability of upmove
1 – p = probability of down move
u : up move
d : down move
 Valuing options – Binomial tree approach

Simplified formulas:
 Probability of up move = (rf – low)/(hi-low)
 Where rf = amount due to risk free on Re 1
 high = up side on fluctuation on Re 1
 low = down side on fluctuation on Re 1
 How to find upside and downside?
 Valuing options – Binomial tree approach

Assume that
 absolute values of upside and downside are the same
 Upside / downside is equal to the observed volatility
 For example,
 observed volatility in Nifty is 10.76% p.a.
 Balance period till expiry : 17 days
 Volatility for the balance period = 10.76% * sqrt(17/365) = 2.32%
 Upside on current market price of Rs 100 : Rs 102.32

 Downside on current market price of Rs 100 : Rs 97.68

 If risk free rate is 6% p.a. , risk free price after 17 days

= 100 + 100 * 6%817/365 = 100.28
 Valuing options – Binomial tree approach

Probability of up move = (rf – low)/(hi-low)

 P = (100.28 – 97.68)/ ( 102.32 – 97.68) = 0.56
Current market price : 9794.2
Upside : 9794.2 * ( 1.0232) = 10021.4
 Call option value : 10021.4 – 9800 = 221.4
Downside : 9794.2 * .9768 = 9567
 Call option value : 0
Expected call option value :
 0.56 * 221.4 + .44 * 0 = 124
PV of expected call option value = 124 / ( 1.0028)
= 123.65
 Example 1 – valuing options

Given
 CMP : 100
 Observed volatility : 12% p.a.
 Time till expiry : 20 days
 Risk free rate : 5% p.a.
 Estimate
 Price of at-the-money European call
 Price of at-the-money European put
 Using one step binomial
 Example 1 – valuing options

Step 1 : Compute price using risk free rate of 5% p.a.

 Current market price = Rs 100
 Tenor = 20 days = 20/365 year
 Risk free price (Rf) = 100 * ( 1 + 5% * 20/365)
 = 100.274

3 digits after decimal point are shown for this example only for the illustrative
purposes. It is not necessary to show more than two digits
 Example 1 – valuing options

Step 2 : Calculate hi and low prices using the given

volatility rate of 12% p.a.
 hi price =
current market price *
(1+ volatility rate p.a. * sqrt( number of days to
expiry / 365))
= 100 * ( 1 + 12% * sqrt ( 20/365))
= 102.809
 low price =
current market price *
(1- volatility rate p.a. * sqrt( number of days to
expiry / 365))
= 100 * ( 1 - 12% * sqrt ( 20/365))

= 97.191
 Example 1 – valuing options

Step 3 : Calculate probability of up move

 p = ( Rf – low) / ( hi – low)
 = (100.274 - 97.191)/(102.809 - 97.191)
 = 0.55
 Example 1 – valuing options

Step 4 : Calculate expected value of call option price

today
 call option payoff on hi price = 102.809 - 100 = 2.809
 Probability : 0.55
 call option payoff on low price = 0, as low price of 97.191 is
below the strike of 100
 Probability : 0.45
 Expected payoff on the call option at expiry
 0.55 * 2.809 + 0.45 * 0 = 1.545
 Present value of the expected payoff is the expected price of
call option = 1.545 / ( 1 + .05 * 20/365) = 1.541
 Example 1 – valuing options

Step 5 : Calculate expected value of put option price

today
 put option payoff on hi price = 0, price of 102.809 is above the
strike of 100
 Probability : 0.55
 put option payoff on low price = 100 – 97.191 = 2.809
 Probability : 0.45
 Expected payoff on the call option at expiry
 0.55 * 0 + 0.45 * 2.809 = 1.264
 Present value of the expected payoff is the expected price of
call option = 1.264 / ( 1 + .05 * 20/365) = 1.261
 Example 2 – valuing options

Given
 CMP : 100
 Observed volatility : 12% p.a.
 Time till expiry : 20 days
 Estimate
 Price of call at strike 95
 Price of put at strike 105
 Using one step binomial
 Valuing European put option using two step binomial

CMP : 50
Strike : 52
Tenor : 2 years, each step of 1 year
Upmove/ Downmove : 20% of the market price
Risk free rate : 5% p.a. simple interest

Probability of up move : ( 1.05– 0.8)/(1.2 – 0.8) = o.625

Probability of down move : 1 – 0.625 = 0.375
uu  50 -> 60 -> 72 ; payoff is zero; probability = 0.625 * 0.625 = 0.391
ud  50 -> 60 -> 48 ; payoff is 4; probability = 0.625*0.375 = 0.234
du  50 -> 40 -> 48; payoff is 4; probability = 0.375*0.625 = 0.234
dd  50 -> 40 -> 32; payoff is 20; probability = 0.375*0.375=0.141
Expected present value= ( 0+4*0.234+4*0.234+20*.141)/(1.10)
= 4.27
 Valuing European put option using two step binomial

CMP : 50
Strike : 52
Tenor : 2 years, each step of 1 year
Upmove/ Downmove : 20% p.a. compounded continuously
Risk free rate : 5% p.a. compounded continuously

Upmpve = exp(20%*1) = 1.2214

Probability of up move : (exp(5%*1)– exp(-20%*1))/(exp(20%*1) – exp(-20%*1) = 0.5775
Downmove = exp(-20%*1) = 1/1.2214 = 0.8187
Probability of down move : 1 – 0.5775 = 0.4225
uu  50 -> 50*1.2214=61.0701-> 50*1.2214*1.2214=74.5912 ; payoff is zero; probability = 0.5775 *
0.5775 = 0.3335
ud  50 -> 61.0701 -> 61.0701*0.8187=50; payoff is 0; probability = 0.5775*0.4224= 0.244
du  50 -> 50*.8187=40.9365 -> 40.9365*1.2214=50; payoff is 0; probability = 0.4225*0.5775 = 0.244
dd  50 -> 40.9365 -> 40.9365*0.8187=33.516; payoff is (52-33.516)=18.484; probability =
0.4225*0.4225=0.1785
Expected present value= (0+4*0.234+0*0.244+18.484*.1785)/(exp(5%*2))
= 3.83
Valuing American Put, simple risk free interest , up/down as 20%
of market price
Valuing American Put, continuously compounded risk free
rate, continuously compounded volatility
 Valuing options using Black Scholes

Three key assumptions

 Risk-neutral return on combination of long stock and short call
 Instantaneous returns follow Markov process, Prices follow log
normal distribution
Other assumptions
 Expected return and standard deviation are constant over the
tenor
 No dividends, no transaction costs, no taxes, no arbitrage
 Trading is continuous
 Risk free interest rate is constant over the tenor
 Valuing options using Black Scholes

Concept of log normal distribution

 Over a relatively small time frame
 Returns follow normal distribution
 Prices follow log normal distribution
 P1 / P0 = exp( return * 1); ratio of prices over 1 period where return is the
continuously compounded return over 1 period
 Hence return = ln (P1/P0)
• If returns follow normal distribution; prices follow log normal distribution
• To illustrate
e^0.1 = 1.1052,
• Continuously compounded return of 10% p.a. is same as 10.52% p.a. of discrete return
• ie Rs 100 invested today would be equal to Rs 110.52
by earning continuously compounded return of 10% p.a.
Additional 52 paise is due to continuous compounding

This is equivalent to the following:

ln (110.52 / 100) = 10%

 Valuing options using Black Scholes

Log normal distribution – properties

 If expected ( ie mean value) return is μ p.a. and standard
deviation of return is σ , then for time period T
 Ln (price) follows normal distribution with
 Expected value of ln(final price) =
ln (initial price) + (μ – (σ^2)/2) T
 Standard deviation = σ*sqrt(T)
 Valuing options using Black Scholes

Example of lognormal distribution of price

 Initial price : 40
 Expected return : 16% p.a.
 Standard deviation : 20% p.a.
 Tenor : 6 months
 Compute the 95% confidence interval for the final price
 Ln(expected price) = ln(40) + (.16 – (.2^2)/2)*0.5 = 3.759
 Standard deviation of the Ln(price) = 20%*sqrt(6/12) = 0.141
 1.96 times standard deviation = 1.96 * 0.1441 = 0.277
 Ln(upper price) = 3.759 + 0.277 = 4.036
 Upper price = exp(4.036) = 56.60
 Ln(lower price) = 3.759 – 0.277 = 3.482
 Lower price = exp(3.482) = 32.51
 Valuing options using Black Scholes

Black- Scholes model

 A formula which applies probability based weights
 to the market price of the underlying and the strike price
 and calculates the difference as the option premium
 If both the weights are equal to 1, the difference (market price
minus strike price, S - K) is same as intrinsic value
 When weighted difference is taken ie ( W1* S – W2 * K); this gives
time value + intrinsic value ie call option premium; (W1 > W2)
 Valuing options using Black Scholes

 C = S * W1 – PV(K) * W2
 W1 = N (d1), where
d1 ={ ln (S/K)) + ( r + (σ^2)/2)* T }/ ( σ* sqrt(T))
• W2 = N (d2) where , d2 = d1 – σ * sqrt ( T)
 C = price of the call option
 S = current market price of the stock
 T = time till expiry
 R = risk free rate
 PV(K) is present value of exercise price = K * exp(-r *T),
 N(d1) and N(d2) are the cdf values of normal distribution at d1 and
d2
 σ = standard deviation of the stock return
 Valuing options using Black Scholes

Option calculators are readily available on the web

using this model to calculate option price or
“implied volatility” given the actual option premium
http://www.cboe.com/framed/IVolframed.aspx?c
ontent=http%3a%2f%2fcboe.ivolatility.com%2fc
alc%2findex.j%3fcontract%3dC1F2E16A-170A-4DE
8-B06B-C41A0EA401C6&sectionName=SEC_TRADING
TOOLS&title=CBOE%20-%20IVolatility%20Service
s
Option calculator
Valuing options using Black Scholes
 Valuing options using Black Scholes

Option price, as per the formula; does not depend

upon the expected return of the stock
Volatility assumption is for a particular instant
 If volatility changes , the option price would change
instantaneously
 Hence constant return and constant volatility are not necessary
 Also, continuous trading ie 24x7 is not necessary
Prices can be taken net of transaction costs
Hence the only assumption necessary to hold
throught out the period till expiry is that prices are
lognormally distributed
 Valuing options using Black Scholes

C = S * W1 – PV(K) * W2
P = PV(K)*(1-W2) – S*(1-W1)
 Valuing options using Black Scholes

 C = S * W1 – PV(K) * W2

 W2 , also referred to as N(d2); is the probability of

ST > K ie probability that the option would be exercised
where ST is the stock price at the time of expiry
S is the current market price
K is the strike price

 W1, also referred to as N(d1);

N(d1) is also called Delta.

For Re 1 change in S , value of C changes by N(d1).

N(d1) for at-the-money options is about 0.5

ie if the underlying stock goes up by Re 1 then the at-the-money call option price goes
up by 0.5
 Math behind Black Scholes

Call option value = PV of Expected value of

{max(S-K), 0}
Let C* = Expected value of {max(S-K), 0}
This is = area under the probability distribution curve of ( S – K)
C* = ∫k (S – K) g (S) dS, where g(S) is the probability distribution
of S
Let Q be the standardized value for Ln(S)
 Q = (Ln(S) – mean)/ standard deviation
 For Ln(S)
 Mean = ln(expected value of S) – (σ^2)* T / 2 = m ( say)
 std devn = σ * sqrt (T) = b (say)
 This implies that S * e^(r * T) = e^(bQ + m) = S T
 also, ST = e^( m + b^2 /2)
 Math behind Black Scholes

Normal probability density g(Q)=

exp(-Q^2 / 2)/ sqrt( 2 * π)
 Hence C* = ∫k (S – K) g (S) dS is transformed to
= ∫kq e^(b*Q + m) * g(Q) dQ
- ∫kq K * g(Q) dQ
={1/sqrt ( 2 * π)} *
∫kq e^(b*Q + m) * e^(-Q^2 / 2) dQ
- ∫kq K * g(Q) dQ
= {1/sqrt (2*π)}*∫kq e^(b*Q+m–Q^2/2)dQ
- ∫kq K * g(Q) dQ
= {e^(m + b^2 / 2) / sqrt (2*π)} *
∫kq e^{-(Q – b)^2 / 2 }dQ - ∫kq K * g(Q) dQ
= ST * ∫kq g(Q – b) dQ - K *∫kq g(Q) dQ

where kq = (ln(K) – m) / b

Note : m + bQ–Q^2 / 2 = m+b^2/2 – (Q-b)^2/2

 Math behind Black Scholes

C * = ST * ∫kq g(Q – b) dQ - K *∫kq g(Q) dQ

C = e^(-r*T) * ST * N(d1) – e^(-r*T)*K*N(d2)

g(Q – b) = 1 – norm.dist.s( Q –b)

= norm.dist.s( b - Q)
 b – Q = b – {(ln(K) – m)/ b}
 =b – {(ln(K) – ln(ST) + b^2 / 2)/ b}
 = {b^2 / 2 + ln(ST) – ln(K)} / b
 ={ln(ST / K ) + b^2 / 2 } / b
 = {ln(S / K ) + r*T + b^2 / 2 } / b, where b = σ * sqrt (T)
 = d1
d2 = -Q = d1 - b
 Example 4 – valuing options

Given
 CMP : 100
 Observed volatility : 18% p.a. compounded continuously
 Time till expiry : 30 days
 Assume risk free rate of 5% p.a. compounded continuously

 Estimate difference in time value between American put and European put option at strike price of
102 using three step binomial method

Formulas : u=exp(σ*sqrt(T)), d=1/u, rf =exp(r*T),

probability of upmove = (rf – d)/ (u – d)

 Compare the calculated European option price value with the value using the Black Scholes formula

Formulas : c = N(d1) * So – N(d2) * PV(K) , where

d1 ={ ln (S/K)) + ( r + (σ^2)/2)* T }/ ( σ* sqrt(T))
d2 = d1 – σ * sqrt ( T)
p = c + PV(K) - So

standardnormaltable.pdf
 Example 4 – step wise solutions

 3 step Binomial
Given 109.35 0.00
CMP 100 Rf factor 1.001 106.14
Volatility 0.18 u 1.03 103.02 103.02 0.00
step 10 100.00 100.00
rf rate 0.05 d 0.971 97.06 97.06 4.94
strike 102 94.22
p upmove 0.516
91.45 10.55

Back-calculation Payoff on Decision to

Node# Price value exercise exercise Node value
Node 1 106.14 0.00 0.00 NO 0.00
Node 2 100.00 2.39 2.00 NO 2.39
Node 3 94.22 7.65 7.78 YES 7.78
Node 4 103.02 1.16 0.00 NO 1.16
Node 5 97.06 5.00 4.94 NO 5.00
Node 6 100.00 3.01 2.00 NO 3.01
 Example 4 – step wise solutions
CMP 100 So
Black scholes strike 102 K
time till
expiry 30 365*T
risk free 5% r
volatility 18.00% σ

Steps for manual calculation

ln(So/K) -0.0198
(σ^2)/2 + r 0.0662
( (σ^2)/2 + r ) * T 0.00544
ln(So/K) + ( (σ^2)/2 + r ) * T -0.0144
sqrt ( T ) 0.28669
σ* sqrt(T) 0.0516
d1={ ln (So/K)) + ( r + (σ^2)/2)* T }/ ( σ* sqrt(T)) -0.2783
d2=d1 - σ* sqrt(T) -0.3299
Nifty call option price calculated
 Reliance call option price calculated

Note : discrete dividends assumed

 Valuing options using Black Scholes for stocks with
dividend

If there is dividend

 Either assumed continuously at the rate q% p.a., the formula
needs to modify the risk free rate r to (r-q) to reflect the
dividend
 Or one time dividend  reduce the initial price (So) by the PV
of dividend / stream of dividends till expiry
 If no dividend is expected prior to the expiry, the calculation is
same as that for a non-dividend paying stock
Option chain
 Option chain

Options get traded for several “strikes” for the same

underlying
Mispricing across strikes gets adjusted through arbitrage
Prices for call and put get adjusted as per arbitrage on put
call parity
Implied volatilities are different at different strikes
 Implied volatilities are different for call and put at the same strike
 This phenomenon is observed across various markets
 Called “volatility smile”
 Shape of the volatility vs strike curve is specific to a particular market
micro-structure
 There has been ample empirical research on this
 Example 5 - valuing options

Compute using Black Scholes formula the price of

Nifty at-the-money call option using the implied
volatility as indicated on the NSE web site.
 Example 6 – valuing options

Compute the number of at-the-money call options to

be sold for hedging 1000 units of stock.
Given : Risk free : 5% p.a.
Volatility : 20% p.a.
Time till expiry : 20 days
 Delta = N(d1) = 0.533
 Re 1 increase in the price of underlying leads to
Re 0.533 increase in the price of the call option
 Number of call options to be sold = 1000 / 0.533 =
1877
 Example 7 – valuing options

Compute the number of at-the-money put options

needed for hedging 1000 units of stock.
Given : Risk free : 5% p.a.
Volatility : 20% p.a.
Time till expiry : 20 days
 Delta for put = -(1- delta for call) = - ( 1- 0.533)
= -0.467
 Buy 1000 / 0.467 = 2140 units of put option
 Example 8 – valuing options

What is the probability that call option in Example 5

would get exercised ?

 N(d2) = 0.514 is the probability that the call option

would get exercised.
 Example 9 – valuing options

 Estimate the call option price using Black Scholes formula for the
following at-the-money call.
Given : Risk free : 5% p.a.
Volatility : 20% p.a.
Time till expiry : 20 days
Dividend of Re 1 expected in 10 days

ln(So/K) 0.0000
(σ^2)/2 + r 0.0700
( (σ^2)/2 + r ) * T C = 1.52 0.00384
ln(So/K) + ( (σ^2)/2 + r ) * T 0.0038
sqrt ( T ) 0.23408
σ* sqrt(T) 0.04682
d1= ln (So/K)) + ( r + (σ^2)/2)* T }/ ( σ* sqrt(T)) 0.08193
d2=d1 - σ* sqrt(T) 0.03511
 Example 10 – valuing options

A company’s stock is trading at 100. It offers 10%

ESOPs at 100 with vesting 3 years hence. Stock
volatility is 30% p.a. Risk free is 5% p.a. No
outstanding ESOP as on now. Assume nil dividend.
Estimate drop in company’s stock price on
announcement of this ESOP scheme assuming that
there is no direct P&L benefit because of this scheme.

 Call option price : 26.8

 Expected drop in the stock price = 26.8 * 10 / 110 = 2.4
 ESOPs

S : stock price before ESOP announcement

N : number of outstanding shares of the company prior to ESOP
M : new ESOPs issued
K : strike
C : call option price of ESOP ( borne by the company)
Before ESOP
 Value of the company : S * N
 Number of shares outstanding : N
 Value per share : S
After ESOP
 Value of the company : S*N + M*K –M*C
 Number of shares outstanding : N+M
 Value per share : (S*N + M*K –M*C)/(N+M)
Estimated drop in value per share
 S - (S*N + M*K –M*C)/(N+M) = M * (S – K + C) / (N+M)
 If S = K ( ie at-the-money option), this is equal to M*C/(N+M)
 Total value of the options issued divided by the total number of shares
 Warrants

A company’s stock is trading at 100. It offers 30% warrants at

70 with vesting 3 years hence. Stock volatility is 30% p.a. Risk
free is 5% p.a. No outstanding warrants or ESOPs as on now.
Assume nil dividend.
Estimate drop in company’s stock price on announcement of
this preferential allotment scheme assuming that there is no
direct P&L benefit because of this scheme.

 Same method as ESOPs

 Expected drop in stock price = Rs 16.90
 Call option price : 43.2
 Drop = (100-70+43.20)*30/130
 Practice sum

Compare delta of at-the-money American put with

at-the-money European put using 3 step binomial
method.
Given 
 price increment of 0.1%
 Risk free : 5% p.a.
 Volatility : 20% p.a.