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A01 Financial Risk Management 01 XXXX.indd 1 6/29/2018 10:29:57 AM

A01 Financial Risk Management 01 XXXX.indd 2 6/29/2018 10:29:57 AM
 Financial
Risk Management

Sundaram Janakiramanan
SIM University, Singapore

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 Editor—Acquisitions: Varun Goenka
Senior Editor—Production: G. Sharmilee

Copyright © 2018 Pearson India Education Services Pvt. Ltd

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 Dedicated to my parents
R. Sundaram and
Neela Sundaram

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A01 Financial Risk Management 01 XXXX.indd 6 6/29/2018 10:29:58 AM
 About the Author

Sundaram Janakiramanan is currently Associate Pro-

fessor and Head of Programme Finance at SIM Univer-
sity, Singapore. He started his teaching career in 1975 at
the P. S. G. College of Technology, Coimbatore. During
his 35-year long teaching career, he has taught vari-
ous topics in finance in several universities including
the University of Minnesota, the University at Albany,
the University of Melbourne, the National University of
Singapore and Singapore Management University.
Dr Janakiramanan has been a consultant for many
organizations such as the World Bank, the United States
Agency for International Development, the Standard
Chartered Bank, and Spectrum Technologies in USA.
He has conducted executive development programs on
using derivatives in portfolio and risk management or-
ganized by the Indian Institute of Science in 1996 and
the Institute of Company Secretaries in February 2000. He also was invited as a guest faculty by Tata Motors for their
program on globalization in December 2003.
Dr Janakiramanan has published a number of articles in refereed journals including the Journal of Finance, the
Journal of Financial and Quantitative Analysis, the Journal of International Money and Finance, and the Journal of
International Financial Markets, Institutions & Money. He has presented research papers in many international
conferences conducted by the Financial Management Association, the American Finance Association, the Eastern
Finance Association, the Western Finance Association and Global Finance and has received the award of best
paper in many conferences.
An engineer from the Indian Institute of Technology Kharagpur, Dr Janakiramanan holds two doctorate
degrees—one in mining engineering from IIT Kharagpur and the other in finance from the University of
Minnesota. He is a member of the Institute of Cost and Works Accountants of India.

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A01 Financial Risk Management 01 XXXX.indd 8 6/29/2018 10:30:00 AM
 Contents

Preface xix

1 Introduction 1
Learning Objectives  1
1.1 What Are Derivatives?  2
1.2 Derivatives Markets  3
1.3 Forward Contracts  3
1.4 Futures Contracts  4
1.5 Options Contracts  4
1.6 Swap Contracts  5
1.7 Uses of Derivatives  5
1.8 What is Risk?  6
1.8.1 Operating or Business Risk  6
1.8.2 Event Risk  6
1.8.3 Price Risk  6
1.9 Risk Management  7
1.10 A Brief History of Risk Management  8
1.11 Implications for Hedging  8
1.12 Upside and Downside Risks  9
1.13 Commodity Price Risk  9
1.13.1 Volatility 10
1.13.2 Liquidity 10
1.14 Interest Rate Risk  10
1.14.1 Deregulation and Interest Rate as a Tool for Developing
Monetary Policy  10
1.14.2 Floating Rate Loans  11
1.14.3 Interest Rates and Inflation  12
1.14.4 Components of Interest Rate Risk  13
1.15 Currency Risk  13
1.16 Approaches to Risk Management  15
1.17 Risks in Derivatives Trading  15
Chapter Summary  16
Multiple-Choice questions  16
Review Questions  17
SELF-ASSESMENT TEST  18
Case Study  18

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 x  Contents

2 The Derivatives Market in India 19

Learning Objectives  19
2.1 The International Derivatives Market  20
2.2 Derivatives in India  21
2.3 Operations of Derivatives Exchanges  22
2.4 The Trading System  22
2.4.1 Types of Orders  24
2.4.2 Order-matching Rules  25
2.4.3 Order Conditions  25
2.5 The Clearing and Settlement System  25
2.5.1 The Members of the Clearing House  26
2.5.2 The Clearing Mechanism  26
2.5.3 Margin and Margin Accounts  27
2.5.4 The Settlement System  27
2.5.5 Risk Management  28
2.6 The Trading Process  28
2.7 Online Trading  29
2.8 The OTC Derivatives Market  29
2.9 The Regulation of Derivatives Trading in India  29
Chapter Summary  30
Multiple-Choice questions  30
Review Questions  31

3 Forward Contracts 33
Learning Objectives  33
3.1 What is a Forward Contract?  34
3.2 The Purpose of Forward Contracts  35
3.3 Advantages of Forward Contracts  35
3.4 Problems with Forward Contracts  35
3.4.1 Parties with Matching Needs  35
3.4.2 Non-performance 36
3.4.3 Non-transferability 36
3.5 The Pricing of Commodity Forward Contracts  37
3.6 Currency Forward Contracts  38
3.6.1 The Operation of the Currency Forward Market  40
3.6.2 Characteristics of Currency Forward Contracts  40
3.6.3 The Pricing of Currency Forward Contracts  40
3.6.4 Covered Interest Arbitrage  43
3.6.5 Rolling Over Currency Forward Contracts  46
3.7 Interest Rate Forwards  47
3.7.1 Mechanics of FRAs  50
3.7.2 The FRA Payment Amount  51
3.7.3 An Alternative View of an FRA and the Settlement Amount  53
3.7.4 Uses of FRAs  54
3.8 Non-deliverable Forwards  56
Chapter Summary  58
Multiple-Choice questions  58

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 Contents    xi

Review Questions  59
SELF-ASSESMENT TEST  59
Case Study  60

4 Futures Contracts 63
Learning Objectives  63
4.1 What Is a Futures Contract?  64
4.2 Futures Contracts Versus Forward Contracts  64
4.2.1 Negotiability 64
4.2.2 Standardization 65
4.2.3 Liquidity 65
4.2.4 Performance 65
4.2.5 Cash Needs  65
4.2.6 Ability to Reduce Losses  65
4.3 Participants in Futures Markets  66
4.3.1 Hedgers 66
4.3.2 Speculators 67
4.3.3 Arbitragers 68
4.4 Specifications of Futures Contracts  68
4.4.1 The Underlying Asset  68
4.4.2 The Contract Size  69
4.4.3 Delivery Arrangements: Location  69
4.4.4 Delivery Arrangements: Alternative Grade  69
4.4.5 Delivery Month  70
4.4.6 Delivery Notification  70
4.4.7 Daily Price Movement Limits  70
4.4.8 Position Limits  71
4.5 Closing out the Positions  71
4.6 Arbitrage Between the Futures Market and the Spot Market  72
4.7 Performance of Contracts  73
4.8 The Clearinghouse  73
4.9 Margins and Marking-to-Market  75
4.10 Price Quotes  79
4.11 Settlement Price  81
4.12 Open Interest  81
4.13 The Pattern of Prices  83
4.14 The Relation Between Futures Price and Spot Price  83
4.15 Delivery  83
4.16 Cash Settlement  84
4.17 Types of Orders  84
4.17.1 Market Orders  84
4.17.2 Limit Orders  84
4.17.3 Stop Orders  84
4.17.4 Stop–Limit Orders  84
4.17.5 Other Orders  84
4.18 How to Trade in Futures?  85
4.19 Pricing of Futures Contracts  86
Chapter Summary  86
Multiple-Choice questions  87

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 xii  Contents

Review Questions  87
SELF-ASSESMENT TEST  88
Case Study  89

5 Hedging Strategies Using Futures 91

Learning Objectives  91
5.1 The Principles of Hedging  91
5.2 Long Hedges  92
5.3 Short Hedges  93
5.4 Should Hedging be Undertaken?  97
5.5 Risks in Hedging  98
5.6 Basis Risk  98
5.7 Factors Affecting Basis Risk  99
5.8 The Hedge Ratio  102
5.9 Static and Dynamic Hedging  105
5.10 Strip Hedges and Stack Rolling Hedges  105
5.11 Losses from Hedging Using Futures  106
Chapter Summary  107
Multiple-Choice questions  107
Review Questions  108
SELF-ASSESMENT TEST  109
Case Study  109

6 Swaps 111
Learning Objectives  111
6.1 What are Swaps?  111
6.2 Types of Swaps  112
6.3 Terminologies in Swaps  112
6.4 Interest Rate Swaps  113
6.5 Swap Rates  114
6.6 Rationale for Swap Arrangements  114
6.7 Swap with Intermediaries  115
6.8 Forward Swaps  116
6.9 Swaptions  118
6.10 Uses of Interest Rate Swaps  119
6.11 Valuation of Interest Rate Swaps  119
6.12 Currency Swaps  121
6.12.1 Differences Between an Interest Rate Swap and a Currency Swap  121
6.12.2 Basic Structure of Currency Swaps  121
6.13 Currency Risk in Currency Swaps  123
6.14 Comparative Advantages of Currency Swaps  123
6.15 Uses of Currency Swaps  124

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 Contents    xiii

6.16 The Valuation of a Currency Swap  124

6.17 Equity Swaps  125
6.18 The Valuation of an Equity Swap  126
6.19 Commodity Swaps  127
6.20 Risks While Entering into Interest Rate Swaps  127
Chapter Summary  129
Multiple-Choice questions  129
Review Questions  130
SELF-ASSESMENT TEST  130
Case Study  131

7 Fundamentals of Options 133

Learning Objectives  133
7.1 Options Issued by Corporations  134
7.1.1 Warrants 134
7.1.2 Employee Stock Options  135
7.1.3 Convertible Bonds  136
7.1.4 Callable Bonds  137
7.1.5 Put Bonds  138
7.1.6 Rights 139
7.2 Options Contracts Between Private Parties  140
7.3 Exchange-traded Options  140
7.4 Options Contracts: An Example  140
7.5 What Is an Options Contract?  141
7.6 Options Terminologies  141
7.6.1 The Underlying Asset  141
7.6.2 Call and Put Options  142
7.6.3 The Option Premium  142
7.6.4 Exercising Options  143
7.6.5 The Exercise Price or the Strike Price  143
7.6.6 The Exercise Date or the Strike Date  143
7.6.7 American and European Options  143
7.6.8 Buyers and Writers of Options  144
7.6.9 The Contract Size  144
7.6.10 In-the-money, At-the-money and Out-of-money Options  144
7.7 Exchange-traded and OTC Options: A Comparison  145
7.7.1 Guarantee of Performance in Exchange-traded Options  145
7.7.2 Margin Requirements  146
7.7.3 Margin Calculation  146
7.7.4 Standardization of Contracts  149
7.7.5 Exercise Dates  150
7.7.6 Exercise Prices  150
7.7.7 Options Classes and Options Series  151
7.8 Trading of Options  151
7.8.1 Types of Orders  152
7.8.2 Offsetting Orders  153
7.9 Price Quotes  153
7.10 Protection Against Corporate Actions  153
Chapter Summary  157
Multiple-Choice questions  157

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 xiv  Contents

Review Questions  158

SELF-ASSESMENT TEST  158
Case Study  160

8 Call and Put Options 161

Learning Objectives  161
8.1 What Are Call Options?  161
8.2 The Terminal Value of a Call Option  164
8.3 Gains and Losses from Purchasing Call Options  166
8.4 Value of a Call Option Before Maturity  167
8.5 Minimum and Maximum Values of a Call  168
8.6 When to Exercise an American Call Option  169
8.7 From a Call Option Writer’s Point of View  170
8.7.1 The Terminal Value of a Written Call  170
8.7.2 Gains and Losses for a Call Writer  171
8.8 Comparison Between the Gains Made by a Call Buyer
and a Call Writer  173
8.9 When to Buy and When to Write a Call Option?  174
8.10 Put Options  175
8.10.1 What Are Put Options?  175
8.10.2 Rationale for Put Options  175
8.11 The Terminal Value of a Put Option  177
8.12 Gains and Losses from Purchasing Put Options  178
8.13 Value of a Put Option Before Maturity  180
8.14 Minimum and Maximum Values of Put  180
8.15 When to Exercise a Put Option  181
8.16 From a Put Option Writer’s Point of View  182
8.16.1 The Terminal Value of a Written Put  182
8.16.2 Gains and Losses for a Put Writer  183
8.17 Comparison Between the Gains Made by
a Put Buyer and a Put Writer  185
8.18 When to Buy and When to Write a Put Option  185
8.19 Comparison Between Calls and Puts  187
Chapter Summary  192
Multiple-Choice questions  193
Review Questions  193
SELF-ASSESMENT TEST  194
Case Study  195

9 Combinations of Options: Trading Strategies 197

Learning Objectives  197
9.1 Naked or Uncovered Positions  198
9.1.1 Naked Long Stock Positions  198
9.1.2 Naked Short Stock Positions  199
9.1.3 Naked Bought Calls  200

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 Contents    xv

9.1.4 Naked Written Calls  201

9.1.5 Naked Bought Puts  202
9.1.6 Naked Written Puts  204
9.2 Hedge or Covered Positions  205
9.2.1 Covered Call Writing  206
9.2.2 Reverse Hedges  207
9.2.3 Protective Puts  208
9.2.4 Short Stocks and Short Puts  210
9.2.5 Partial Hedges  211
9.2.6 Summary of Hedged Positions  212
9.3 Spread Positions  213
9.3.1 Money Spread Using Calls  213
9.3.2 Money Spreads Using Puts  216
9.3.3 Box Spreads  219
9.3.4 Butterfly Spreads  220
9.3.5 Calendar Spreads  224
9.3.6 Iron Condor Spreads  226
9.4 Combinations of Puts and Calls  228
9.4.1 Straddles 228
9.4.2 Strips 230
9.4.3 Straps 233
9.4.4 Strangles 234
9.4.5 Other Pay-offs  235
9.5 Losses from Options Trading  236
9.6 Strategies Using Options, a Risk-free Security
and Underlying Assets  237
9.6.1 Combination of Call Options and Risk-free Securities  238
9.6.2 Combination of Long Stocks and Long Puts  239
9.7 The Put–Call Relationship  240
Chapter Summary  241
Multiple-Choice questions  242
Review Questions  243
SELF-ASSESMENT TEST  243
Case Study  245

10 The Binomial Options Pricing Model 247

Learning Objectives  247
10.1 The Binomial Options Pricing Model for Call Options  248
10.2 The Binomial Options Pricing Model for Put Options  252
10.3 The Relation Between the Hedge Ratios for Call and Put Options  255
10.4 The No-arbitrage Pricing Argument  255
10.5 The Derivation of the Binomial Options Pricing Model  256
10.6 The Single-period Binomial Options Pricing Model  257
10.7 The Two-period Binomial Options Pricing Model  259
10.8 The Multi-period Binomial Options Pricing Model  262
10.9 The Determination of u and d 264
10.10 The Valuation of a European Call Paying a Given
Dividend Amount  265

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 xvi  Contents

10.11 The Valuation of an American Call Paying a Given Dividend Amount  266
10.12 The Binomial Put Options Pricing Model  267
Chapter Summary  270
Multiple-Choice questions  271
Review Questions  271
SELF-ASSESMENT TEST  272
Case Study  273

11 The Black–Scholes Options Pricing Model 275

Learning Objectives  275
11.1 The History of Options Pricing Research  276
11.2 Stock Price Behaviour  276
11.2.1 Lognormal Distribution  276
11.2.2 The Valuation of Options  277
11.3 The Assumptions in the Black–Scholes Options Pricing Model  277
11.4 The Black–Scholes Model for Pricing Call Options  278
11.5 The Black–Scholes Model for Pricing Put Options  280
11.6 Determinants of Options Prices  281
11.6.1 The Current Price of the Underlying Asset  282
11.6.2 The Exercise Price  283
11.6.3 The Time to Expiration  284
11.6.4 Volatility of the Underlying Asset  285
11.6.5 The Risk-free Rate  286
11.7 The Options Pricing Model for Securities that
Pay Known Dividends  288
11.8 Volatility  290
11.9 Implied Volatility  292
11.10 Volatility Smile  292
Chapter Summary  294
Multiple-Choice questions  294
Review Questions  295
SELF-ASSESMENT TEST  295
Case Study  296

12 Greeks in Options 297

Learning Objectives  297
12.1 Risks in Options Trading  297
12.2 Characteristics of Options Hedging  298
12.2.1 The Naked Position  299
12.2.2 The Covered Position  299
12.2.3 Hedging Through the Cap  299
12.3 Greeks in Options Hedging  299
12.4 Delta  300
12.4.1 The Use of Futures in Delta Hedging  303
12.4.2 The Delta of a Portfolio  304

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 Contents    xvii

12.5 Gamma 306
12.5.1 Making a Portfolio Gamma-neutral  306
12.5.2 Calculating Gamma  307
12.6 Theta 308
12.7 The Relationship Between Delta, Gamma and Theta  309
12.8 Vega 310
12.9 Rho  311
12.10 Creating Portfolio Insurance Using Synthetic Puts  313
12.11 Hedging Options Positions in Practice  316
Chapter Summary  316
Multiple-Choice questions  317
Review Questions  318
SELF-ASSESMENT TEST  318
Case Study  319
Glossary321
Bibliography327

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A01 Financial Risk Management 01 XXXX.indd 18 6/29/2018 10:30:01 AM
 Preface

The deregulation of markets and interest rates in the early 1970s resulted in a phenomenon whereby interest rates
came to be determined primarily by the market. Currency exchange rates followed quickly and, in course of time,
both became increasingly volatile.
  These developments resulted in the emergence of a slew of never-before-seen risks for organizations. Fluctuat-
ing interest and currency exchange rates, together with the constantly changing commodity prices, created risks
that had to be mitigated to maintain the accuracy of forecasts regarding future cash flow. This need gave rise to a
new kind of financial instrument—derivatives. Derivative securities, viewed as an exotic practice, were predomi-
nantly used in the US market in the initial days. Now, they have become a powerful and commonplace financial
tool routinely used by corporations to hedge risk. This complex process which requires a deep understanding of all
the derivative securities available is very important for the health of any organization.
  The widespread use of derivative instruments is considered to be one of the main causes of the 2008 financial
crisis. The collapse of Lehman Brothers, Barings Bank of London and Long-term Capital Management, in addi-
tion to the near-bankruptcy of Orange County, California, and the huge government payouts intended to shore
up companies including AIG have been widely publicized. However, the use of derivative instruments has not
flagged. Though there is a lesson to be taken from this attribution, derivative securities cannot be blamed for the
events of 2008 which were caused the improper use of these derivatives, not the derivatives themselves.
  Derivative securities were first introduced in India in 2000 in organized exchanges. Today, the National Stock
Exchange is the number one trading spot in the world for index futures. Currency and interest rate futures have
been introduced over the past two years, and currency options are in the pipeline. The volume of trade of both
financial and commodity-related derivatives has increased significantly over the past few years. Many of the newly
introduced products have been specifically designed for the Indian market.
  This text, therefore, has two main goals. The first goal is to provide readers with a thorough knowledge of the
functions of derivatives and the many risks associated with their use so readers can successfully deploy them.
The second goal is to provide an understanding of the particular derivative instruments that are available in
India today.
  To accomplish these goals, the book concentrates on four types of derivatives—forward contracts, futures con-
tracts, swap contracts and options contracts. It examines their nature, describes how they are valued, and explains
their utility in risk management. Although a number of texts have already been written and published on this
subject, few pertain to the rapidly increasing use of derivatives in the Indian market as this volume does.
  The book is primarily intended for classroom use in both basic and upper-level derivatives courses. It will also
prove useful for financial managers and general interest readers. In terms of classroom use, it can be used as the
main textbook in a basic course and as a companion in an advanced course that discusses complex mathematical
concepts in derivatives. The book will benefit not only Indian readers but also international derivatives traders
with an interest in the Indian market.

Organization of the Book

The book is divided into 12 chapters. The first two chapters provide an introduction to derivative securities; the
next four chapters describe forward, futures and swap contracts. The last six chapters relate to options contracts
and credit derivatives
  Chapter 1, “Introduction”, explains basic derivatives, risks, and their usage in risk management. Chapter 2, “The
Derivatives Market in India”, discusses the trade of derivatives in the Indian market, both in exchanges and over-
the-counter markets.

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 xx Preface

Chapter 3, “Forward Contracts”, examines forward contracts: how to use them, value them, and hedge com-
modity price, interest rate, and exchange rate risks. Chapter 4, “Futures Contracts”, discusses the basics of futures
contracts, and their traditional role in Indian exchanges. Chapter 5, “Hedging Strategies Using Futures”, focuses on
the valuation and usage of commodity futures. Chapter 6, “Swaps”, explains the basics, mechanics and valuation of
interest rates, currency, equity and commodity swaps.
Chapter 7, “Fundamentals of Options”, begins with a discussion of the basics of options and how to trade them.
Chapter 8, “Call and Put Options”, describes call and put options. Chapter 9, “Combinations of Options: Trading
Strategies”, explains how to use options and their various combinations in order to make money. Chapters 10, “The
Binomial Options Pricing Model”, and 11, “The Black–Scholes Options Pricing Model”, elucidate the two pricing
models—binomial and Black–Scholes—used to value options. Chapter 12, “Greeks in Options”, describes how to
use Greeks in order to hedge option positions.

Features of the book

The book includes several features to help explain challenging theoretical and mathematical concepts in a lucid
reader-friendly manner. The theory is interspersed with relevant examples from the real world to make it easier for
readers to link the theoretical with the real.

1
1 Learning Objectives
11 Introduction
The Learning Objectives for
each chapter are captured as
2
Fundamentals of Options
questions that readers will be
able to answer after reading
chapter-opening box

Each chapter starts of with a real-life situation describing the practical

the chapter. application of concepts explained in the chapter.

Learning Objectives
Learning Objectives
While dealing with derivatives, a number of points are to be kept
After completing this chapter, you
in mind. First, a derivative contract is based on a zero-sum game,
will be able to
After completing this chapter, youanswer the following
In order to help which
Indianmeans
companies to reduce currency derivatives
that for every person who makes money from de-
questions:
will be able to answer the following losses, Reserve Bank of India
rivatives, there(RBI)
musthas
besuggested
one loser.that companies
Second, many derivative con-
questions:  What are derivatives and should be allowed toare
tracts write
verycurrency
complexoptions. According
and are based to RBI mathematical
on advanced
 what
What is an options are the main usesguidelines,
contract? of importers and and
concepts; exporters
many with foreign
traders do notcurrency expo-clearly how these
understand
derivatives? sures will be permitted
derivativeto contracts
write covered
work.call and
Third, put options
hedge funds and as banks that trade
 What are call options and put

options?  What are forwards, these
futures, would protect
in them from
derivatives making
use losses
borrowed while
funds using
and currency
high leverage to enhance
options, and swaps? derivatives.” the returns from derivatives, and this can lead to financial dif-
 What is an option premium,
What
 and are risks and how do ficulties
Source: ET Bureau, for“Cos
these organizations.
May BecauseOptions,”
Get to Write Currency of these factors, deriva-
exercise price, exercise
they affect businesses? tives can be Thevery risky. Evidence
Economic Times, 13 suggests
November that even sophisticated,
2009.
date?
professional investors have no idea as to the level of risk they
  What
What are American and are commodity price
undertake while trading derivatives.
European options?risks, interest rate risks, and
currency risks? BOX 11.1 CompaniesSource: May Get Chris
to Sholto Heaton, “The
Write Currency Dangers of Derivatives,”
Options
 What are the uses of options? MoneyWeek, September 27, 2006.
 Why is it important to manage
 How to trade options on
risks?
exchanges and over-the-
 What is meant by hedging?
counter markets?
What are the approaches to BOX 1.1 Caution While Using Derivatives
 What are theprotections
risk management?
for corporate actions for
exchange-traded options?

Derivatives contracts, which have been in existence for more than 2000 years now, started as a way for
farmers and merchants to manage the risks of the price of agricultural commodities moving against
them. They started off as very simple contracts, and the parties entering into the contract had a good
In Chapters 4 to understanding
10, we discussed of forward
the riskscontracts,
involved. futures contracts,
Currently, there areandderivative
swap contracts. Onetoofmanage
securities the the risks as-
problems with these contracts
sociated withisequity
that these contracts
and debt will provide
investments; gains
credit if the underlying
exposures; asset price
and changing moves prices, currency
commodity
against the hedger but theyrates,
exchange would andresult in losses
interest rates.when the underlying
According to the Bankasset
forprice moves in Settlement
International favour of the(BIS), the notional
hedger. These contracts
value ofcanall also lead to huge
derivatives speculative
contracts losses
by the end ofifDecember
the speculator
2008does not guess
was USD the direc-
644,686 billion. This shows the
tion of movementimportance
of the pricesof of
thethe underlying
derivatives assetsincorrectly.
market the world. That is where options come in. As will
be explained later inDerivatives
this chapter, options
trading in will
Indiaprovide gainsrapidly
has grown if the underlying
since 2000, asset
whenprice movesin
exchanges against
India were allowed to
the hedger and the losses
trade will be limited
derivative if thePrior
contracts. underlying
to 2000,asset price moves
derivatives wereinonly
favour of the hedger.
available Simi- between private
as contracts
larly, a speculator can make gains if they guess the direction of price movement correctly and their losses
will be small if they guess the direction wrongly. Box 11.1 explains this rationale of reducing losses by
A01 Financial Risk Management 01 XXXX.indd 20allowing companies with foreign currency exposure to write options. In this chapter, we will discuss what 6/29/2018 10:30:04 AM
 Preface xxi

3 examples

A number of Examples are intertwined with the theory to elucidate the concepts discussed in
each chapter.
112 Derivatives and Risk Management

ExamPlE 6.5
Suppose today is January 1, and an Indian company expects to receive USD 5 million at the end of May.
The delivery date for U.S. dollar futures contracts is the 24th of every month. Each contract is for the de-
livery of USD 1 million.
Step 1: Which contract should be used?
Since the exporter is receiving U.S. dollars on May 31 and contract delivery is on May 24, the hedger
will use a June contract.
Step 2: Should a long or short position be used to hedge?
The company will sell five June U.S. dollar futures contracts on January 1. When the U.S. dollars are
received on May 31, the futures contract will be closed out and the U.S. dollars will be exchanged at the
prevailing spot rate.
Suppose the exchange rate on January 1 is USD 1 = INR 50 and the futures price is INR 51. Also assume
that the spot exchange rate and the futures price on May 31 are INR 49.40 and INR 50.50, respectively.
The final basis is the difference between the spot price and the futures price on the day the contract is

4
closed out, i.e., INR 49.40 – INR 50.50 = INR –1.10. The gain from the futures contract is the difference
between the rate at which the contract is closed and the rate at which the contract was entered into, i.e.,
INR 50.50 – INR 51 = INR 0.50. This gain has been made because the company agreed to sell U.S. dollars Problems
at INR 51 under the futures contract when it entered into the contract, and it agreed to buy U.S. dollars at
INR 50.50 at the time it closed the contract. Thus, the effective price obtained is
Several solved Problems haveSpot been
priceincluded infutures
+ Gain on the eachcontract
chapter to explain the mathematical
details of the theory presented= INR
in the
49.40chapter.
+ INR 0.50
Hedging Strategies Using Futures 115
= INR 49.90.
This can also be written as:
ProblEm 6.3
Futures price contracted + Basis at the time the contract is closed out
On November 20, the spot price of jute is INR 2,198 per 100 kg and the price of December jute futures with expiry
= INR 51 – INR 1.10
on December 15 is INR 2,276. The standard deviation of the spot price change is estimated as INR 260, and the stan-
dard = INR 49.90
deviation Hedging
of the futures price change is estimated as INR 248.Strategies Using
The correlation Futuresbetween
coefficient 119 the spot price
change andreceive
The company will thus the futures price change
5,000,000 is estimated
× 49.90 to be million.
= INR 249.5 0.99. What is the hedge ratio and the hedging effectiveness?

Continued Solution to Problem 6.3

ExamPlE 6.6 The hedge ratio is calculated as:
Another problem also arose during this period. The oil mar- hedging with s S rollovertoof260
contracts would result in losses that
Consider a merchant dealing in aluminium; they are
h* = r ×expecting
= 0.99 × buy=10 MTMT of aluminium on
1.0379
ket shifted from normal backwardation to contango. In the oil cannot be recovered, s Fcontractasto the spot price drops below the futures
248
November 1. They enter into an October aluminium futures hedge the price risk. The contract
market, the futures price is generally lower than the spot price price. Thus, as long as the market stayed in contango, the
size is 5 MT, and the price is specified in terms of Indian rupees per kg. On September 1, the futures price

5
When inrollover
contracts thatlosses
jute should be would
require thembetoheavy.
covered by futures Thisworthrollover
and the market is said to be This
is INR 91.90, inandnormal
perloss is the real
meansbackwardation.
that each rupee exposed INR 1.0379.
the merchant buys two pay INR 91,900 contract or
the market turns into contango, the futures price would be loss suffered by Metallgesellschaft.
a total of INRHedging
183,800effectiveness
for the twoiscontracts.
calculatedSince
as: they have entered into an aluminium futures contract,
chapter Summary
higher than the spot price. In the oil market, backwardation The case study shows that the hedge was undertaken in
the spot price of aluminium on October 31 will be the same as the futures price on that date, according
can be considered as the market expectation that the spot the belief that thes oil 2 price would increase 2 and the market
to the arbitrage principle. This means that the final basis will2 be zero. Hence, they 248are
 assured that they
Hedging
will effectiveness × F 2 = (0.99)2However,
would be =inh*backwardation. × = 0.8917
the
prices will fall in the future, as the OPEC’s cartel pricing
need to pay exactly INR 183,800 for the 10 MT of aluminium that s they would purchase 
 260  onexpectations
October 31.did
A detailed Chapter
not be sustainable overSummary
the long run atandthe end
hence of each
collapse. In notchapter provides
realize and a dropped;
the Soil prices snapshot of theinconcepts
this resulted margin
1993, the expectation that the cartel pricing would collapse calls on the futures position and the market went into con-
covered
E xwas
am inP lthe
realizedE and6chapter.
.the
This
7 spot price
shows that the hedge is able to cover 89.17 per cent of the variation in the spot price,
decreased, causing the mar- tango, causing real losses because of the rolling over of the
and the hedger is exposed to
10.83 per cent of the variation in the spot price of jute.
ket to be in contango. When the market is in contango, stack contracts.
Suppose they require 12 MT of aluminium on November 1; they will be able to enter into a futures con-
E xtract
a mfor
P lcovering
E 6 . 1only
1 10 MT of aluminium, as the contract size is 5 MT. Thus, they will be able to hedge
10 MT and be assured that they need to pay exactly INR 183,800 for these 10 MT. However, they will
notP be The optimal number of contracts refers to the number of futures contracts that must be used to hedge the
CHa T Eable
r toSexposure.
hedge
U m the exposure
mThis
a to the remaining 2 MT of aluminium that is not covered by the futures
risycalculated as shown below:
contract. They will be exposed to price risk on these 2 MT. Thus, a perfect hedge is obtained only when
the amount
The major participants
 in aofLet
exposure
futures in the
Nmarket
= sizeare underlying
the positionasset
ofhedgers. is hedged,

being the same
If the asmoves
price the amount of of
in favour exposure under
the hedger, theythe
willfutures
not be
A
contract.
A perfect hedge
 is achieved when the price risk is completely able to take advantage of this favourable movement and
QF = size of the futures contract,might face losses.
eliminated and the hedger is able to lock in a known price for the
exchange of an asset at a future time.N* = optimal
A long hedge isnumber of futures
undertaken  Bcontracts for hedging.
asis is defined as the difference between the futures price
when a person needs to buy the underlying asset in the future.
Then, and the spot price.
A long hedge involves buying the futures at the current time.
 For most assets, the basis on the maturity date will be zero, as

NA
For a long hedger, the concern is that the price of the
 N* price
the futures × the
= h* on maturity date would converge to the
Q
underlying asset may increase in the future, thereby requiring spot price on that day.F
them to pay a higher price when they neediftoh*buy
For example, the asset
= 0.8, NA =at10,000, If theQbasis
and F = 1,000,
 on the maturity date of the futures is not zero,
a future time. the hedger is said to face basis risk and the hedge will not be
10,000
By entering into a long hedge, any loss that the hedger will
 N* = 0.8 ×
perfect. =8
1,000
face in the spot market will be offset by the gains in the  Basis risk arises when the position in an asset has to be
futures market. That is, eight futures contracts are needed hedgedto hedge so thatonthe
using futures hedgeasset,
another effectively
when thereduces
size of the
the risk.
A short hedge is undertaken by a hedger when they need to
 exposure in the asset is different from the contract size of
sell the underlying asset at a future time. the futures, or when the date on which the hedge needs to be
ExamPlE 6.12 lifted is different from the maturity date of the futures.
A short hedge involves selling the futures at the current time.

A short hedge would result Kingfisher
 in gains fromAirlines uses
the futures 20,000
when barrels
 of aviation
Hedge fuel every
ratio indicates month.
the ratio of the On
size January 1, Kingfisher would
of the position
like to hedge the price risk of aviation taken
the underlying asset price decreases. fuel for March
in the andcontracts
futures would like to size
to the enter intoexposure.
of risk a futures contract with
A01 Financial Risk Management 01
XXXX.indd expiry
Hedging21through futures would oninFebruary
lock 28. Since
a known rate for thethere
are Th
noe futures
optimal on aviation
number fuel, thethat
of contracts chief financial
should officer
be chosen to of Kingfisher 6/29/2018 10:30:08 AM
 usually over-the-counter contracts. demand for funds in the market and monetary policy actions.
Continued
Risk means that the future is uncertain and hence the cash
 Interest rates are related to future inflation, and the relationship

flows that will be generated in the future are also uncertain. between the interest rate and inflation is written as:
Another
Businesses face risk in three
 aspects,problem
namely,also during this period. The oil mar- hedging with rollover of contracts would result in losses that
arose risk,
business
ket shifted from normal Nominal interest rate = Real interest rate + Expected inflation
n rate
to contango. In the oil cannot be recovered, as the spot price drops below the futures
event risk, and price risk. Business risk, also backwardation
known as
operating risk, is imposed market, the futures
on businesses price
as a result ofiseconomic
generally lower
 than therate
Interest spot affectsprice.
price
risk in twoThus,
ways:asthe long as atthe
price market
which the stayed in contango, the
and business cycles, and itand theallmarket
affects is said
businesses to be
in the in normal backwardation.
industry. When can
financial instrument rollover
be soldlosses would
in the be heavy.
market, knownThisas rollover loss is the real
Event risk occurs when an theunforeseen
market turns eventinto contango,
arises, affectingthe futures
priceprice
risk, would loss
and theberate at suffered
which any by Metallgesellschaft.
interim cash flows from
xxii Preface both the revenue and the higher
cash flowthanof athe spot
firm. price.
Price riskInrefers
the oil market, nancial investment The
the fibackwardation can case study shows
be reinvested, knownthat as
thethe
hedge was undertaken in
to the risk of price changes can inbetheconsidered
inputs andasoutputs
the marketof a expectation that the
reinvestment risk. the belief that the oil price would increase and the market
spot
rate
company that will have anpricesimpactwill
on fall in thecash
future, as the OPEC’s cartel pricing would be
will a company in backwardation. However, the expectations did

6
its future flows.  Currency risk affects when the value of the current
not be sustainable over the long run andand hence collapse.
future cash flows not realize
In depends on and
the the oil prices
exchange rate. dropped; this resulted in margin
 Changes in the prices of inputs and outputs affect the future
1993, the expectation that the cartel pricing would collapse calls on the futures position and the market went into con-
Multiple-choice questions
cash flows of a company. Changes in the prices of financial  A company can manage risk in three ways: (i) do nothing
was realized and the spot price decreased, causing the mar- tango, causing real losses because of the rolling over of the
instruments mainly affect investment companies, as their cash and face the risk completely; (ii) cover everything or hedge
ket to be in contango. When the market is in contango, stack contracts.
flow depends on the value of the financial instruments held each and every risk; (iii) cover partially, that is, hedge only a
Multiple-choice
by them. Changes Questions are
in interest rates willadded at thecost
affect a company’s end of part each chapter
of the cash flow. for practice.

CHaPTEr SUmmary
The major participants in a futures market are hedgers.
 If the price moves in favour of the hedger, they will not be

M U l T i p l E
- CAHperfect
OiC E isQachieved
hedge U E Swhen
T i OtheNprice
S risk is completely able to take advantage of this favourable movement and
eliminated and the hedger is able to lock in a known price for the might face losses.
1. A one-year forward contractexchange
is an agreement
of an asset at a future time. A longD.
where One
hedge side has the obligation
is undertaken  Basistoisbuy an asset
defined fordifference
as the the marketbetween the futures price
A. One side has the right to buy an asset for a certain price in price in one year’s time.
when a person needs to buy the underlying asset in the future. and the spot price.
one year’s time.
A long 2. atWhich of thetime.
following
is Fapproximately
or most assets,true whenonsize
theismaturity date will be zero, as

B. One side has the obligation to hedge
buy aninvolves
asset forbuying the futures
a certain the current the basis
measured in terms of the underlying principal
the futures price on theamounts
maturityordate would converge to the
price in one year’s time.
 For a long hedger, the concern is that the price of the
value of the underlying assets
C. One side has the obligation to buyasset
underlying an asset
mayfor a certain
increase in the future, thereby requiring spot price on that day.
A. The exchange-traded market is twice as big as the over-
price at some time during theto
them next
payyear.
a higher price when they need to buy the assetmarket.
at  If the basis on the maturity date of the futures is not zero,
the-counter
a future time. the hedger is said to face basis risk and the hedge will not be
 By entering into a long hedge, any loss that the hedger will perfect.
face in the spot market will be offset by the gains in the  Basis risk arises when the position in an asset has to be
futures market. hedged using futures on another asset, when the size of the

7
 A short hedge is undertaken by a hedger when they need to exposure in the asset is different from the contract size of
sell the underlying asset at a future time. the futures, or when the date on which the hedge needs to be
 A short hedge involves selling the futures at the current time. review questions
lifted is different from the maturity date of the futures.
A short hedge would result in gains from the futures when
 Hedge ratio indicates the ratio of the size of the position


M01 Financial Risk Management 01 XXXX.indd 16 the underlying asset price decreases. taken in the futures contracts to6/22/2018
the size10:11:18
of riskAMexposure.
Review
 Questions
Hedging at the
through futures end
would lockof
in aeach
known chapter
rate for the enable
Thereaders
 to review
optimal number the
of contracts thatconcepts from
should be chosen to the
hedge the exposure depends upon the volatility of the asset
chapter.
exchange of an asset at a future time, if the hedge is perfect.
price and the volatility of the futures price.
Hedging using futures will protect the hedger if the price

moves against them.

rEviEw QUESTionS
1. What is meant by basis and basis risk? (ii)A tyre manufacturer wants to reduce the price risk of
2. Under what conditions would a hedger not be able to get a rubber, which they use in the manufacture of rubber,
perfect hedge using futures? and rubber futures are available in MCX India.
3. What type of hedging would be undertaken under the follow- (iii) An oil producer would like to reduce the unknown price
ing circumstances? Explain. risk of crude oil. Crude oil futures are available in the
(i) An Indian company has exported products to the NCDEX.
USA and expects to receive USD 10 million from 4. Explain what happens to the position of a short hedger if the
the importer in the USA in three months’ time. basis strengthens and if the basis worsens.
Indian rupee futures are available through banks in 5. If the minimum variance hedge ratio is 1, does it mean that
India. you can completely eliminate price risk?

8 Self-Assesment test

Problems have been included at the end of relevant chapters to facilitate a thorough
understanding of mathematical concepts used in derivatives.
228 Derivatives and Risk Management

pROBlEMS
1. Company A wants to borrow at a fixed rate while Company B Current 9.5%
wants to borrow at a floating rate. Company A can borrow at Six months later 9.8%
a fixed rate of 8% or at a floating rate of MIBOR + 150 basis One-year later 10.1%
points. Company B can borrow at a fixed rate of 9% or at a One-and-a-half year later 10.4%
floating rate of MIBOR + 50 basis points. Show that these two
Calculate the various exchanges that would take place under
companies can improve their position through an interest
this swap.
rate swap. What would be the gain to the two parties?

2. ABC Corporation can borrow at 6% fixed rate or at a 6. Calculate the value of the following interest rate swap for the
floating rate of LIBOR + 50 basis points. GH Corporation floating-rate payer:
can borrow at 8% fixed rate or at a floating rate of LIBOR
Notional principal USD 100 million
+ 100 basis points. Show that these two corporations can be
Fixed swap rate 8%
better off by entering into an interest rate swap. Assume
Floating swap rate LIBOR + 200 bps
that the comparative advantage is equally shared by the two
Payment exchange every six months
parties.
The tenure of swap remaining 24 months
3. Figment Corporation wants to enter into a three-year swap
commencing in three months’ time. The current yield curve The yield curve for interest rate is as follows:
for interest rate is given below: Term Yield
Term Yield Current 7%
90 days 4.6% 180 days 7.6%
180 days 4.9% 1 year 8.4%
A01 Financial Risk Management 01 XXXX.indd 22 11/2 years 6/29/2018 10:30:11 AM
1 year 5.2% 8.7%
 calculate the number of contracts that Jet Airways
(i) How should Indian Spice Corporation hedge this expo-
should enter into.
sure?
3. On May 10, Indian Aluminium Products Limited estimates (ii) If the spot price of cardamom on December 15 is INR
773.75 and the spot price and January futures price of
price of aluminium on May 10 is INR 89.50. It wants to cardamom on January 5 are INR 772.50 and INR 772.00,
hedge the risk of an increase in the price of aluminium in the respectively, calculate the result of hedging using January
future and decides to hedge this price risk using aluminium futures and December futures.

6. On January 1, Ramesh Jewellers estimates that they would

Preface xxiii
on January 1 is INR 26,500, and futures are available on silver
has estimated that the standard deviation of changes in the

9
spot price is 10, the standard deviation of changes in the
with delivery on February 25 is INR 27,230, and the price
futures price is 11, and the correlation between the changes
of March futures with delivery on March 28 is INR 28,320.
in the spot price and futures price is 0.96
case Study
(i)
How should Indian Aluminium Products Limited hedge
this exposure? correlation of the price changes is 1. Calculate the result of
(ii) If the spot price of aluminium on June 5 is INR 91.25 hedging using February futures and March futures. How
A Case Study providing the details of real-life
and the futures price on June 5 is INR 92.40, what is the
situation is included in most chapters.
should Ramesh jewellers hedge the price risk?

CASE STUDY

Sairam Metals are traders in metals. One of the products they trade
steel plates.
Sairam, the owner–manager of Sairam Metals has heard that one
and the usual monthly demand is 320 MT. If they get an order
activity using futures markets. Since Sairam is just a trader, he is
buy the steel plates at the prevailing market price and sell them not sure what hedging involves. However, he decides to see what
at a markup of 15 to 20 per cent. Since the price of steel plates is
dependent on steel prices and the price of steel is very volatile in contracts available in the Multi Commodity Exchange of India
the world market, Sairam Metals face a problem with regard to the

10 Glossary
glossary
A Glossary of important terms is presented at the end of the book for easy reference.

A C
Accrued interest: The prorated portion of a bond’s coupon since Calendar spread: A combination of the same type of option with
the previous coupon payment. the same exercise price but different exercise dates.
American options: Options that can be exercised anytime during Callable bonds: Bonds that can be redeemed before maturity by
the life of the option. an issuer on payment of an amount known as the call price.
Arbitrage: Making profits with zero net investment and taking Call option: An option to buy the underlying asset at a fixed price,
no risk when there is a mispricing of related securities in the known as the exercise price, on or before a specified date,
market. known as the exercise date or strike date.
Arbitrager: A trader who enters into arbitrage trades. Call price: The price at which the issuer will redeem the bond us-
Asian options: Options in which pay-off is based on the average ing the call provision.
price of the underlying asset over an agreed period of time and Call risk: The risk that the issuer will redeem the callable bonds
the exercise price. before maturity and is faced by buyers of callable bonds.

11
At-the-money option: An option where the underlying asset Cash settlement: A procedure in which settlement of a deriva-
price is close to its strike price. tive contract is in terms of cash exchange instead of delivery

B Bibliography of the asset. bibliography

Cheaper-to-deliver bond: The bond that can be delivered under
Backwardation: Occurs when the futures prices are falling with the interest rate futures contract that provides the maximum
time to expiration. benefit to the trader who delivers the bond.
The Bibliography at the end of the book
Badla: A system of forward trading in Indian stock exchanges. It provides a list
Chooserof relevant
option: An option publications
in which the buyeron can derivatives
decide whether and
risk management.
has been banned For ease
since 2001 of by theidentifi cation,
Securities this list is divided
and Exchange the option shouldinto be credit derivatives,
a call option or a put option forwards
after a pre-and
Board of India (SEBI). determined time.
futures,Barrier
options,
options:riskOptionsmanagement and swaps.
that can be either activated or terminated Clearing: Refers to the process of clearly recording the transac-
when the underlying asset price reaches a predetermined bar- tions A.
concluded in the exchanges.
Risk Management
rier or boundary price.
Phillips,
Clearing
L. “Derivatives
nancialmember:
Management, A member
Practices and Instruments Survey” Fi-
Vol. 24, ofNo.
the 2(Summer
clearing corporation who is
1995): 115–125.
Basis (at George,
Benston, any time): andThe difference
Shehzad Mian.between the spot
“Financial price and
Reporting the
of De- authorized
Smith, C. W. and to clear all the
R. Stulz. trades
“The undertaken
Determinants ofby traders
Firms’ in the
Hedging
futures price
rivatives: An (at that time).
Analysis of the Issues, Evaluation of Proposals, exchange.
Policies. ” Journal of Financial and Quantitative Analysis, Vol.
Basis
andrisk: The risk that
a Suggested the basis
Solution. at maturity
” Journal of the Engineering,
of Financial futures con- Clearing
20, No.corporation
4(Decemberor Clearinghouse:
1985): 391–405. The clearing and set-
tract4,isNo.
Vol. different from zero.
3(September 1995): 217–46. tlement
Stulz, agency for
R. “Optimal all transactions
Hedging Policies”executed
Journal in of the exchanges.
Financial and
Basket option:
Berkman, H. andAnM. option that is written
E. Bradbury. on a portfolio
“Empirical Evidence of assets.
on the Cliquet or Ratchet
Quantitative option:
Analysis, Vol.A series
19, No.of2(June
at-the-money options with
1984):127–140.
Bermudan option: An option that provides a
Corporate Use of Derivatives.” Financial Management, Vol. 25, number of prede- periodic settlement and the exercise price
Tufano, P. “Who Manages Risk? An Empirical Examination of is reset at the price
termined
No. 2(Summerdiscrete
1996):exercise
5–13. dates on which an option can be level at
Risk the time of reset.
Management Practices in the Gold Mining Industry.”
exercised.
Bodnar, G. M., G. S. Hayt, R. C. Marston, and C. W. Smithson. Closing
Journaloutofthe position:
Finance, Vol. Refers to the trader
51(September 1996):taking an opposite
1097–1138.
Binary or digital
“Wharton option:ofAnDerivatives
Survey option that provides
Usage by a pay-off
U.S. which
Non- position to the position taken initially so that the net position
would be Firms.
financial a fixed” amount
Financial is the option is in-the-money
Management, Vol. 24, No.and 2 in the derivative contract is zero.
zero otherwise. Commodity swap: A swap in which the floating market price of
———.
(Summer
Binomial “Wharton
1995):104–114.
options Survey
pricingofmodel:DerivativesUsedUsage
to value the Non-fi-
by U.S. optionsForwards and Futures
the commodity is exchanged for a fixed price over a certain
Acknowledgements based onFirms.
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Allayannis,
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rivatives and FirmAn optionvalue.
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1(Spring 2001): 243–276.
I ments
am thankful
DeMarzo,
over time
to
Duffie.
in which
the students
“Corporate
the assetofprice
of
Incentives
can either
Singapore
Hedging
moveVol.
up or
Management
Contango: R.
Anderson, Refers University
to the situation
“Comments
and
on Margins
UniSIM,
whenandthe Futures who
futures prices were
keep
Contracts. ”
the guinea pigs for
and Hedge Accounting. ” Review Financial Studies, 8,
the
down
No. material
by a given
3(1995): that appears
amount
743–772. every period.in this book. I gratefully Journal acknowledge
increasingof Futures Markets, Professor
with decreasing time
Vol. 1,toNo. Koh Hian
expiration.
2(Summer Chye, Dean of the Busi-
1981): 259–
Black–ScholesA., D.options pricingand model: C. Used to“Avalue the options Contract size: The quantity of the underlying asset specified in a
ness
Froot, K.School; Professor
S. Scharfstein J.Tsui Kai
Stein. Chong,
Framework Provost,
for UniSIM
264.
derivatives
and the countless other individuals who have aided me
basedManagement.
Risk on the assumption
” Journalthat the stock
of Applied return evolves
Corporate Finance,as Vol.
log- Arak, M., P. contract.
Fischer, L. Goldman, and R. Daryanani. “The
through
normal this
distribution. process.
7, No. 1(Fall 1994): 22–32. I acknowledge my wife Bhooma
Conversion for
factor:
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rate
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Bradley
355–372. Crammond, who thoroughly
ally a government
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B. and A. Hodgson. factor“Arbitrage
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edited
Bond option:andAn proofread
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3(Winter 1998): 53–69. written onthe
bonds manuscript
as the underlying and provided
asset. bond feedback.
that is delivered.I also acknowledge
Trading.” Review of Futures Markets, Vol. 11, No. 3(1992): Jonaki Ray and other members
ofspread:
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combination team
C. W. Smith, at Pearson
of aJr.bullish money Risks
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Financial prices Vol.
Engineering, and exercise dates.
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Barnhill, T. M.to“Quality
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Butterfly
1995): spread:
101–26. Involves positions in options with three differ- Convertible bonds: Margin
its, and Variation Bonds that Costs: canAnbeEvaluation
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Howta, S. D. andprices and with
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Interest-rate number
and of shares
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on Treasury BondaFutures
certain time
Prices.period.
” Journal of Fi-
tives Use in U.S. Firms.” Financial Management, Vol. 27(Win- nancial and Quantitative Analysis, Vol. 25, No. 1(March 1990):
ter 1998):111–121. 65–86.
Jorion, P. “Risk Management lessons from Long-term Capital Barnhill, T. M. and W. E. Seale. “Optimal Exercise of the Switch-
Management.” European Financial Management, Vol. 6, No. ing Option in Treasury Bond Arbitrages.” Journal of Futures
A01 Financial Risk Management 01 XXXX.indd 23
1(September 2000): 79–87. Markets, Vol. 8, No. 5(October 1988): 517–532. 6/29/2018 10:30:16 AM
A01 Financial Risk Management 01 XXXX.indd 24 6/29/2018 10:30:16 AM
 1
introduction

LEARNING OBJECTIVES

After completing this chapter, you While dealing with derivatives, a number of points are to be kept
will be able to answer the following in mind. First, a derivative contract is based on a zero-sum game,
questions: which means that for every person who makes money from de-
rivatives, there must be one loser. Second, many derivative con-
What are derivatives and
 tracts are very complex and are based on advanced mathematical
what are the main uses of concepts; and many traders do not understand clearly how these
derivatives? derivative contracts work. Third, hedge funds and banks that trade
What are forwards, futures,
 in derivatives use borrowed funds and high leverage to enhance
options, and swaps? the returns from derivatives, and this can lead to financial diffi-
What are risks and how do
 culties for these organizations. Because of these factors, deriva-
they affect businesses? tives can be very risky. Evidence suggests that even sophisticated,
professional investors have no idea as to the level of risk they un-
What are commodity price

dertake while trading derivatives.
risks, interest rate risks, and
currency risks? Source: Chris Sholto Heaton, “The Dangers of Derivatives,”
Why is it important to manage
 MoneyWeek, September 27, 2006.
risks?
What is meant by hedging?

What are the approaches to
 BOX 1.1 Caution While Using Derivatives
risk management?

Derivatives contracts, which have been in existence for more than 2000 years now, started as a way for
farmers and merchants to manage the risks of the price of agricultural commodities moving against
them. They started off as very simple contracts, and the parties entering into the contract had a good
understanding of the risks involved. Currently, there are derivative securities to manage the risks as-
sociated with equity and debt investments; credit exposures; and changing commodity prices, currency
exchange rates, and interest rates. According to the Bank for International Settlement (BIS), the notional
value of all derivatives contracts by the end of December 2008 was USD 644,686 billion. This shows the
importance of the derivatives market in the world.
Derivatives trading in India has grown rapidly since 2000, when exchanges in India were allowed to
trade derivative contracts. Prior to 2000, derivatives were only available as contracts between private

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 2   Financial Risk Management

Notes parties. The total turnover of derivatives contracts has increased from INR 23.65 billion in 2001 to INR
68,896.41 billion in 2009, an annual growth rate of 242 per cent. In addition to the derivatives traded on
the exchanges, the value of currency derivatives has increased from USD 1,647 billion in 2005 to USD
7,044 billion in 2008. The value of interest rate derivatives has also increased from INR 100 billion in 2005
to INR 300 billion in 2009. These statistics show that derivatives have become a very important part of the
Indian market and that Indian businesses are using derivatives securities to a large extent. Therefore, it is
important to know what derivatives are and how they can be used and traded.
Popular opinion about the existence of derivatives contracts has been mixed. While their advantages
in managing risks have been understood, they have also been identified with the following incidents
(explained in detail in later chapters):
 Huge losses incurred by Metallgesellschaft AG in 1993

 Bankruptcy faced by Orange County, California in 1994

 Collapse of the Barings Bank in 1995

Near-collapse of Long-Term Capital Management (LTCM) and its ultimate bailout in 1998
 

 Collapse of Lehman Brothers in 2008

 Bailout of AIG in 2008

 Financial crisis of 2008–2009

  In the Chairman’s letter of the 2002 Annual Report of Berkshire Hathaway, Inc., finance guru, Warren
Buffett cautioned the use of credit derivatives with the following phrase: “I view derivatives as time
bombs, both for the parties that deal in them and the economic system. Derivatives are financial weapons
of mass destruction, carrying dangers that, while now latent, are potentially lethal”.
Even though the financial crisis of 2008–2009 is attributed to credit derivatives, it is widely accepted
that the crisis was caused because the users of derivatives did not really understand the risks involved in
these instruments.
Box 1.1 captures why caution needs to be used while using derivatives. Popular opinion, too, is divided
on the subject of increasingly complex securities and their negative impact on the economy. In this book,
discuss the advantages of derivative contracts and the dangers associated with their use.

1.1  What Are Derivatives?

All investors have the opportunity to invest in either real assets or financial assets. Real assets are assets
such as land, buildings, precious metals, and machinery. An investor would get the return from the in-
vestment in real assets on the basis of the changes in the price of these assets.
For example, if Rekha invests in 10 sovereigns of gold at INR 1,200 per sovereign, her total investment
in gold would be INR 12,000. She will get a positive return if the price of gold increases and a negative
return if it decreases. For example, if the price of gold increases to INR 1,250 per sovereign, she will gain
INR 50 per sovereign, or INR 500 on an investment of INR 12,000. On the other hand, if the price of gold
decreases to INR 1,100, she would lose INR 100 per sovereign, or lose INR 1,000 of the investment. Thus,
the return on investment from real assets depends directly on the changes in the real asset prices.
A financial asset, on the other hand, is a claim on an issuer of financial security. Examples of financial
assets could be bonds or equity securities. Consider a bond—the issuer of the bond will issue a piece of
paper to the buyer indicating that they are indebted to the buyer for the face value of the bond and will
promise to make periodic coupon payments, as stated in the paper. Thus, the buyer of the bond is eligible
to receive the amount that was stated by the issuer at the time of issue of the bond. Thus, a bond invest-
ment provides a predetermined set of payments from the issuer.
Equity security is also known as the share or stock of a company, and it represents ownership in the
company. The shareholder is eligible to receive periodic dividends issued by the company. Since divi-
dends are issued from the profits made by the company, the return from investing in shares is based on
the efficiency with which the real assets owned by the company are utilized to realize profits. Thus, the
value of shares will depend on how well the company utilizes its assets.

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 Introduction  3

Notes Both bonds and shares can be considered as claims on the cash flow generated by a company by
utilizing its assets. These assets, in turn, are procured by using the funds raised from issuing bonds
and shares.
A derivative security, on the other hand, realizes its value from the value of the asset, which forms the
basis of the derivative contract. The asset whose value determines the value of the derivative contract is
known as the underlying asset. The value of the derivative product will change depending on the changes
in the value of the underlying asset. Popular derivative products are classified into forward contracts,
futures contracts, options contracts, and swap contracts.
Derivative contracts can be written on real assets as well as on financial assets. The derivative products
written on real assets are called commodity derivatives, whereas those written on financial assets are
called financial derivatives.

1.2  Derivatives Markets

Derivatives contracts can either be over-the-counter contracts or exchange-traded contracts.
Over-the-counter contracts are between private parties, and the terms of the contract are decided be-
tween the two parties. The main problem with over-the-counter contracts is searching for a party willing
to enter into the contracts. However, this problem is solved by brokers whose job is to bring the parties
together. These contracts are highly unregulated and less transparent.
Exchange-traded contracts are traded on derivatives exchanges. The exchanges decide upon the terms
of the contract, and the parties can trade these contracts in a manner similar to the trading of shares in a
stock exchange. Exchanges are regulated, and they also offer transparency.
Forward contracts and swaps are generally over-the-counter contracts. Futures always trade on
exchanges. On the other hand, options can either be traded on exchanges or they can be written as over-
the-counter contracts. The difference between over-the-counter contracts and exchange-traded contracts
for futures and options will be explained in Chapter 4 and Chapter 7, respectively.

1.3  Forward Contracts

A forward contract provides the holder of the contract the right to buy or sell the underlying asset at
a future time at a price that is agreed upon at the time of entering into the contract. Typically, forward
contracts are short-term contracts and are non-negotiable, and the two parties that enter into the contract
will have to fulfil their obligations when the contract expires. Forward contracts are usually entered into
by private parties and, hence, are called over-the-counter contracts. Forward contracts are explained in
detail in Chapter 3.

  E x am p l e 1 . 1
Iyengar Bakery enters into a forward contract with Sakthi Sugars, a sugar manufacturer, on January 1 to
buy sugar on March 31 at INR 30,000 per 1,000 kg. There will be no cash exchange on January 1; however,
on March 31, Iyengar bakery will pay INR 30,000, irrespective of the price of sugar in the market, and
Sakthi Sugars will deliver 1,000 kg of sugar to the bakery. This contract will be binding on both parties,
and both will have to honour their commitments.

  E x am p l e 1 . 2
Tiruppur Hosiery, an exporter to the United States, enters into a currency forward contract with the
Canara bank on July 1 to sell USD 25,000 on October 31 at INR 48 per U.S. dollar. There will be no
cash exchange on July 1; however, on October 31, the exporter will be paid INR 1.2 million by the
Canara Bank in exchange of USD 25,000. This amount will be paid irrespective of the exchange rate
prevailing in the market. This contract will be binding on both parties, and both will have to honour their
commitments.

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 4   Financial Risk Management

Notes 1.4  Futures Contracts

A futures contract provides the holder of the contract the right to buy or sell the underlying asset at a
future time at a price that is agreed upon at the time of entering into the contract. Although a futures
contract is similar to a forward contract, futures contracts are negotiable and either party to the contract
has the right to transfer the contract obligation to a third party anytime before the expiry of the contract.
These contracts are traded on futures exchanges. Futures contracts can either be written on real assets
or financial assets. If they are written on real assets, they are called commodity futures, and if they are
written on financial assets, they are called financial futures. Futures contracts are explained in detail in
Chapter 4.

  E x am p l e 1 . 3
Assume that Cadbury India needs 5,000 kg of cocoa on March 31 to meet the requirements of produc-
tion of chocolate in April. On January 1, Cadbury enters into a futures contract in cocoa. If the fu-
tures contract is designed for buying 1,000 kg of cocoa, Cadbury will buy five cocoa futures contracts on
January 1. The futures price on January 1 indicates the price at which Cadbury can purchase cocoa on
March 31. If the futures price is INR 40,000, it means that Cadbury will pay INR 40,000 to buy 1,000 kg
of cocoa; in other words, Cadbury is fixing a liability of INR 200,000 to buy 5,000 kg of cocoa. On March
31, when the contract matures, Cadbury will pay INR 200,000, and the seller of the futures will deliver
5,000 kg of cocoa to Cadbury.

  E x am p l e 1 . 4
Assume that Mohan has been told on November 1 that he will be receiving a bonus of INR 50,000 on
January 1. He does not have any need for that money till April 30 as he plans to take a vacation with his
family in May. Therefore, he plans to invest this amount from January 1 to April 30 in government bonds.
However, he would be unable to buy the government bonds on November 1 since he will be receiving the
money only on January 1. However, he can enter into a government bond futures contract on November
1 to buy these bonds on January 1. The price of the bonds will be determined on November 1. By entering
into the government bond futures contract, Mohan can be sure of investing this amount on the bonds on
January 1.

1.5  Options Contracts

An options contract gives the holder the right to buy or sell the underlying asset on or before the maturity
date of the contract. The major difference between options contracts and forward or futures contracts is
that the holder of forward or futures contracts will have to fulfil the obligations under the contract, ir-
respective of whether the position in the contract results in a gain or a loss. However, the options contract
holder has the option of not having to fulfil the obligations under the contract if the position results in
a loss. An options contract is more valuable than a futures contract and consequently requires an initial
investment at the time of entrance. Options contracts are explained in detail in Chapter 7. Options can be
traded in options exchanges or options can be contracted between private parties, in which case they are
known as over-the-counter options.

  E x am p l e 1 . 5
Assume that Cadbury India needs 5,000 kg of cocoa on March 31 to meet the requirements of production
of chocolate in April. However, the price of cocoa is volatile and can either increase or decrease. Thus,
Cadbury faces the risk of price fluctuations. If the price is expected to increase, it would like to settle
on a lower price. On the other hand, if the price decreases, it would like to buy at the lower price. To ac-
complish this, on January 1, Cadbury will enter into an options contract in cocoa with a strike price of
INR 38,000. If the options contract is designed for buying 1,000 kg of cocoa, Cadbury will buy five cocoa
options contracts on January 1. On March 31, Cadbury will decide on whether or not to exercise the op-
tion and buy cocoa at INR 38,000. If the price of cocoa in the market is more than INR 38,000, Cadbury

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 Introduction  5

Notes will exercise the option and buy cocoa at INR 38,000. However, if the market price for cocoa is less than
INR 38,000, Cadbury will buy cocoa in the market at the prevailing market price instead of exercising
the option. Since an option holds value to the option buyer, the buyer will have to pay the option seller a
certain amount of money, known as option premium, which is determined in the options market at the
time of entry into the option contract.

  E x am p l e 1 . 6
ITC intends to borrow Rs.100,000,000 three months in the future. Since borrowing will be done at a later
date, ITC faces interest rate risk. To hedge this risk, ITC enters into an interest rate options contract with
the strike rate of 7%. This means that if the actual market interest rate is above 7%, ITC will exercise the
option and borrow at 7%. If the market interest is below 7%, ITC will let the option expire without exer-
cise and borrow lower market interest rates. In order to get this option, ITC will have to pay the party with
which entered into the options contract upfront, which is known as the option premium.

1.6  Swap Contracts

In general, forward contracts and futures contracts have short-term maturity, whereas swap contracts can
have long-term maturity. Swaps are contracts wherein two parties agree to exchange future cash flows
according to a mutually agreeable formula. The swaps are used to exchange interest rates or currencies.
Swaps are explained in detail in Chapter 6.

  E x am p l e 1 . 7
BHP, an Australian company, may want to borrow in Indian rupees to invest in India, while Tata Steel
may be planning an investment in Australia that requires Australian dollars. In such a scenario, both
firms may find it convenient to borrow money in their own currencies and then swap the loans. Hence,
BHP will borrow Australian dollars in Australia and Tata Steel will borrow Indian rupees in India and
then the two firms will swap the loans so that BHP will pay interest on the Indian rupee loan and Tata
Steel will pay interest on the Australian dollar loan.

1.7  Uses of Derivatives

Derivatives are mainly used for risk management. Companies face risks in the form of changes in the
prices of their inputs and outputs, changes in interest rates, and changes in currency exchange rates. Since
these risks are inherent in any business, it is important that they are managed effectively. Generally, com-
panies try to reduce the risk of price variability. The process of reducing risks is known as hedging. Thus,
the major use of derivatives is in hedging. In hedging, the manager tries to fix the following: the price at
which the business will buy or sell a commodity or service, the price at which the business will buy or
sell a financial instrument, the interest rate at which the business will borrow or lend, and the currency
exchange rate at which the business will buy or sell foreign currency.
Derivatives are also used for speculation. Since the price of derivatives is based on the expected
future value of the underlying assets, one can speculate on the value of the underlying assets in the future.
Derivatives can provide a better and cheaper vehicle for speculation as compared to speculating directly
with the underlying assets. For example, assume that gold is selling at INR 1,500 per gram today. If you
believe that gold price is likely increase in the next three days, you can speculate using this information.
One way is to buy the gold today at INR 1,500 per gram and sell the same when the price increases as
expected. If the price increases as expected, say to INR 1,550, you can sell the gold at INR 1,550 and
make a profit of INR 50. However, this strategy requires an investment of INR 1,500 today. Alternatively,
you can enter into a futures contract. As will be shown in Chapter 4, futures will also provide a profit of
INR 50, but the amount of investment will be very low. Most speculators use derivatives to make profits.
It is to be noted that speculation is a risky activity, and if the price does not move as expected, it can result
in losses. In fact, most of the losses associated with derivatives (listed in the beginning of the chapter)
were due to speculations.

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 6   Financial Risk Management

Notes Derivatives are also used for the purpose of arbitrage. An arbitrage opportunity exists when one
can make non-zero profit with no net investment or risk. Since futures contract values are based on
the value of the underlying asset, there should be a relationship between the value of the futures and
the value of the underlying asset. If, at anytime, this relationship is violated, there will be an arbitrage
opportunity. For example, assume that the price of gold in the market is INR 15,000 and the theoreti-
cal value of gold futures is INR 15,500. If the futures are actually priced at INR 15,800, there will be an
arbitrage opportunity. An arbitrager can sell the futures at INR 15,800. If many arbitragers enter the
market like this, the futures price will fall to its theoretical value of INR 15,500, and the arbitrager can
buy the futures back at INR 15,500 and earn a profit of INR 300 with no risk at all. Arbitrage is an
important use of derivatives, and it provides stability to both the futures market and the market for the
underlying assets.
The concept of risk management is discussed in the following sections.

1.8 What is Risk?
All businesses face risks because they operate in a world of uncertainties. The risks that a business faces
can be classified into four major categories:
 Operating or business risk

 Event risk

 Price risk

 Credit risk

Risk makes it very difficult for company managers to forecast future cash flows, which is essential for
making appropriate financial decisions on when to finance new investments, how to finance the invest-
ments, whether to pay dividends, and so on. Therefore, risk management is critical to the ability of a
business to successfully manage its operations.

1.8.1  Operating or Business Risk

Operating or business risk is the risk imposed on a business because of economic cycles and business
cycles, and this risk affects all businesses in an industry. During an economic downturn, most people’s
wealth will decrease, resulting in a lower demand for goods and services provided by most companies.
Conversely, a turnaround in the economy results in increased wealth, an increased demand for goods and
services and, consequently, increased sales and revenue.

1.8.2  Event Risk

Event risk occurs when an unforeseen event arises and affects both the revenue and the cash flow of a
firm. For example, the OPEC cartel’s oil price increase in 1973 precipitated changes in the way most com-
panies operated. Another example is that of the Japanese auto manufacturers who gained a foothold in
the American market with their small cars—a segment that American manufacturers had not explored.

1.8.3 Price Risk
Price risk is a major risk faced by businesses, and it refers to the risk of price changes in inputs and out-
puts that have an impact on a business’ cash flow. Cash flow can be affected by:
 Changes in the prices of commodity inputs and outputs

 Changes in the prices of financial instruments

 Changes in interest rates

 Changes in currency exchange rates

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 Introduction  7

Notes Changes in prices of commodities.  When a business uses tangible goods in its operations, the
changes in the prices of its inputs and outputs will have an impact on cash flows. If input prices change,
the cost of the product changes, resulting in uncertain cash flows. If output prices change, the revenue
changes, resulting in uncertain cash flows. The impact of changes in input and output prices is related to
price volatility—high price volatility results in a large impact, whereas low price volatility results in mini-
mal impact. For example, the price of crude oil showed dramatic behaviour during 2008. From a price
of around USD 70, it increased rapidly to USD 150 within two months, and dropped to USD 40 in about
two months’ time. Similarly, the price of steel is also highly volatile. For a steel manufacturer like Tata
Steel, any increase in steel price would result in increased revenue, whereas any decrease would cause a
decrease in revenue. On the other hand, users of steel, such as a construction company, will find that the
cost of operating the business is lesser when the steel price is lower.

Changes in prices of financial instruments.  Most businesses also make investments in financial
assets. Some businesses such as investment companies invest only in financial assets. When the prices of
financial instruments change, the value of these companies’ investments also changes, and this change
can affect their cash flow. If the prices of financial instruments increase, cash flow will increase, whereas
any price decrease would decrease the cash flow. Consider the case of an insurance company. It collects
insurance premiums periodically and is required to payout the claims whenever they arise. Insurance
companies usually invest the premiums they receive in financial instruments and use the proceeds to pay
for the claims. For insurance companies, changes in the prices of the financial instruments that they have
invested in will be of great concern. This is because if the prices decline significantly, they may not be able
to pay for the claims.

Changes in interest rates.  Interest rate can be considered as being equivalent to the price of
money. When the interest rate changes, both borrowers as well as investors are affected. If the interest
rate increases, a borrower will face a higher interest charge, while an investor will be able to get a higher
return on the investment. Conversely, if the interest rate decreases, a borrower will get a loan at a cheaper
rate, while an investor will get a lower return. Since interest paid or received is part of the total cash flow
of an organization, any change in interest rate will also affect its cash flow.

Changes in currency exchange rates.  Changes in the currency exchange rate affect businesses
that have cash flows denominated in foreign currency. If the local currency appreciates against the foreign
currency, a business with foreign currency inflows will receive less local currency, thereby resulting in a
reduced cash flow. On the other hand, a business with foreign currency outflows will pay less local cur-
rency, thereby resulting in an increased cash flow. Conversely, if the local currency depreciates against
foreign currency, foreign currency outflows will result in lower cash flows and foreign currency inflows
will result in higher cash flows.

Credit risk.  Many businesses provide credit to customers who are considered creditworthy and con-
form to the standards set by the company. However, the credit standing of a customer may change after
the credit is granted, and this may prevent even a very good creditworthy customer from paying the
due amount. This is particularly true for banks that grant credit to a number of customers. The unpre-
dictability of the creditworthiness of customers causes credit risks. Many credit derivatives have been
introduced to reduce credit risks.

1.9  Risk Management

Risks are unavoidable. However, businesses can take steps to ensure that they are fully equipped to man-
age these risks and can consequently plan to have more control over their cash flows. Operating or busi-
ness risks and event risks are not faced by businesses on a regular basis; these arise at various irregular
intervals. The higher management is responsible for anticipating the possible timing of these risks and for
planning to cope with them. In other words, these risks are managed at a strategic level. Credit risks also
do not arise often. Companies can regularly monitor the creditworthiness of the customers and take the
appropriate action when necessary.

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 8   Financial Risk Management

Notes On the other hand, businesses face price risks on a regular basis. It is essential that businesses develop
strategies to manage price risks. In managing price risks, the task for the manager is not to forecast prices,
but to ensure that prices are fixed for buying and selling at a future time without having to worry about
price volatility. This is known as hedging the price risk. Hedging strategies would depend on the expected
direction of movement of prices. The process of hedging using forward contracts, futures contracts, op-
tions contracts, and swap contracts will be explained in later chapters.

1.10  A Brief History of Risk Management

Risk management in commodity prices was one of the earliest forms of risk management. This practice
started in agricultural and livestock industries, where buyers and sellers of agricultural commodities and
livestock engaged in the first futures markets. An example would be a store owner agreeing to purchase
the entire harvest of a farmer at a set price before planting even took place. It is important to note that risk
management is necessary only when there is a chance of price volatility of the underlying commodity.
Risk management in financial instruments did not gain importance until the early 1970s. Interest rates
in most countries were government regulated as instruments of monetary policy to manage the economy.
Further, prior to 1973, exchange rates among currencies were fixed using strict rules that governed the
timing of devaluing or revaluing of the currency by a country. In a world of fixed currency exchange rates
and interest rates, the volatility of interest rates and exchange rates was more or less non-existent; hence,
there was no need for risk management.
In 1973, many currencies changed from a fixed- to a floating-rate regime. Under the floating-rate
regime, currency exchange rates were fixed by market forces rather than by governments, with a conse-
quent increase in the currency exchange rate volatility. When currency exchange rates became volatile,
mechanisms were needed to manage currency risk. The mechanisms that were developed to do this in-
cluded currency options and currency futures.
This change to a floating-rate currency regime also resulted in a change in the way interest rates
were fixed. Since currency exchange rates are related to the interest rates prevailing in each country, the
floating-rate regime prohibited the government from exercising its freedom to fix interest rates, which
also came to be determined by market forces.
By this time, the Eurodollar market had also grown to be an important segment of the financial world.
In the Eurodollar market, floating-rate loans, in which the interest rate on a long-term loan is fixed peri-
odically in short-term intervals, became the norm. Floating-rate loans soon found their way into national
markets as well. Under the floating-rate loan system, it became necessary and important to hedge the risk
of changing interest rates at the next short-term interval. To assist in this hedging activity, new instru-
ments such as forward rate agreements, interest rate futures, and interest rate options were developed.

1.11 Implications for Hedging

Hedging risk is the process by which a financial manager tries to fix a price for a future purchase or sale
of a given asset. This can be accomplished by any of the four following instruments:
 forward contracts

 futures contracts

 options contracts

 swap contracts

When prices are volatile, they can either increase or decrease from their current levels. Consider the
case of a company planning to borrow money three months from today. Because interest rate could
change over time, it is not certain what the interest rate might be when the company seeks to borrow.
The interest rate could rise, in which case it would be making a higher interest payment on the loan as
compared to what it would be making if the borrowing took place today. On the other hand, if the interest
rate goes down, the amount of interest would be lower than what it would be if the borrowing took place

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 Introduction  9

Notes today. If the interest rate moves up, the interest rate is said to move against the interests of the company,
and if the interest rate moves down, it is said to move in the company’s favour. The direction of movement
of interest rate will have implications on hedging activities.

1.12  Upside and Downside Risks

Hedging with futures or forward contracts enables a company to fix the interest rate at which it will bor-
row. For example, assume that the current interest rate is 8% and the interest rate under a futures contract
for borrowing three months later is 9%. In this contract, the company is fixing the future interest rate at
9%, irrespective of what the market interest rate will be after three months. However, market interest rates
can move in any direction. If the market interest rate was to rise to 10% after three months, the decision
to hedge and fix the rate at 9% would be considered fruitful. On the other hand, if the interest rate moved
only to 8.5%, the company would be paying 9% interest on the loan under the futures contract; it would
have had to pay only 8.5% had it not hedged.
This example shows that the company benefits from hedging using futures contracts only if the interest
rate moves against the company. If the interest rate moves in favour of the company, hedging becomes
costly. When the interest rate moves against the company, the firm is said to face a downside risk, and if
the interest rate moves in favour of the company, it is said to face an upside risk.
It is important that a business considers the implications of both upside and downside risks. It is also
important that a business uses hedging instruments when there is a possibility of downside risk, as this
would produce beneficial results. However, if the price moves in favour or if there is a possibility of an
upside risk, then that factor should also be considered in taking a hedging decision. If the competitors of
a business consider the upside risk in their hedging decisions but the business does not, then the competi-
tors will gain an advantage, which could become crucial in the survival of the business.
Futures contracts and forward contracts provide favourable results when a business faces downside
risks, but hedging using forwards and futures could be costly when a business faces an upside risk. On the
other hand, options contracts may provide favourable results when the company faces either a downside
risk or an upside risk. This can be illustrated with an example.
Suppose the same company as in the previous example had entered into an options contract to borrow
at 9% in three months’ time. If the actual interest rate were 10% after three months, when the company
actually borrows, the company would exercise the right and borrow at 9%. If market interest rates were
below 9%, say, 8.5%, the company could choose to not exercise the right and could instead borrow at the
lower market rate of 8.5%.
This example indicates that options provide protection against downside risks, and at the same time
they provide an upside potential. Because of this range of pay-off possibilities, options are assets and they
require an upfront investment in order to buy them. The critical question then is whether the benefits
provided by options are worth their cost.

1.13  Commodity Price Risk

Price risk arises because the price at which a commodity can be bought or sold at a future time is not
known. For example, consider the case of a manufacturer of confectionery products. This company will
need sugar as an ongoing ingredient. However, the price of sugar in the future is uncertain. This uncer-
tainty of the future price of sugar will have a bearing on the pricing of the confectionery produced by the
company as well as on the profits of the company.
Price risk arises because of many reasons. In India, especially when the agricultural commodity output
is dependent on the monsoon, the weather can have an impact on the prices of agricultural inputs. If the
monsoon is good, the output is likely to be good, and this would result in comparatively lower prices, as
opposed to when the monsoon is poor and the output is low. The prices of inputs based on petroleum,
such as chemicals and tyres, will depend on the variability in the price of oil.
Two of the major determinants of price risk are volatility of the movement of prices and liquidity of
the market.

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 10   Financial Risk Management

Notes 1.13.1 Volatility
The two major determinants of price risk are commodity price volatility and commodity market liquidity.
Volatility refers to the average change in the price of a commodity over a specific time interval. If the vola-
tility is low, the average change in price is small and hence the risk of price changes is also small. However,
a high volatility means that the average price change is large and hence the risk of price changes is also
large. When the risk of price changes is small, the company using the commodity will not have to worry
much, because it will not be required to reconsider its pricing decisions and the impact on its profits will
be almost negligible. On the other hand, if the risk of price changes is large, then it is important that the
company takes steps to reduce the risk of price changes, because large changes in the prices of input com-
modities will have a heavy impact on pricing and profitability.

1.13.2 Liquidity
Market liquidity can have an impact on price volatility. Liquidity refers to the ease with which a com-
modity can be sold without causing significant price changes. A commodity is said to have high liquid-
ity if there is active trading in the commodity. When a market has high liquidity, price changes will be
comparatively small, thereby leading to lower volatility. This relationship between liquidity and volatility
is more applicable for financial assets. The volatility of non-financial assets could be affected by factors
other than liquidity.
Volatility changes with the period over which it is estimated. Intra-day volatility refers to the aver-
age price changes over a single day, weekly volatility refers to the average price change over a week, and
monthly volatility refers to the average price change over an interval of a month. The appropriate measure
of volatility to estimate the risk of price change for a company that is trying to manage its price risk de-
pends on the period for which the risk needs to be managed. Non-financial assets typically exhibit lower
short-term and higher long-term volatility, whereas financial assets exhibit higher short-term and lower
long-term volatility.

1.14 Interest Rate Risk

Interest rate risk arises because the future interest rates are not known. Investors, fund managers, and
portfolio managers (for example, mutual fund managers) face risk from interest rate changes, because
they hold fixed-interest rate securities whose value changes when the interest rates change. Corporations
face interest rate risk because they need to obtain funds by issuing fixed-interest securities.
Until the early 1970s, interest rates were highly regulated in all countries. The central bank used to
fix the interest rate on deposits as well as on the loans provided by banks and, therefore, interest rate
risk did not arise during the period of regulation. In 1973, various governments led by the United States
started to deregulate the interest rates and allowed the market to determine the interest rate. The mar-
ket determines the interest rates on the basis of the demand and supply of funds at any given time; this
led to an increase in the uncertainty about the future interest rate. In addition to the market forces, the
governments also influenced the interest rates, because they used interest rate as a tool for developing
the monetary policy. Next, we shall discuss these changes to show why businesses need to hedge their
interest rate risks.

1.14.1 Deregulation and Interest Rate as a Tool for Developing

Monetary Policy
Interest rates can be classified as short-term and long-term rates. Short-term interest rates are those
that are determined in the cash market. The basis of cash markets are settlement accounts that the banks
hold with the central bank. The banks use these accounts to settle balances arising from their clearing
processes and to implement transactions with the central bank.
The central bank controls the cash rates so that it can determine the amount of base money in
the financial system. The central bank does this by buying or selling foreign currency and government

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 Introduction  11

Notes securities. When the central bank buys foreign currency and government securities, it adds cash to the
financial system. When it sells foreign currency and government securities, cash is taken out.
The central bank first decides the interest rate it wants to set based on its monetary policy to combat
inflation and then adjusts the money supply that is consistent with this desired interest rate. This means
allowing variations in the money base, because the demand for cash changes over time. If the central bank
attempted to maintain a constant value for the money base, interest rates would become highly volatile
because of fluctuations in demand.
Cash interest rate is the sole instrument of the central bank’s monetary policy in a deregulated envi-
ronment. Thus, it is used to deal with the most pressing economic problems. If there is high inflation or
current account deficit, a high interest rate can be maintained, whereas the stimulation of a depressed
economy will require easing of the monetary policy or fixing a low interest rate.
This reliance on monetary policy to deal with economic problems has implications for interest
rates. First, this creates a wide cycle in interest rates with huge variations. Second, in order to forecast
interest rates, economic developments and the central bank’s response to the developments have to
be predicted.
Interest rate volatility has increased in many countries because of increased government deregula-
tion and reliance on interest rates as the only flexible tool for developing monetary policy. Deregulation
in these countries has removed the ceiling on interest rates on both deposits and loans by banks and
other financial institutions. Thus, on the basis of their profitability, banks and financial institutions can
determine the interest rates they charge on loans as well as the rates they pay on deposits. Owing to this
deregulation, many financial institutions started to offer floating rate loans and deposits, as opposed to
fixed rate loans and deposits.

1.14.2  Floating Rate Loans

In a floating rate loan, the interest is fixed for a short period, and when that period expires, a new inter-
est rate is fixed for the next period, which could be higher or lower than the one for the previous period.
The interest rate is based on a reference rate, and a premium over this reference rate is also specified. The
reference rate is set such that it takes the reset period into account. The reset period indicates how often
the interest rate is going to be reset. If the interest rate is reset every six months, the reference rate will be
the rate for six months. For example, the loan rate can be expressed as six-month Mumbai interbank of-
fer rate (MIBOR) + 200, where 200 is the premium stated in basis points. A basis point equals 1/100 of a
per cent, i.e., 100 basis points equal one per cent.

  E x am p l e 1 . 8
Consider a floating rate loan taken on January 1, 2008, with the following characteristics:
Principal amount INR 1 million
Interest reset period Every six months
Maturity of loan 3 years
Base rate 6-month MIBOR
Premium over base rate 200 basis points or 2%
Assume that the actual rates on January 1, 2008; July 1, 2008; and January 1, 2009, are:
6-month MIBOR as of January 1, 2008   5%
6-month MIBOR as of July 1, 2008 5.4%
6-month MIBOR as of January 1, 2009 4.8%
(i)  What will be the interest rate starting January 1, 2008; July 1, 2008; and January 1, 2009?
The interest rate for any period is calculated as:
Interest rate for period starting on date t = 6-month MIBOR on date t + Premium
Since the 6-month MIBOR on January 1, 2008, is 5% and the premium over MIBOR is 200 basis
points or 2%, the interest rate for six months starting January 1, 2008 = 5.0% + 2% = 7.0%.

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 12   Financial Risk Management

Notes In a similar manner, the interest rate starting on July 1, 2008, and January 1, 2009, can be calculated as:
Interest rate for six months starting July 1, 2008 = 6-month MIBOR on July 1, 2008 + Premium
= 5.4% + 2% = 7.4%
Interest rate for six months starting January 1, 2009 = 6-month MIBOR on January 1, 2009 + Premium
= 4.8% + 2% = 6.8%
(ii)  What will be the amount of interest payments on June 30, 2008; December 31, 2008; and June 30, 2009?
The interest due on June 30 can be calculated as follows:
Since the interest rates are specified on an annual basis and the period for which interest amount is
calculated is over six months, the appropriate rate over the six-month period will be equal to half the
annual interest rate. The amount of interest is obtained by multiplying this rate with the principal
amount. Thus,
Interest rate for six months starting January 1, 2008 
Amount of interest = Principal amount  
 2
7%
= 1,000,000 × = INR 35,000
2
In a similar manner, the interest due on December 31, 2008 and June 30, 2009 can be calculated as:
7.4%
Interest due on December 31, 2008 = 1,000,000 × = INR 37,000
2
6.8%
Interest due on June 30, 2009 = 1,000,000 × = INR 34,000
2
The main problem with a floating rate loan is that the future interest rates are not known, and if the
interest rates rise, debt service payments can be quite high, thereby leading to high funding costs
for the company.

1.14.3 Interest Rates and Inflation

It is believed that inflation is a major determinant of nominal interest rates, i.e., the actual monetary return
earned by a lender or the monetary cost paid by a borrower. In a deregulated economy, monetary authori-
ties rely on variations in interest rates as the main tool for influencing economic conditions, and they usual-
ly react to an increase in inflation rates by tightening the monetary policy or by increasing the interest rates.
The relationship between inflation and interest rates was given by Irving Fisher, and it is termed the
“Fisher effect”. The idea behind the Fisher effect is that any investor will demand an increase in his or
her purchasing power whenever money is lent. According to the Fisher effect, the nominal interest rate,
which is the interest rate quoted on financial securities, is given by the following relation:
1 + Real interest rate
Nominal interest rate = −1
1 + Expected inflation rate
where the real interest rate is the increase in purchasing power required by investors. This relationship is
approximated as:
Nominal interest rate = Real interest rate + Expected inflation rate

  E x am p l e 1 . 9
Assume that an investor provides funds of INR 100,000 at a nominal rate of 10% for one year. If the in-
flation during the year is 6%, the increase in the purchasing power of the investor can be calculated as:
Amount received after one year = 100,000 × 1.1 = INR 110,000
INR 110, 000
Purchasing power of INR 110,000 in today’s currency value = = INR 103,773.60
1.06
Thus, the actual increase in purchasing power from this investment = 3.7736%.

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 Introduction  13

Notes This increase in purchasing power is termed as the real interest rate, and the Fisher effect relates the real
interest rate and the nominal interest rate as:
1+ Nominal rate
Real interest rate = −1
1+ Expected inflation rate

The Fisher effect is usually expressed as an approximate form as:

Real interest rate = Nominal interest rate – Expected inflation rate
In financial markets, the real interest rate is determined on the basis of supply and demand; the nominal
rate is then calculated from this real rate as:
Nominal interest rate = Real interest rate + Expected inflation rate
Note that the interest and inflation rates are for the investment period—they are not the current real rate
or inflation rate. This means that interest rates at any time depend on the expected inflation rate in the
future.

1.14.4  Components of Interest Rate Risk

Investors, fund managers, portfolio managers, and financial institutions face risk from interest rate move-
ment, because they hold fixed-interest securities as part of their investment. The value of fixed-interest
securities such as bonds and debentures changes with the interest rate. When the interest rate increases,
the prices of bonds and debentures decreases; this results in a lower portfolio value. However, when the
interest rates decrease, the prices of bonds and debentures increase, and this results in a higher portfolio
value. This aspect of interest rate risk is known as the price risk component.
Another aspect of the interest rate risk is known as the reinvestment rate risk. Regular coupon inter-
est payments received from the bond issuer must be reinvested when received. The actual return from
bond investment depends on the rates achieved on the reinvestment of these coupon interest payments.
If interest rates increase, the value of the bond portfolio decreases, but the reinvestment of coupon inter-
est payments can be made at a higher rate. If interest rates decrease, the value of the bond portfolio will
increase, but the reinvestment of the coupon interest payments will have to be made at a lower rate. It
must be noted that price risk and reinvestment rate risk move in opposite directions. Thus, the portfolio
manager cannot be certain of the portfolio value, as the future interest rates are not known.
Financial institutions also face interest rate risks because of a mismatch in the timing of cash in-
flows and outflows. Consider, for example, an insurance company. This company receives premiums and
invests them in fixed-interest instruments. These companies’ outflows increase when claims are made.
Since claims cannot be predicted, it is difficult to exactly match the inflows and outflows, and the net
interest income is subject to interest rate movements.
It will be shown in later chapters that these risks can be minimized by the use of forward contracts,
futures contracts, and swaps.

1.15  Currency Risk

A business faces currency risk or foreign exchange exposure when its economic value depends on the
exchange rate. The economic value of a business is defined as the present value of all future net cash flows.
Therefore, a company is subject to foreign exchange exposure when the value of current and future cash
flows depends on the exchange rate.
A company will face foreign exchange exposure under the following circumstances:
1. The company engages in importing goods from a foreign country. If the foreign supplier sends
the invoice in foreign currency, the importer is exposed to risk since the currency value will change
over time.
2. The company exports goods to a foreign country and sends the invoice in foreign currency. In this
case, the amount of the local currency depends on the value of the foreign currency, which will
change.

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 14   Financial Risk Management

Notes 3. The company does not import or export, but its competitors are foreign entities. In this case, if the
foreign currency depreciates, the competitors gain a competitive advantage. They can reduce the
prices of their goods and receive the same revenue.

  E x am p l e 1 . 1 0
A shoe manufacturer in the United States is selling shoes in India. The shoe costs USD 10. The shoe’s
selling price in India is INR 900. The current exchange rate is 1 USD = INR 40.00.
Profit for the manufacturer by selling one shoe = INR 900 – INR 400 = INR 500 = USD 12.50
Assume that the U.S. dollar depreciates to INR 38.
Profit for the manufacturer by selling one shoe at INR 900 = INR 900 – INR 380 = INR 520 = USD 13.68
When the U.S. dollar depreciates, the manufacturer gets a higher profit if it maintains the same price.
Alternatively, the company could reduce its price to maintain the same profit of USD 12.50.
Profit of USD 12.50 means a profit of INR 12.50 × 38 = INR 475
Cost of shoe = USD 10 = INR 380
Price at which profit remains the same = 380 + 475 = INR 855
Thus, the manufacturer could reduce the price of the shoe from INR 900 to INR 855 and still maintain
the same profit in U.S. dollars.

In Example 1.10, the manufacturer enjoys a competitive advantage. The Indian companies compet-
ing with this manufacturer will face stiffer competition, because the manufacturer is able to reduce its
prices even if its costs do not change, mainly because of the U.S. dollar depreciation. Meanwhile, Indian
companies would lose their profit if they were forced to reduce prices in following their competitor’s
example.
Currency risk has become more predominant since 1973, when most major currencies moved from
the fixed to floating exchange rate regimes. Most countries allow free floating of their currencies, whereby
the value of the currency is determined in the market on the basis of supply and demand. However,
governments do intervene in the market if they believe that the value of the currency has risen or fallen
excessively. Therefore, currency rate forecasting has to take into account possible government actions,
which makes forecasting very difficult. The firms that face currency exposure thus need to take the ap-
propriate action in order to manage this risk.
Currency exposure can be classified into three types—translation exposure, transaction exposure, and
operating exposure.
Translation exposure arises when a company has operations subsidiaries in many countries. In such
a situation, the company will have to consolidate its accounts. Consolidation requires that the assets and
liabilities of the subsidiaries located in various countries and their denominations in various currencies
be translated into a single currency. This translation can result in gains or losses, depending upon the
changes in exchange rate over time. Since translation exposure relates to financial account transactions,
this exposure needs very little management.
Transaction exposure relates to the risk that a company faces for transactions it has already entered
into. Since the transactions have already begun, the amount and timing of exposure will be clearly
known. Examples of transaction exposure include payment of imports, receipts of exports, receipt
of interest on amount invested, or payment of interest on borrowed amount. Since both the timing
and amount of exposure are known, this type of exposure can be more easily managed using derivative
instruments.
Operating exposure relates to the exposure that a company faces when its future cash flows are
affected by changes in exchange rates. This cash flow change occurs because the exchange rate
changes alter the competitive position of the company in both the domestic and foreign markets. This
is the most difficult exposure to manage, and its management requires changes in the company’s
strategic plans.

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 Introduction  15

Notes 1.16  Approaches to Risk Management

Two approaches can be used to manage risk:
Do nothing: This means the company will ignore all the risks. This is appropriate if the exposure is very
 
small or if the cost of managing the risk exceeds the benefits that might be reaped from doing so.
Cover
  everything: This means that the company will take a position in a derivative instrument
to manage every exposure. This approach allows the company to manage all the risks that can be
identified and sufficiently quantified.
The first alternative is passive, whereas the second alternative is active risk management. In active risk
management, the business leaves exposures uncovered when prices or rates appear to be moving in its
favour and covers them when the movement in prices or rates could lead to losses. This process is also
known as selective hedging.
The merits of each of these alternatives will have to be weighed against the costs in order to achieve the
best possible solution at that moment.
The success of active management relies on the ability of the business to make reasonably accurate
forecasts on future movements in prices, interest rates, or exchange rates.
In managing risks, businesses use financial instruments such as derivatives to modify the uncertainty
of future cash flows. If financial instruments are used to decrease the uncertainty of future cash flows, the
companies are said to hedge. If the instruments are used to increase the uncertainty of the future cash
flows, they are said to speculate. It should be noted that a decision to not use instruments to cover an exist-
ing exposure is also a form of speculation.
Using derivatives to hedge business risks is in itself a risky proposition. If one enters into speculative
activity using derivatives, the speculator also faces risks. The risks that are faced by hedgers and specula-
tors are discussed next.

1.17  Risks in Derivatives Trading

Earlier, a number of examples of the collapse of companies such as the Barings Bank and Lehmann
Brothers and the bankruptcy of organizations such as Orange County, AIG, and LTCM due to their trad-
ing in derivatives were cited. But where does the risk come from while trading in derivatives?
When a hedger uses derivatives to hedge, they are trying to reduce the risk of the prices going against
them. In forward contracts, futures contracts, and swap contracts, the price at which the future exchange
will take place is fixed. If the price moves against the hedger, they will benefit from these contracts. On the
other hand, if the prices move in favour of the hedger, they will face a loss. Depending upon the volume
of transaction, the losses could be large.
Speculators use derivatives on the basis of their expectations of the future price movement. In case
they are correct in their assessments, they make profits. On the other hand, if the assessments turn out to
be wrong, they face losses while using forward contracts, futures contracts, or swap contracts.
Option contracts can also result in losses, even though the amount could be comparatively less when
compared to forward contracts, futures contracts, or swaps. This is particularly true when speculators
combine options to make money on the basis of their expectations of future prices. If the price does not
move as expected, options can also result in huge losses.
Recent developments in derivatives that include complex products such as exotic derivatives and cred-
it derivatives can also result in huge losses. These losses arise because payment patterns are not very clear
in these derivatives. Most of these derivatives would result in payments when a particular event occurs. It
is very difficult to calculate the probability of such an event occurring or the amount that is to be paid if
that event occurs. Because of these factors, even sophisticated investors find it very difficult to assess the
risks of these exotic derivatives.
In using derivatives, therefore, it is important that one clearly understands the risks involved while
trading a particular derivative. If one cannot understand the conditions under which payment would
have to be made or the amount that would have to be paid, it would be better not to enter into such
derivative contracts. The popular adage “Buyers Beware” also applies to derivatives.

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 16 Financial Risk Management

CHApTER SUMMARY
 Derivative securities are used for risk management. of capital. Changes in currency exchange rates will have an
A derivative security is one whose value depends on the
 impact on cash flows denominated in foreign currencies.
underlying asset on which the derivative contract is written. It is important to identify the risks faced by a company and

In a forward contract, one party agrees to buy the underlying
 manage these risks so that there is minimum impact on the
security and the other party agrees to sell the same at a future future cash flows.
time at a price that is agreed upon at the time of entering Hedging means reducing the impact of the risks on future

into the contract. These are private contracts in the over-the- cash flows.
counter market. Upside risk means that the price moves in favour of the

In a futures contract, one party agrees to buy the underlying
 company so that future cash flows will increase, and downside
security and the other party agrees to sell the same at a future risk means that the price moves against the company so that
time at a price that is agreed upon at the time of entering into future cash flows will decrease. Although it is important
the contract. These are traded in exchanges. that downside risk should be hedged, it is also necessary to
An options contract gives the holder the right to buy or sell the
 consider the upside risk while hedging the downside risk.
underlying asset on or before the maturity date of the contract. The extent of price risk depends on price volatility and the

These contracts could be either traded in exchanges or in the liquidity of the commodity and instruments in the market.
over-the-counter market. Interest rate risk arises because future interest rates are not

Swaps are contracts where two parties agree to exchange future
 known at the current time.
cash flows according to an agreed-upon formula. These are Interest rates are determined on the basis of the supply and

usually over-the-counter contracts. demand for funds in the market and monetary policy actions.
Risk means that the future is uncertain and hence the cash
 Interest rates are related to future inflation, and the relationship

flows that will be generated in the future are also uncertain. between the interest rate and inflation is written as:
Businesses face risk in three aspects, namely, business risk,
 Nominal interest rate = Real interest rate + Expected inflation
n rate
event risk, and price risk. Business risk, also known as
operating risk, is imposed on businesses as a result of economic Interest rate risk affects in two ways: the price at which the

and business cycles, and it affects all businesses in the industry. financial instrument can be sold in the market, known as
Event risk occurs when an unforeseen event arises, affecting price risk, and the rate at which any interim cash flows from
both the revenue and the cash flow of a firm. Price risk refers the financial investment can be reinvested, known as the
to the risk of price changes in the inputs and outputs of a reinvestment rate risk.
company that will have an impact on its future cash flows. Currency risk affects a company when the value of the current

Changes in the prices of inputs and outputs affect the future
 and future cash flows depends on the exchange rate.
cash flows of a company. Changes in the prices of financial A company can manage risk in three ways: (i) do nothing

instruments mainly affect investment companies, as their cash and face the risk completely; (ii) cover everything or hedge
flow depends on the value of the financial instruments held each and every risk; (iii) cover partially, that is, hedge only a
by them. Changes in interest rates will affect a company’s cost part of the cash flow.

MUlTiplE-CHOiCE QUESTiONS
1. A one-year forward contract is an agreement where D. One side has the obligation to buy an asset for the market
A. One side has the right to buy an asset for a certain price in price in one year’s time.
one year’s time.
2. Which of the following is approximately true when size is
B. One side has the obligation to buy an asset for a certain
measured in terms of the underlying principal amounts or
price in one year’s time.
value of the underlying assets
C. One side has the obligation to buy an asset for a certain
A. The exchange-traded market is twice as big as the over-
price at some time during the next year.
the-counter market.

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 Introduction 17

B. The over-the-counter market is twice as big as the 6. Which of the following best describes a central counterparty
exchange-traded market. A. It is a trader that works for an exchange
C. The exchange-traded market is ten times as big as the B. It stands between two parties in the over-the-counter
over-the-counter market. market
D. The over-the-counter market is ten times as big as the C. It is a trader that works for a bank
exchange-traded market. D. It helps facilitate futures trades
3. Which of the following best describes the term “spot price” 7. Forward contracts are generally _________ in nature.
A. The price for immediate delivery A. OTC
B. The price for delivery at a future time B. Exchange traded
C. The price of an asset that has been damaged C. Both the above
D. The price of renting an asset D. None of the above
4. An investor sells a futures contract an asset when the futures 8. Futures contracts are preferred to forward contracts because
price is $1,500. Each contract is on 100 units of the asset. The of_______
contract is closed out when the futures price is $1,540. Which A. High liquidity
of the following is true B. High counterparty risk
A. The investor has made a gain of $4,000 C. Low liquidity
B. The investor has made a loss of $4,000 D. All of the above
C. The investor has made a gain of $2,000
9. An equity index comprises of ______.
D. The investor has made a loss of $2,000
A. basket of stocks
5. A company knows it will have to pay a certain amount of a B. basket of bonds and stocks
foreign currency to one of its suppliers in the future. Which of C. basket of tradeable debentures
the following is true D. None of the above
A. A forward contract can be used to lock in the exchange
10. Changes in interest rates is an example of:
rate
A. Business Risk
B. A forward contract will always give a better outcome than
B. Event Risk
an option
C. Price Risk
C. An option will always give a better outcome than a for-
D. None of the above
ward contract
D. An option can be used to lock in the exchange rate

Answer
1. B 2. D 3. A 4. B 5. A 6. B 7. A 8. A 9. A 10. C

REViEW QUESTiONS
1. Differentiate between a forward contract and a futures contract. 9. Discuss the impact of exchange rate risk on the value of a
2. Differentiate between a futures contract and an options con- firm.
tract. 10. What is meant by hedging? How does hedging improve the
3. Why does an options contract have an intrinsic value? effectiveness of the operations of a business?
4. Why is it that only price risk can be hedged, and not operating 11. How does inflation affect interest rates?
risk or event risk? 12. How can monetary policy and fiscal policy affect interest
5. What is meant by credit risk? How can it be reduced? rates?
6. Why does price risk exist? 13. What factors determine the need to hedge?
7. Why does commodity price risk need to be hedged by a firm? 14. What is the difference between real interest rate and nominal
8. How does interest rate risk affect a firm? interest rate?

M01 Financial Risk Management 01 XXXX.indd 17 6/27/2018 10:50:15 AM

 18 Financial Risk Management

SElF-ASSESMENT TEST
1. Mahindra and Mahindra decide to take a floating rate loan in (ii) A floating-rate loan with the base rate of 6-month
the Euro market on April 1, 2009, with the following charac- MIBOR, with a reset period every six months. The
teristics: rate on the loan will be 6-month MIBOR + 180 basis
points, and interest will be payable at the end of every six
Principal amount USD 10 million
months. MIBOR on January 1, 2009, at the time of taking
Interest reset period Every three months
the loan is 6%.
Maturity of loan Five years
Sheela is not sure which of these loans she should opt
Base rate 3-month USD LIBOR
for. She has contacted some analysts to get some idea
Premium over base rate 250 basis points
about where MIBOR rates could be in the next two years,
Assume that the actual rates on April 1, 2009; July 1, 2009; and the analysts estimates are: 6-month MIBOR on July 1,
October 1, 2009; and January 1, 2010, are: 2009 is 6.8%; on January 1, 2010, is 7.3%; and on July 1,
2010, is 7.1%.
3-month LIBOR as of April 1, 2009 6.3%
3-month LIBOR as of July 1, 2009 5.6% (a) Calculate the effective interest rates on January 1,
3-month LIBOR as of October 1, 2009 5.9% 2009; July 1, 2009; January 1, 2010; and July 1, 2010,
3-month LIBOR as of January 1, 2010 6.6% under the floating rate loan.
(i) What will be the effective interest rate for Mahindra and (b) Calculate the interest amount on June 30, 2009;
Mahindra starting April 1, 2009; July 1, 2009; October 1, December 31, 2009; June 30, 2010; and December
2009; and January 1, 2010? 31, 2010, under both fixed rate loan and floating
(ii) What will be the amount of interest payments on June rate loan.
30, 2009; September 30, 2009; December 31, 2009; and (c) On the basis of the interests calculated, determine
March 31, 2010? which alternative should be chosen. What other
factors need to be considered in deciding on which
2. Sheela, the finance manager of Gemini enterprises requires loan should be opted for?
INR 5,000,000 for expansion over a period of two years. She
approaches the bank for a loan to finance this expansion 3. The expected inflation for the next year is 4.6% and, currently,
project on January 1, 2009. The bank offers her two choices: the yield of treasury bills with a maturity of one year is 9%.
What is the real interest rate in the economy?
(i) A loan with a fixed rate of 9% for the next two years, with
interest payable every six months.

CASE STUDY

Jet Airways, which commenced operations on May 5, 1993, has baggage handling costs. The remuneration of pilots and airline
established its position as a market leader in India. The airline personnel will have to be competitive since there is a huge demand
has been repeatedly adjudged India’s best domestic airline by for these personnel because of the presence of a number of new
Abacus-TAFI and has won several national and international airlines that operate throughout the world.
awards. The revenue for airlines comes mainly from passenger fares
Jet Airways operates a fleet of 85 aircraft, which includes and cargo fares. The passengers of Jet Airways come from various
10 Boeing 777-300 ER aircraft, 10 Airbus A330-200 aircraft, 54 countries and pay their fares in the currency of their own country.
classic and next-generation Boeing 737-400/700/800/900 aircraft, Jet Airways finances the purchase of its airplanes by borrow-
and 11 modern ATR 72-500 turboprop aircraft. With an average ing money either in India or in other countries through bond
fleet age of 4.45 years, the airline has one of the youngest aircraft issue. The interest payments will have to be paid in the currency
fleets in the world. in which the bond is issued. Future plans for Jet Airways include
Jet Airways operates to 63 destinations, both within and out- purchase of additional planes, which will also be financed through
side India. International routes include New York, San Francisco, borrowing.
Toronto, Brussels, London (Heathrow), Hong Kong, Singapore,
Shanghai, Kuala Lumpur, Colombo, Bangkok, Kathmandu, Dhaka,
Discussion Questions
Kuwait, Bahrain, Muscat, Doha, Abu Dhabi, and Dubai.
Its major cost is the cost of aviation fuel. In addition to fuel 1. What are the various risks that Jet Airways is facing?
costs, the other costs include landing costs at various airports and 2. How can these risks be reduced using derivative securities?

M01 Financial Risk Management 01 XXXX.indd 18 6/27/2018 10:50:15 AM

 2
The Derivatives
Market in India

LEARNING OBJECTIVES

After completing this chapter, you Derivatives trading in India has increased tremendously since 2000
will be able to answer the following when Indian stock exchanges were allowed to trade derivatives.
questions: Based on the volume of trading, Indian exchanges rank first in the
 Which of the exchanges world with 32 per cent of all trades in single stock futures. It is of
in India trade in derivative interest to note that trading in currency futures in India accounted for
products? 49 per cent of trades in the world in 2009 even though they were
introduced only in August 2008.
 What are the various types
of orders used in derivatives
exchanges?
What is the trading

mechanism in derivatives BOX 2.1 Derivatives Trading in India
exchanges?
What is an OTC derivatives

market? How are derivatives
traded on it?
What contracts are available

in Indian exchanges?

In Chapter 1, we saw that the notional value of all derivatives was USD 644,686 billion at the end of
December 2008. In this chapter, we will discuss the major international derivatives markets, the develop-
ment of derivatives market in India, the various exchanges in which derivatives are traded in India, and
the basic trading procedure.
Internationally, derivatives have been traded as private contracts between two parties for a long time.
Most of these contracts were forward contracts in agricultural commodities and livestock. Since these
were private contracts, they were called over-the-counter (OTC) market contracts. When it became
difficult to find parties with matching needs to enter into contracts, the system of brokerage emerged
and brokers became the middlemen who brought together parties interested in hedging the price risk.
When a broker was unable to find a counterparty, the broker started trading with the other party and
became the dealer. This market was called the OTC market. OTC markets were developed all over the

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 20   Financial Risk Management

Notes world, and most of the contracts traded on these markets were commodity contracts, owing to their high
price volatility. However, the OTC market had a major problem—counterparty risk, which is the risk
that one of the parties in the contract would not honour the commitments made. Furthermore, OTC
market transactions were between two parties and, hence, the details of these contracts were not known
to anyone other than the parties entering into the contract. Thus, OTC markets lacked transparency. In
addition, it was not possible to bring in any regulations to govern this market, as this market was a loose
connection between brokers and dealers. As time progressed, the dealers formed their own associations
and promoted self-regulation. However, these regulations could not be enforced. Hence, in order to solve
these issues, derivatives exchanges were created.

2.1  The International Derivatives Market

The first organized derivatives exchange was the Dojima Rice Exchange in Japan, created in 1710. The
contracts were mainly forward contracts, and the exchange functioned as a place where parties could
meet and enter into forward contracts.
In 1848, the Chicago Board of Trade (CBOT) was started, and it introduced forward contracts on corn
on March 13, 1851. The CBOT introduced standardized futures contracts on live cattle and agricultural
commodities. The Chicago Produce Exchange was created in 1874, and it was renamed the Chicago
Butter and Egg Board in 1898. It was reorganized as the Chicago Mercantile Exchange (CME) in 1919.
The Minneapolis Grains Exchange (MGEX) was created in 1881, and futures trading started in 1883.
Currently, it is the only exchange in the world to trade red spring wheat options and futures.
Financial derivatives came into existence in 1972, when the fixed exchange rate system was abol-
ished as a consequence of the deregulation of interest rates. In 1972, the International Money Market
(IMM) was created under the CME to start trading futures on currencies. The Chicago Board of Options
Exchange (CBOE) was started in 1973 to trade options on equity and equity indexes.
Derivatives exchanges also stared functioning in other countries to provide for hedging and specula-
tion. In 2006, the New York Stock Exchange, in collaboration with the Amsterdam, Brussels, Lisbon, and
Paris exchanges, created Eurex—an electronic transcontinental futures and options exchange.
In line with the introduction of new instruments in exchanges, the OTC market also started introdu-
cing new instruments. The currency swap between the World Bank and IBM in 1981 became successful,
and other types of swaps such as interest rate swap, equity swap, and commodity swap became common
in the OTC market.
The introduction of mortgage-backed securities by the Federal National Mortgage Association
(FNMA; commonly known as Fannie Mae) and the Government National Mortgage Association
(GNMA; commonly known as Ginnie Mae) started the concept of credit derivatives through which credit
risk could be transferred from one party to another. In the 1990s, credit derivatives became a very impor-
tant part of credit risk management, with the introduction of credit default swaps and total return swaps.
With the growth of hedge funds that made money through the use of derivatives, the total trading in
derivatives increased in the last 10 to 15 years. Currently, derivative products are available in the following:
Commodities:
  Options and futures on agricultural commodities, cattle, metals, energy products
such as oil and electricity traded on exchanges. forward contracts and swaps traded on OTC markets
Equity: Options and futures on single stocks as well as on stock indexes traded on exchanges; equity
 
swaps traded on OTC markets
Interest
  rate: Options, forwards, and futures on short-term and long-term interest rates traded on
exchanges and OTC markets; interest rate swaps traded on OTC markets
Currency: Options, forwards, and futures on currencies traded on exchanges and OTC markets; cur-
 
rency swaps traded on OTC markets
 Credit: Credit derivatives, which are generally OTC market instruments

Table 2.1 shows some details of derivative trading in the international derivatives exchanges in 2009.
It shows that options are more popular for managing equity risk, whereas futures are mostly used to
hedge interest rate risk. In hedging currency risk and commodity price risk, futures are more often used
when compared to options.

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 The Derivatives Market in India   21

Notes Table 2.1  Derivatives Trading in 2009

Instrument Number of Contracts

Single stock options 3,374,346,574

Single stock futures 500,818,495

Stock index options 3,868,878,556

Stock index futures 1,927,787,061

Short-term interest rate options 397,363,680

Short-term interest rate futures 1,005,923,331

Long-term interest rate options 77,614,702

Long-term interest rate futures 895,538,596

Currency options 37,293,662

Currency futures 919,422,628

Commodity options 92,592,625

Commodity futures 2,429,729,242

Source: www.world-exchanges.org

2.2  Derivatives in India

In India, derivatives are traded on organized exchanges as well as on OTC markets. Derivatives trading
in organized exchanges in India commenced only in the 21st century. Derivatives in financial securities
were introduced in the National Stock Exchange of India (NSE) and the Bombay Stock Exchange (BSE)
in 2000, and commodity derivatives were introduced in the year 2003 with the establishment of the
Multi Commodity Exchange of India (MCX), the National Multi Commodity Exchange (NMCE), and
the National Commodity & Derivatives Exchange Limited (NCDEX). However, the growth in derivatives
trading has been phenomenal, and Indian exchanges have excelled on a global level. In 2009, the NSE
had the largest volume of trading in single-stock futures and stock index futures among all the exchanges
in the world.
Derivatives have been used in India for a long time. The Bombay Cotton Trade Association started
trading commodity futures in 1875, and in the early 20th century, India had one of the largest futures
market in the world. However, the government banned cash settlement and options trading in 1952, as
a result of which, an informal market to trade forward contracts emerged. This ban on futures trading
in many commodities was lifted in early 2000, and the national electronic commodity exchanges were
created around that time.
In the equity market, a system known as badla, which is a form of forward trading, has been in exist-
ence for a long time. However, this system failed a number of times, and it was placed under a ban and
then again allowed until 2001, when it was banned by the Securities and Exchange Board of India (SEBI).
In 1990, the Indian economy was liberalized and the stock market was reformed. This paved the way
for a derivatives market. In 1993, the government started the NSE in collaboration with state financial
institutions. Through a fully automated screen-based trading system and real-time price dissemination,
the NSE was able to provide efficiency and transparency in the stock market. In 1995, the ban on trading
options was removed. In 1996, the SEBI set up the L. C. Gupta Committee, based on a proposal by the
NSE to start listing exchange-traded derivatives. This committee recommended that derivatives trad-
ing be allowed in a phased manner, with the exchanges regulating the processes and the SEBI taking up
the supervisory role. The J. R. Verma Committee worked out the various operational details such as the
margining system. The Securities Contracts (Regulation) Act of 1956 was amended in 1999 in order to
declare derivatives contracts as “securities” and enable them to be traded on stock exchanges. The ban on
forward trading was also lifted in 1999.

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 22   Financial Risk Management

Notes The first derivative product offered and traded on the BSE and NSE was index futures, which was
introduced in June 2000. This was followed by index options in June 2001. Options and futures on indi-
vidual securities were introduced in July 2001 and November 2001, respectively. All these contracts are
cash settled and do not involve physical delivery of the underlying assets.
The NSE launched short-term and long-term interest rate futures in June 2003. These futures, valued
on the basis of the concept of zero-coupon yield curve, were cash-settled. However, the trading activity in
interest rate futures was very thin. The major reason for this low volume of trading in interest rate futures
is the existence of well-developed OTC markets for interest rate swaps and forward rate agreements. The
NSE had suspended the interest rate futures contracts in 2006, and new interest rate futures were intro-
duced in 2009. The new futures are long-term interest rate futures on 10-year government bonds, and
they are settled through the delivery of these bonds. Although there was sufficient interest in these futures
when they were introduced, the volume of trading so far has not been considerable.
Currency futures contracts were introduced in the BSE and NSE in August 2008 and in the Multi-
Commodity Exchange in October 2008. The only available contract at that time was the U.S.-dollar-to-
rupee contract. In 2010, futures were also introduced on the Japanese yen, British pound, and euro.
Apart from these exchange-traded derivatives, a number of derivatives are traded on OTC markets.
The Reserve Bank of India (RBI) allowed the trading of interest rate swaps, currency swaps, and forward
rate agreements on July 7, 1999. Originally, these were allowed only for resident Indians, but their scope
has later been widened to include non-resident Indians and non-resident financial institutions.
Since 2003, the RBI has been looking into the introduction of credit derivatives, and on May 17, 2007,
it allowed banks to enter into single-entity credit default swaps.
Since the introduction of derivatives, trading in derivatives has been increasing every year at a phe-
nomenal rate. Table 2.2 shows the growth in the derivatives business on the NSE from the year 2000–2001
to 2009–2010. It can be seen that the total turnover in the derivatives segment of the NSE increased from
INR 23,650 million in 2000–2001 to INR 176,636,645.7 million in 2009–2010. This translates into an
average daily turnover of INR 110 million in 2000–2001 and INR 723,920 million in 2009–2010.
The foreign exchange derivatives market has also grown. The total foreign exchange derivatives con-
tracts outstanding in the balance sheets of all banks authorized to deal in foreign exchange and foreign
exchange derivatives by the end of August 2007 amounted to USD 1,100 billion (INR 44,000,000 million).
The interbank rupee swap market turnover averaged around USD 4 billion per day (INR 16,000 million)
in notional terms. The outstanding rupee swap contracts in banks’ balance sheets as on August 31, 2007,
was USD 1,600 billion in notional terms. The notional amount of the outstanding cross-country interest
rate swaps in the banks’ books amounted to USD 57 billion (INR 224,000 million).1

2.3  Operations of Derivatives Exchanges

There are three major operations in any derivatives exchange, namely, trading, clearing, and settlement.
For an exchange to function smoothly, an efficient trading system should be developed so that traders in
futures can get into any position in derivatives with ease. The exchange should also provide for a mecha-
nism that will ensure that the traders will fulfil their obligations when necessary and the amount of cash
and goods to be paid and delivered is calculated correctly and delivered to the traders on time. In the next
section, we will discuss the trading system as well as the clearing and settlement system in the NSE. All
the other exchanges have similar systems in place.

2.4  The Trading System

All exchanges use fully automated screen-based trading strategies. They also use a modern, fully comput-
erized trading system for the safety and convenience of investors across the country. All the systems are
based on the principle of an order-driven market.

1 Bank for International Settlements, Triennial Central Bank Survey of Foreign Exchange and Derivatives Market
Activity—2007, Final Results, available online at http://www.bis.org, accessed 10 May 2018 at 1pm IST.

M02 Financial Risk Management 01 XXXX.indd 22 6/28/2018 4:19:10 PM

 Notes

M02 Financial Risk Management 01 XXXX.indd 23

Table 2.2  Business Growth in the Derivatives Segment at NSE

Index Futures Stock Futures Index Options Stock Options Total Average
Daily
Year Notional Notional Turnover
Number of Turnover Number of Turnover Number of Number of Number of Turnover (crore
Turnover Turnover
Contracts (crore INR) Contracts (crore INR) Contracts Contracts Contracts (crore INR) INR)
(crore INR) (crore INR)

2009–10 178,306,889 3,934,388.67 145,591,240 5,195,246.64 341,379,523 8,027,964.20 14,016,270 506,065.18 679,293,922 17,663,664.57 72,392.07

2008–09 210,428,103 3,570,111.40 221,577,980 3,479,642.12 212,088,444 3,731,501.84 13,295,970 229,226.81 657,390,497 11,010,482.20 45,310.63

2007–08 156,598,579 3,820,667.27 203,587,952 7,548,563.23 55,366,038 1,362,110.88 9,460,631 359,136.55 425,013,200 13,090,477.75 52,153.30

2006–07 81,487,424 2,539,574 104,955,401 3,830,967 25,157,438 791,906 5,283,310 193,795 216,883,573 7,356,242 29,543

2005–06 58,537,886 1,513,755 80,905,493 2,791,697 12,935,116 338,469 5,240,776 180,253 157,619,271 4,824,174 19,220

2004–05 21,635,449 772,147 47,043,066 1,484,056 3,293,558 121,943 5,045,112 168,836 77,017,185 2,546,982 10,107

2003–04 17,191,668 554,446 32,368,842 1,305,939 1,732,414 52,816 5,583,071 217,207 56,886,776 2,130,610 8,388

2002–03 2,126,763 43,952 10,676,843 286,533 442,241 9,246 3,523,062 100,131 16,768,909 439,862 1,752

2001–02 1,025,588 21,483 1,957,856 51,515 175,900 3,765 1,037,529 25,163 4,196,873 101,926 410

2000–01 90,580 2,365 - - - - - - 90,580 2,365 11

Source: Historical Data, National Stock Exchange 2010

6/27/2018 10:50:27 AM
 24   Financial Risk Management

Notes At the NSE, the futures and options trading system provides a fully automated trading environment
for screen-based, floorless trading on a nationwide basis and an online monitoring and surveillance
mechanism. The system supports an order-driven market and provides complete transparency in terms
of the trading operations. Orders, as and when they are received, are stamped with the time of order and
are immediately processed for potential matches. If a match is not found, the orders are stored in different
books. Orders are stored according to the price–time priority in the following sequence:
 First, according to the best price

 Second, according to time

Whether it would be stored according to best price or time depends on the type of order placed, which
is discussed next.

2.4.1  Types of Orders

The various types of orders used in Indian derivatives exchanges are:
 Market orders

 Limit orders

 Stop-loss orders

 Immediate or cancel orders

 Good-till-day orders

 Good-till-cancelled orders

 Good-till-date orders

 Spread orders

A market order is an order that should be executed immediately at the best possible price. For example,
a sugar manufacturer wants to enter into a sugar futures contract. If he places a market order, this order
will be executed immediately at the best possible price. The major problem with a market order is that the
price at which the order will be executed is not known until the order is executed. However, the advantage
is that the order will be executed for sure.
A limit order is an order that sets a price known as the limit price, and orders can be executed at
that price or higher. If a trader places a limit buy order at INR 250, the order will be executed at a price
that is less than or equal to INR 250. If the price is higher than INR 250, the limit buy order will not be
executed. If a trader places a limit order to sell at INR 250, the order will be executed at a price more
than or equal to INR 250. If the price is lower than INR 250, the limit sell order will not be executed.
The main advantage of the limit order is that the price at which the order will be executed is known.
However, there is no guarantee that the order will be executed. Limit orders are entered into the order
book of an exchange.
A stop-loss order is one in which the trader will place a stop price and, if the actual market price
reaches this stop price, the order will become a market order and will be executed. If the stop price is not
reached, the order will not be executed. An immediate or cancel order is one in which the order should
be executed immediately; if this is not done, the order will be cancelled. A good-till-day order is one
in which the order will have to be executed on the day on which the order is placed; if not, the order will
be cancelled.
A good-till-cancelled order is one in which the order will remain open unless the original trader cancels
the order. A good-till-date order is one in which the order will remain open until a given date. If it is not
executed within the date specified, it will be cancelled. A day order is an order which lasts only for the day
on which the order is made. If the order is not executed on that day, it is cancelled at the end of that day.
A spread order is one in which the trader will place two orders on the same underlying asset with
different maturities—in the case of futures—and either with different maturities or different exercise
prices—in the case of options.

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 The Derivatives Market in India   25

Notes 2.4.2  Order-matching Rules

The best buy order will be matched with the best sell order. An order may match partially with another
order, resulting in multiple trades. For order matching, the best buy order is the one with the highest
price and the best sell order is the one with the lowest price. This is because the computer views all buy
orders available from the point of view of a seller and all sell orders from the point of view of a buyer in
the market. So, of all the buy orders available in the market at any point of time, a seller would obviously
like to sell at the highest possible buy price that is offered. Hence, the best buy order is the order with the
highest price and vice versa.
Members can proactively enter orders in the system, and these orders will be displayed until the full
quantity is matched by one or more counter-orders, resulting in trade(s). Alternatively, members may
be reactive and put in orders that match with the existing orders in the system. Orders lying unmatched
in the system are called passive orders, and the orders that match with the existing orders are called
active orders. Orders are always matched at the passive order price. This ensures that the earlier orders
get priority over orders that come in later.

2.4.3  Order Conditions

Orders can be categorized on the basis of either time or price. These categories are discussed here.

On the Basis of Time.  On the basis of time, orders may be classified as under:
Day orders: A day order, as the name suggests, is an order that is valid for the day on which it is en-
 
tered. If the order is not matched during the day, the order gets cancelled automatically at the end of
the trading day.
Immediate-or-cancel orders: An immediate-or-cancel (IOC) order allows a trading member to buy
 
or sell a security as soon as the order is released into the market, failing which the order will be
removed from the market. If a partial match is possible for the order, the unmatched portion of the
order is cancelled immediately.

On the Basis of Price.  On the basis of price, orders may be classified as under:
Limit price/orders: A limit price/order is one that allows the price to be specified while entering the
 
order into the system.
Market
  price/orders: A market price/order is an order to buy or sell securities at the best price ob-
tainable at the time of entering the order.
Stop-loss
  price/orders: A stop-loss price/order is one that allows the trading member to place an
order that gets activated only when the market price of the relevant security reaches or exceeds a
threshold price. Until then, the order does not enter the market.
Sell orders: A sell order gets triggered in the stop-loss book when the last traded price in the normal
 
market reaches or falls below the trigger price of the order. A buy order in the stop-loss book gets
triggered when the last traded price in the normal market reaches or exceeds the trigger price of the
order. For example, if for a stop-loss buy order, the trigger is INR 93.00, the limit price is INR 95.00,
and the market (last traded) price is INR 90.00, then this order is released into the system once the
market price reaches or exceeds INR 93.00. This order is added to the regular lot book as a limit order
of INR 95.00, with the triggering time as the time stamp.

2.5  The Clearing and Settlement System

Clearing means that the transactions concluded in the exchanges are clearly recorded, and when a trader
closes the position, the resultant cash and delivery arrangements, known as settlement, are carried out.
The clearing and settlement procedure is very similar in all exchanges. Each exchange has a clearing cor-
poration as its subsidiary that carries out these functions.

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 26   Financial Risk Management

Notes The clearing and settlement system is the most important part of any derivatives exchange. When
traders enter into a derivatives contract, the system should be such that their orders are correctly entered
into the system and when the contract expires or when the trader closes out the position, there is no
default and the traders receive the money made from their contracts. The clearing and settlement system
is designed to provide for this. The clearing and settlement is done by the clearing corporation, which is
usually a subsidiary of the derivatives exchange.
The National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement agency
for all the deals executed in the derivatives (futures and options) segment of the NSE. The NSCCL acts as
a legal counterparty to all the deals in the NSE’s futures and options segment and guarantees settlement.

2.5.1  The Members of the Clearing House

The clearing house has members called clearing members, who are authorized to clear the trades under-
taken by the traders on the derivatives exchanges. Unless a trade is cleared by a clearing member, it is not
recognized by the exchange.
The members of any exchange can be classified as:
 Clearing members (CM)

 Trading members (TM)

A TM is allowed to carry out the trades, that is, match the orders received by the TMs from the futures
traders. A CM of the NSCCL is responsible for the clearing and settlement of all deals executed by the
TMs, who clear and settle such deals on the NSE through the CM.
Primarily, a CM performs the following functions:
Clearance: Clearance involves determining all their TM’s obligations, i.e., determining positions to
1. 
settle.
Settlement: Settlement refers to the actual settlement. Only funds settlement is allowed at present in
2. 
index and stock futures and options contracts.
Risk management: Risk management refers to setting position limits on the basis of upfront depos-
3. 
its/margins for each TM and monitoring positions on a continuous basis.
A CM can be classified as a trading member/clearing member, (TM/CM), professional clearing mem-
ber (PCM), or self-clearing member (SCM) , depending on the activities they are allowed to undertake.
Members who trade for clients as well as for themselves, thereby acting as trading members, and al-
lowed to clear and settle all the trades done by themselves and other trading members at the same time
are called a trading members/clearing members (TM/CM). Members not allowed to trade on the ex-
change but allowed only to clear the trades done by the trading members are called professional clearing
members (PCMs). Usually, banks and custodians are PCMs. Members who are trading members and are
only allowed to clear and settle their own proprietary trades and their clients’ trades but not allowed to
clear and settle the trades executed by other trading members are called self-clearing members (SCMs).
The qualifications required by the NSCCL to become a clearing member are as follows:
A trading member/clearing member should have a net worth of at least INR 30 million. If the mem-
 
ber is an SCM, the net worth requirement is required to be INR 10 million.
All
  members need to deposit INR 50 million to the NSCCL; this will make up the base minimum
capital of the CM.
If the
  member clears and settles for other trading members, the member should provide additional
incremental deposits of INR 1 million to the NSCCL for each additional trading member whose
trades are cleared and settled by the CM.

2.5.2  The Clearing Mechanism

The main function of the clearing house is to guarantee the performance of all the contracts entered into
by the trades on the exchange. This is performed by the CM by taking the position of the counterparty for
each of the contracts that is cleared through the CM.

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 The Derivatives Market in India   27

Notes   E x a m p le 2 . 1
For example, if Amit takes a long position and Mukund enters into a short position in a contract through
their respective TMs, each TM will have to get these trades cleared by the CMs. A long position typically
means that the trader has agreed to buy the asset at a future time, while a short position means that the
trader has agreed to sell the asset at a future time. If Amit’s CM is Seth, the contract is considered as a
contract between Amit and Seth, with Seth taking a short position in the contract. Thus, Amit need not
be concerned about Mukund defaulting on the contract, since the counterparty is Seth. Similarly, the TM
for Mukund will also have to get the trade cleared by a CM, say, Roy. Thus, the counterparty for Mukund
will be Roy, who will take a long position in the contract. Thus, the original contract between Amit and
Mukund will be considered as a contract between the CMs—Seth and Roy. Although Seth and Roy did
not enter into the contract themselves, both will get open positions in the contract. Basically, the CMs
guarantee the performance of the contracts cleared through them.

The clearing corporation will aggregate the open position of each clearing member in the following
manner:
1. While entering orders into the trading system, the TMs are required to identify them as either pro-
prietary trade (if these are their own trades, i.e., trades in which the TM is one of the parties) or client
(if entered on behalf of clients and the TM is not one of the parties) through the “Pro/Cli” indicator
provided on the order-entry screen.
2. Proprietary positions are calculated on a net basis (buy/sell), and client positions are calculated on
the gross of the net positions of each client, i.e., a buy trade is offset by a sell trade and a sell trade is
offset by a buy trade. Open positions for proprietary positions are calculated separately from client
positions.
3. A CM’s open position is calculated by aggregating the open positions of all the TMs and all the cus-
todial participants clearing through them. A TM’s open position, in turn, includes their proprietary
open position and their clients’ open positions.

2.5.3  Margin and Margin Accounts

Each CM is required to post a certain amount of money, called margin, on all the trades that are cleared
through the member. The margin is based on the value of the contract cleared through that member. The
exchange will maintain a margin account for each CM, and this account will show all the positions that
are held by the CM and the amount of exposure. The margin account will be updated every day using the
daily settlement price to indicate the daily gains and losses made by the CM. In case the margin falls be-
low a certain level, known as the variation margin, the exchange will issue a margin call, urging the CM to
post the additional margin amount. The margin amount for each contract is determined by the exchange
on the basis of the contract size and volatility of the underlying asset prices. The exchange can also specify
substitute securities that can be used as margin payments.

2.5.4  The Settlement System

Settlement means that the parties will be settling their obligations under the contract. In futures con-
tracts, there are two settlements—daily mark-to-market settlement and final settlement. Since futures
contracts are subject to margin and mark-to-market on a daily basis, there will be a daily mark-to-market
settlement. The settlement made on the maturity date of the contract is known as the final settlement.
If the contract is for the physical delivery of the contract, the final settlement will require one party to
deliver the asset and the other party to provide the agreed upon cash. If the contract is cash-settled, the
party that loses will pay the other party. However, all the payments will be made to the exchange clearing
corporation, which will pass on the money to the other party. Thus, the amount that is to be paid to the
exchange by any outside party is called the pay-in, and the amount that is paid by the exchange is known
as the pay-out.

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 28   Financial Risk Management

Notes 2.5.5  Risk Management

The main risk for any derivatives exchange is CMs defaulting on their obligations. If a CM defaults on
their obligations, the exchange should still honour the commitments under the contract; however, this
would cause a loss for the exchange. This risk is managed by the derivatives exchanges through a compre-
hensive risk containment system.
The most important component of risk containment is the online position monitoring and margin-
ing system. The actual position monitoring and margining is done on an intra-day basis. NSCCL uses a
standard portfolio analysis of risk (SPAN®2) system for determining the margin requirements. SPAN®
uses the volatility of the underlying asset to determine the margin. The assets that have a higher volatility
require a higher margin.
The CMs are also required to report the details of the margin collected and due from all the traders
whose trades have been cleared by the CM on a daily basis. The position limits of all the CMs are also
monitored continuously to ensure that the clearing member does not exceed the position at any time.
The NSCCL uses a parallel risk management system (PRISM), which is a real-time position moni-
toring and risk management system. The risk of each TM and CM is monitored on a real-time basis,
and alerts/disablement messages are generated if the member crosses the set limits. Strict penalties are
imposed if there are violations in respect to the margins or position limits.

2.6  The Trading Process

The mechanism of trading, clearing, and settlement in a derivatives exchange is explained through an
example.
Amit, a manager of Prime Fund, wants to enter into a derivative contract to hedge the risk of a
decrease in portfolio value. The steps for trading in derivatives exchanges are:
Step 1: Amit will contact a broker who is authorized to trade in derivatives. Amit can place any of the
orders discussed earlier. Let us assume that Amit has placed a market order to buy five June contracts of
CNX Nifty Index Futures on the NSE.
Step 2: The broker will access the order book of the NSE and key in the order placed by Amit. The
market orders specify only the quantity, and not the price. The order will be matched by the computer
at the NSE. The order book will have all the orders received from the various brokers, classified on the
basis of both price and time. If there is a corresponding matching order available in the order book—
for example, if there is an order already in the order book to sell five June contracts of CNX Nifty Index
Futures—the broker will match the orders and this information will be recorded on the computers
of the NSE. The orders will be matched with the highest selling price—for buy orders—and with the
lowest buying price—for sell orders. In case the order is a limit order, the broker will enter the order
into the order book with the limit price. If there is a matching order in the order book, the computer
at the NSE will automatically match the two orders. In case there are no matching orders in the order
book, the order entered into by the broker will remain in the order book until a matching order arrives,
otherwise it is cancelled.
Step 3: If the order is executed, the broker will then have to get this order cleared by a CM of the
clearing corporation of the exchange. The CM is responsible to the exchange for fulfilling the
contract. The broker will approach the clearing member asking for their permission to clear the trade.
Once the CM clears the trade, the exchange will notify the broker that the order has been cleared.
When a CM clears a trade, they take the responsibility of fulfilling the obligations of the contract
at maturity even though they have not traded. The purpose of having the CM responsible for clear-
ing the trade is to ensure organized functioning of the derivatives exchange so that the default rate
is minimized.
Step 4: For the CM to be responsible for the fulfilment of the contract at maturity, the CM will have to
post a margin that is usually based on the volatility of the underlying asset price. The exchange will notify
the CM about the amount of margin that needs to be posted by them.

2 SPAN® is a registered trademark of the Chicago Mercantile Exchange.

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 The Derivatives Market in India   29

Notes Step 5: Since the CM only clears the trade and takes no position in the trade, the CM will ask the broker
to provide the funds for this margin, which will be collected by the broker from Amit.
Step 6: The broker will maintain an account known as the margin account, which will be updated daily
on the basis of the settlement price of that day, known as the mark-to-market. The details of margin and
mark-to-market are explained in Chapter 4.
Step 7: As long as Amit wants to keep his position in futures before maturity, his only responsibility is to
follow the instructions of the broker with respect to the margin account. In case the margin balance falls
below the variation margin, the broker will issue a margin call to Amit, specifying that the margin bal-
ance has fallen and informing him to deposit additional money.
Step 8: At maturity, the contract will be settled. The settlement price will be calculated by the NSE and
will be known to all the brokers. Amit’s broker will calculate the position of Amit’s margin account
using the settlement price. If the margin account shows a positive amount, this amount is the gain for
Amit from futures trading, and this amount will be given to Amit by the broker. If the margin account
shows a negative amount, it indicates a loss from futures for Amit, and Amit needs to pay this amount
to the broker.

2.7  Online Trading

Many brokerage houses also allow customers to trade online. In order to do so, customers have to sign up
with the brokerage firm, and the brokerage firm provides the software that allows the customer to trade
using the broker’s platform. The customer can place the order to buy or sell derivatives contracts using
the software provided. Once the contracts are matched, the broker initiates the procedure for clearing the
transaction.
The contracts traded on Indian exchanges are shown in Exhibit 2.1 at the end of this chapter.

2.8  The OTC Derivatives Market

Equity options, equity futures, currency futures, and interest rate futures are traded on the BSE and NSE,
while commodity futures are traded on the NCDEX and MCX. On the other hand, forward contracts in
currency, commodity, and interest rate are traded on the OTC market. Currency options, interest rate
options, and interest rate and currency swaps are also traded on the OTC market.
Currency forwards are usually entered into by a customer and a bank, with the bank providing the
forward rates for the contract. The bank may require documentation to check that the customer has a
position to hedge and is using the forward contract to hedge it. The bank may also require the customer
to deposit some cash to keep as the balance.
Currency options, interest rate options, and swaps are usually entered into through brokers. The bro-
kers will find the counterparty to enter into these contracts. Very often, the counterparty is a bank.

2.9  The Regulation of Derivatives Trading in India

Derivatives trading in India is regulated by three authorities: SEBI, RBI and FMC. Equity derivatives
contracts are regulated by the SEBI. Interest rate derivatives and currency derivatives are regulated by the
RBI. Commodity derivatives are regulated by the Forward Market Commission (FMC).
The regulations require that all the contracts be approved by the regulating body before they are of-
fered in the market, whether through exchanges or through the OTC market. The operation of these
exchanges, composition of the clearing corporation, and risk management by the exchanges is regulated
so that the derivatives market functions smoothly.

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 30 Financial Risk Management

CHapTER SUMMaRY
Commodity derivatives are traded on the Multi-Commodity
 Stop-loss order is used to minimize the loss that a trader may

Exchange of India (MCX) and the National Commodity and face.
Derivatives Exchange Limited (NCDEX). A market order does not specify any price and will be executed

Financial derivatives are traded on the Bombay Stock
 immediately at the best possible price; on the other hand, limit
Exchange (BSE) and the National Stock Exchange (NSE). orders specify a price, and the order will be executed only at
All exchanges use the online trading system.
 the limit price or higher.
All trades are to be cleared by a clearing member (CM) of the
 A spread order is an order to buy two securities with different

exchange. maturities or different exercise prices.
The exchanges require the CMs to post a margin amount,
 The best buy orders will be matched against the best sell orders

which is based on the volatility of the underlying asset prices. by the system.
The various types of orders used in exchanges are regular lot
 Clearing members (CMs) are those who qualify for clearing

order, market order, limit order, stop-loss order, immediate- membership and are responsible to the exchange for fulfilment
or-cancel order, good-till-day order, good-till-cancelled order, of the contracts cleared through them.
good-till-date order, and spread order.

MULTIpLE-CHOICE QUESTIONS
1. Which of the following is true C. Reducing systemic risk due to collapse of futures markets
A. Both forward and futures contracts are traded on D. All of the above
exchanges.
5. For a futures contract trading in April 2012, the open interest
B. Forward contracts are traded on exchanges, but futures
for a June 2012 contract, when compared to the open interest
contracts are not.
for Sept 2012 contracts, is usually
C. Futures contracts are traded on exchanges, but forward
A. Higher
contracts are not.
B. Lower
D. Neither futures contracts nor forward contracts are
C. The same
traded on exchanges.
D. Equally likely to be higher or lower
2. Which of the following is NOT true
6. Clearing houses are
A. Futures contracts nearly always last longer than forward
A. Never used in futures markets and sometimes used in
contracts
OTC markets
B. Futures contracts are standardized; forward contracts are
B. Used in OTC markets, but not in futures markets
not.
C. Sometimes used in both futures markets and OTC mar-
C. Delivery or final cash settlement usually takes place with
kets
forward contracts; the same is not true of futures con-
D. Always used in both futures markets and OTC markets
tracts.
D. Forward contracts usually have one specified delivery 7. With bilateral clearing, the number of agreements between
date; futures contract often have a range of delivery dates. four dealers, who trade with each other, is
A. 12
3. The frequency with which margin accounts are adjusted for
B. 1
gains and losses is
C. 6
A. Daily
D. 2
B. Weekly
C. Monthly 8. Which of the following best describes central clearing parties
D. Quarterly A. Help market participants to value derivative transactions
B. Must be used for all OTC derivative transactions
4. Margin accounts have the effect of
C. Are used for futures transactions
A. Reducing the risk of one party regretting the deal and
D. Perform a similar function to exchange clearing houses
backing out
B. Ensuring funds are available to pay traders when they 9. Which of the following are cash settled
make a profit A. All futures contracts

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 The Derivatives Market in India 31

B. All option contracts B. Is an order that can be executed at a specified price or one
C. Futures on commodities more favorable to the investor
D. Futures on stock indices C. Is an order that must be executed within a specified
period of time
10. A limit order
D. None of the above
A. Is an order to trade up to a certain number of futures con-
tracts at a certain price

Answer
1. C 2. A 3. A 4. D 5. A 6. C 7. C 8. D 9. D 10. B

REVIEW QUESTIONS
1. Which of the exchanges in India trade commodity derivatives 7. What is (i) an immediate-or-cancel order, (ii) good-till-day
contracts? order, (iii) good-till-cancelled order, and (iv) good-till-date
2. Which of the exchanges in India trade financial derivatives order?
contracts? 8. What is a spread order?
3. What is the trading mechanism in derivatives exchanges? 9. What are the order-matching rules?
4. What are the various types of orders used in derivatives ex- 10. What are the order conditions?
changes? 11. Who are clearing members?
5. What is a stop-loss order? Why is it used? 12. What is the clearing mechanism for contracts?
6. What is the difference between a market order and a limit order? 13. What are the contracts available in Indian exchanges?

✧ EXHIBIT 2.1 LIST OF CONTRACTS AVAILABLE IN INDIAN EXCHANGES

2.7.1 Multi-Commodity Exchange of India (MCX)  Energy: Brent Crude Oil, Furnace Oil, Natural Gas,
and ME Sour Crude Oil
The MCX trades futures on precious metals, oil and oil  Plantations: Arecanut, Cashew Kernel, Coffee
seeds, spices, metals, fibers, pulses, energy, plantations, pet- (Robusta), and Rubber
rochemicals, and carbon credits. The various contracts are:  Petrochemicals: HDPE, Polypropylene, and Poly
 Precious metals: Gold, Gold Guinea, Gold HNI, Vinyl Chloride
Gold M, i Gold, Silver, Silver HNI, and Silver M  Others: Guar Gum, Guar Seed, Gurchaku, Mentha
 Oil and oil seeds: Castor Oil, Castor Seeds, Coconut Oil, Potato, and Sugar
Cake, Coconut Oil, Cotton Seeds, Crude Palm Oil,  Carbon credit
Groundnut Oil, Kapasi Khalli, Mustard Oil, Mustard 2.7.2 National Commodity & Derivatives Exchange
Seeds, RBD Palmolein, Refined Soy Oil, Refined Limited (NCDEX)
Sunflower Oil, Rice Bran, Rice Bran Oil, Sesame
Seeds, Soy Meal, Soy Bean, and Soy Seeds The NCDEX trades futures on agricultural products,
 Spices: Cardamom, Jeera, Pepper, Red Chilli, and precious metals, base metals, ferrous metals, energy,
Turmeric polymers, and carbon credits. The list of the various
 Metal: Aluminium, Copper, Lead, Nickel, Sponge contracts is given below:
Iron, Steel Long, Steel Flat, Tin, and Zinc  Agricultural products: Ground Nut Expeller Oil, Guar
 Fiber: Cotton L Staple, Cotton M Staple, Cotton S
Gum, Guar Seeds, Gur, Indian Parboiled Rice, Indian
Staple, Kapas, and Jute Pusa Basmati Rice, Indian Raw Rice, Indian Traditio-
 Cereals: Maize

Continued

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 32   Financial Risk Management

Continued

nal Basmati Rice, Cotton, Jeera, Jute Sacking Bags, 2.7.4 Bombay Stock Exchange (BSE)
Masoor Grain Bold, Medium Staple Cotton, Mentha
Stock index futures, stock index options, futures on indi-
Oil, Mulberry Green Cocoons, Mulberry Raw Silk,
vidual stocks, and options on individual stocks are traded
Rapeseed–Mustard Seeds, Pepper, Potato, Raw Jute,
on the BSE. The various contracts are:
Rapeseeds–Mustard Seed Oil Cake, RBD Palmolein,
Refined Soy Oil, Rubber, Sesame Seeds, Soy Bean,  I ndex futures: BSE 30 Sensex Index, BSE Sensex Index
Sugar, Tur Dal, Turmeric, Urad Dal, Wheat, Yellow Mini, BSE Teck Index, BSE Bankex Index, BSE Oil,
Peas, Yellow Red Maize, and Yellow Soybean Meal and Gas Index
 Precious metals: Gold and Silver  Index options: BSE 30 Sensex Index, BSE Sensex
 Base metals: Copper Cathode, Aluminium Ingot, Index Mini, BSE Teck Index, BSE Bankex Index,
Nickel Cathode, and Zinc Ingot BSE Oil, and Gas Index
 Ferrous metals: Mild Steel Ingots and Sponge Iron  Individual stock futures: Individual stock futures are
 Polymers: Linear Low-Density Polyethelene, Poly- available on 87 securities traded on the BSE.
propylene, and Poly Vinyl Chloride  Individual stock options: Individual stock options are
 Energy: Brent Crude Oil, Furnace Oil, and Light available on 87 securities traded on the BSE.
Sweet Crude Oil  Weekly options: Sensex Index, Sensex Index Mini,
 Carbon credits Reliance Industries, State Bank of India, and TISCO
 Currency futures: USD–INR
2.7.3 National Multi Commodity Exchange (NMCE)
The NMCE trades futures on precious metals, oil and oil 2.7.5 National Stock Exchange (NSE)
seeds, spices, metals, fibers, pulses, energy, plantations, pet- Stock index futures, stock index options, futures on indi-
rochemicals, and carbon credits. The various contracts are: vidual stocks, options on individual stocks, and interest
  recious metals: Gold (100 grams), Kilo Gold, and
P rate derivatives are traded on the NSE. The various con-
Silver tracts are:
 Oil and oil seeds: Castor Oil, Castor Seeds, Coconut  I ndex futures: S&P CNX Nifty Index, S&P CNX Nifty
Oil cake, Coconut Oil, Cotton Seeds, Crude Palm Index Mini, CNX Nifty Junior Index, CNX IT Index,
Oil, Groundnut Oil, Mustard Seeds, RBD Palmolein, CNX 100 Index, Bank Nifty Index, and Nifty Midcap
Soybean Oil, Sesame Seeds, Soy Bean, Copra, 50 index
Groundnut, Linseed, Rapeseed-42, Cotton Seed Oil,  Index options: S&P CNX Nifty Index, S&P CNX
Linseed Oil, Rape/Mustard Seed Oil, Sesame Seed Nifty Index Mini, CNX IT Index, Bank Nifty Index,
Oil, Rice Bran Oil, Vanaspati, Castor Oil Cake, Cot- and Nifty Midcap 50 index
ton Seed Oil Cake, Groundnut Oil Cake, Linseed Oil  Individual stock futures: Individual stock futures are
Cake, Rape/mustard Seed Oil Cake, Sesame Oil Cake, available on 180 securities traded on the NSE.
and Soybean Oil Cake  Individual stock options: Individual stock options are
 Spices: Cardamom, Pepper, Ungarbled Pepper, available on 180 securities traded on the NSE.
Cumin Seed, and Turmeric  Interest rate derivatives: Futures are available on 10-
 Metal: Aluminium, Copper, Lead, Nickel, Tin, and year notional coupons bearing Government of India
Zinc security (notional coupon of 7% with semi-annual
 Pulses: Tur/Arhar Dal, Urad Dal, Moong Dal, Masoor compounding).
Dal, and Chana Dal  Currency futures: Futures are available on USD–INR,
 Others: Rubber, Sacking, Sugar, Sugar S-30, Gur, Guar EUR–INR, JPY–INR, and GBP–INR.
Seeds, Wheat, Rice, Raw Jute, Coffee Arabica, Coffee
Rep Bulk, Menthol, Isabgul Seeds, and Kalyan Kapas
V-797

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 3
Forward Contracts

LEARNING OBJECTIVES

After completing this chapter, you In India, there is a disparity in the power demands of different
will be able to answer the following states and regions, which results in seasonal surpluses in some
questions: areas and deficits in some areas. This mismatch of demand and
 What are forward contracts? supply can be managed by bringing power industry participants
to buy and sell electricity in an auction-based system. This was
 How are forward contracts
accomplished by the establishment of the Indian Energy Exchange,
used?
which started operations in June 2008. In this auction-based sys-
 How are commodity forward tem, the bidders buy and sell electricity using forward contracts. Pri-
contracts priced? or to the introduction of this system, only a day-ahead contract was
 What are currency forward being offered. After the auction-based system was implemented,
contracts? the exchange introduced week-ahead, season-ahead, and quarter-
 What are the uses of currency ahead forward contracts.
forward contracts? Source: Introduction, India Energy Exchange (IEX), www.iexindia.com
 How are currency forward
contracts priced?
 What is a forward rate Box 3.1 India Introduces Electricity Forward Contracts
agreement?
 What are the uses of forward
rate agreements?

The origin of forward contracts can be traced back to more than 2000 years when farmers and
merchants used forward contracts to reduce the risk of the price of agricultural goods moving against
them. There is no clear indication as to when the first forward contract was initiated, but forward
contracts in some form or the other have been in existence for many centuries. Since 1973, forward
contracts on currency and interest rates have been in existence. Forward contracts have also been cre-
ated in other assets such as electricity, as shown in Box 3.1. In 2007, the Baltic Exchange, a global market
for shipbrokers, owners, and charters, approached the Government of India to start freight forward
contracts.1 In 1989, Pepsi Foods limited entered into a forward contract with the farmers in Punjab
whereby Pepsi would provide selected inputs such as seedlings and technical assistance and the farmers

1 “Baltic Exchange for allowing forward freight contracts in India,” The Financial Express, May 23, 2007.

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 34   Financial Risk Management

Notes would produce the tomatoes needed by Pepsi for its processing plant. The payment to the farmers is based
on a forward contract.2
These examples show that forward contracts are widely used. So what exactly is a forward contract?

3.1 What is a Forward Contract?

A forward contract is an agreement to buy or sell a specified asset at a certain time in the future for a
specified price agreed upon at the time of entering into the contract.
In a forward contract, the parties just enter into an agreement to exchange assets and cash at a mutu-
ally agreeable price at the present time. The actual exchange of assets and cash takes place in the future.
Forward contracts came into existence because they allowed for a reduction in the price risk faced by
individuals and businesses. The way in which forward contracts work to reduce price risk is explained
through Example 3.1.

  Example 3.1
Bala is a rice farmer. He will be harvesting rice in the month of January next year. On September 1, Bala
is uncertain about the price he will receive in January for the rice because the price will depend on the
harvest. If the harvest is poor throughout the country, the price of rice may rise and the farmer will be
able to get a high price for the rice he has produced. On the other hand, if the harvest is good across the
country, the price will be low because of a large supply of rice. Thus, Bala is uncertain about the price he
will receive in January for selling his rice.
Raja is a wholesale rice merchant who buys rice from farmers and sells it to the customers. Raja also
faces a price risk because the price he may have to pay for buying rice from the farmer could either be
high or low, depending upon the harvest.
Since Bala and Raja both face the risk of price uncertainty, it makes sense for them to get together in
September or even earlier and agree upon a price at which Bala will sell the rice to Raja in January. This
is a forward contract because Bala and Raja have agreed upon the time of delivery (January of the next
year), and the price at which the exchange will take place is agreed upon in September for a transaction
that will take place in January of the next year. There will be no exchange of rice or cash in September, and
the actual exchange will take place in January. Thus, both parties will be able to avoid price uncertainty
by entering into a forward contract.
Assume that the price agreed upon by Bala and Raja in September for the delivery in January is INR
25 per kg. This means that Bala will receive a price of INR 25 per kg of the rice that he sells to Raja,
irrespective of the market price. Similarly, Raja is assured of buying rice at INR 25. Since the price at
which Bala will sell rice is known in September, there is no price risk for Bala. There is no price risk for
Raja either since the price at which Raja will buy the rice is known in September.
Suppose that the harvest is poor and the price of rice in the market in January is INR 32 per kg. Bala
will receive only INR 25 from Raja under the agreement, which will result in a loss of INR 7 per kg for
Bala, while Raja will make a gain of INR 7 per kg of rice. However, if the harvest is very good and the
price in January is INR 20 per kg, Bala will gain INR 5 per kg, while Raja will lose INR 5 per kg. This is
shown as follows:
Harvest Price Bala Raja
Good 20 5 5
Bad 32 7 7

  It is clear from Example 3.1 that a forward contract assures a price to both the parties for a future tran-
saction; however, either party could gain or lose from a forward contract because of the movement in the
price of the underlying asset. It should also be noted that the gain for one party will result in a loss of the
same amount for another party.

2  A. K. Goel (ed.), “Contract Farming Ventures in India: A Few Successful Cases,” Spice, Vol. 1, No. 4(2003):1–6.

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 Forward Contracts   35

Notes 3.2  The Purpose of Forward Contracts

If a forward contract could result in a loss, why would anyone enter into a forward contract? The major
purpose of entering into a forward contract is to avoid price uncertainty and lock in a price for a transac-
tion that will take place in the future. While this strategy may result in a loss or a gain, depending upon
the movement of the price of the underlying asset, the party entering into the contract is not concerned
about the loss or gain because, at the time that the contract is entered into, it will not be known whether
the future price of the underlying asset will be higher or lower than the forward price that is agreed upon.

  Example 3.2
Bala would make a gain if the price fell below the forward price of INR 25, while he would make a loss if
the price rose above the forward price of INR 25. If Bala is certain that the price of rice in January would
be below INR 25 per kg, he would enter into a forward contract at the price of INR 25. Thus, the expec-
tation at the time of contract maturity will have an impact on the decision of whether to hedge or not.
In a similar manner, Raja would enter into the forward contract only if he expects the price of rice in
January to be above INR 25, because he would gain if the price in January is above INR 25.

However, under these expectations, there will be no forward contract. Since neither is sure about the
exact price, they would negotiate the forward price. Therefore, the forward price will be determined on
the basis of the expected price of the asset at the maturity of the contract and will be negotiated by the
two parties to the contract.
How about the needs of the merchant at other times of the year? If the harvest of rice takes place only
once a year, say, in January, the merchant can buy all the requirements for the whole year in January
through a forward contract. However, this will require that the merchant arrange for the storage of rice
for the other months. Thus, buying the required amount of rice for the whole year through a forward
contract will eliminate the price risk, but it will incur storage cost. If the merchant decides not to purchase
the amount of rice required for the whole year in January but to purchase rice once every three months,
then the storage will have to be arranged for by the farmer during these periods, and both the merchant
and the farmer will face price uncertainty if no one enters into a forward contract.

3.3 Advantages of Forward Contracts

Forward contracts are flexible tools that eliminate price uncertainty. Price uncertainty is eliminated for
both the parties, because they can lock in an asset price for exchanging an asset for cash in the future.
Further, since forward contracts are agreements between two parties, they can be flexible with respect
to the amount, quality, and delivery details of the asset. The contract can be tailored such that the price
uncertainty for both parties can be eliminated.

3.4 Problems with Forward Contracts

Although forward contracts are flexible, there are a number of problems associated with them.

3.4.1 Parties with Matching Needs

A forward contract requires that the needs of the two parties entering into the contract match. It is often
difficult to find a party with matching needs. Matching needs can be explained as follows:
1. The quantity of goods being bought and sold must be the same.
2. The quality of goods being bought and sold must be the same.
3. The time of delivery by the seller must match the time at which the buyer needs the goods.
This means that if a buyer wants to buy 1,000 kg of rice on January 20, they have to find a seller who
will be willing to sell them that amount of rice on that day; otherwise price risk will not be completely
eliminated.

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 36   Financial Risk Management

Notes Since it is difficult to find an organized forward market for many goods, finding a corresponding party
is a major problem for those wishing to enter into forward contracts, especially commodity forward
contracts. There are commodity brokers who act as intermediaries to find matching partners. For most
financial forwards such as currency or interest rate forwards, financial intermediaries such as banks act
as middlemen in bringing the parties together.

3.4.2 Non-performance
Forward contracts specify the price at which assets will be exchanged for cash in the future at the time the
contract is entered into, and both parties agree to exchange the assets and cash at the time of the contract’s
maturity. Both parties try to fix the price so that they can hedge the price risk. The ability of one party to
hedge the price risk depends on the fulfillment of the contract by the other party. If one of the parties fails
to fulfil the contract, the other party will not be able to hedge the price risk. This is known as counterparty
risk. This is explained through Example 3.3.

  Example 3.3
Bala and Raja agree on September 1 on a forward price of INR 25 per kg of rice, with the delivery date
in January for a quantity of 50 MT. The total value of the contract is 50 × 1000 × 25 = INR 1,250,000. On
January 31, Raja will pay INR 1,250,000 to Bala, who will deliver 50 MT of rice to Raja.
Suppose the harvest that year is very good and rice is sold in the market for INR 20 a kg in the month
of January. Raja could have bought his requirement of 50 MT of rice at INR 20 a kg for a total of INR
1,000,000 from the market. However, in order to honour his obligations under the forward contract, he
has to pay INR 1,250,000. It would cost the merchant INR 250,000 for keeping up his side of the contract.
The fact that the asset price has moved against him is an incentive for the merchant to renege the contract.
If Raja fails to honour the contract, Bala will have to sell rice at the market price of INR 20 and thus will
have incurred a loss of INR 250,000. Thus, non-performance of the contract will make Bala unable to
hedge the price risk.
In a similar manner, Bala will have an opportunity to renege the contract if the price of rice in the
market rises above INR 25 per kg. If the price of rice is INR 30, Bala will receive INR 1,500,000 by selling
50 MT of rice in the market, instead of receiving only INR 1,250,000 through the forward contract. If Bala
reneges on the contract, Raja will suffer a loss.

This possibility that one of the parties in the forward contract might renege the contract and not fulfil
their obligations under it is known as counterparty risk, or risk of non-performance. This risk of non-
performance is always present in forward contracts and cannot be eliminated.
A case of non-performance of contract occurred in 2005, when Egypt cancelled cotton export con-
tracts to India following an increase in the price of cotton owing to a decrease in production. Many cotton
suppliers had entered into forward contracts with Indian spinning mills, and if they had to honour their
obligations at the forward prices, it would have led to huge losses due to an increase in the market price
of cotton.3

3.4.3 Non-transferability
The obligations under a forward contract are legally binding and both parties are obliged to keep their
sides of the contract on the contract delivery date.
Consider the case where Raja and Bala have entered into a forward contract in the month of
September to exchange rice at INR 25 per kg on January 31. During the period from September to
January, assume that the circumstances of the farmer have changed and because of floods, his entire crop
has been damaged. Even if the farmer knows that he cannot honour his commitments under the forward
contract, he cannot get out of the contract. He has to fulfil his obligations by buying rice in the market

3 G. Gurumurthy, “Egypt cancels cotton export contracts to India—Shippers cite growers’ reluctance to sell
their produce at lower rates as reason,” The Hindu Business Line, November 25, 2005.

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 Forward Contracts   37

Notes and selling it to the merchant at the agreed-upon forward price, unless agreed to by both the parties to
cancel the original contract.

3.5  The Pricing of Commodity Forward Contracts

Earlier it was discussed that the commodity forward contract price, which is the price to be paid at the
time of delivery, will be decided by the two parties involved in the contract, by carrying out negotiations.
However, there is a theoretical relationship between the forward price and the price of the commodity in
the spot market.
To understand how a commodity forward contract can be priced, consider a simple example:
On January 1, Raja realizes that he will need 20 MT of rice on July 1. Raja has three options to get this
rice on July 1.
Alternative 1: Not do anything until July 1, and purchase 20 MT of rice on July 1 at the prevailing market
price P1
Alternative 2: On January 1, enter into a forward contract to buy 20 MT of rice on July 1 at a forward
price
Alternative 3: Buy 20 MT of rice on January 1 at the price of p0, which is the price of rice in the
market today, and keep it stored in a warehouse. This price p0 is also known as the spot price at time 0.
Among these alternatives, the first alternative is risky because the price of rice on July 1 is not known
on January 1, whereas this price risk has been eliminated in alternatives 2 and 3. In alternative 2, the
forward price f0, which is the price at which the rice will be bought on July 1, is decided today and hence
this price is known with certainty. In alternative 3, the rice is being bought today at the spot price, which
is also known with certainty. However, buying rice on January 1 at the spot price requires that the rice be
stored in the warehouse until July 1, and this would mean incurring storage costs. Thus, the price that is
paid today should be adjusted for the storage costs when considering the cost of using this strategy.
Since alternatives 2 and 3 do not result in any risk, both of them must result in the same cost to the
buyer,
f 0 = p0 + c
where,  f0 is the forward price;
p0 is the current spot price of the underlying commodity; and
c is the cost of carrying the commodity from the day on which the contract is entered into until
the delivery date of the forward contract.
The cost of carry includes:
1. The actual cost of storage in the warehouse, including warehouse rent
2. The expenses in connection with storage, such as freight and insurance
3. The opportunity cost of funds invested in buying the goods
Assume that the spot price on January 1 is INR 22 per kg, and buying 20 MT of rice will require an
investment of 20 × 22 × 1000 = INR 440,000. This amount will be needed for investment today. On the
other hand, if the futures price is INR 25 per kg, the amount of 25 × 20 × 1000 = INR 500,000 will have to
be paid only on July 1. The amount of INR 440,000 can be invested today in other financial instruments
that can offer a positive return. The rate at which the amount can be invested today at no risk is known as
the opportunity cost, and this cost should also be taken into consideration in the cost of carry.
Usually, the cost of carry is expressed as a percentage of the spot price.

Problem 3.1
Sun Jewellers, a gold jewellery manufacturer, requires 1,000 grams of gold on July 1. On April 1, the price of gold
is INR 12,000 per gram. It plans to enter into a forward contract to buy gold, with the delivery date of July 1. It has
estimated that the storage of this gold will cost INR 80,000 and that it can invest its funds at 8% elsewhere. Calculate
the forward price of gold on April 1 for delivery on July 1.

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 38   Financial Risk Management

Notes Solution to Problem 3.1

Step 1: Calculate the cost of carry.

Since the total cost of carry consists of opportunity and storage costs, these costs need to be calculated.

Opportunity Cost:

Amount of investment on April 1 = 12,000 × 1,000 = INR 12,000,000

Opportunity interest rate = 8% per year or 2% for 3 months
Interest lost = 12,000,000 × 2% = INR 240,000
Storage cost = INR 80,000
Total cost of carry = INR 240,000 + INR 80,000 = INR 320,000

Step 2: Calculate the cost of carry per gram of gold.

320,000
Cost of carry per gram of gold = = INR 320
1000
Step 3: Calculate the forward price.

 Forward price = Spot price + Cost of carry = INR 12,000 + INR 320 = INR 12,320

Problem 3.2
A palm oil trader wants to enter into a forward contract on June 1, for delivery on July 1. The spot price of palm oil is
INR 50 per litre, and the trader wants to buy 10,000 litres of oil. If the cost of carry is 4% of the spot price, what will
be the forward price?
Solution to Problem 3.2

Step 1: Calculate the cost of carry.

Cost of carry = 4% of the spot price = 4% × 50 = INR 2 per litre

Step 2: Calculate the forward price.

Forward price = Spot price + Cost of carry = INR 50 + INR 2 = INR 52

3.6 Currency Forward Contracts

Currency forward contracts are the contracts for buying or selling a foreign currency on a future date
for an exchange rate that is fixed today. Currency forward contracts are used by Indian importers and
exporters. Currency forwards can be used by any party that has a known obligation to pay or receive
a certain amount of foreign currency at known times so that the exchange rate risk can be eliminated.
Currency forward contracts are used extensively by Indian companies for hedging currency risk. In April
2007 alone, the average daily turnover of forward contracts in India was USD 6,299 million.4
Currency forward contracts are preferred for hedging currency risk, because the hedger can custom-
ize the forward contracts on the basis of their needs. Currency forwards can be negotiated between the
customer and the bank for any currency, any amount, and any maturity.

  Example 3.4
Most of the revenue for Infosys is generated from its contracts in the USA, and the payment it receives is
in U.S. dollars. Infosys needs to convert the U.S. dollar receipts into Indian rupees periodically. However,
the exchange rate between the U.S. dollar and the Indian rupee is volatile, and at any given time, Infosys is

4 Bank for International Settlements, Triennial Central Bank Survey of Foreign Exchange and Derivatives Market
Activity in 2007 – Final results, available online at http://www.bis.org, accessed 10 May 2018 at 1pm IST.

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 Forward Contracts   39

Notes uncertain about the exchange rate at which it can convert the U.S. dollars into Indian rupees in the future.
By entering into currency forward contracts, Infosys can hedge the risk of unknown exchange rates.

  Example 3.5
Ford Motor Company, India imports major parts of its automobiles from its sister concerns such as Ford
USA and Ford Europe. It needs to make payments for imports in foreign currencies such as the U.S.
dollar or euro. Thus, Ford needs to convert Indian rupees into foreign currencies periodically at unknown
exchange rates. By entering into currency forward contracts, Ford India can hedge the risk of unknown
exchange rates.

  Example 3.6
Assume that the exchange rate is USD 1 = INR 48.32 today. Raymond, an Indian exporter, has supplied
garments to Macy’s, a department store in New York, for USD 1 million, and Macy’s will pay this amount
in 90 days. Raymond is uncertain about the exchange rate after 90 days and would like to eliminate this
uncertainty. The CFO of Raymond can enter into a currency forward contract with the State Bank of
India to sell U.S. dollars to the bank after 90 days. Assume that the forward rate, which is the rate at which
the State Bank of India will buy U.S. dollars after 90 days, is USD 1 = INR 49.09.
Suppose that the exchange rate after 90 days is USD 1 = INR 48.85. If Raymond had not entered into
a currency forward contract, it would have sold USD 1 million at the spot market rate of USD 1 = INR
48.85 for a total of INR 48.45 million. If the exchange rate after 90 days is USD 1 = INR 49.65, it would
have sold USD 1 million at the spot market rate of USD 1 = INR 49.65 for a total of INR 49.65 million,
in the absence of a forward contract. Thus, the amount that Raymond would receive after 90 days is
uncertain and depends on the spot exchange rate at that time. On the other hand, if Raymond enters into
a forward contract at a forward rate of USD 1 = INR 49.09, Raymond can be certain that it will receive
INR 49.09 million, irrespective of the spot price on that date.

  Example 3.7
In Example 3.6, Raymond enters into a forward contract to sell USD 1 million at the exchange rate of
USD 1 = INR 49.09. If the exchange rate after 90 days is USD 1 = INR 48.85, Raymond will sell USD
1 million at the spot market rate of USD 1 = INR 48.85 for a total of INR 48.85 million in the absence of
a forward contract. Thus, it will gain INR 240,000 (difference between INR 49.09 and INR 48.85 million),
because it entered into a forward contract. If the exchange rate after 90 days is USD 1 = INR 49.65, it will
sell USD 1 million at the spot market rate of USD 1 = INR 49.65 for a total of INR 49.65 million in the
absence of a forward contract. Thus, Raymond will lose INR 560,000 (the difference between INR 49.65
and INR 49.09 million), because it entered into a forward contract. Thus, currency forward contracts help
in hedging currency risk but can lead to losses or gains, depending upon the movement in the exchange
rate in the market.

Box 3.2 shows examples of the results of currency hedging by some of the companies in India.

BOX 3.2 Non-dollar Foreign Exchange Hedging

During the last quarter of 2008, the British pound lost 18%, (INR 25 billion). Infosys would start hedging its non-dollar
the euro dropped 11%, and the Australian dollar fell by revenue, as about one-third of its revenue comes from Eu-
23%, all against the U.S. dollar. This resulted in losses to rope and rest of the world.
Infosys (INR 21.8 billion) and Tata Consulting Services

Source: Surabhi Agarwal, “Currency Swings Dampen IT Mood,” Financial Express, January 22, 2009.

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 40   Financial Risk Management

Notes 3.6.1  The Operation of the Currency Forward Market

Currency forward contracts are usually provided by banks. If an Indian exporter needs to enter into a U.S.
dollar forward sell contract, they will approach a bank authorized to deal in the foreign exchange for the
same. The bank will quote the forward rate, and the contract will be finalized.
Banks take a risk by entering into a forward contract. For the exporter, there is no risk, because they
have an open position in a foreign currency that they are covering with the forward contract. An open
position means that the exporter is exposed to foreign exchange risk. This exposure to foreign exchange
risk arises because the exporter will be receiving U.S. dollars after 90 days and they need to convert the
received U.S. dollars into Indian rupees at that time. When a person has an open position in the underly-
ing asset, they are exposed to the risk of changes in the prices of the underlying asset and they need to
hedge this risk of exposure. The exporter, therefore, uses the forward contract in the foreign currency to
hedge this exposure. By entering into a forward transaction, the hedger is able to cover his exposure so
that his net position is zero. This is explained as follows.
At the current time, the exporter has an open position in U.S. dollars to the tune of USD 1 million,
which will be received after 90 days. They cover their position by entering into the forward sale of USD
1 million after 90 days. The net position is therefore zero.
However, for a bank, this forward contract creates an open position. For example, assume that
the bank has entered into a forward contract to buy USD 1,000,000 after three months at the exchange
rate of USD 1 = INR 49.09. This means that the bank will receive USD 1,000,000, which was bought
with INR 49.09 million, after three months. After three months, the bank will have an open position
in U.S. dollars to the value of USD 1,000,000. This is an open position subject to exchange rate risk. To
eliminate this risk, the bank will have to develop strategies. This can be done by entering into an off-
setting forward contract with another party or by entering into currency futures or currency options
contracts.
Currency forward contracts are used by parties that develop exposure to a foreign currency at a future
time. The exposure can result from the following reasons:
1. Export of goods and services with the invoice denominated in a foreign currency
2. Import of goods and services from a foreign country with the invoice denominated in the foreign
currency
3. Investments in foreign securities, which pay interest or dividends in foreign currency at known fu-
ture time periods
4. Borrowing from a foreign entity, which requires payment of interest in foreign currency at known
future intervals

3.6.2  Characteristics of Currency Forward Contracts

Currency forward contracts are entered into when a party has an open position in a foreign currency
that will be either received or paid at a known future time. Thus, the important characteristics of a for-
ward contract are:
1. The party entering into a currency forward contract should have an exposure to that currency.
2. The amount of exposure should be known with certainty.
3. The time at which the exposure will develop should be known with certainty.
These conditions should be satisfied before the party can enter into a forward transaction with a bank.
The RBI regulations require that the bank verifies these details before the contract is entered into. The
regulations also provide for the cancellation and renegotiation of the forward contract.

3.6.3  The Pricing of Currency Forward Contracts

The pricing of currency forward contracts is based on the principle of covered interest rate arbitrage.
Covered interest rate arbitrage provides an arbitrage opportunity when the theoretical relationship

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 Forward Contracts   41

Notes between the interest rates in two countries and the forward exchange rate is violated. To understand this,
consider the following situation:
1. Borrow USD 1 in the USA at the interest rate of RUSD for one year.
2. Convert USD 1 into Indian rupees at the exchange rate e0, which would give INR e0.
3. Invest INR e0 in India at an interest rate of RINR for one year, which would give e0 × (1 + RINR) after one
year.
4. Enter into a forward contract to buy U.S. dollars after one year at a forward rate of f0.
5. After a year, enforce the forward contract and sell e0 × (1 + RINR) at f0. This would give USD [e0 ×
(1 + RINR)/f0].
6. Pay back the loan, which is (1 + RUSD), from the amount received after converting the Indian rupees
at the forward rate.
7. Net gain = [e0 × (1 + RINR)/f0] – (1 + RUSD).
8. Since the values of the spot exchange rate, forward rate, and interest rates in the two countries are
known, there is no risk and hence the two investments should have the same value, i.e., there should
be no gain.
9. Therefore, the forward rate can be derived as:
1 + RINR
f 0 = e0 ×
1 + RUSD

This is the theoretical relationship between the current spot rate and the forward rate. Note that the inter-
est rates must match the maturity of the forward contract.
In general, the forward rate is calculated as:
e (1 + rh )
0
f =
0 1 + rf

where,  f0 denotes the forward rate;

rh denotes the interest rate in the home country;
rf denotes the interest rate in the foreign country; and
e0 denotes the current exchange rate expressed as the number of home currency units per unit
of the foreign currency.
Whenever this theoretical relationship is violated, there will be an arbitrage opportunity. It is called the
covered interest rate arbitrage, because the risk of unknown receipt of U. S. dollars from the investment
in Indian rupees is covered through the use of a forward contract.

Problem 3.3
Arjun is an NRI investor who has an opportunity to invest in India as well as in the USA. In the USA, the investment
can be made at 4% per annum, while the interest rate in India is 10% per annum. Since the interest rate in India is
higher, the NRI investor from the USA decides to invest USD 100,000 in India for 90 days. Assume that the current
exchange rate is USD 1 = INR 40. Calculate the 90-day and 180-day forward rates.
Solution to Problem 3.3
Since the cover period is 90 days, the 90-day interest rate in India = 10% × (90/365) = 2.4658%, and the 90-day inter-
est rate in the USA = 4% × (90/365) = 0.9863%.
 Since
1 + RINR
f 0 = e0 × ,
1 + RUSD
1 + 0.024658
90-day forward rate = 40 × = INR 40.5860
1.009863

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 42   Financial Risk Management

To calculate the 180-day forward rate, we should first calculate the 180-day interest rates.
Notes
180
180-day interest rate in India = 10% × = 4.9315%
365
180
180-day interest rate in the USA = 4% × = 1.9726%
365
1.049315
180-day forward rate = 40 × = INR 41.16067
1.9726
This relationship, known as forward premium, can be expressed in terms of currency appreciation
on a forward basis. Forward premium is the forward rate expressed as the percentage increase from the
current spot rate and is written as:
f 0 − e0 f 0
Forward Premium = = −1
e0 e0
Since
1 + RINR
e0 = f 0 ×
1 + RUSD
f 0 1 + RINR
= ,
e0 1 + RUSD
f0 1 + RINR R − RUSD
−1 = − 1 = INR
e0 1 + RUSD 1 + RUSD

This shows that the forward premium is calculated as the difference between the home interest rate and the
foreign interest rate divided by (1 + foreign interest rate). Very often, the denominator is considered as one,
since the interest rate is small and the forward premium is approximated by the difference in the interest rates.
When the home interest rate is higher than the foreign interest rate, the home currency is expected
to depreciate by a rate equal to the difference between the two interest rates. In Example 3.1, the annual
interest rates are 10% in India and 4% in the USA, or the interest rate difference is 6%, with the interest
rate in India being higher. Therefore, the Indian rupee is expected to depreciate by about 6% over a year,
or by about 1.5% every 3 months.

Problem 3.4
Hyundai Motors exports cars to Germany, and every three months, it would receive EUR 500,000 from car ship-
ments. On March 1, the exchange rate between the Indian rupee and the euro is EUR 1 = INR 70.7242. The interest
rate in Germany is 6% per annum, while the interest rate in India is 9% per annum. Hyundai wants to hedge its euro
receipt through forward contracts for the next 6 months.
(i)  What type of hedging activity would be suitable for Hyundai?
(ii) What would be the amount in Indian rupees that Hyundai will receive after 90 days and after 180 days if it
enters into a 90-day and 180-day forward contract, respectively?
Solution to Problem 3.4
(i) Since Hyundai will be receiving euros and converting them into Indian rupees, the appropriate hedging con-
tract will be the forward selling of euros.
(ii) The amount in Indian rupees that Hyundai will receive can be determined as follows:
Step 1: Calculate the forward rate.
Step 2: Convert EUR 500,000 into Indian rupees at the calculated forward rate.
Amount in Indian rupees from the 90-day forward contract:

90
90-day interest rate in euro = 6% × = 1.4795%
365
90
90-day interest rate in Indian rupees = 9% × = 2.2192%
365

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 Forward Contracts   43

1 + RINR
Notes 90-day forward rate = e0 ×
1 + REUR

1.022192
= 70.7242 ×
1.014795
= INR 71.2397

Rupee amount after 90 days = Amount in euros × forward rate

= 500,000 × 71.2397
= INR 35,619,850

Amount in Indian rupees from the 180-day forward contract:

180
180-day interest rate in euros = 6% × = 2.9589%
365
180
180-day interest rate in Indian rupees = 9% × = 4.4384%
365
1 + RINR
180-day forward rate = e0 ×
1 + REUR
1.044384
= 70.7242 ×
1.029589
= INR 71.74046

Amount in Indian rupees after 180 days = Amount in euros × forward rate

= 500,000 × 71.74046
= INR 35,870,230

3.6.4  Covered Interest Arbitrage

The forward rate is calculated from the theoretical relationship between the interest rates in the two
countries by using the principle of covered interest arbitrage. If the actual forward rate is different from
the theoretical value, it would lead to an arbitrage opportunity. An arbitrage opportunity arises if one
can make positive profits with zero net investment and no risk. One would achieve arbitrage through the
following steps:
Step 1: Identify whether the forward contract is overpriced or underpriced.
  A forward contract is overpriced relative to the current spot rate if the actual forward rate is more than
the theoretical forward rate, and a forward contract is underpriced relative to the current spot rate if the
actual rate is less than the theoretical forward rate.
Step 2: Take a long position in an underpriced security and a short position in an overpriced security.
If the actual forward rate is higher than the theoretical forward rate, the forward is overpriced and the
current spot contract is underpriced. This means that the arbitrager will buy the foreign currency at the
spot market rate and sell it through a forward contract. This requires the arbitrager to
1. borrow money in the home currency;
2. use this money to buy the foreign currency;
3. invest the foreign currency amount in the foreign country at the foreign interest rate;
4. convert the proceeds of the investment into the home currency; and
5. pay the borrowed funds with interest in the home country.
This process will result in a profit.
If the actual forward rate is less than the theoretical forward rate, the forward is underpriced and the
current spot contract is overpriced. This means that the arbitrager will sell the foreign currency at the spot
market rate and buy them through a forward contract. This requires the arbitrager to

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 44   Financial Risk Management

Notes 1. borrow money in the foreign currency;

2. sell the borrowed funds to buy the home currency;
3. invest the home currency amount at the home interest rate;
4. convert the proceeds of the investment in the home country at the forward rate into the foreign cur-
rency; and
5. pay the borrowed funds with interest in the foreign country.
This process will result in a profit.
The actions of arbitragers will bring the mispriced forward rate to its theoretical value.

Problem 3.5
Arjun is an NRI investor who has an opportunity to invest in India as well as in the USA. In the USA, the investment
can be made at 4% per annum, while the interest rate in India is 10% per annum. Since the interest rate in India is
higher, the NRI investor from the USA decides to invest USD 100,000 in India for 90 days. Assume that the current
exchange rate is USD 1 = INR 40 and the 90-day forward rate is USD 1 = INR 40.6752.
(i)  Calculate the 90-day theoretical forward rate.
(ii)  Identify whether there is any arbitrage opportunity.
(iii)  If there is an arbitrage opportunity, calculate the arbitrage profit for USD 100,000.
Solution to Problem 3.5
(i)  To calculate the theoretical forward rate:
Step 1: Calculate the 90-day interest rate in India and in the USA.
90
90-day interest rate in India = 10% × = 2.4658%
365
90
90-day interest rate in the USA = 4% × = 0.9863%
365
Step 2: Calculate the theoretical forward rate.
1 + RINR
f0 = e0 ×
1 + RUSD
1 + 0.024658
The 90-day forward rate = 40 × = INR 40.5860
1.009863

(ii) In order to identify whether an arbitrage opportunity exists, compare the actual forward rate with the theoreti-
cal forward rate. The theoretical forward rate is USD 1 = INR 40.586, and the actual forward rate is USD 1 =
INR 40.6752. Thus, the actual forward rate is higher than the theoretical value and hence there exists an arbi-
trage opportunity. The forward contract is priced at a higher value and hence the arbitrage requires selling the
U.S. dollar at the forward rate and buying it at the spot rate.
(iii) To calculate the arbitrage profit for USD 100,000:
Step 1: Borrow money in the home currency.
Since the arbitrager needs USD 100,000 and the spot exchange rate is USD 1 = INR 40, the amount to be
borrowed is 40 × 100,000 = INR 4,000,000.
Step 2: Use the borrowed funds to buy foreign currency.
Amount in U.S. dollars that would be bought at the exchange rate of USD 1 = INR 40 is USD 100,000.
Step 3: Invest the foreign currency amount in the foreign country at the foreign interest rate.
Invest USD 100,000 at 4% for 90 days. The amount at the end of 90 days would be:

 90 
100,000 × 1 + 4% ×  = USD 100,986.30
 365 

Step 4: Convert the proceeds of the investment in the foreign country at the forward rate into the home currency.
Amount in Indian rupees upon converting USD 100,986.30 at the forward rate of USD 1 = INR 40.6752 is
INR 4,107,638

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 Forward Contracts   45

Step 5: Pay the borrowed funds along with interest in the home country.
Notes
Amount to be repaid for borrowed funds of INR 4,000,000 at 10% for 90 days = 4,000,000 × (1 + 10% × 90/365)
= INR 4,098,630

Step 6: Calculate the arbitrage profit as the difference between the home currency received from the foreign
investment and the payment of the borrowed funds in the home country

Arbitrage profit = INR 4,107,638 – INR 4,098,630 = INR 9,008

Problem 3.6
Hyundai Motors exports cars to Germany, and every three months, it receives EUR 500,000 from car shipments.
On March 1, the exchange rate between the Indian rupee and euro is EUR 1 = INR 70.7242. The euro interest rate
is 6% per annum, while the interest rate in India is 9% per annum. Hyundai wants to hedge its euro receipt through
forward contracts for the next 6 months. The 180-day forward rate is EUR 1 = INR 71.5642.

(i)  Calculate the 180-day theoretical forward rate.

(ii)  Identify whether there is any arbitrage opportunity.
(iii)  If there is an arbitrage opportunity, calculate the arbitrage profit for EUR 500,000.
Solution to Problem 3.6
(i)  To calculate the theoretical forward rate, the following steps are needed:

Step 1: Calculate the 180-day interest rate in India and in Germany.

180
180-day interest rate in India = 9% × = 4.4384%
365
180
180-day interest rate in Germany = 6% × = 2.9589%
365
Step 2: Calculate theoretical forward rate.
1 + RINR
f 0 = e0 ×
1 + REUR
1 + 0.044384
90-day forward rate = 70.7242 × = INR 71.7405
1.029589

(ii) In order to identify whether an arbitrage opportunity exists, compare the actual forward rate with the
theoretical forward rate. The theoretical forward rate is EUR 1 = INR 71.7405, and the actual forward rate is
EUR 1 = INR 71.5642. Thus, the actual forward rate is lower than the theoretical value and hence there exists
an arbitrage opportunity. The forward contract is priced at a lower value and hence arbitrage requires buying
the euro at the forward rate and selling it at the spot rate.

(iii)  To calculate the arbitrage profit for EUR 500,000:

Step 1: Borrow money in the foreign currency.
Borrow EUR 500,000 in Germany.
Step 2: Use the borrowed funds to buy in the home currency (Indian rupee).
Amount in Indian rupees that would be bought at the exchange rate of EUR 1 = INR 70.7242 is INR
35,362,100.
Step 3: Invest the local currency amount in India at the home interest rate.
Invest INR 35,362,100 at 9% for 180 days. The amount at the end of 180 days would be:

 180 
Amount at the end of 180 days = 35,362,100 × 1 + 9% ×  = INR 36,931,596
 365 
Step 4: Convert the proceeds of the investment in the home country at the forward rate into the foreign currency.
Amount in euros on converting INR 36,931,596 at the forward rate of EUR 1 = INR 71.5642 is EUR 516,062.40.

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Step 5: Pay the borrowed funds with interest in the foreign country.
Notes
Amount to be repaid for borrowed funds of EUR 500,000 at 6% for 180 days =

 180 
500,000 × 1 + 6% ×  = EUR 514,794.50
 365 
Step 6: Calculate the arbitrage profit as the difference between the home currency received from the foreign
investment and the payment for borrowed funds in the home country.
Arbitrage profit = EUR 516,062.40 – EUR 514,794.50 = EUR 1,267.92

Problem 3.7
Assume that an importer in India is importing goods from Australia for AUD 500,000 and that this payment will
have to be made one month later. The current exchange rate is AUD 1 = INR 25. The exchange rate after one month
from the current time is not known, and the importer would like to know the amount in Indian rupees they need to
pay when the payment of AUD 500,000 is due one month hence. They decide to enter into a forward contract to buy
Australian dollars in one month. Suppose that the interest rate in India and Australia is 12% and 6%, respectively,
(i)  What would be the forward rate?
(ii)  If the actual forward rate is AUD 1 = INR 24.95, what is the arbitrage profit?
Solution to Problem 3.7

(i) The 30-day forward rate can be calculated using the covered interest rate parity as:

1.01
30-day forward rate = 25 × = INR 25.1244
1.005

(ii) Since the actual rate is higher than the theoretical rate, arbitrage opportunity exists. This shows that the Austra-
lian dollar is undervalued on a forward basis and the Indian rupee is overvalued with respect to the theoreti-
cal forward rate. Therefore, arbitrage would involve borrowing Australia dollars, converting them into Indian
rupees at the current spot rate, investing in Indian rupees today, and then converting the net proceeds from the
investment in India into Australian dollars one month down the line at the forward rate. This would result in
the following cash flows:

Step 1: Borrow AUD 500,000 today at 6% per annum for a month.

Step 2: Convert AUD 500,000 into Indian rupees at AUD 1 = INR 25 to get INR 12,500,000.

Step 3: Invest INR 12,500,000 at 12% per annum for a month.

Step 4: Enter into a forward contract to buy Australian dollars after one month at AUD 1 = INR 24.95.

At the end of the month, the net proceeds would be: INR 12,500,000 × (1 + 12%/12) = INR 12,625,000.

At the end of the month, convert INR 12,625,000 into Australian dollars at the forward rate of AUD 1 =
INR 24.95 to get 12,625,000/24.95 = AUD 506,012.

Step 5: Pay off the loan of AUD 500,000 at an interest of 6% (= AUD 502,500).

The arbitrage profit = AUD 506,012 – AUD 502,500 = AUD 3,512

3.6.5 Rolling Over Currency Forward Contracts

In currency forward contracts, banks sometimes allow a trader to rollover the forward contract for a
subsequent period at the same forward rate. For example, consider a firm that has exported goods to
the USA for USD 5,000,000 on March 1 and the merchant in the USA has agreed to make payments on
June 30. In order to hedge the currency risk, the exporter has entered into a currency forward contract
to sell the U.S. dollars at a forward rate of USD 1 = INR 45.3763 for 122 days, with maturity on June 30.
However, on June 26, the merchant in the USA expresses his inability to make payments on June 30 and
requests extension till October 30. Since the exporter is not receiving U.S. dollars on June 30, they can

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 Forward Contracts   47

Notes approach the bank and request for rolling over the contract for another 122 days at the same forward rate
of USD 1 = INR 45.3763.
Although a rollover is usually allowed because of a change in exposure, some traders use the rollover
procedure to avoid making losses. In the above example, assume that the merchant in the USA agrees
to pay on June 30, but the exchange rate has changed in the market and is at USD 1 = INR 44.3756 on
June 26. It is also believed that the Indian rupee is likely to appreciate further during the next few days. In
that case, the forward contract will result in a loss of (45.3763 – 44.3756) × 5,000,000 = INR 5.0035 mil-
lion. If the exporter believes that the Indian rupee will depreciate over the next 122 days, they can avoid
realizing the loss on June 30 and ask for a rollover of the contract, hoping that the market rate on October
30 will be close to USD 1 = INR 45.3763 or higher. Although banks do not like to enter into such rollover
contracts, some traders do use rollover of forward contracts. In 2002, John Rusnak, a trader working for
Allfirst Financial in Baltimore, USA, used rollover forward contracts to reduce losses. However, the risk
of rolling over a forward contract is that the exchange rate may change in the opposite direction, increas-
ing the losses. This was what happened to Rusnak, and during a period of about 12 months, he had ac-
cumulated losses of USD 750 million.5
This example shows that rolling over forward contracts to defer losses could actually result in higher
losses and hence the hedger should be very careful while rolling over contracts. Unless there is a change
in exposure, rollover is not a suitable option.

3.7 Interest Rate Forwards

Interest rate forwards are also called forward rate agreements (FRAs). These are used when a corpora-
tion is planning to borrow after some time or when a borrower has borrowed on a floating-rate loan and
would like to hedge the risk of changes in the interest rates at the next reset period. FRAs are also used by
banks to hedge interest rate risk when they provide loans to corporations. FRAs can also be used to hedge
the interest rate risk associated with floating-rate loans.
The risk in borrowing at a future time is that the borrower is not certain about the future interest
rates. By entering into an FRA, they can eliminate this risk and lock in a known rate for the entire period
of the loan. When a company enters into an FRA, the borrowing is actually done in the debt market. The
FRA does not involve the exchange of principal. The purpose of an FRA is to fix the interest rate for future
borrowing at a certain rate, irrespective of the prevailing market interest rate.
Typically, most loan rates in the market are indexed to some basic rates such as the government bond
rate, prime rate, bill discount rate, or the Mumbai interbank offer rate (MIBOR). The actual cost of a loan
will be the basic rate at which the loan is indexed along with some premium added for the riskiness of
the borrower. For example, if the base rate is the MIBOR, the cost of a loan can be written as MIBOR +
180 basis points, where 180 basis points is the premium over the base rate. Thus, the uncertainty in future
borrowing is the unknown value of the base rate to which the loan is indexed. By entering into an FRA,
the borrowing party fixes this base rate.
In an FRA, there are three defined time periods:
1. the time at which the FRA is entered into;
2. the FRA settlement date; and
3. the end-of-exposure date.
The time at which the FRA is entered into is the starting point of an FRA contract. The terms of the FRA
contract are decided upon at this time. The major term agreed upon is the settlement date, the end-of-
exposure date, and the effective interest rate for the borrower.
The settlement date is the day on which the FRA comes into effect, that is, it is the date on which the
borrowing actually takes place. The borrower will borrow the funds needed in the debt market, and there
will be an exchange of cash between the two parties on the settlement date such that the effective interest
rate on the loan is the same as the one agreed upon at the start of the FRA.
The time to end exposure is the date on which the borrower will either repay the money or the date on
which the borrower decides to no longer to keep the interest rate exposure hedged.
5  Jonathan Fuerbringer, “Arcane Rollover System Let Trader Hide Losses,” The New York Times, February 19, 2002.

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Notes An FRA is defined in terms of the settlement date and the time to end the exposure. For example, a
30 × 210 FRA means that the FRA is settled on day 30 from the time of the agreement and the exposure
ends on day 210. This means that the hedge lasts for 180 days.

  Example 3.8
On January 1, the finance manager of Maruti forecasts that Maruti will need INR 10,000,000 on
March 1, for a six-month period. The loan will be repaid on August 31. Since the interest rate at which
Maruti can borrow this amount on March 1 is not known on January 1, Maruti faces an interest rate
risk and would like to enter into a forward contract that will fix the interest rate on January 1 for the
loan that will be taken on March 1. Since the borrowing is on March 1, which is 59 days from January 1,
and the end of exposure is on August 31, which is 243 days from January 1, this will be known as a
59 × 243 FRA.
The steps involved in the operation of an FRA are as follows:
Step 1: Setting up the FRA on January 1
(i)  Maruti will approach an FRA dealer and ask for a forward contract on January 1.
(ii) Maruti and the FRA dealer will decide the most appropriate benchmark rate that will be applicable
to the loan when Maruti borrows from the debt market. The benchmark rate can be the Treasury
bill rate, bill discount rate, prime rate, or the MIBOR. The benchmark rate is known as the refer-
ence rate (RR). The benchmark rate will be decided so that it is close to the rate at which Maruti
can borrow in the market.
(iii) The FRA dealer will quote a rate, which is the forward rate; it is also known as the agreed rate (AR).
The AR is the effective borrowing rate for Maruti.
Step 2: Settlement on March 1
(i)  This is the day on which Maruti will be borrowing the money.
(ii) Maruti will borrow the money it needs in the debt market at the prevailing rate. Since the cost
of a loan is the sum of the RR and the premium, the amount of interest that Maruti needs to pay
is the amount borrowed multiplied by the cost of the loan. This is equal to (Amount borrowed ×
RR) + (Amount borrowed × Premium). Under the FRA, the AR provides the effective interest
rate on the loan. The interest amount that the borrower agrees to pay is the amount borrowed
multiplied by the cost of the loan based on the AR. This is equal to the amount borrowed multi-
plied by the (AR + Premium), which is equal to (Amount borrowed × AR) + (Amount borrowed ×
Premium).
(iii) The FRA dealer will find the prevailing RR in the market on March 1. If the MIBOR is the RR, the
FRA dealer will find out the MIBOR on March 1.
(iv) The FRA dealer will then compare the RR on March 1 with the AR.
(v) If the RR is greater than the AR, the amount of interest to be paid by Maruti will be higher than
what was agreed upon in the FRA. The extra amount of interest that Maruti will pay = Amount
borrowed × (RR – AR). Since Maruti had agreed to pay interest based only on the AR, Maruti will
have to pay only this amount. Thus, the counterparty to Maruti in the FRA will provide sufficient
funds to Maruti so that Maruti pays only (Amount borrowed × AR) + (Amount borrowed × Pre-
mium). The funds that need to be paid by the counterparty to Maruti will therefore equal Amount
borrowed × (RR – AR). However, the full amount of this difference will not be paid to Maruti,
because Maruti needs to pay interest only at the time to end the exposure. The amount that Maruti
will receive is the present value of this extra interest payment, which will be paid on the settlement
date.
(vi) If the RR is lower than the AR, the amount of interest to be paid by Maruti will be less than what
was agreed upon in the FRA. The amount of interest that Maruti will save = Amount borrowed ×
(AR – RR). Since Maruti had agreed to pay the interest based on the AR, Maruti will have to pay
this amount as the effective interest. Since the actual interest amount for Maruti is less than the
agreed amount, the difference between the agreed amount and the actual amount of interest will
be paid to the counterparty by Maruti. Thus, Maruti will pay the counterparty the difference in the
interest payments based on the RR and the AR. The funds that need to be paid by Maruti to the

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 Forward Contracts   49

Notes counterparty will therefore be equal to Amount borrowed × (AR – RR). However, the full amount
of this difference will not be paid by Maruti, because Maruti needs to pay the interest only at the
time to end the exposure. The amount that Maruti will pay is the present value of this savings in
interest payment, which will be paid on the settlement date.
Step 3: End-of-exposure Date
When the end-of-exposure date arrives, Maruti will pay the interest due on the loan, based on the RR.
However, the effective interest amount will be the interest calculated based on the AR, because Maruti
will be compensated with additional cash in case the RR is higher than the AR on the settlement date. If
the AR is higher than the RR, Maruti will pay the interest savings to the counterparty.

To summarize, in an FRA, there are two interest rates, the agreed rate (AR), which it guarantees,
and a mutually agreed reference rate (RR). If the AR is below the RR on the settlement date, the coun-
terparty, also known as the seller of the FRA, will provide sufficient money to the borrower so that the
borrower will be able to pay the interest at the RR. However, if the AR is above the RR, the borrower
will provide sufficient money to the seller of the FRA. In an FRA, the principal amount is borrowed in
the market. The principal amount is only a notional one. This means that the FRA will cover only this
amount of principal and there will be no borrowing of the principal amount. This is explained through
Example 3.9.

  Example 3.9
Consider the case of Bengal Corporation, which plans to borrow money after 30 days for a period of 180
days. Since the money is being borrowed after 30 days, the borrower faces the uncertainty of not knowing
what the interest rate will be on the 180-day loan when the loan is taken after 30 days. Thus, it will enter
into a 30-day × 210-day FRA. The AR is 8%, the RR is the MIBOR, and the cost of the loan is MIBOR + 200
basis points.
Since the FRA is 30 day/210 day, the interest rate which is of concern is the RR after 30 days. Assume
that the 180-day MIBOR after 30 days is 7%. Then the RR will be 7% + 2% = 9%. This means that the
borrower will have to borrow at 9%. However, the AR is 8%. This means that the borrower will have to
pay an interest that is 1% more than the AR. If the principal agreed upon is INR 1,000,000, the borrower
will have to pay an additional interest of INR 5,000 for six months over the AR of 8%. Payment will be
made to the borrower to cover this 0.5% by the counterparty to the FRA, so that the interest rate paid by
the borrower is 8%, as agreed upon under the FRA.
On the other hand, if the 180-day MIBOR is 5%, the RR is only 7%. This means that the borrower can
get the loan at 7%. However, the AR is 8%. Therefore, the borrower will have to pay INR 5,000 to the FRA
counterparty so that the actual interest to the borrower is 8%.
The calculations are as shown:
The notional principal: INR 1,000,000
AR: 8%
RR: MIBOR + 2%
If at the end of 30 days, the 180-day MIBOR = 7%, the RR for the loan = 7% + 2% = 9%. The borrower will
have to borrow INR 1,000,000 in the market at 9% for 180 days. Assuming 360 days in a year, the amount
of interest that they have to pay under this loan will be:
180
Interest to be paid by the borrower at the RR = 1,000,000 × 9% × = INR 45,000
360
However, the AR is 8%, and if the borrower can borrow at this rate, the amount of interest they have to
pay will be:
180
Interest to be paid by the borrower at the AR = 1,000,000 × 8% × = INR 40,000
360
Thus, the borrower has to pay INR 5,000 more if they borrowed at the RR rather than at the AR.

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Notes The lender will therefore have to pay money to the borrower so that the actual interest paid by them is
only INR 40,000, as agreed upon.
If at the end of 30 days, the 180-day MIBOR = 5% and the RR for loan = 5% + 2% = 7%, the borrower
will have to borrow INR 1,000,000 in the market at 7% for 180 days. Assuming 360 days in a year, the
amount of interest that they have to pay under this loan will be:
180
Interest to be paid by the borrower at the RR = 1,000,000 × 7% × = INR 35,000
360
However, the AR is 8% and if the borrower can borrow at this rate of 8%, the amount of interest they have
to pay will be:
180
Interest to be paid by the borrower at the AR = 1,000,000 × 8% × = INR 40,000
360

Thus, the borrower has to pay INR 5,000 less if they borrowed at the RR, rather than at the AR.
The borrower will, therefore, have to pay money to the lender so that his actual interest payment is
INR 40,000, as agreed upon.
The actual amount that is to be paid is calculated using a formula that is explained in Section 3.7.2.
This shows that the actual interest rate for the borrower is the AR under the FRA, irrespective of the
interest rate prevailing in the market.

Example 3.9 also shows that the FRA locks in a known interest rate for the loans, but if the interest rate
decreases below the RR, the borrower will have a notional loss, as they could have borrowed at a lower
rate in the absence of the FRA.
FRAs are cash-settled. This means that money is not actually borrowed or lent on the settlement
date. On the settlement date, the RR, which is the rate at which the borrower will borrow, is fixed and
depending on whether the RR is greater or less than the AR, cash will be paid by one party to the oth-
er. If the RR is more than the AR, the borrower needs to pay a higher interest rate on the borrowing
than what was agreed to under then FRA and, thus, the counterparty will have to make cash payments
to the borrower to make up for the increased interest amount that will have to be paid by the borrower.
In case the RR is less that the AR, the borrower will be able to borrow at a lower rate and will have
to make a cash payment to the counterparty so that the actual interest amount will equal the amount
based on the RR.

3.7.1 Mechanics of FRAs
There are two dates specified in any FRA, namely:
1. the settlement date, which is also known as the delivery date of the forward contract or the start of
the forward period, which is given by t1, and
2. the end-of exposure period, also known as the end of the forward period, given by time t2.
The length of the loan period is t2 – t1, which is the length of time for which the money is borrowed.
The buyer of the FRA agrees to borrow money at time 0 from t1 to t2 at an interest rate of fr  (t1,t2),
which is the AR or the forward rate. The spot rate on t1, which is the RR, is not known at the time of
entering into the contract.
The FRAs are referred to as t1 × t2 FRA, or t1 versus t2 FRA, or t1 V. t2 FRA, where t1 is the settlement
date for the FRA and t2 is the end of the exposure period. For example, a 1 × 4 FRA means that it is an
agreement to borrow or lend for a 3-month period beginning one month hence. It is also referred to as
“one month against four months” or “1’s against 4’s.”
Many banks around the world quote and trade FRAs and the market is very liquid. The bid–asked
spreads are usually quite narrow—as little as 3 to 4 basis points. For a 6 × 12 FRA (borrowing for 6
months, beginning 6 months from now), a bank may be willing to borrow at a rate of 6.05% for a 6-month
period, 6 months hence, and lend at a rate of 6.08%; this is a spread of 3 basis points.

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Notes 3.7.2  The FRA Payment Amount

Payment is made on the settlement date, t1, which is the start of the loan period. The payment amount is
calculated as follows:
The forward rate according to the FRA is known and is denoted as fr  (t1,t2).
On t1, the spot interest rate is known and hence the RR can be calculated, which is denoted by
r (t1,t2).
The RR is subtracted from the forward rate. Since these rates are stated in annual terms, the rates are
converted to the rates applicable for the loan period. For example, if the RR is 8% and the forward rate is
10%, the difference is 2% on an annual basis. If the loan period is six months, the rate for the six-month
period is 1%.
The difference in interest rate, which is (AR – RR), is multiplied by the principal to find the amount
of interest differential. This amount is then discounted at the spot rate. Discounting happens because the
settlement is at the start of the loan period t1 and interest is paid at the end of exposure period t2. The
following notations are used in the FRA payment calculation.
Principal amount: P
Number of days in a year B (either 360 or 365, as specified in the FRA; usually,
360 days is used)
Number of days in the loan period: D, which is equal to t2 – t1, in days
Fraction of year of the loan period: D/B
The payment amount is given by:
D
P [r (t1 , t 2 ) − fr (t1 , t 2 )]  
B
Amount =  (3.1)
  D 
1 + r (t1 , t 2 )   
  B 

The payment amount or settlement amount is calculated in the following steps:

Step 1: Calculate the difference between the RR and the AR, which equals r (t1,t2) – fr (t1,t2).
Step 2: Convert the interest rate differential to match the maturity of the FRA.
  Since the interest rates are stated in annual terms, we need to convert this annual interest rate differen-
tial into the interest rate differential for the FRA duration. This is done by multiplying the annual interest
rate differential by the maturity of the FRA expressed as a fraction of one year. Since D = (t2 – t1) is the
duration of the FRA and B is the number of days in a year, which is usually 360 days, the interest rate dif-
ferential for the duration of FRA = [r (t1,t2) – fr (t1,t2)] × (D/B).
  The number of days for the loan period may not equal 90 days, even if the contract covers a time period
of three months, because the number of days from January 1 to March 31 is 90 days in a normal year and 91
days in a leap year. Similarly, if the three-month period is from July 1 to September 30, the number of days
will be 92. Therefore, it is important to use number of days, rather than months. The actual number of days
in a year depends on where the contract is entered. If it is in the USA, 360 days in a year is the standard,
whereas if the contract is in the UK, 365 days in a year is used. In India, the 360-day convention is used for
calculating the settlement amount in the FRA.
Step 3: Calculate the amount of interest differential on the basis of difference between AR and RR.
The amount of interest differential is calculated by multiplying the notional principal amount by the dif-
ference between the RR and AR adjusted for the duration of FRA as,
D
Amount of interest differential = P × [r (t1,t2) – fr (t1,t2)] ×
B
This amount of interest differential represents the difference between the amount of interest that would
be paid on the loan if taken at the market rate and the amount of interest that would be paid on the basis
of the AR.

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 52   Financial Risk Management

Notes   If the amount of interest differential is positive, the borrower would need to pay this amount in ad-
dition to the interest based on the AR. Since the effective rate is the AR, the counterparty will have to
provide a sufficient settlement amount on the settlement date so that the borrower will be able to pay the
interest based on the RR. This can be understood as:
Total interest based on AR = Interest paid by the borrower at RR – Funds provided by the counterparty
for the difference between the RR and AR.
If the amount of interest differential is negative, the borrower is able to save this amount as he could bor-
row at the RR, which is lower than the AR. However, he had agreed to pay interest at the higher interest
rate of AR. Thus, the borrower would pay this interest savings to the counterparty, in addition to the
interest based on the RR. This can be understood as:
Total interest based on AR = Interest paid by the borrower at RR + Funds provided to the counterparty
for the difference between the RR and AR.
Step 4: Discount the amount of interest differential calculated in Step 3 at the prevailing spot market rate
to get the settlement amount.
  The amount calculated in Step 3 shows the additional interest paid by the counterparty to the borrower
if the RR if higher than the AR and the interest savings of the borrower that is paid to the counterparty
if the AR is higher than the RR. However, the interest is paid on the end-of-exposure date t2, whereas
the amount of interest differential is either paid or received on the settlement date t1. Since the party that
receives this amount on the settlement date can invest the funds received at the spot rate prevailing on
date t1, the value on the end-of-exposure date t2 will be sufficient to pay the additional interest beyond the
interest at the AR, if the RR is higher than the AR. Thus, the settlement amount will be the present value
of the amount of interest differential calculated.
Settlement amount = Present value of amount of interest differential calculated in Step 3
D
P [r (t1 , t 2 ) − fr (t1 , t 2 )]  
B
Settlement Amount =
  D 
1 + r (t1 , t 2 )   
  B 
This is the same as Equation (3.1).

Problem 3.8
Canara Bank sells a 1 × 4 FRA on April 1 with a principal amount of INR 5 million at an AR of 8%. The RR on the
FRA is the MIBOR, and the cost of the loan is MIBOR + 100. On the settlement date, which is one month ahead, the
MIBOR is 6.4% and the RR is MIBOR + 100. A year is said to have 360 days. What will be the settlement payment?
Solution to Problem 3.8
Step 1: Calculate the difference between the RR and the AR on May 1.
Since the RR is MIBOR + 100, and the MIBOR on May 1 is 6.4%, the RR is 6.4% + 1% = 7.4%.
AR = 8%
Difference between the RR and AR = 7.4% – 8% = –0.6%
Step 2: Convert the difference between AR and RR to match the maturity of the FRA.
The loan period is 3 months starting May 1, and the end-of-exposure date is July 31. Thus, the duration of the FRA
is 92 days [31 (May) + 30 (June) + 31 (July)].

D
Difference between AR and RR for the duration of the FRA = [r (t1,t2) – fr (t1,t2)] ×
B
92
= (–0.6%) ×
360
= –0.1533%

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 Forward Contracts   53

Step 3: Calculate the amount of interest differential on the basis of this rate differential.
Notes
D
Amount of interest differential = P × [r(t1,t2) – fr(t1,t2)] ×
B
= INR 5,000,000 × (–0.1533%)
= INR 7,677

Since the amount of interest differential is negative, the borrower using the FRA needs to pay the counterparty or the
seller of the FRA an amount that will be equal to INR 7,677 on the end-of-exposure date. Since Canara Bank is selling
the FRA, it will receive this amount on the settlement date.
Step 4: Discount the amount calculated in Step 3 at the prevailing spot market rate to get the settlement amount.
Since the market interest rate on the settlement date is the RR of 7.4%, the settlement amount can be calculated using
Equation (3.1) as,

D
P [r (t1 , t 2 ) − fr (t1 , t 2 )]  
B
Settlement Amount =
  D 
1 + r (t1 , t 2 )   
  B 

7677
Settlement Amount = = INR 7, 524.37
92
1 + 0.074 ×
360

Thus, Canara Bank will receive INR 7,524.37 as the settlement amount. This can be explained as follows. The buyer will
be borrowing INR 5,000,000 at the market rate of 7.4% for 92 days and hence the total interest he would pay would be:
92
5,000,000 × 0.074 × = INR 94,555
360
However, he had agreed to pay 8% under the FRA. At the rate of 8%, the interest payment would be:

92
5,000,000 × 0.08 × = INR 102,222
360
Thus, the buyer is able to reduce the interest amount by INR 7667 × (102,222 – 94,555) by borrowing at the RR. Since
the settlement date is the starting date of the loan, the present value of this amount on the settlement date would be
INR 7,524.37, and this amount would be paid to the seller (Canara Bank).

3.7.3 An Alternative View of an FRA and the Settlement Amount

The FRA buyer has agreed to borrow at 8%, and they borrow INR 5,000,000 at 8% for 92 days. Their
interest payment would be INR 102,222 after 92 days. However, the market rate is only 7.4% for 92 days,
and they need to pay the FRA seller INR 7,524.37 on the settlement date. Thus, they need to borrow the
INR 5,000,000 they need as well as the INR 7,524.37 they need to pay the FRA seller. The total borrowing
will then be INR 5,007,524.37, and the borrowing will be at the market rate of 7.4% for 92 days. Thus, the
amount they need to repay along with interest after 92 days is given by:
 92 
5,007,524.37 × 1 + 0.074 × = INR 5,102,222
 360 
This shows that the interest they pay on a loan of INR 5,000,000 is INR 102,222, or the effective
interest rate for borrowing INR 5,000,000 is 8%.
On the other hand, assume that the market rate is 7.5%. In this case, the RR would be 7.5% + 1% =
8.5%. This RR is higher than the AR of 8%. In this case, the FRA seller will pay the difference of 0.5% to
the FRA buyer. The settlement amount would be calculated as:
92
5,000,000 × 0.005 ×
360 = INR 6,253
92
1 + 0.085 ×
360

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 54   Financial Risk Management

Notes This amount would be received by the FRA buyer. Thus, the FRA buyer needs to borrow INR 5,000,000 –
INR 6,253 = INR 4,993,747. This amount would be borrowed at the market rate of 8.5%, and the amount
of interest to be paid would be:
 92 
4,993,747 × 1 + 0.085 × = INR 5,102,222
 360 
If they had borrowed INR 5,000,000 at 8% at the AR, they would have had to pay back INR 5,102,222, as
calculated earlier. The FRA in both the cases results in the borrower paying an effective rate of the AR,
which is 8% in this example.

3.7.4  Uses of FRAs

FRAs are used by firms and financial institutions to hedge against unexpected changes in interest
rates. The parties might use an FRA to lock in a borrowing rate or a lending rate for transactions
they will undertake at a future time. By buying an FRA, the party locks in an interest rate on a future
loan, and by selling one, a party is able to lock in an interest rate on the lending. A corporation
can use FRAs to lock in future borrowing rates while taking up floating-rate loans or for rolling
over short-term loans such as commercial papers. FRAs can also be used to speculate on interest
rates.
Banks also use FRAs to reduce risks. Banks have loans with their assets and deposits as liabilities. Since
by nature most deposits and loans are short-term and long-term, respectively, the variation in the value of
deposits and loans with changes in the interest rates will be different for assets and liabilities.
If a bank expects a decrease in interest rates and if its assets are more than its liabilities, it will sell an
FRA for that period for a value equal to the value of assets minus the value of liabilities. The decrease in
the net interest income, that is, the interest on assets minus the interest on liabilities, will be offset by the
gain from the FRA. On the other hand, if liabilities exceed assets and if interest rates are expected to
increase, the bank can buy an FRA for that time period. Depending on the relationship between assets and
liabilities and the expectation of future interest rates, the bank can set up a number of FRAs to hedge inter-
est rate risk.
A bank can also use FRAs to lock in its borrowing costs. A bank may expect substantial cash inflows
in three months, but the loan demand may not pick up until after six months. In order to lock in a target
return, the bank can sell the FRAs. Similarly, a bank that is funding its long-term loans by rolling over
shorter-term liabilities may buy FRAs to lock in borrowing costs.
A bank that has liabilities of longer duration but still lends a certain amount of its liabilities in the
interbank market for three months owing to capital adequacy or other considerations can use FRAs to
cover its exposure to movements in short-term rates. To hedge its exposure, this bank can sell a series
of FRAs to match its liabilities and lock in to a spread. Similarly, another bank that has limited access to
funds with maturities greater than six months and relatively longer-term assets might prefer a contract
for a 6 × 12 FRA and thus increase the extent to which it can match the asset and liability maturities from
the perspective of interest rate. In both these situations, the banks can choose to buy FRAs, depending on
their market views and their perceptions of uncertainty periods.

Problem 3.9
Bharat Alloys produces metal products from various alloys and sells them all over the world. Since the demand has
increased substantially in the last two years, Bharat Alloys is expanding its production facilities at a total cost of
INR 20,000,000. Since the interest rates are quite low at this time, Bharat Alloys decides to go for a three-year
floating-rate loan. On January 1, 2008, the loan is approved. The details of the loan are:
Principal Amount INR 20,000,000
Maturity or tenor 3 years
Interest Rate Floating
Interest Reset Every 6 months
RR 6-month MIBOR
Loan rate RR + 250
MIBOR as on January 1, 2008 6%

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 Forward Contracts   55

Bharat Alloys is concerned that the interest rate may increase in the future and hence would like to hedge the loan
Notes
interest rate through FRAs. The dealer in the FRA provides the following details of the available FRAs:
6 × 12 FRA with an AR of   8.6%
12 × 18 FRA with an AR of   9.0%
18 × 24 FRA with an AR of   9.3%
24 × 30 FRA with an AR of   9.7%
30 × 36 FRA with an AR of 10.0%
Bharat Alloys enters into five different FRAs in order to hedge its interest rate exposure throughout the loan period.
Calculate the settlement amount at the start of each FRA if the actual MIBOR at various dates are as follows:
Date MIBOR
July 1, 2008 6.4%
January 1, 2009 6.9%
July 1, 2009 6.5%
January 1, 2010 6.8%
July 1, 2010 7.2%
Solution to Problem 3.9
The following table provides the RR and the AR for each FRA.
Date MIBOR Loan rate MIBOR + 250 AR
July 1, 2008 6.4% 6.4% + 2.5% = 8.9%   8.6%
January 1, 2009 6.9% 6.9% + 2.5% = 9.4%   9.0%
July 1, 2009 6.5% 6.5% + 2.5% = 9.0%   9.3%
January 1, 2010 6.8% 6.8% + 2.5% = 9.3%   9.7%
July 1, 2010 7.2% 7.2% + 2.5% = 9.7% 10.0%
The settlement amount for each FRA is calculated using the following steps:
Step 1: For each FRA, calculate the number of days to maturity.
6 × 12 FRA: Settlement on July 1, 2008, and end of exposure on December 31, 2008. therefore:

number of days = 184 [31 (July) + 31 (August) + 30 (September) + 31 (October)

+ 30 (November) + 31 (December)]
Step 2: For each FRA, calculate the interest rate differential on annual basis.
interest rate differential = RR – AR
Step 3: Calculate the interest rate differential on maturity basis.

Interest rate differential for the maturity of the FRA = Interest rate differential on annual basis
FRA maturity in days
×
360
Step 4: Calculate the settlement amount for each FRA.

Principal amount × Interest rate differential on maturity basis

Settlement amount for each FRA =
1 + FRA RR × Days to maturity
360
The following table provides the settlement amounts for different FRAs:
Number of Interest rate Interest Rate Settlement
FRA Days to Maturity Differential (Annual) Differential (Maturity) Amount (in INR)
6 × 12 184 0.3% 0.001533 29,332
12 × 18 181 0.4% 0.002011 38,407
18 × 24 184 0.3%   0.00153 29,318
24 × 30 181 0.4%   0.00201 38,425
30 × 36 184 0.3%   0.00153 29,218
In the 6 × 12 FRA and the 12 × 18 FRA, the loan rate is higher than the AR and hence Bharat Alloys will receive the
settlement amounts from the FRA dealer.

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 56   Financial Risk Management

In the 18 × 24 FRA, 24 × 30 FRA, and 30 × 36 FRA, the loan rate is lower than the AR and hence Bharat Alloys
Notes
will pay the settlement amount to the FRA dealer.

3.8  Non-deliverable Forwards

Forward contracts generally require delivery of assets in exchange for cash. For example, if you en-
ter into a gold forward contract to sell gold in three months, you need to deliver the gold in exchange
for cash. If you enter into a forward contract to sell U.S. dollars in 60 days, you need to deliver U.S. dol-
lars in exchange for Indian rupees. Thus, forward contracts require the delivery of assets in exchange for
cash. However, there are some contracts that are forward contracts, but they do not involve the deliv-
ery of assets. These are called non-deliverable forward contracts. These contracts are usually based on
currencies.
All currency forward contracts are entered through banks. When a hedger has a long position in
a foreign currency, say, a U.S. dollar, the hedger will approach a bank to enter into a forward contract
to sell U.S. dollars to reduce the exchange rate risk. However, the bank does not have a short position in
U.S. dollars to hedge and when it enters into a futures contract, it gains a long position in U.S. dollars at
the maturity of the contract. The bank will then have to hedge this open position either by entering into
a forward contract to sell U.S. dollars at the maturity of the original forward contract or hedge using cur-
rency futures. In case there are no parties available for entering into a forward or a futures contract in
that currency, the bank will have an open position in that currency, and this position cannot be hedged.
In such a case, the bank will not like to enter into a contract that will provide an open position and would
rather prefer to enter into a non-deliverable forward contract. Thus, in a non-deliverable forward con-
tract, there is no delivery of the asset. If that is the case, how will the contract be settled at the time of
maturity?
A non-deliverable forward contract is settled through cash payment. Under a non-deliverable forward
contract, a forward rate and a notional amount is agreed upon between the two parties, and on the matu-
rity of the forward contract, cash is exchanged between the parties on the basis of the spot market rate at
the maturity of the forward contract. The amount of cash exchange will be calculated as:
Cash amount = (Spot rate – Forward rate) × Notional amount
The losing party will make a cash payment to the winning party. This is explained through Example 3.10.

  Example 3.10
Mr. Karim, owner of Karim Toys, has imported toys from Chang Brothers in China for Chinese yuan
(CNY) 200,000 on April 1, and this amount will be paid to Chang Brothers on April 30. The exchange
rate on April 1 is CNY 1 = INR 7.0561. He is uncertain about the amount in Indian rupees that would be
needed to pay CNY 200,000 on April 30, as the exchange rate on that date is unknown today. He would
like to hedge this currency risk through a forward contract. He approaches the State bank of India (SBI),
and the manager of the SBI informs him that it will only enter into a non-deliverable forward contract at
CNY 1 = INR 7.2145. They enter into the non-deliverable forward contract. This means that he will pay
200,000 × 7.2145 = INR 1,442,900 on the maturity date.
In a non-deliverable forward contract, there is no delivery of foreign currency; it only involves cash
settlement. The payment amount is calculated as the difference between the spot rate at the maturity of
the forward contract and the forward rate multiplied by the notional amount.
Assume that the spot rate at the maturity of the forward contract is CNY 1 = INR 7.1845. At the
spot rate, the amount that Mr. Karim needs to pay will be 200,000 × 7.1845 = INR 1,436,900. Since he
had agreed to pay INR 1,442,900 under the forward contract and the amount under the spot contract
is less than the amount under the forward contract, he needs to pay the difference to the SBI so that the
actual amount will be the same as the amount agreed upon under the forward contract. Thus, he will pay
INR 1,442,900 – INR 1,436,900 = INR 6,000 to the SBI.
If the spot rate at the maturity of the forward contract were to be CNY 1 = INR 7.2368, the amount
that Mr. Karim would have had to pay at the spot rate would be 200,000 × 7.2368 = INR 1,447,360. Since
he had agreed to pay INR 1,442,900 under the forward contract and the amount under the spot contract
is more than the amount under the forward contract, the SBI needs to pay him the difference so that the

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 Forward Contracts   57

Notes actual amount will be the same as the amount agreed upon under the forward contract. Thus, the SBI will
pay him INR 1,447,360 – INR 1,442,900 = INR 4,460.

Problem 3.10
Apollo Apparel exported textiles to Ng Imports in Vietnam for Vietnam dong (VND) 50 million on June 10, and
Ng Imports will pay the amount on July 20. The exchange rate on June 10 is INR 1 = VND 369.9668. Since Apollo
Apparel is concerned about currency risk, it enters into a non-deliverable forward contract with the ICICI Bank
for a notional amount of VND 50 million. According to the forward contract, the forward rate is fixed at INR 1 =
VND 374.5684, with expiry on July 20. If the actual spot rate on July 20 is INR 1 = VND 379.4356, what will be the
settlement on July 20?
Solution to Problem 3.10
Step 1: Since it is a non-deliverable forward, there will be a cash settlement. First, calculate the amount in Indian
rupees that Apollo Apparel will receive under the forward contract.

50,000,000
Amount in Indian rupees under the forward contract = = INR 133,487
374.5684
Step 2: Calculate the amount in Indian rupees that Apollo Apparel will receive at the spot rate at maturity, July 20.

50,000,000
Amount in Indian rupees at the spot rate at maturity = = INR 131,774.70
379.4356
Step 3: Calculate the difference between the amounts at the forward rate and the spot rate at maturity.

Difference between the amounts at the forward rate and the spot rate at maturity = 133,487 – 131,774.70 =
INR 1,712.30.

Step 4: Identify whether Apollo Apparel is making a loss or a gain through the forward contract.
  Since Apollo Apparel is receiving money at a future time and this amount will be converted at the spot rate at
maturity, Apollo Apparel will gain if the amount at the forward rate is more than the amount at the spot rate, whereas
it will lose under the forward contract if the amount at the spot rate is more than the amount at the forward rate.
Since the amount at the forward rate is more than the amount at the spot rate, Apollo Apparel gains under the
forward contract.

Step 5: Identify whether Apollo Apparel will pay or receive this difference.
  Since Apollo Apparel gains under the forward rate, the difference will be paid by the ICICI Bank to Apollo Apparel
so that the net amount that Apollo Apparel receives will be INR 131,774.70 (from the spot contract) plus INR 1,712.30
(from the ICICI Bank), which gives a total of INR 133,487 (the amount under the forward contract).

Problem 3.11
Ram Textiles has imported cotton from Dang exports in Cambodia for Cambodian riel (KHR) 20 million on
August 10, and Ram Textiles will pay the amount on September 30. The exchange rate on August 10 is INR 1 = KHR
86.3844. Since Ram Textiles is concerned about currency risk, it enters into a non-deliverable forward contract with
the HSBC Bank for a notional amount of KHR 20 million. According to the forward contract, the forward rate is
fixed at INR 1 = KHR 87.4356, with expiry on September 30. If the actual spot rate on September 30 is INR 1 = KHR
86.3245, what will be the settlement on September 30?
Solution to Problem 3.11
Step 1: Since it is non-deliverable forward, there will be a cash settlement. First, calculate the amount in Indian
rupees that Ram Textiles will pay under the forward contract.
20,000,000
Amount in Indian rupees under the forward contract = = INR 228,739.80
87.4356

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 58 Financial Risk Management

Step 2: Calculate the amount in Indian rupees that Ram Textiles will pay under the spot rate at maturity, July 20.
20,000,000
Amount in Indian rupees at the spot rate at maturity = = INR 226,437.70
88.3245
Step 3: Calculate the difference between the amounts at the forward rate and the spot rate at maturity.
Difference in amounts between the forward rate and the spot rate at maturity = INR 228,739.80 – INR 226,437.70
= INR 2,302.10
Step 4: Identify whether Ram Textiles is making a loss or a gain through the forward contract.
Since Ram Textiles is paying money at a future time and this amount will be converted at the spot rate at maturity,
Ram Textiles will gain if the amount at the forward rate is less than the amount at the spot rate. On the other hand,
Ram Textiles will lose under the forward contract if the amount at the spot rate is less than the amount at the forward
rate. Since the amount at the forward rate is more than the amount at the spot rate, Ram Textiles gains under the
forward contract.
Step 5: Identify whether Ram Textiles will pay or receive this difference.
Since Ram Textiles gains under the forward contract, the difference will be paid to the HSBC Bank by Ram Textiles
so that the net amount that Ram Textiles pays will be INR 226,437.70 (from the spot contract) plus INR 2,302.10 (to
be paid to the HSBC Bank), which gives a total of INR 228,739.80 (the amount under the forward contract).

CHapTEr SUmmary
 A forward contract is an agreement to buy or sell a specified the hedgers, but they have problems of non-transferability and
asset at a certain time in the future for a specified price that is non-performance.
agreed upon at the time of entering into the contract.  Commodity and financial forwards are priced using the cost-
 In a forward contract, the price at which the asset and cash of-carry model.
would be exchanged at a future time is determined at the current  Currency forward contracts are priced using the model of
time and the actual exchange takes place at a future time, which covered interest rate parity.
is mutually agreed upon by the concerned parties.  Interest rate forward contracts are called forward rate
 Forward contracts lock in the price at which the asset and cash agreements (FRAs) and are used for hedging the interest rate
will be exchanged at a future time. risk in the short term.
 Forward contracts are contracts between two private parties.  Banks use FRAs to manage the interest rate risks that they
 Forward contracts are custom-made according to the needs of face.

mUlTiplE-CHoiCE QUESTioNS
1. Which of the following is a consumption asset? A. $40.50 B. $22.22
A. The S&P 500 index C. $33.00 D. $33.16
B. The Canadian dollar
4. The spot price of an investment asset is $30 and the risk-free
C. Copper
rate for all maturities is 10% with continuous compounding.
D. IBM stock
The asset provides an income of $2 at the end of the first year
2. An investor shorts 100 shares when the share price is $50 and and at the end of the second year. What is the three-year for-
closes out the position six months later when the share price is ward price?
$43. The shares pay a dividend of $3 per share during the six A. $19.67 B. $35.84
months. How much does the investor gain? C. $45.15 D. $40.50
A. $1,000 B. $400
5. An exchange rate is 0.7000 and the six-month domestic and for-
C. $700 D. $300
eign risk-free interest rates are 5% and 7% (both expressed with
3. The spot price of an investment asset that provides no income continuous compounding). What is the six-month forward rate?
is $30 and the risk-free rate for all maturities (with continuous A. 0.7070 B. 0.7177
compounding) is 10%. What is the three-year forward price? C. 0.7249 D. 0.6930

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 Forward Contracts 59

6. Which of the following is true? C. The forward price is less than the expected future spot price.
A. The convenience yield is always positive or zero. D. The forward price is sometimes greater and sometimes
B. The convenience yield is always positive for an invest- less than the expected future spot price.
ment asset.
9. Which of the following describes the way the futures price of a
C. The convenience yield is always negative for a consump-
foreign currency is quoted?
tion asset.
A. The number of U.S. dollars per unit of the foreign
D. The convenience yield measures the average return
currency
earned by holding futures contracts.
B. The number of the foreign currency per U.S. dollar
7. A short forward contract that was negotiated some time ago C. Some futures prices are always quoted as the number of
will expire in three months and has a delivery price of $40. U.S. dollars per unit of the foreign currency and some are
The current forward price for three-month forward contract is always quoted the other way round
$42. The three month risk-free interest rate (with continuous D. There are no quotation conventions for futures prices
compounding) is 8%. What is the value of the short forward
10. Which of the following describes the way the forward price of
contract?
a foreign currency is quoted?
A. +$2.00 B. −$2.00
A. The number of U.S. dollars per unit of the foreign
C. +$1.96 D. −$1.96
currency
8. The spot price of an asset is positively correlated with the mar- B. The number of the foreign currency per U.S. dollar
ket. Which of the following would you expect to be true? C. Some forward prices are always quoted as the number
A. The forward price equals the expected future spot price. of U.S. dollars per unit of the foreign currency and some are
B. The forward price is greater than the expected future spot always quoted the other way round
price. D. There are no quotation conventions for forward prices

Answer
1. C 2. B 3. A 4. B 5. D 6. A 7. D 8. C 9. A 10. C

rEViEW QUESTioNS
1. Forward contracts are used to hedge future uncertainty. With 5. A firm wishes to get out of a forward contract that it entered into
respect to commodities, when would a party enter into a long two months ago, and the contract maturity is three months hence.
forward contract to buy and when would a party enter in to a What are the ways in which it can get out of the forward contract?
short forward contract, i.e., a contract to sell? 6. Entering into a forward contract can result in a profit or a loss,
2. What is meant by covered interest arbitrage? How can it be depending upon the movement in the price of the underlying
used to calculate the forward rate on a currency? asset. Knowing that there could be losses, why would anyone
3. FRAs are cash-settled. Explain the meaning of cash settle- enter into a forward contract?
ment. 7. Explain what is meant by counterparty risk with respect to for-
4. When a party enters into a forward contract, the price paid fi- ward contracts.
nally is the same as the price at which the forward contract was 8. An Indian vegetable merchant exports fruits and vegetables to
entered into, irrespective of the price of the underlying asset Singapore, pricing them in Singapore dollars. What price risks
in the cash market. Explain this with an example. does he face and how can he reduce the risks?

SElF-aSSESmENT TEST
1. On January 2, a bank sells a 2 × 5 FRA. The contracted forward The reference rate for the loan in the market is MIBOR +
rate is 5.34%. The principal amount is INR 1 million. On the 50 basis points.
settlement date, the spot MIBOR rates are: What amount would the bank pay or receive on the
settlement date?
Maturity Rate
1 month 4.85% 2. An Indian gold merchant enters into a contract to buy 200
2 months 4.92% ounces of gold from an Australian gold mining company at a
3 months 4.95% price of USD 910 per ounce, and the payment would be made
4 months 5.01% after three months from the date of the contract. The current
5 months 5.04% exchange rate is USD 1 = INR 42.8754. The interest rate in the
6 months 5.08% USA is 5%, and the interest rate in India is 8%. The merchant

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 60   Financial Risk Management

decides to hedge the risk of exchange rate by entering into Assume that the banks use the convention of 360 days in a
a forward contract. What would be the forward rate? How year to compute the settlement amount and the number of
much amount in Indian rupees would the merchant pay three days per month is 30 days.
months later?   When will the payments be made? Will you receive a
payment on the settlement day or will you have to make a
3. Suppose the gold merchant enters into a forward contract to
payment? What will be the settlement amount?
buy gold from an Australian gold mining company 6 months
later at USD 930 per ounce. At the end of three months from 6. Shriram Cosmetics has exported cosmetics to Dang Imports
the date this contract was entered into, the forward price of a in Vietnam for Vietnam dong (VND) 100 million on March
forward contract to sell gold three months hence is USD 920 14, and Dang Imports will pay the amount on May 28. The
per ounce. Does the gold merchant gain or lose on the original exchange rate on March 14 is INR 1 = VND 372.4578. Since
forward contract? Suppose it is expected that the price of gold Shriram Cosmetics is concerned about currency risk, it enters
is likely to decrease further in the next three months, what into a non-deliverable forward contract with Citibank for
should the gold merchant do? a notional amount of VND 100 million. According to the
forward contract, the forward rate is fixed at INR 1 = VND
4. Suppose that on April 1, 2008, you entered into a forward
374.4964, with expiry on May 28. If the actual spot rate on
contract to buy 100,000 U.S. dollars at USD 1 = INR 42.2478,
May 28 is INR 1 = VND 373.3894, what will be the settlement
for delivery on July 1, 2008. The spot rate on April 1, 2008, is
on July 20?
USD 1 = INR 42.1145. On July 1, 2008, the spot rate is USD 1 =
INR 42.3245 and the forward rate for delivery (three months 7. Mohan Textiles has imported cotton from Ng Exports in
later) is USD 1 = INR 42.4223. Did you profit or lose on this Cambodia for Cambodian riel (KHR) 40 million on May 20,
transaction? What is the amount of profit or loss made? and Mohan Textiles will pay the amount on July 20. The
exchange rate on May 20 is INR 1 = KHR 86.3844. Since
5. A market maker quotes 3 × 5 FRAs at 7.5 (bid) and 7.64 (asked).
Mohan Textiles is concerned about currency risk, it enters
You buy an FRA with a principal amount of INR 1 million. On
into a non-deliverable forward contract with the IDBI Bank
the settlement date, the following spot rates are observed:
for a notional amount of KHR 40 million. According to the
Maturity Rate forward contract, the forward rate is fixed at INR 1 = KHR
2 months 8.45% 86.4356, with expiry on July 20. If the actual spot rate on July
3 months 8.38% 20 is INR 1 = KHR 87.3542, what will be the settlement on
4 months 8.32% September 30?
5 months 8.26%

   C a se S tu d y

Tamil Nadu Steel is one of the major steel dealers in the world. It   The customers require that Tamil Nadu Steel quotes the price at
has its headquarters in Chennai and a branch office in London, which the steel will be sold one month in advance. That is, the price
United Kingdom. Tamil Nadu Steel purchases steel from steel com- at which Tamil Nadu Steel will sell steel in the month of January
panies in India and supplies it to customers in various parts of the will have to be quoted to the customers on December 1 itself. The
world, except India since there are many Indian steel companies customers who have bought the steel will pay the amount due
that provide steel for customers in India. on the last day of the month in which the sales are made. The
  When Tamil Nadu Steel purchases steel from Indian steel customers will pay the amount of purchase in either U.S. dollars or
companies, the price is determined in U.S. dollars, but the money in euros on January 31.
is to be paid in Indian rupees. When it sells steel to customers in   The cost of shipping and other costs in relation to selling steel for
other countries, the customers are invoiced in U.S. dollars, except various regions are estimated in US dollars: USA: USD 64; Europe:
for customers in Europe, where they are invoiced in euros. USD 52; Asia: USD 40; Others: USD 56
  Tamil Nadu Steel purchases the steel required for any month at   Tamil Nadu Steel sells steel with a margin of 14%. This is over
the beginning of the month and pays for the steel in Indian rupees the price paid for the steel and other costs.
to the Indian steel mills by the end of the month in which the steel   Tamil Nadu Steel has made forecasts of its sales to customers
was bought. For example, the steel needed to be sold in the month in the various regions for the next year, as shown in Table 1.
of January will be purchased on January 1 and the payment will be
made to the steel companies in Indian rupees on January 31.

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 Forward Contracts   61

Table 1 Demand for Steel (in MT)

Month USA Europe Asia Others Total

January 8,000 18,000 35,000 7,000 68,000

February 6,000 18,000 38,000 4,000 66,000

March 6,000 18,000 42,000 6,000 72,000

April 8,000 20,000 45,000 5,000 78,000

May 10,000 22,500 45,000 3,500 81,000

June 12,500 25,000 50,000 4,500 92,000

July 15,000 25,000 50,000 5,000 95,000

August 18,000 20,000 55,000 6,000 99,000

September 18,000 20,000 50,000 5,000 93,000

October 16,000 18,000 48,000 5,000 87,000

November 12,000 18,000 50,000 5,000 85,000

December 10,000 18,000 50,000 6,000 84,000

Steel prices have been highly volatile during the period between Table 2  Forward Prices of Steel (USD per MT)
January 2008 and May 2009. The price of hot-rolled steel coil
steadily increased from USD 639 per MT in January 2008 to USD
Delivery Month Forward Price
1,099 per MT by June 2008. From June 2008, the price started
falling, and it was selling at USD 474 per MT in May 2009. A January   740
similar pattern was also seen for the other steel products such
as hot-rolled steel plate, cold-rolled steel coil, steel wire rod, and February   780
medium steel sections. The prices of all these products increased March   850
from January 2008 and reached a maximum in July 2008. From July
2008, the prices started falling, and by May 2009, all these products April   940
were selling at very low prices.6 This is a big concern for Tamil
May 1,200
Nadu Steel, because it has to provide the quotes to its customers
one month in advance. In order to hedge its risk, Tamil Nadu Steel June 1,060
approached the steel mills in India to arrange for forward contracts
in steel. Table 2 shows the forward prices of steel for delivery in July 1,020
each month. August   940
September   850
October   740
November   700
December   640

6  Source: MEPS Steel Prices Online

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 62   Financial Risk Management

Tamil Nadu Steel estimated that it would require USD 50 million to Table 3  Exchange Rates: Spot and Forward Rates
finance the working capital as well as for warehouse construction
and maintenance. It has entered into a floating-rate loan, whose
Rupees per Rupees
details are as follows: Month
U.S. dollar per euro
Amount of principal USD 50 million
Interest rate 6-month LIBOR + 150 basis points January 1 (Spot) 49.2852 70.6359
Interest reset period every six months, on January 1
January 31 (Forward) 49.4639 70.3875
and July 1
Tenor of loan Three years February 28 (Forward) 43.8368 70.2422
LIBOR on January 1 6.25%
March 31 (Forward) 50.0354 70.1211
To reduce the interest rate risk, Tamil Nadu Steel enters into a 6 ×
12 forward rate agreement with the Emerson group, London, the April 30 (Forward) 50.1245 69.8754
terms of which are as follows:
May 31 (Forward) 49.6738 69.8245
Notional Principal Amount USD 50 million
AR 8.1% June 30 (Forward) 49.6542 69.4758
RR 6-month LIBOR + 150 basis points
July 31 (Forward) 49.4958 69.6492
At the end of every month, the Emerson Group will remit the receipt
from sales after keeping 5% of the sales for the next month as reserve. August 31 (Forward) 50.3475 69.8345
Since the payment to the steel suppliers will be in Indian rupees and
September 30 (Forward) 50.8678 69.9892
the remittance every month will also be in Indian rupees, Tamil
Nadu Steel has collected the following information on exchange October 31 (Forward) 51.2432 70.4579
rates between the U.S. dollar and the Indian rupee as well as between
the euro and the Indian rupee. This is presented in Table 3. November 30 (Forward) 51.5487 70.5682

December 31 (Forward) 51.3845 70.7459

The analysts have predicted that the 6-month LIBOR for the U.S.
dollar will be 6.95% on June 30.

Discussion Questions
Calculate the amount in Indian rupees that will be left with Tamil
Nadu Steel at the end of every month if the costs involved in
running the Chennai office is INR 0.15 million. The balance on
January 1 is INR 4 million. Assume that Tamil Nadu Steel will
hedge steel price risk, exchange rate risk, and interest rate risk
through forward contracts.

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 4
Futures Contracts

LEARNING OBJECTIVES

After completing this chapter, you In November 1967, Milton Friedman, a professor, believed that
will be able to answer the following the Bank of England was likely to devalue the British pound. He
questions: approached a Chicago bank to borrow money in order to make
 What is a futures contract? gains when the value of British pound falls but was turned down on
What
 are the differences the grounds that private speculation in currencies was prohibited.
between a futures contract He then wrote a series of articles in Newsweek complaining about
and a forward contract? this lack of opportunity. A member of the Board of Governors of the
Chicago Mercantile Exchange, Leo Melamed read these articles
What is the role of a

and saw the possibility of a currency futures market. In 1971, the
clearing corporation in futures markets assumed the responsibility for the U.S. dollar value, and
exchanges? this resulted in the opening of the currency futures market in May
What is meant by margin and
 1972.
marking-to-market in futures
markets?
How to understand futures

BoX 4.1 The Birth of Currency Futures Markets
quotes?
How can one arbitrage

between futures markets and
spot markets?
How are futures contracts

traded?

In Chapter 3, the concept of forward contracts and how forward contracts can be used for hedging pur-
poses were discussed. Certain inherent problems with forward contracts led to the development of fu-
tures contracts. In this chapter, we will discuss the reasons for the development of futures markets, the
difference between a forward contract and a futures contract, and how one can trade a futures contract.
The producers of agricultural commodities such as rice and wheat face problems in selling their har-
vest, as the market is huge and spreads across the country. Typically, dealers in agricultural goods buy
the output from the farmers and then sell them to wholesalers across the country. The dealers usually
take the upper hand by exploiting the farmers, who have to sell their output in order to take care of
their needs, by not giving them a fair price for their output. The introduction of forward markets did
not help the farmers much because the farmers had to find parties to enter into forward contracts with.

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 64   Financial Risk Management

Notes In addition, since the forward contracts were private contracts in which the forward price was fixed
through negotiation between two parties, the farmers were again at a disadvantage because of their poor
educational background and lack of awareness. This resulted in the development of a futures market
which became a boon for farmers. In a futures market, the price is determined in the market through in-
teraction between different market participants and hence the price tends to be fair. For the market price
of futures contracts to be fair, it is necessary that speculators are allowed to trade. In contrast to forward
markets, futures markets allow speculative trading, which results in a fair market price. Currency futures
were introduced in order to allow speculators to enter into the market and make the market prices fair.
The birth of this market is outlined in Box 4.1.

4.1  What Is a Futures Contract?

A futures contract is an agreement to buy or sell a specified quantity of a specified asset at a certain
time in the future for a price that is agreed upon at the time of entering into the contract. The spe-
cified asset is known as the underlying asset, the time at which the asset is bought or sold in the future
is known as the expiry date or maturity date of the futures contract, and the price at which the
transaction will take place on the expiry date that is determined at the current time is known as the
futures price.

  Example 4.1
September Pepper Futures expiring on September 20 at INR 15,700 at MCDEX India
This means that the underlying asset is pepper, and the specified quantity per contract is 1,000 kg.
Expiry is in the month of September, and the expiry date is September 20. The futures price is INR 15,700
per quintal (100 kg).
This means that a producer of pepper who buys a single pepper futures contract can buy 1,000 kg of
pepper on September 20 at a price of INR 15,700 per quintal.

4.2  Futures Contracts Versus Forward Contracts

If the definition of a futures contract is compared to the definition of a forward contract, it is seen that
these two definitions are exactly the same. Basically, a futures contract, like a forward contract, is an
agreement to exchange assets and cash at a future time and the price at which the exchange will take place
in the future is decided at the present time.
Although forward contracts and futures contracts are conceptually the same, there are certain differ-
ences between these two types of contracts; these differences are discussed next.

4.2.1 Negotiability
One of the problems with forward contracts is that they are not negotiable. For example, if two parties
enter into a forward contract, both parties will have to fulfill their obligations under the contract even if
there is a change in situation and one party wants to get out of the contract. For example, suppose that
an exporter is notified on January 1 that their customer in the USA will make a payment of USD 500,000
on March 31. In order to avoid the exchange rate risk, the exporter enters into a forward contract with a
bank to sell USD 500,000 on January 1, with an expiry date of March 31. However, the customer does not
make the payment on March 31, as expected. In this case, the exporter will have to sell USD 500,000 to
the bank even though they have not received the amount. The exporter needs to buy USD 500,000 in the
spot market and sell the same to the bank to receive the Indian rupees on the basis of the forward rate.
Although the obligations can be fulfilled in this manner, the procedure can be quite cumbersome and
can lead to losses.
However, futures contracts are negotiable. This means that a party that enters into a futures contract
to buy an asset can, at later time, enter into a futures contract to sell the same asset before the maturity of
the contract. Thus, futures contracts provide more liquidity as compared to forward contracts.

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 Futures Contracts   65

Notes 4.2.2 Standardization
Since futures contracts are negotiable, it is necessary that all parties clearly understand all the details
about the type of contract they are entering into. This requires that the contracts be standardized in terms
of the size, date of maturity, and details of delivery.
Standardization of futures contracts reduces their flexibility as compared to forward contracts, which
can be tailor-made to suit the needs of the parties with respect to contract size, delivery date, and mode
of delivery. This flexibility is lost when the contracts are standardized.

4.2.3 Liquidity
Since futures contracts are standardized and negotiable, they can be traded on futures exchanges. Con-
tracts that are listed and traded on exchanges are easier and cheaper to trade than forward contracts,
which require middlemen to bring in counterparties. Furthermore, the liquidity of the market increases
as a result of an increase in the number of people trading in organized exchanges.

4.2.4 Performance
One of the major problems with forward contracts is the possibility of non-compliance with the contrac-
tual obligations by either of the two parties to the contract. Since futures are traded on exchanges, futures
exchanges have developed a mechanism through which non-compliance with the contractual obligations
by either party to a futures contract is eliminated. These details are explained Section 4.7.

4.2.5  Cash Needs

Typically, in the case of a forward contract, there is no exchange of cash or asset at the time the contract is
entered into. Cash and assets are exchanged only at contract maturity. However, the parties to a forward
contract may require some form of assurance in the form of compensating balances in case one of the
parties is a bank, or a performance letter of credit.
In the case of futures contracts, the parties will be asked to post a margin, according to the rules of the
exchange. The details of margins are discussed in Section 4.9. In addition to the margin, the broker may
require a performance bond in the form of government securities.

4.2.6 Ability to Reduce Losses

In a forward contract, the two parties agree to exchange assets and cash on the maturity date. If one of
the parties realizes that fulfilling the contract would result in losses, they have no other alternative but
to incur losses. There is no way for the party to reduce losses if the asset price moves against that party.
On the other hand, in a futures contract, the losing party has opportunities to reduce the losses that
may be incurred if the price moves against that party. This is because futures contracts are negotiable
and one can easily take an opposite position in the asset and get out of the futures contract at anytime.
This is explained in Example 4.2.

  Example 4.2
Assume that Nikhil enters into a forward contract with Shyam on January 1 to buy 100 g of gold at INR
1,450 per gram, with the expiry date on March 27. By the end of January, the gold prices have shown a
decreasing trend, and on February 5, gold is selling at INR 1,375 per gram. It is also estimated that the
price of gold is likely to decrease further till the end of March, and the expected price on March 27 is INR
1,340 per gram.
Consider the position of Nikhil on February 5. He needs to buy 1,000 g of gold at INR 1,450 per gram
on March 27, regardless of the price of gold in the spot market on March 27. If the price of gold reaches
the expected price of INR 1,340, Nikhil will have to fulfil his obligations under the forward contract and
buy the gold at INR 1,450 per gram. Thus, he would incur a loss of INR 110 per gram or INR 11,000 in

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 66   Financial Risk Management

Notes total for 100 grams, which is the difference between the amount he needs to pay to buy at INR 1,450 per
gram and the amount he would have paid in the market to buy gold at INR 1,340 per gram.
Suppose there are gold futures contracts available and the futures price on January 1 is INR 1,450 per
gram, and suppose Nikhil enters into a futures contract; since he can see that the gold price has dropped
to INR 1,375 per gram on February 5 and the price is expected to fall further, he can get out of the
futures contract altogether by selling the futures contract in the market at INR 1,402 per gram, which is
the futures price on February 5. This will result in a loss of only INR 48 per gram or INR 4,800 in total.
This loss is incurred because he had agreed to buy at INR 1,450 per gram on January 1 and agreed to sell
at INR 1,402 on February 5.

Thus, it can be seen from Example 4.2 that a futures contract is a forward contract that is standar-
dized, negotiable, and traded on an exchange, which guarantees compliance with contractual obligations.
The difference between forward contracts and futures contracts are shown in Table 4.1.

Pr o b l e m 4 . 1
Agriproducts Private Limited produces and sells agricultural commodities. One of the major products of Agriprod-
ucts is chillies. On September 1, the spot price of chillies is INR 5,400 per quintal. Futures contracts are available
on chillies, with expiry in October, and the futures price is INR 5,478 per quintal. The contract size of the futures
is 5 MT, each MT being equal to 1,000 kg. On the expiry date of the futures, that is, October 20, the spot price
of chillies is INR 5,350 per quintal. Calculate the gain or loss on 10 MT of chillies if Agriproducts enters the
futures market.
Solution to Problem 4.1
When Agriproducts enters the futures market, it would take the position in futures to sell chillies at INR 5,478 on
October 20. If it did not take a position in futures, it would be able to sell chillies at the market price prevailing
on October 20. Thus, the gain on entering the futures market = Futures price on September 1 – Market price on
October 20 = INR 5,478 – INR 5,350 = INR 128 per quintal.
  Since the total volume is 10 MT, i.e., 10,000 kg, the total gain = 128 × 100 = INR 12,800.

4.3 Participants in Futures Markets

The participants in a futures market can be classified as hedgers, speculators, or arbitragers, according to
the motive with which they enter the market.

4.3.1 Hedgers
Hedgers are those who want to reduce price risk using futures contracts. Producers of commodities and
the users of these commodities use commodity futures contracts so that the price risk of the commodities

Table 4.1  Differences Between Futures Contracts and Forward Contracts

Parameter Forward Contract Futures Contract

Negotiability Non-negotiable Negotiable

Trading place Over-the-counter Exchanges

Liquidity Non-liquid Highly liquid

Type of contract Custom-made Standardized

Counterparty risk Present Absent

Cash needs None at the beginning Margin amounts

Ability to reduce losses Cannot reduce losses Can reduce losses

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 Futures Contracts   67

Notes can be eliminated. Borrowers and investors use interest rate futures contracts to hedge the risk of uncertain
future interest rates. Businesses and individuals that are exposed to foreign currency risk use currency
futures contracts to hedge the risk of uncertain future currency exchange rates. Portfolio managers and
individual investors use stock futures and stock index futures to hedge price movements in stocks.
As in a forward contract, a futures contract locks in a price for exchanging assets in the future. How-
ever, hedging can result in losses or gains depending on the difference between the future price of the
underlying asset and the locked-in futures price. This will be explained later.

  Example 4.3
Kingfisher Airlines uses aviation fuel to fly its planes. Since the price of crude oil and hence that of avia-
tion fuel is highly volatile, Kingfisher is uncertain of the future prices of aviation fuel. In order to hedge
this price risk, Kingfisher can use futures contracts. However, futures contracts are available only on
crude oil and not on aviation fuel. Therefore, Kingfisher will use crude oil futures to hedge the price risk.

4.3.2 Speculators
The motive for hedgers is to reduce the impact of adverse movements in prices when the hedger faces an
exposure. Exposure means that the hedger either owns an asset whose value could fall at a future time or
they would like to own the asset at a future time but is concerned that the price may increase in the mean
time. In general, hedgers have an uncertain future cash flow because of uncertain future prices and, con-
sequently, they enter into futures contracts to avoid this uncertainty. On the other hand, speculators like
to take positions in the market without any underlying future cash flow. Speculators enter the market by
placing bets on the movement of prices in the market and expect to make money from their predictions.

  Example 4.4
Assume that a speculator believes that the U.S. dollar will strengthen against the Indian rupee over the
next month and is prepared to bet up to INR 100,000 to back this intuition. One thing that the speculator
can do is to use INR 100,000 today to buy U.S. dollars and sell them when the U.S. dollar strengthens so
that they can make a profit. If the current exchange rate is INR 48 per U.S. dollar, the speculator will re-
ceive USD 2,083.33 at the current exchange rate. After a month, if the U.S. dollar strengthens to INR 48.50
per U.S. dollar, they can sell their U.S. dollars to receive INR 101,041.70, realizing a profit of INR 1,041.70.
However, this strategy will require an immediate investment of INR 100,000. The speculator could do bet-
ter by selling futures contracts on the U.S. dollar to make the same gain. The advantage of using futures
contracts to speculate is that they do not require immediate cash flows and they bring in the same gains.
Speculators face the risk of making losses if the price of the underlying security does not move as expect-
ed. For example, if the U.S. dollar weakens to INR 47.50, instead of strengthening to INR 48.50, the cash
flow will be INR 98,958.30, which results in a loss of INR 1,041.70. Speculators enter the market because
they believe that they have valuable information, and they use this information to enter into the market.

The role of speculators is very important in futures markets as they provide stability and liquidity to
the market.

Pr o b l e m 4 . 2
The price of crude oil is highly volatile, and on September 1, the price of Brent Crude Oil is at INR 3,278 per barrel.
You believe that the Organization of the Petroleum-exporting Countries (OPEC) is going to meet on September
5 and the countries are likely to cut down the supply of oil; hence, you expect the crude oil price to increase on
September 6 and want to speculate using futures. Currently, crude oil futures are available with expiry in October,
and the contract delivery unit is 50,000 barrels. The futures price is at INR 3,295 per barrel on September 1.

(i)  How would you use futures to speculate on the price of crude oil?
(ii) If the crude oil spot price on September 5 is INR 3,400 per barrel and the October futures price on
September 5 is INR 3,468 per barrel, what will be your gain from the speculation?

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 68   Financial Risk Management

(iii) If the crude oil spot price on September 5 is INR 2,860 per barrel and the October futures price on September
Notes
5 is INR 2,904 per barrel, what will be your gain from the speculation?
Solution to Problem 4.2
(i) Since you believe the price of crude oil will increase on September 5, you should sell the futures on September 5
and buy the futures today. Thus, you should buy one October futures contract on September 1 at INR 3,295 per
barrel and sell one October futures contract at the futures price prevailing on September 5. Your speculative
gain would be the difference between the futures price on September 5 and the futures price on September 1.
(ii)  Gain per barrel = Futures price on September 5 – Futures price on September 1
= INR 3,468 – INR 3,295
= INR 173
Total gain for 50,000 barrels = 173 × 50,000 = INR 8,650,000

(iii) Since the price has fallen, it would lead to a loss.

Loss per barrel = Futures price on September 5 – Futures price on September 1

= INR 3,295 – INR 2,904 = INR 391

Total loss for 50,000 barrels = 391 × 50,000 = INR 19,550,000

4.3.3 Arbitragers
Arbitrage means making a riskless profit by entering into transactions in two or more markets simultan-
eously.
The purpose of an arbitrage is to even out the price of assets in the markets in which they are traded.
If assets are not correctly priced relative to each other, arbitragers can make riskless profits by buying un-
derpriced assets and selling overpriced ones. However, such arbitrage opportunity cannot exist for long,
because the arbitragers’ actions will bring asset prices in line in all the markets.
An arbitrage opportunity arises in futures trading, because the prices of futures contracts and the
prices of the underlying assets are related to each other. When the futures price and the price of the un-
derlying asset move out of line, there will be arbitrage opportunities.
In general, participants that are hedgers at present can, at a later time, be speculators and vice versa.
Therefore, although the classification of participants is arbitrary, it is the motive for which a party enters
the futures market that classifies a participant as a hedger, speculator, or arbitrager.

4.4  Specifications of Futures Contracts

Whenever a new futures contract is made, the futures exchange must specify in detail the exact nature
of the agreement between the two parties. This requires that the exchange specifies the asset on which
the contract is written; the contract size, i.e., the number of units of the asset that is being traded in the
futures contract; the quality of the asset; and the time and location of delivery. In addition, the exchange
may specify any alternatives for the asset to be delivered or the delivery arrangements.

4.4.1  The Underlying Asset

When the asset is a commodity, there may be quite a variation in the quality of what is available. There-
fore, the futures contract must specify the grade or grades of a commodity that can be delivered under
the contract. For example, the cashew contract at the National Commodity and Derivative Exchange
(NCDEX) specifies the quality in terms of colour and characteristics, count/454 grams, moisture, and
brokens allowed. The quality specification is as shown in Box 4.2.
In case of the NCDEX gold contract, the quality is stated as “not more than 999.9 fineness bearing a
serial number and identifying the stamp of a refiner approved by the Exchange.”
In the case of financial assets, futures contracts are well-defined, because there is no need to specify
the grade. For example, in the case of currency futures on the U.S. dollar, the asset is clearly defined as
U.S. dollars. In the case of an index future, the underlying index will be specified, for example, “BSE
Sensex Futures or the S & P CNX Nifty Index futures.” If it is a stock future, the name of the stock must

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 Futures Contracts   69

Notes
BOX 4.2 Quality Specification for a Cashew Contract at the NCDEX

1. Colour and characteristics  

5% (next lower size grade and scorched wholes
  White Wholes together)
  White/pale ivory/light ash and characteristic shape 6. Kernels shall be completely free from infestation, insect
2. Count/454 gm size description damage, mould rancidity, adhering testa, and objec-
 300–320 tionable extraneous matter.
3. Moisture: 4% maximum 7. Scraped and partially shrivelled kernels also permitted,
4. Brokens allowed: 5% maximum provided such scraping/shrivelling does not affect the
5. Next lower size grade and next lower grade: characteristic shape of the kernel.

be specified, for example, “Allahabad Bank Stock futures.” With bond futures contracts, it is necessary to
specify the maturity date and the coupon rate on the bond, as there are many bonds available with differ-
ent maturity dates and coupon rates.

4.4.2  The Contract Size

The contract size specifies the amount of the asset that is deliverable under the futures contract. This is a
very important decision for the futures exchange, because a large contract will deter many investors from
using futures to hedge or to speculate. On the other hand, a small contract will result in an increase in
the price for the traders.
In the case of commodity futures, the size will be specified in the standard units in which these com-
modities usually trade. For example, in the NCDEX, the size of a cashew contract is 50 cartons and the
net weight of each carton would be 22.68 kg, while a single gold futures contract in the NCDEX is for 1 kg
of gold. In the case of currency futures contracts, the number of units of currency will be mentioned, for
example, “1,000 U.S. dollars.” In bond futures contracts, the face values of the bonds will be mentioned,
for example, “bonds with face value of INR 200,000.” In the case of index futures, a multiplier will be
mentioned. For example, a multiplier of 15 is used for the BSE Sensex Index Futures. This means that the
size of the contract is the value of the index multiplied by the multiplier. If the BSE Sensex index value is
INR 16,000, then the size of the contract is 16,000 × 15 = INR 240,000.

4.4.3  Delivery Arrangements: Location

The place where the delivery will be made must be specified by the exchange. This is particularly impor-
tant for commodities with significant transportation costs. The exchange may also specify alternative
delivery locations, with the price of the contract adjusted appropriately according to the location chosen
by the party. In general, the choice of alternative location is given to the party that has the short position
in the futures contract, that is, the party that has contracted to sell the asset. For example, for the cashew
contract in the NCDEX, the delivery centre is designated as Kollam and the additional delivery centre is
designated as Mangalore. For the gold contract in the NCDEX, the delivery centre is Mumbai, while the
additional delivery centre is Ahmedabad.
In the case of financial futures, the delivery is usually in the form of a book entry. That is, the traders
will have to open an account with the clearing system and in the case of delivery, the seller’s account will
be debited and the buyer’s account will be credited with the asset and, simultaneously, the buyer’s bank
account will be debited and the seller’s bank account will be credited.

4.4.4  Delivery Arrangements: Alternative Grade

In the case of commodities and financial assets where different grades are available for delivery, a range of
grades can be delivered with the price of the contract appropriately adjusted by the exchange, depending
on the grade chosen for delivery. For example, in the NCDEX, the gold contract specification is gold bars
of 999.9/995 fineness.

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Notes A premium will be paid for fineness above 995. The settlement price for fineness of more than 995
will be calculated as (Actual fineness/995) × Final settlement price. A premium of 0.49% is paid for gold
delivered with 999.9 purity.

4.4.5  Delivery Month

A futures contract is referred to by its delivery month, and the exchange must specify the day of the
month on which the delivery can be made. For example, if the contract is a July cashew contract, the de-
livery date is the 20th day of the delivery month. If the 20th happens to be a holiday, Saturday, or Sunday,
the due date is the immediately preceding trading day of the exchange. On the expiry date, contracts will
not be available for trading after 5 p.m.
Delivery months can vary from contract to contract and are chosen by the exchange to meet the needs
of the market participants.
At any given time, contracts usually trade for the closest delivery month and for a number of subse-
quent months. The exchange also specifies the date on which the contract will be launched and the last
date on which the trading can take place for a given contract.

4.4.6  Delivery Notification

The exchange must also specify when the party that has a long position in the contract should notify the
exchange as to whether it has any intentions of enforcing the contract. In general, most futures contracts
are closed out with offsetting transactions before the maturity date and only about 1 to 2 per cent of the
contracts are held for delivery.
For the gold contracts traded on the NCDEX, the person who wants to take delivery needs to notify
the exchange within a period known as the tender period. The tender period would be for five working
days, during the trading hours, prior to and including the expiry date of the contract. Once a person with
a long position has tendered their intention to take delivery, the exchange will randomly assign a person
with a short position to fulfil the contract. The person chosen randomly has the obligation to deliver the
gold. The day on which the contract will be settled through delivery is known as the pay-in and pay-out.
In the NCDEX, the pay-in and pay-out is determined on a T + 1 basis. That is, if the tender date is T, then
the pay-in and pay-out would happen on day T + 1. If this happens to be a Saturday, Sunday, or a holiday
at the exchange, clearing banks, or any of the service providers, the pay-in and pay-out would be cleared
on the next working day.
There would be five pay-ins and pay-outs, starting from day T + 1, the fifth being the final settlement.

4.4.7  Daily Price Movement Limits

When futures are traded, the speculative action is quite likely to cause substantial price movements. In
order to protect traders from wide fluctuations on a single day, daily price movement limits are specified
by the exchange for most contracts.
If the prices move down by an amount equal to the daily price limit, the contract is said to be limit
down, while it is limit up if the prices move up by an amount equal to the daily price limit. In general,
the trading will be halted for the day once the contract is limit up or down. However, the exchange has
the authority to change the limits. It should be noted that the price of a futures contract is closely related
to the price of the asset in the spot market. Therefore, if there is substantial price movement in the spot
market, there will be substantial price movement in the futures market also. In such a case, stopping the
trading in the futures markets may prove to be unwise. In such situations, the exchange may step in and
change the limits.
For example, the price limit for a gold contract in the NCDEX is stated as follows:
“Base daily price fluctuation limit is (+/–) 3%. If the trade hits the prescribed base daily price limit, the
limit will be relaxed up to (+/–) 6% without any break/cooling-off period in the trade. In case the daily
price limit of (+/–) 6% is also breached, then after a cooling-off period of 15 minutes, the daily price limit
will be further relaxed up to (+/–) 9%. Trade will be allowed during the cooling off period within the price
band of (+/–) 6%.”

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Notes 4.4.8 Position Limits

The position limit refers to the maximum number of contracts that can be held by a trader in futures.
The purpose of position limits is to prevent speculators from exercising any influence on the market or
to prevent any particular trader from cornering the market. For example, the position limit for a cashew
contract in the NCDEX is stated as:
“200,000 cartons for all contracts for members and 50,000 cartons for all contracts for clients. The
above limits will not apply to bona fide hedgers. For bona fide hedgers, the Exchange will, on a case-to-
case basis, decide the hedge limits. For near-month contracts, the following limits would be applicable
from one month prior to the expiry date of a contract—Member: Maximum of 40,000 cartons; Client:
Maximum of 10,000 cartons.”

  Example 4.5
In 1995, the Sumitomo Corporation1 announced that it has made a loss of at least USD 2.6 billion through
the actions of an employee named Mr Hamanaka. Mr Hamanaka bought copper at market prices and, at
the same time, entered into futures contracts to buy copper in the London Metals Exchange. The London
Metals Exchange does not impose any position limits, and when these futures were maturing, the parties
that held the short position had to deliver copper by buying it in the open market, which was actually
controlled by Mr Hamanaka through his vast holding of copper. This was actually increasing the price
of copper in the spot market, and Mr Hamanaka was making profits. However, when more participants
entered the market and new supplies of copper were introduced in the market, the spot price of copper
dropped dramatically, causing the total value of the copper held by Mr Hamanaka to decrease. The overall
loss was claimed to be USD 2.6 billion, amassed over a 10-year period.

4.5  Closing out the Positions

Closing out a position means that a trader has entered into an offsetting transaction. A person is said
to open a position when they enter into a futures contract. While opening a position, it could either be
a long position, which means that the trader is entering into a contract to buy the underlying assets at
expiry, or it could be a short position in which the trader is agreeing to sell the underlying asset at expiry
at the futures price at the time of entering into the contract. When a trader takes a position in the futures,
they are said to have an open position in the futures contract.
If the trader decides not to have the open position at expiry, which calls for taking the delivery if the
open position is long and making the delivery if the open position is short, then the trader can close out
their open position before contract expiry. When a trader closes out their position, it means that they will
take a position opposite to the position they had taken while taking the open position. If the trader had
taken a long position while taking the open position, they will close out by taking a short position in the
same contract for the same number of contracts. Similarly, if their open position is short, they will close
out the position by taking a long position at the time of closing out their position in the same contract
and for the same number of contracts.
If a producer has cashew and wants to sell at a known price, why should they close out the position?
This happens because making or taking deliveries under futures contracts is often inconvenient, and in
some cases, quite expensive. If the producer is located in Tamil Nadu and the delivery requirement stipu-
lates that the delivery will have to be made in Kollam or Mangalore, then making the delivery is incon-
venient as well as expensive, as the producer will have to bear the transport charges. Instead, the trader
can arrange to sell their cashews in the spot market in Tamil Nadu in March, when the cashews are ready
to be sold. Similarly, the person who contacts to buy using futures will not be willing to take delivery at
Kollam or Mangalore if they are located in Agra, as it becomes the producer’s responsibility to arrange for
transport from Kollam or Mangalore to Agra.

1 Paul Krugman, “How Copper Came a Cropper,” The Dismal Science, 19 July, 1996, available online at
http://web.mit.edu

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Notes Both the buyer and the seller enter into futures contracts mainly to fix a price for the future purchase
or sale of an asset. In general, most hedgers would close out the position close to the delivery date so that
the actual price at which they trade their asset in the spot market is close to the price at which they en-
tered to trade in the futures market. This is done in order to ensure that the asset price in the spot market
and in the futures market is the same during the delivery period. If the two prices are not the same, it will
lead to arbitrage opportunities. This is explained in Section 4.6.

  Example 4.6
On January 15, Malabar Cashews, a cashew producer enters into a March cashew futures contract where-
by they agree to sell cashews in the month of March at the futures price of INR 5,460. The futures price
of cashew is stated in terms of price per carton. The futures contract price of one cashew contract on
January 15 is INR 273,000, as each cashew contract is for 50 cartons. This means that the producer will
receive INR 273,000 by selling cashews in March. However, before the delivery date, say, on March 1, they
close out the position. This means that they will enter into an offsetting transaction. That is to say that
they will enter into a futures contract to buy cashews in the month of March at the price prevailing in the
futures market on March 1. Suppose the futures price on March 1 is INR 5,400. Since the contract size is
50 cashew cartons, the producer has entered into a contract to buy 50 cartons of cashews for INR 5,400 a
carton. In this case, the producer has gained INR 60 per carton or INR 3,000 by closing out the position.

  Example 4.7
In the case of speculators, closing out the position is necessary because the purpose of their entry into the
market is to make short-term gains and to not take delivery. Consider a speculator who believes that the
price of gold will decrease in the next seven days. On May 15, gold is priced at INR 13,800 per 10 grams.
The speculator believes that this price will decrease to INR 13,000 in a week. The speculator would enter
the futures market to sell gold today by opening a short position in the futures at a price of INR 14,000.
On May 22, the speculator finds that the price of gold has actually decreased to INR 13,100 per 10 g in the
spot market and the corresponding gold futures price is INR 13,350 per 10 grams. The speculator would
close the original short position by entering into a long futures contract. Since the speculator has agreed to
sell at INR 14,000 per 10 g on May 15 and has entered into a buy contract at INR 13,350 per 10 g on May
22, the speculator would make a gain of INR 650. Speculators can make gains only when they close their
position.

A speculator or a hedger will also close out the position if he believes that he would incur higher loss
if the contract is held till maturity.

4.6 Arbitrage Between the Futures Market and the Spot Market

During the delivery period, the futures price should be the same as the price of the underlying asset in
the spot market, because one can take a short position in the futures and deliver the underlying asset by
buying it in the spot market. If the futures price is not the same as the spot market price, arbitrage op-
portunity will arise. An arbitrage opportunity arises whenever two assets whose prices are related to each
other are mispriced relative to each other. Mispricing means that one of the assets is relatively overpriced
and the other is relatively underpriced. If such mispricing occurs, the arbitragers will enter the market
and arbitrage between the two assets that are relatively mispriced. The actions of the arbitragers will bring
the prices of the two assets in line so that the relative mispricing will disappear. An arbitrage transaction
requires the arbitrager to buy the relatively underpriced asset and sell the relatively overpriced asset.
To understand this, assume that the futures price is more than the spot price during the delivery
period. This shows a relative mispricing—with the futures relatively overpriced and the underlying asset
relatively underpriced in the spot market. In such a case, an arbitrager might adopt the following strategy:
1.  Sell a futures contract at price F;
2.  Buy the asset at spot price S; and
3.  Enforce the futures contract, that is, make delivery at F.

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Notes Since all transactions take place during the deliver period, the arbitrage profit from this strategy would be
F – S. In the case where the spot price is higher than the futures price, the strategy for the arbitragers will be:
1.  Buy a futures contract at price F and take delivery.
2.  Sell the asset at spot price F.
This will result in an arbitrage profit of S – F.

Pr o b l e m 4 . 3
Assume that the futures price of the cashew contract is INR 5,500 and the spot price of cashews is INR 5,400 during
the tender period. The prices are per carton and each futures contract is for 50 cartons.

(i)  What transactions would an arbitrager undertake?

(ii)  What would be the arbitrage profit?
Solution to Problem 4.3
Since the futures price is greater than the spot price of the underlying asset, the arbitrager would take a short position
in the futures at INR 5,500, buy the cashew at INR 5,400 in the spot market, and deliver cashew under the futures at
INR 5,500 per carton. Thus, the profit per carton would be INR 5,500 – INR 5,400 = INR 100. The total gain would
be 50 × 100 = INR 5,000.

Pr o b l e m 4 . 4
Assume that the futures price of a gold contract is INR 13,500 and the spot price of gold is INR 13,800 during the
tender period. The prices are per 10 g of gold and each futures contract is for 100 g.
(i)  What transactions would an arbitrager undertake?
(ii)  What would be the arbitrage profit?
Solution to Problem 4.4
Since the futures price is less than the spot price of the underlying asset, the arbitrager would take a long position
in the futures at INR 13,500 and take delivery of 10 g of gold by paying INR 13,500. The arbitrager would then sell
the gold at INR 13,800 per 10 g in the spot market. Thus, the profit per 10 g would be INR 13,800 – INR 13,500 =
INR 300. The total gain would be 10 × 300 = INR 3,000.

4.7 Performance of Contracts
The major advantage of futures is that it is traded on futures exchanges, and all futures exchanges have
instituted mechanisms by which non-performance of the contracts is eliminated. In this section, we will de-
scribe how exchanges guarantee the performance of all futures contracts. This is accomplished through the
 creation of a clearinghouse,

 institution of margins, and

 marking-to-market all futures accounts.

4.8  The Clearinghouse

The exchange clearinghouse is a part of the futures exchange and acts as an intermediary in all futures
transactions. For example, assume that Amit, a cashew producer, has sold five cashew contracts to
Mukund, a cashew merchant. Even though the contract is between Amit and Mukund, the clearinghouse
will interpose itself in this contract. That is, it will be considered that Amit has sold five cashew contracts
to the clearinghouse and the clearinghouse, in turn, has sold five cashew contracts to Mukund. Thus, the
clearinghouse guarantees performance, as it is the counterparty to each of the futures transactions.
The clearinghouse will have a number of members. When a trader wants to buy or sell futures con-
tracts, the deal will have to be cleared through a member of the clearinghouse, known as the clearing
member (CM). The clearinghouse will keep track of all transactions that take place during the day so that
it can calculate the net positions of each of the CMs.

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Notes Each CM of the exchange is required to maintain a margin account with the clearinghouse. A margin
is some percentage of the contract value that is cleared through the CM, and this amount will have to be
provided by the CM to the clearinghouse. This is known as the clearing margin, and the clearinghouse
maintains a margin account for each of its CMs.

  Example 4.8
Assume that the margin for the cashew contract is 5% and a contract to buy five cashew futures is cleared
through a clearinghouse member at a price of INR 5,600 per carton. The contract size is 50 cartons.
Value per contract = Futures price per carton × Number of cartons = 5,600 × 50 = INR 280,000
Total value of the five contracts = Value per contract × Number of contracts
= 280,000 × 5 = INR 1,400,000
Margin amount = Total value of the five contracts × Margin percentage
= 1,400,000 × 5% = INR 70,000
A margin amount of INR 70,000 will have to be provided by the CM to the clearinghouse.

Once the margin amount is provided, it will be entered into the CM’s margin account, which is main-
tained by the clearing corporation. This margin account will be updated every day on the basis of the
settlement price of the contract on that day. This procedure is known as marking-to-market.
If the original position is a long position in the contract, any subsequent price increase before expiry
will result in a gain for the trader. This is because a long position allows the trader to buy the underlying
asset at the original futures price at which the long position was taken, and if futures price increases, the
trader would gain, because they can close the position by going short at a higher futures price. When a
trader goes short, they agree to sell the underlying asset. Thus, if the futures price at closing out is higher
than the futures price at which the contract was entered into, the trader will benefit and the gain will be
equal to the product of the difference in the price, the contract size and the number of contracts. This
gain will be added to the existing margin. On the other hand, if the futures price decreases subsequent to
taking a long position, the trader will make a loss, and the amount of loss will be equal to the product of
the difference in the price, the contract size and the number of contracts. This loss will be deducted from
the margin amount in the account.
If the original position is a short position in the contract, any subsequent price decrease before expiry
will result in a gain for the trader. This is because a short position allows the trader to sell the underlying
asset at the original futures price at which the short position was taken, and if futures price decreases,
the trader would make a gain, because they can close the position by going long at a lower futures price.
When a trader goes long, they agree to buy the underlying asset. Thus, if the futures price at closing out
is lower than the futures price at which the contract was entered into, the trader will benefit and the gain
will be equal to the product of the difference in the price, the contract size and the number of contracts.
This gain will be added to the existing margin. On the other hand, if the futures price increases subse-
quent to taking a long position, the trader will lose and the amount of loss will be equal to the product of
the difference in the price, the contract size and the number of contracts. This loss will be deducted from
the margin amount in the account.
In a sell futures contract or a short futures contract position, any price increase will decrease the mar-
gin, while any price decrease will increase the margin. In a buy futures contract or a long futures contract
position, the margin will decrease when the price decreases and the margin will increase when the price
increases.

  Example 4.9
Assume that the margin for the cashew contract is 5% and a contract to buy five cashew futures is cleared
through a clearinghouse member at a price of INR 5,600 a carton. The contract size is 50 cartons. The CM
needs to post INR 70,000 as the margin. Suppose the next day the futures price increases to INR 5,640.
Since the original contract is a long position in five contracts, any price increase will lead to a gain.

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Notes gain = Difference in futures price × Contract size × Number of contracts

= (5,640 – 5,600) × 50 × 5 = INR 10,000
This gain is added to the margin amount, and the margin account balance will be INR 70,000 + INR
10,000 = INR 80,000. Instead of increasing to INR 5,640, if the price decreased to INR 5,560, the trader
will make a loss.
Loss = Difference in futures price × Contract size × Number of contracts
= (5,600 – 5,560) × 50 × 5 = INR 10,000
This loss is subtracted from the margin amount, and the balance in the margin account will be equal to
INR 70,000 – INR 10,000 = INR 60,000.
It is necessary that the CMs post margins whenever they clear contracts. However, the clearinghouse
may require margins based on either the gross number of contracts or the net number of outstanding
contracts. If a CM has cleared 15 long contracts and 5 short contracts in cashew futures all at a price of
INR 5,600 a contract, the total number of outstanding contracts will be 15. Long contracts as well as short
contracts will require margins. However, if the price increases, long contracts will show a gain, while
short contracts will show a loss, and if the price decreases, short contracts will show a gain, while long
contracts will show a loss. Moreover, the amount of loss in a long contract will be the same as the amount
of gain in the short contracts. Since the gains and losses offset each other while combining long and short
positions, netting out of positions is allowed. Thus, the clearing margin can be calculated on the total
number of outstanding contracts, both long and short, which in our example is 20, or the margin can be
calculated on the net number of contracts outstanding after netting out the offsetting contracts, which
is equal to 10 long contracts in our example. The rationale behind netting out is that the gain in short
contracts and the loss in long contracts will offset each other and hence the margin does not need to be
paid for these offsetting transactions. Most exchanges follow clearing margins on a net basis.

4.9 Margins and Marking-to-Market

The above discussion shows that the CMs will need to post margins for the contracts cleared by them.
Since most CMs act on behalf of others, they require that all parties entering into futures contracts
through them also post margins.
When a trader wants to enter into a futures contract, they will call a broker who is authorized to trade
in futures exchanges and provide the broker with the details of the contract position to be taken—long or
short—and the number of contracts. The broker will then find a matching party and conclude the deal.
Once the deal is concluded, the broker will contact a CM to clear the deal. This means that the CM will
inform the clearing corporation the details of the contracts entered into and agrees to take responsibility
of the fulfilment of the contracts at expiry. The CM is required to post the clearing margin to the clearing
corporation and ask the broker for the margin amount. The broker will, in turn, ask the trader to provide
the money. Typically, the margin percentage for the trader would be slightly higher than the margin per-
centage for the CM. Once this margin amount is provided by the trader, the broker will open a margin
account for the trader. This margin is known as the initial margin posted by the trader.
The margin account will be maintained by the broker for each trader until the trader closes out the
position or until the expiry of the contract, whichever is earlier. The broker is also responsible for updat-
ing the margin account daily on the basis of the daily settlement price of the contract. This process of up-
dating the margin account is known as marking-to-market. If the trader makes a gain on any given day as
a result of changes in the futures price, the gain will be added to the margin account balance. If the trader
makes a loss on any given day as a result of changes in the futures price, the loss would be deducted from
the margin account balance.
Whenever the margin account balance shows an amount higher than the initial margin amount, the
trader has the option to withdraw this excess amount. However, most traders choose to keep this extra
amount in the account, as the balance can decrease if the price moves against them. As discussed earlier,
a long position will provide gains if the futures price increases and will result in losses if the futures price
decreases, while a short position will provide gains if the futures price decreases and will result in losses
if the futures price increases.

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Notes When the margin account balance decreases below the initial margin amount, the trader will not have
to add money immediately. The clearing corporation also provides a minimum amount that should be
available in the margin account at all times. This minimum amount is known as the variation margin or
maintenance margin.
If the margin account balance decreases below the variation margin, the broker will have to notify
the trader of the situation and ask the trader to provide additional funds. This is known as a margin call.
The broker will either call the trader or send a notification to the trader stating that the margin account
balance has decreased below the variation margin, and the trader is required to provide the additional
money. The amount of money to be provided on receiving a margin call will be equal to the difference
between the initial margin and the margin account balance. Thus, if the trader provides the needed funds
on receiving the margin call, the margin account balance will be equal to the initial margin provided at
the time of taking a position in the futures.
If the trader, on receiving a margin call, does not provide the required funds to the broker, the broker
has the right to close out the trader’s position and update the margin account with the gain or loss made
on closing out the position. The balance remaining in the margin account will be given to the trader.
This process of daily marking-to-market will continue till the expiry date or until the trader closes the
position. If the trader desires to close out the position, they will inform the broker of their intention, and
the broker will complete the deal and clear the trade through the original CM. Any gain or loss on clos-
ing out will be adjusted with the margin account balance, and this balance will be provided to the trader.
In case the trader does not wish to close out but wants to take delivery, they will inform the broker of
their intention to take delivery. The broker will then inform the CM who will, in turn, inform the clear-
inghouse. The clearinghouse will randomly assign one of the short-position holders to make the delivery.
The cash needed for taking the delivery will be adjusted with the margin account balance and hence the
additional amount to be provided by the trader is equal to Total contract price – Balance in the margin
account.

Pr o b l e m 4 . 5
Mukund, a cashew merchant, wants to buy five cashew contracts on March 5 at INR 5,600 each. The initial margin
for Mukund is 5.5% of the contract value. The futures price is for each carton, and the contract size is 50 cartons.
Mukund closes out his position on March 16. The futures prices from March 6 to March 16 are shown below. The
variation margin is INR 50,000. Prepare a margin account for Mukund. March 5 is a Monday, and trading takes place
only on weekdays.
Date Futures Price
March 5 INR 5,600
March 6 INR 5,650
March 7 INR 5,675
March 8 INR 5,610
March 9 INR 5,570
March 12 INR 5,520
March 13 INR 5,400
March 14 INR 5,480
March 15 INR 5,570
March 16 INR 5,650
Solution to Problem 4.5
On March 5, Mukund takes a long position in five cashew futures at INR 5,600. The total value of five cashew con-
tracts = 5 × 50 × 5,600 = INR 1,400,000.

Initial Margin = 5.5% of the total contract value = 0.055 × 1,400,000 = INR 77,000

The margin account for Mukund is shown in Table 4.2. The total value of contracts on each day is calculated as:

Total value = Futures price on that day × Contract size × Number of contracts.

The daily gain or loss is the difference between the total value of contracts on that day and the total value
of contracts on the previous day. A buyer of futures gains when the futures price increases and loses when
the futures price decreases.

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Notes Table 4.2 Margin Account for the Buyer

Total Value Daily Margin Margin

Futures Cumulative
Date of Five Gain/ Account Call
Price Gain/Loss
Contracts Loss Balance Amount

March 5 5,600 1,400,000 - - 77,000

March 6 5,650 1,412,500 12,500 12,500 89,500
March 7 5,675 1,418,750 6,250 18,750 95,750
March 8 5,610 1,402,500 –16,250 2,500 79,500
March 9 5,570 1,392,500 –10,000 –7,500 69,500
March 12 5,520 1,380,000 –12,500 –20,000 57,000
March 13 5,400 1,350,000 –30,000 –50,000 27,000 + 50,000 50,000
= 77,000
March 14 5,480 1,370,000 20,000 –30,000 97,000
March 15 5,570 1,320,000 22,500 –7,500 119,500
March 16 5,650 1,347,500 20,000 12,500 139,500

Cumulative gain/loss is the difference between the total value of contracts on that day and the total
value contracted at the time of entering into the contract.
Margin balance is the sum of the previous day’s margin balance and the daily gain/loss for that day.
A margin call is issued when the margin balance decreases below the variation margin. On receiving
a margin call, the trader needs to add sufficient funds so that the margin balance is equal to the initial
margin amount. In this problem, the margin call will be issued on March 13, when the margin balance
reaches INR 27,000. The trader will add the additional amount of INR 50,000 so that the margin amount
equals the initial margin of INR 77,000.
The final margin amount is the sum of all margins paid and the gain from futures trading. In this
problem, the gain from futures trading is given as the cumulative gain/loss, which is INR 12,500. The total
margin paid is the sum of the initial margin and any amount added on receiving the margin call. Thus,
the total margin paid = INR 77,000 + INR 50,000 = INR 127,000, and the final margin account balance
is INR 127,000 + INR 12,500 = INR 139,500. This amount will be returned to the trader after the futures
position is closed out.

Pr o b l e m 4 . 6
Amit, a cashew producer, wants to sell five cashew contracts on March 5 at INR 5,600 each. The initial margin for
Amit is 5.5% of the contract value. The futures price is for each carton, and the contract size is 50 cartons. The futures
prices from March 6 to March 16 are shown below. The variation margin is INR 50,000. Prepare a margin account for
Amit. March 5 is a Monday, and trading takes place only on weekdays.

Date Futures Price (INR) Date Futures Price (INR)

March 5 5,600 March 12 5,520
March 6 5,650 March 13 5,400
March 7 5,675 March 14 5,480
March 8 5,610 March 15 5,570
March 9 5,570 March 16 5,650
Solution to Problem 4.6
On March 5, Amit takes a short position in the five cashew futures at INR 5,600. The total value of five cashew con-
tracts = 5 × 50 × 5,600 = INR 1,400,000.

Initial Margin = 5.5% of the total contract value = 0.055 × 1,400,000 = INR 77,000

The margin account for Amit is shown in Table 4.3. The total value of contracts on each day is calculated as:

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Notes Table 4.3  Margin Account for the Seller

Total Value Margin Margin

Futures Daily Cumulative
Date of Five Account Call
Price Gain/Loss Gain/Loss
Contracts Balance Amount

March 5 5,600 1,400,000 - - 77,000

March 6 5,650 1,412,500 –12,500 –12,500 64,500
March 7 5,675 1,418,750 –6,250 –18,750 58,250
March 8 5,610 1,402,500 16,250 –2,500 74,500
March 9 5,570 1,392,500 10,000 7,500 84,500
March 12 5,520 1,380,000 12,500 20,000 97,000
March 13 5,400 1,350,000 30,000 50,000 127,000
March 14 5,480 1,370,000 –20,000 30,000 107,000
March 15 5,570 1,320,000 –22,500 7,500 84,500
March 16 5,650 1,347,500 –20,000 –12,500 64,500

Total value = Futures price on that day × Contract size × Number of contracts

The daily gain or loss is the difference between the total value of contracts on the previous day and the total value of
contracts on the day on which the margin is calculated. A seller of futures gains when the futures price decreases and
loses when the futures price increases.
The cumulative gain/loss is the difference between the total value of contracts on that day and the total value
contracted at the time of entering into the contract.
The margin balance is the sum of the previous day margin balance and the daily gain/loss for that day.
A margin call will be issued when the margin balance decreases below the variation margin, and the trader needs
to add sufficient funds so that the margin balance becomes equal to the initial margin amount. In this problem, there
is no margin call for the seller, as the margin balance never decreases below the variation margin of INR 50,000.
The final margin amount is the sum of all margins paid and the gain from futures trading. In this problem, the
gain from futures trading is given as the cumulative gain/loss, which is INR 12,500. The total margin paid is the sum
of the initial margin and any amount added upon receiving the margin call. Thus, the total margin paid = INR 77,000.
Therefore, the final margin account balance is INR 77,000 – INR 12,500 = INR 64,500.

The operation of margin and margin account can be explained as follows:

  1. On the day the contract is entered into, credit the account with the initial margin amount.
  2. On a daily basis, compute gains and losses on the futures contracts entered into.
  3. If there is any loss, debit this loss from the margin account.
  4. If there is any gain, credit the gain in the margin account.
  5. As long as the balance in the margin account is above the variation margin amount, the trader does
not need to do anything.
  6. If the balance in the margin account decreases below the variation margin amount, the trader will
receive a margin call.
  7. On receiving the margin call, the trader needs to provide the additional funds to the broker: Ad-
ditional funds to be provided = Initial margin amount – Balance in the margin account
  8. When the additional money is paid to the broker, it will be credited in the margin account.
  9. If the additional money is not provided, the broker has the right to unwind the original position,
and the trader will receive the balance amount in the margin account.
10. The balance amount in the margin account will be returned to the trader when the position is closed
out or on the expiry date of the futures if the position is not closed out.

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Notes Some brokers may allow the client to earn interest on the margin account balance. If the interest rate
is competitive with the interest rates that could be obtained elsewhere, the margin account balance is not
the true price of the futures contracts.
Some brokers may also accept securities as cash equivalents for margin accounts. However, they will
not be accepted at their face value but rather at a value less than the face value so as to take into account
the possible value erosion over time due to price changes in these securities. The CMs who need to post
margins to the clearinghouse can post margins using securities that are specified by the clearinghouse as
substitutes for cash.
The process of marking-to-market implies that a futures contract is settled daily rather than at expiry.
Effectively, each day, a futures contract is closed out and is rewritten again the next day with its new price.
The minimum levels for the initial margin and variation margin are set by the exchange. These are
relevant to the CMs who need to post margins for all the contracts that they clear. Individual brokers may
require a different set of margins from their clients. The margin levels are determined on the basis of the
variability of the price of the underlying asset, with a higher level of margin for assets that have higher
variability in price.
Margin requirements may also be set depending on the objective of the trader as well as on the basis
of the type of trade. The margin requirements for a bona fide hedger such as a rice merchant who needs
rice in the future and buys futures contracts will be somewhat lower, because the risk of non-performance
is smaller.
Similarly, the margin requirements for an investor with a day trade will also be lower. A day trade
means that the investor wants to take a position in a futures contract for just one day and will close the
position the next day. For a day trader, the risk of non-performance is very small.
An investor who enters a spread contract will have a lower margin. A spread transaction requires that
the trader simultaneously takes a long position in a contract corresponding to one month and a short
position in another contract corresponding to another month. Since spread positions involve both long
and short positions, variations in the margin account will be much smaller, as gain in short positions will
be compensated by loss in long positions and vice versa. If a single trader has a number of outstanding
futures contracts, there may be a combined margin account for all the contracts.

4.10 Price Quotes
To understand the trading details in a futures exchange, it is important to know how the quotes are made.
Quotes include the following:
 Asset underlying the futures contract

 Contract size

 How the price is quoted (in kg, MT, ounces, etc.)

 Maturity of the contract

 Opening price

 Highest price during the day

 Lowest price during the day

 Settlement price

 Change in settlement price

 Open interest

 Volume of trading

Tables 4.4 and 4.5 show examples of the price quotes for financial futures at the NSE and for commod-
ity futures at the NCDEX. In Tables 4.4 and 4.5, the first column (Symbol) indicates the names under
which the futures are traded. When a broker initiates a trade in futures, they need to provide the symbol.
For example, Nifty indicates the futures on Nifty Index on the NSE. Goldpurahm represents a gold con-
tract with delivery in Ahmedabad.

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 Notes

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Table 4.4  Example of Price Quotes for Financial Futures

Symbol Expiry_dt Open High Low Close Settle_pr Contracts Val_inlakh Open_int Chg_in_oi

MINIFTY 26-Mar 2622 2732 2564 2582 2582 86337 44362 853321 104500

MINIFTY 30-Apr 2587 2692.5 2582 2584.5 2584.5 6122 3285.75 102487 17450

MINIFTY 28-May 2600 2675.45 2542.5 2562 2562 584 310.3 10462 2075

ABAN 26-Mar-09 275.32 288.4 264.32 278.5 278.5 7077 7832.4 1527500 120346

ABAN 30-Apr-09 273.25 286.30 265.7 274.5 274.5 128 129.2 46320 15850

Table 4.5  Example of Price Quotes for Commodity Futures

Delivery Value
Symbol Expiry Price unit Open High Low Close Quantity Trades Open Int
centre in lakh

CHARJDDEL 20-Mar DELHI Rs/Qunital 2145 2255 2162 2245 26450 2235 5875.40 25980

CHARJDDEL 20-Apr DELHI Rs/Qunital 2216 2266 2204 2262 40142 2862 8952.42 31425

CHARJDDEL 20-May DELHI Rs/Quintal 2253 2302 2238 2294 6340 564 1472.45 7150

CRUDEOIL 13-Mar MUMBAI Rs./Barrel 2140 2195 2082 2128 338452 2575 7122.05 100890

CRUDEOIL 15-Apr MUMBAI Rs./Barrel 2213 2324 2197 2245 65320 294 1422.45 54300

CRUDEOIL 15-May MUMBAI Rs./Barrel 2304 2401 2289 2312 1148 16 28.34 1456
Note: Quantity of CHARJDDEL is in MT and of CRUDEOIL is in barrels.

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Notes Expiry date indicates the date on which the futures contract expires. There are three different expiry
dates for Nifty, namely March 26, April 30, and May 28; each expiry date indicates a different contract.
For Goldpurahm, the expiry dates are April 20 and May 20.
In Tables 4.4 and 4.5, the first column (Symbol) indicates the names under which the futures are
traded. When a broker initiates a trade in futures, they need to provide the symbol. For example,
MINIFTY indicates the futures on Mini Nifty Index on the NSE. Crude Oil represents a crude oil con-
tract with delivery in Mumbai.
Expiry date indicates the date on which the futures contract expires. There are three different expiry
dates for MINIFTY, namely March 26, April 30, and May 28; each expiry date indicates a different con-
tract. For Crude Oil, the expiry dates are March 13, April 15, and May 15.
Open, High, Low, and Close indicate the open price of a contract on that day, the highest price at
which it traded, the lowest price at which it traded, and the closing price on that day, respectively. These
prices are based on the number of units representing the contract. For example, in the Crude oil contract,
the open price is INR 2,140 for the March contract, and this price represents the price of 1 barrel of crude
oil. This is indicated in the price unit.
In the financial futures quotes, Contracts shows the number of contracts entered into on that day and
Value (in lakh) shows the total contract value traded on that day.
In the case of commodity futures, Quantity shows the number of units of the commodity traded on
that day, and Trades shows the number of trades entered into on that day.
In case of commodity futures, delivery centre is provided for each contract. For example, the delivery
centre for chana dal contract (CHARJDDEL) is Delhi while it is Mumbai for the crude oil contract.

4.11  Settlement Price

The settlement price is normally the average of the prices at which the contract was traded, immediately
before the end of trading for the day. Each exchange has its own procedure to calculate the settlement
price on each day as well as on the expiry day.
In the NSE, the settlement price is calculated on the basis of the last half an hour weighted average
price.
Daily gains and losses and margin account balance are calculated on the basis of the settlement price.
In case there are no trades during the period in which the average price is calculated, the settlement
price is usually calculated as the theoretical price, on the basis of the price of the underlying asset in the
spot market.

4.12 Open Interest
Open interest is the total number of outstanding futures contracts available for delivery at that time,
and it is the sum of all long positions or all short positions. Open interest is important in futures trad-
ing because it is an indication of the trading in the contract as well as the liquidity of the contract. An
increase in the open interest indicates an increase in the number of contracts available for delivery, and
a decrease in the open interest indicates a decrease in the number of contracts available for delivery. This
is an indication of the liquidity of the contract. When the open interest is high and if a trader wants to
close the position, it will be comparatively easier to do so as compared to the situation where the open
interest is very low.

  Example 4.10
Consider the following transactions in ICICI single-stock futures that took place in one of the exchanges.
On January 2, when the contract started trading, Megafund took a long position in 10 contracts,
Minifund took a long position in 12 contracts, Ram took a short position in 7 contracts, and Interfund
took a short position in 15 contracts
On January 3, Megafund took a short position in 5 contracts, Minifund took a long position in
8 contracts, Ram took a long position in 3 contracts, and Interfund took a short position in 6 contracts.
On January 4, Megafund took a short position is 10 contracts, Minifund took a short position in
5 contracts, Ram took a long position in 8 contracts, and Interfund took a long position in 7 contracts.

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Notes The open interest is calculated as follows:

January 2:
Total number of long positions: Megafund’s 10 + Minifund’s 12 = 22 contracts
Total number of short positions: Ram’s 7 + Interfund’s 15 = 22 contracts
Thus, 22 contracts are available for delivery and hence the open interest is equal to 22 contracts.
January 3:
Total number of long positions: Minifund’s 8 + Ram’s 3 = 11 contracts
Total number of short positions: Megafund’s 5 + Interfund’s 6 = 11 contracts
Although there were 11 contracts, the open interest does not increase by 11 contracts, as some of these
contracts were used to close the position taken on January 1.
To calculate the open interest on January 3, let us look at the position of each trader on January 3:
Megafund—January 2: 10 long; January 3: 5 short; net position = 5 long contracts
Minifund—January 2: 12 long; January 3: 8 long; net position = 20 long contracts
Ram—January 2: 7 short; January 3: 3 long; net position = 4 short contracts
Interfund—January 2: 15 short; January 3: 6 short; net position = 21 short contracts
Thus, the number of contracts available for delivery is 25 and the open interest on January 2 is 25 contracts.
Even though 11 contracts were traded on January 2, the open interest increased only by 3 contracts.
This is because Megafund closed out the long position in 5 contracts by taking a short position and Ram
closed out the short position in 3 contracts by taking a long position in 3 contracts. The open interest
increased only with the new contracts.
January 4:
Total number of long positions: Interfund’s 7 + Ram’s 8 = 15 contracts
Total number of short positions: Megafund’s 10 + Minifund’s 5 = 15 contracts
To calculate the open interest on January 4, let us look at the position of each trader on January 4:
Megafund—January 3: net position = 5 long; January 4: 10 short; net position = 5 short contracts
Minifund—January 3: net position = 20 long; January 4: 5 short; net position = 15 long contracts
Ram—January 3: net position = 4 short; January 4: 8 long; net position = 4 long contracts
Interfund—January 3; net position = 21 short; January 4: 7 long; net position = 14 short contracts
Open interest on January 3 is 19 contracts:
Even though there were 15 contracts traded on January 3, the open interest decreased from
25 contracts to 19 contracts.

Thus, the volume of trading, which only indicates the number of contracts that were traded on a par-
ticular day, is not the most important factor in futures trading.
The calculation of the open interest involves the following:
1. When two traders conclude a trade for the first time in a particular futures contract, the open interest
will increase by the number of contracts entered into by these traders.
2. If one of the parties to the trade is closing out a position taken earlier and the other party is a trader
who is not closing the position, there will be no change in open interest as this transaction just shifts
the obligation from the party that is closing the position to the other party.
3. If both the parties are closing their positions because they had opposite positions in the futures
before the trade, the open interest will decrease by the number of contracts these two parties had
entered into.

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Notes Typically, whenever trading in a new contract is started, the open interest will be initially low. As time
passes, more and more new traders will enter, and the number of contracts traded by them will be more
than the number of contacts that are closed out and hence the open interest would increase. However,
near the maturity of the contract, most traders would close out their position—both long and short—and
these offsetting trades among the traders who already had positions will cause the open interest to de-
crease. At the time of maturity, the open interest will be very small, because the number of contracts held
for delivery will be very small.

4.13  The Pattern of Prices

A number of different patterns of futures prices are possible. Since the pricing of most futures is similar
to that of forwards in terms of the cost of carry model as will be explained in Chapter 5, the futures price
should decrease as the maturity approaches, because of the fact that the cost of carry now applies to a
much smaller period of time. Thus, if the futures price decreases with a decrease in the time to maturity,
it is referred to as a normal market. If the futures price increases with a decrease in the time to maturity,
it is referred to as an inverted market. This can happen for commodities whose prices depend on future
demand and supply; if the future demand is likely to be higher than the future supply, the futures price
might be higher. For some commodities, it is likely that the futures price first increases, then decreases,
and then increases again as the time to maturity decreases.

4.14  The Relation Between Futures Price and Spot Price

Since the futures price is the price at which the asset will be exchanged, the parties to the contract expect
either the spot price at the maturity of the contract to be equal to the futures price or the current futures
price to be equal to the expected spot price at maturity. However, the futures price may not always be
equal to the expected spot price, because the estimates of futures spot prices vary from one market par-
ticipant to the other.
If the futures price is higher than the expected spot price, it means that the futures price is likely to
fall. If the futures price is lower than the expected spot price, the futures price is likely to increase.
If hedgers tend to hold short positions and speculators tend to hold long positions, the futures price
will be lower than the expected spot price. This is because speculators hold long positions, expecting
futures prices to increase so that they can make speculative profits. Similarly, if hedgers tend to hold
long positions and speculators tend to hold short positions, the futures price will be higher than the
expected spot price. When the futures price is below the expected spot price, it is referred to as normal
backwardation. When the futures price is above the expected spot price, the situation is referred to as
contango.

4.15 Delivery
As has been discussed earlier, very few futures contracts lead to delivery of the asset, because most con-
tracts are closed out before maturity.
The period during which delivery can be made is decided by the exchange, and it varies from contract
to contract. The exact delivery time during the delivery period is determined by the party with the short
position in the contract. When this party decides to deliver, they will inform their broker of their inten-
tions. The broker will then issue the clearinghouse a notice of their intention to make the delivery. This
notice will state the number of contracts that will be delivered, the location of the delivery, and the grade
that will be delivered. The exchange will then randomly choose a party that holds a long position in the
contract to take that delivery. Similarly, if a party that holds a long position wants to take delivery, they
will notify the exchange of their intention to take delivery. The exchange will then randomly choose a
party that holds a short position to make the delivery. The person who will be delivering will decide the
place of delivery and the quality to be delivered. The exchange will then adjust the price of the contract
accordingly.

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Notes 4.16  Cash Settlement

For contracts such as stock index futures, where delivery is in terms of cash settlement, the contract is
marked to market at the end of the last trading day and all the positions are declared closed. The settle-
ment price on the last trading day is the closing spot price of the underlying asset. There will be no deliv-
ery of the underlying asset, and the margin account balance will be the cash flow for the futures trader.

4.17  Types of Orders

As in a stock market, various types of orders can be placed in the futures market too. These are explained
in this section.

4.17.1 Market Orders
The simplest type of order for an individual to place is a market order. This means that a trade will be
carried out at the best prevailing market price, regardless of what that may be.

4.17.2 Limit Orders
A limit order specifies a particular price. The order will be executed either at this price or at a price more
favourable to the trader. There is, however, no guarantee that the order will be executed at all, as there is
a possibility that the limit price is not reached.

4.17.3  Stop Orders

A stop order or a stop-loss order specifies a particular price. The order is executed at the best available
price, once there is a bid at this particular price or at a less-favourable price. Suppose a stop order to sell
at INR 3,000 is issued when the market price is INR 3,200, this will become an order to sell as soon as
the price falls to INR 3,000, or it will become a market order as soon as the stop price is reached. A stop
order is used to close out a position if the prices move in an unfavourable direction, thereby limiting
the losses.

4.17.4  Stop–Limit Orders

A stop–limit order is a combination of a stop order and a limit order. The order will become a limit
order as soon as the price reaches a price equal to or less favourable than the stop price. Two prices will be
specified in a stop–limit order: the stop price and the limit price. Suppose the market price is INR 3,500
and a stop–limit order with a stop price of INR 4,000 and a limit price of INR 4,100 is executed. As soon
as there is a bid or offer at INR 4,000, it becomes a limit order at INR 4,100.

4.17.5 Other Orders
A market-if-touched order is executed at the best available price, after a trade occurs at a specified price
or at a price more favourable than that which is specified. This means that a market-if-touched order
becomes a market order once the specified price is reached. This is also called a board order.
Suppose an investor has a long position in a futures contract and would like to close out their posi-
tion. If the futures price is likely to move unfavourably, they are likely to place a stop order to reduce the
loss. However, if the futures price is likely to move favourably, they will place a market-if-touched order
to ensure profits.
A time-of-day order specifies a particular time of day at which the order can be executed.
An open order or a good-till-cancelled order is in effect until it is executed or until trading in that con-
tract is ended.
A fill-or-kill order must be executed immediately or not at all.

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Notes 4.18  How to Trade in Futures?

The mechanism of trading, clearing, and settlement in futures contracts is explained below:
The steps in trading in futures are:
Step 1: First, the trader will contact a broker who is authorized to trade in futures. The order can be either
a market order or a limit order. Assume that the trader has placed a market order to buy five June cashew
contracts in the NCDEX.
Step 2: The broker will access the order book of the NCDEX and key in the order placed by the trader.
The market orders have no price specified and specify only the quantity. The order will be matched by the
computer at the NCDEX. The order book has all the orders received from various brokers with the orders
classified on the basis of both price and time. If there is a corresponding matching order available in the
order book, for example, if there is an order already in the order book to sell five June cashew contracts,
the broker will match the two orders and this information will be recorded in the computers of the NC-
DEX. The price at which these contracts are matched will be the latest price at which the contract will be
traded. In case there is no matching order, the broker will find a dealer who is a market maker and ask
for a quote for buying the futures contracts. The dealers are required to provide both buy and sell quotes
whenever asked for. The broker will then buy the contracts from the dealer at the price quoted and the
details will be entered into the computers of the NCDEX.
If the order is a limit order, the broker will enter the order in the order book with the limit price. If
there is a matching order in the order book, the computer at the NCDEX will automatically match the two
orders. In case there are no matching orders in the order book, the order entered into by the broker will
remain in the order book until a matching order arrives; if not, it is cancelled.
Step 3: If the order is executed, the broker will then have to get this order cleared by a CM of the Clear-
ing Corporation of the Exchange. The CM is responsible to the Exchange to fulfil the contract. The bro-
ker will approach the CM asking for permission to clear the trade. Once the CM clears the trade, the
Exchange will notify the broker that the order has been cleared. When a CM clears a trade, they take
responsibility to fulfil the contract at maturity, even though they have not entered into the contract. The
purpose of having a CM clear the trade is to ensure organized functioning of the derivatives exchange in
order to minimize the default rate.
Step 4: In order to take the responsibility for the fulfilment of the contract at maturity, the CM will have
to post a margin, which is usually based on the volatility of the underlying asset price. The Exchange will
notify the CM of the margin amount that needs to be posted.
Step 5: Since the CM only clears the trade and takes no position in the trade, they will ask the broker to
provide the funds for this margin, which will be collected by the broker from the trader.
Step 6: The broker will maintain an account known as the margin account, which will be updated daily on
the basis of the settlement price of the contract on that day; this is known as marking-to-market.
Step 7: As long as the trader wants to keep their position in futures before maturity, the only responsi-
bility for the trader is to follow the instructions of the broker with respect to the margin account. In case
the trader receives a margin call, they are required to provide the additional money as specified by the
broker. In many cases, the trader will have to provide the bank account number and the broker has the
authority to draw money from this bank account, unless the trader instructs otherwise.
Step 8: At maturity of the contract, the contract will be settled. The settlement price will be calculated by
the NCDEX and will be known to all brokers. The trader’s broker will calculate the position of the margin
account on the basis of the settlement price. If the margin account shows a positive amount, this amount
is the gain for the trader from futures trading, and this amount will be given to the trader by the broker. If
the margin account shows a negative amount, it indicates a loss from futures for the trader, and the trader
needs to pay this amount to the broker.
All futures exchanges also allow online trading by individual traders directly. In order to trade online,
the trader needs to register and open an account with an authorized broker. The broker will provide the

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software that needs to be used in order to do online trading. Once the trader is registered with the bro-
ker, the trader will have access to online quotes from the exchange and can place orders themselves. The
traders are also required to provide a link to a bank account so that all the amounts relating to the online
transactions are directly debited from or credited to that account. The broker will maintain the margin
account and any amount due from the trader for the margin account is directly taken from their bank
account.

4.19 pricing of Futures Contracts

The method of determination of futures prices is similar to that used to determine the prices of for-
ward contracts. However, one small difference needs to be noted: In a forward contract, the price is
determined by the two parties and the model that is used to calculate the price is based on the cost of
carry model, as described in Chapter 3. In futures contracts too, the value of the futures is based on the
cost of carry model. However, the actual price can also be influenced by the demand and supply for the
contract in the exchanges. Thus, the actual price of futures could be slightly different from the prices
based on the cost of carry model, because of fluctuations in demand and supply. This will be explained
in Chapter 5.

CHapTER SUmmaRY
A futures contract is an agreement to buy or sell a specified
 Performance of contracts is guaranteed in a futures contract

asset at a certain time in the future for a specified price that is through:
agreed upon at the time of entering into the contract. Futures  The creation of a clearinghouse
contracts are negotiable and are traded on futures exchanges.  The institution of margins
While forward contracts are non-negotiable, tailor-made,
  Marking-to-market the margin account on a daily basis
illiquid, and have counterparty risks, futures contracts are
Every trader in a futures exchange should post a margin, which

negotiable, standardized, liquid, and have no counterparty risks.
is based on the value of the contract. The actual margin will
The participants in the futures markets include hedgers,

be determined by the exchange. The broker will maintain an
speculators, and arbitragers
account known as the margin account, which is updated daily.
Hedgers are traders who have a position in some assets and are

By marking-to-market the margin account, the broker will

interested in hedging the price risk on their position, whereas
update the margin account on the basis of the settlement price
speculators do not have any position in the asset but would
on a daily basis. By marking-to-market, the trader will know
like to make money by estimating price changes.
the losses and gains in their futures trading activity on a daily
Arbitragers try to make profits with no investment and no risk

basis.
through price imbalances between the price of the asset in the
spot market and the price of the asset in the futures market. If the margin account balance falls below the minimum

amount, which is specified by the exchange, the trader will
A futures contract should specify the underlying asset, the

receive a margin call that would require them to provide
contract size, the maturity of the contract or delivery month,
additional money to bring the margin account balance to the
the delivery arrangements, the delivery notification details,
level of the original margin amount.
how the price will be quoted, the limits on daily price
movements, and the position limits. The margin amount can be paid in cash or in the form of

securities that are approved by the exchange.
Most contracts are closed out before maturity. Closing out the

position means that the trader will place an offsetting order so Open interest refers to the number of outstanding contracts at

that the net position is zero. any given time.
On the maturity date of the contract, the spot price should be
 The types of orders used in futures trading are market order,

the same as the futures price. If the two are different, one can limit order, stop–loss order, stop–limit order, spread order,
arbitrage by short-selling the relatively overpriced asset and market-if-touched order, time-of-day order, good-till-
buying the relatively underpriced asset. cancelled order, and fill-or-kill order.

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 Futures Contracts 87

mUlTIplE-CHoICE QUESTIoNS
1. Which of the following is true A. $58 B. $62
A. Both forward and futures contracts are traded on C. $64 D. $66
exchanges.
6. One futures contract is traded where both the long and short
B. Forward contracts are traded on exchanges, but futures
parties are closing out existing positions. What is the resultant
contracts are not.
change in the open interest?
C. Futures contracts are traded on exchanges, but forward
A. No change B. Decrease by one
contracts are not.
C. Decrease by two D. Increase by one
D. Neither futures contracts nor forward contracts are traded
on exchanges. 7. Who initiates delivery in a corn futures contract
A. The party with the long position
2. Which of the following is NOT true
B. The party with the short position
A. Futures contracts nearly always last longer than forward
C. Either party
contracts
D. The exchange
B. Futures contracts are standardized; forward contracts are
not. 8. You sell one December futures contracts when the futures
C. Delivery or final cash settlement usually takes place with price is $1,010 per unit. Each contract is on 100 units and the
forward contracts; the same is not true of futures con- initial margin per contract that you provide is $2,000. The
tracts. maintenance margin per contract is $1,500. During the next
D. Forward contracts usually have one specified delivery day the futures price rises to $1,012 per unit. What is the bal-
date; futures contract often have a range of delivery dates. ance of your margin account at the end of the day?
A. $1,800 B. $3,300
3. In the corn futures contract a number of different types of
C. $2,200 D. $3,700
corn can be delivered (with price adjustments specified by the
exchange) and there are a number of different delivery loca- 9. A hedger takes a long position in a futures contract on a com-
tions. Which of the following is true modity on November 1, 2012 to hedge an exposure on March
A. This flexibility tends increase the futures price. 1, 2013. The initial futures price is $60. On December 31, 2012
B. This flexibility tends decrease the futures price. the futures price is $61. On March 1, 2013 it is $64. The con-
C. This flexibility may increase and may decrease the futures tract is closed out on March 1, 2013. What gain is recognized
price. in the accounting year January 1 to December 31, 2013? Each
D. This flexibility has no effect on the futures price contract is on 1000 units of the commodity.
A. $0 B. $1,000
4. A company enters into a short futures contract to sell 50,000
C. $3,000 D. $4,000
units of a commodity for 70 cents per unit. The initial margin
is $4,000 and the maintenance margin is $3,000. What is the 10. A speculator takes a long position in a futures contract on a
futures price per unit above which there will be a margin call? commodity on November 1, 2012 to hedge an exposure on
A. 78 cents B. 76 cents March 1, 2013. The initial futures price is $60. On December
C. 74 cents D. 72 cents 31, 2012 the futures price is $61. On March 1, 2013 it is $64.
The contract is closed out on March 1, 2013. What gain is
5. A company enters into a long futures contract to buy 1,000
recognized in the accounting year January 1 to December 31,
units of a commodity for $60 per unit. The initial margin is
2013? Each contract is on 1000 units of the commodity.
$6,000 and the maintenance margin is $4,000. What futures
A. $0 B. $1,000
price will allow $2,000 to be withdrawn from the margin ac-
C. $3,000 D. $4,000
count?

Answer
1. C 2. A 3. B 4. D 5. B 6. B 7. B 8. A 9. D 10. C

REVIEW QUESTIoNS
1. Discuss the advantages of futures contracts over forward contracts. 7. What is the purpose of a margin requirement in futures trading?
2. Explain the role of speculators in a futures market. 8. What is the purpose of marking-to-market the margin accounts?
3. Why is it that delivery options are given to the seller and not 9. What is meant by an open interest?
the buyer of a futures? 10. What is the difference between open interest and trading vol-
4. Why are position limits instituted in a futures contract? ume? In a futures contract, the open interest may not change
5. What are the various ways in which a trader in a futures con- in spite of a high volume of trading. Explain why.
tract might get out of their contractual obligations? 11. In general, many traders in futures contracts close out their
6. What is the role of a clearinghouse in a futures exchange? position before the delivery date. Explain why.

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 88 Financial Risk Management

SElF-aSSESmENT TEST
1. Suppose you buy a futures contract on BSE 30 Sensex futures Jewellers would buy the required gold on January 1. What
at INR 16,500 on March 10. The initial margin is INR 8,500 would be the effective price per 10 g for Lalitha Jewellers?
and the maintenance margin is INR 5,000. At what futures
price would you receive a margin call? 6. On September 1, gold is trading at INR 13,500 per 10 grams.
Lotus Jewellers requires 3,000 g of gold on January 1 for pre-
2. On January 2, when the futures contract on Jet Airways stock paring new jewellery for the marriage season next year. The
started trading for expiry on March 31, Kishore sold 10 contracts gold price has been highly volatile in the past 3 months, and
to Raghav, Raja sold 15 contracts to Jeeva, and Rama sold 20 experts differ in their opinion as to whether the gold price
contracts to Bose. On January 3, Jeeva bought 5 contracts from would increase or decrease in the future. Lotus Jewellers
Raghav and Bose sold 10 contracts to Asjeet. Calculate the open believes that the gold price would decrease to about INR
interest in this contract on January 2 and January 3. 12,600 by September 12 and would like to speculate using
futures. There is a futures contract available with expiry on
3. Assume that you enter into a long position in a January gold December 20, and the futures price is INR 14,100.
futures (100 grams) contract at INR 10,079 on October 15,
2007. On January 16, 2008, you decide to close your position (i) Explain how Lotus Jewellers can use futures to speculate
when the futures price is INR 11,269. One contract is for 10 g on the gold price.
of gold. What is your profit? (ii) On September 12, the spot price of gold is INR 12,900
per 10 g and the futures price is INR 13,150. What would
4. The BSE Senses index futures contract has a multiplier of 10. be the speculative gain for Lotus Jewellers?
Assume that you enter into a BSE Index futures contract at
INR 16,125 at 11 a.m. on March 1. Assume that the initial 7. On September 1, gold is trading at INR 13,500 per 10 grams.
margin is 5% of the initial contract value (INR 8,062.50) and Indian Jewellers requires 3,000 g of gold on January 1 for pre-
the maintenance margin is INR 5,000 at any given time. The paring new jewellery for the marriage season next year. The
following table shows the settlement prices on the days of gold price has been highly volatile in the past 3 months, and
trading between March 1 and March 12. You close out your experts differ in their opinion as to whether the gold price
position on March 12. Prepare a table showing the daily would increase or decrease in the future. Indian Jewellers
margin balances in your account. would like to hedge against the price risk and is looking at the
gold futures contract. There is a futures contract available with
Date Settlement Value of the Index (INR) expiry on December 20, and the futures price is INR 14,100.
March 1 16,140 On December 20, gold is selling at a spot price of INR 14,750
March 2 16,250 and the futures are selling at INR 14,900.
March 3 15,850 (i) Is there any arbitrage opportunity? Explain.
March 4 15,740 (ii) If you undertake arbitrage for 3,000 g of gold, what
March 5 15,350 would be your arbitrage profit?
March 8 15,900
March 9 16,850 8. Sun TV futures contract has a lot size of 1,000 shares. Assume that
March 10 16,450 you take a short position on 10 Sun TV futures contracts at INR
March 11 17,035 271.25 at 11 a.m. on September 6. Assume that the initial margin
March 12 16,438 is 10% of the initial contract value and the maintenance margin is
8% of the initial margin. The following table shows the settlement
5. On September 1, gold is trading at INR 13,500 per 10 grams. prices on the days of trading between September 6 and September
Lalitha Jewellers requires 3,000 g of gold on January 1 for 10. You close out your position on September 10. Prepare a table
preparing new jewellery for the marriage season next year. showing the daily margin balances in your account.
The gold price has been highly volatile in the past 3 months,
and experts differ in their opinion as to whether the gold price Date Settlement Value of the Index (INR)
would increase or decrease in the future. Lalitha Jewellers September 6 271.25
would like to hedge against the price risk and is looking at the September 7 273.80
gold futures contract. There is a futures contract available with September 8 276.90
expiry on December 20, and the futures price is INR 14,100. September 9 272.50
September 10 272.10
(i) Explain how Lalitha Jewellers can use the gold futures
to hedge.
(ii) On December 20, the gold price in the spot market is INR
14,600. On January 1, the gold price is INR 14,900. Lalitha

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 Futures Contracts   89

   C a se S tudy

Ram Hosiery is a manufacturer and exporter of undergarments   Mr Hari is aware that the exchange rate has been fluctuating,
and T-shirts. Its manufacturing facilities are located in Tiruppur, and he needs to have an estimate of his revenue in rupees when
Tamil Nadu. Its operations were started in the year 2006, and in he receives it in U.S. dollars. This will aid him in preparing his
the past three years, its sales have increased from INR 8 million cash flow statement and also help him to finance his short-term
to INR 12 billion. Of this, 20% of the sales are from Europe and needs. He has heard about the forward contracts that he can enter
60% of the sales are from the USA. The other 20% are from Asian into with banks. He is also aware that currency futures have been
countries. The European customers are invoiced in euros, while introduced in Indian exchanges. However, he is not sure about the
the customers in the USA and Asia are invoiced in U.S. dollars. procedure that is to be followed.
Since 80% of the total sales are invoiced in U.S. dollars, Mr Hari,
the Chief Executive Officer of Ram Hosiery, is concerned about the Discussion Questions
movement of the Indian rupee against the U.S. dollar. His assistant 1. Should he hedge with forwards or futures? Or should he just
has looked at the exchange rate between the U.S. dollar and the leave the exposure unhedged?
Indian rupee for the period from September 2008 to February 2. Mr Hari approaches you for guidance. Explain to him the
2009 and found that it has been highly volatile. The exchange rate best course of action for him by considering the exchange rate
movements are shown in Fig. 1. variability.




([FKDQJH5DWH








7LPH3HULRG

Figure 1  Exchange Rate Between the U.S. Dollar and the

Indian Rupee (September 2008–February 2009)

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M04 Financial Risk Management 01 XXXX.indd 90 6/27/2018 10:52:14 AM
 5
Hedging Strategies
Using Futures

LEARNING OBJECTIVES

After completing this chapter, you As the regulators tried to avoid the high volatility of oil and natural
will be able to answer the following gas prices in 2008, the producers of oil and natural gas started
questions: relying more and more on the futures market to hedge the risk
 What is the major motive in of falling prices. Many energy companies such as the El Paso
hedging? Corporation, XTO Energy Corporation, and Chesapeake Energy
Corporation announced increased earnings from futures contracts
How to hedge using futures?


that locked in high prices for natural gas. This hedging brought
What are the risks in hedging?

some stability to these companies that engage in inherently risky
What is hedge ratio?

business.
How to calculate the number

Source: Ann Davis, Hedges Pay Off for Gas Producers,
of futures contracts to be used The Wall Street Journal, August 13, 2009
for hedging?

Box 5.1 Energy Companies Make Huge Profits

Through Hedging Using Futures

In Chapter 4, the basics of futures and how they can be traded were explained. One of the major reasons
for the existence of futures contracts is that they can be used for hedging. Hedgers are the major partici-
pants in futures markets. The idea behind hedging is to use futures markets to reduce the hedger’s risk.
This risk could be commodity price risk, currency exchange rate risk, interest rate risk, or the level of the
stock market. As shown in Box 5.1, companies engaging in inherently risky business, wherein their rev-
enues are subject to variability in market prices, can use futures to hedge the risk of falling prices and can
try to bring stability in their earnings. In this chapter, we will discuss how futures can be used for hedging.
The main focus would be to explain the process of hedging using commodity futures.

5.1 The principles of Hedging

The basic idea in hedging is to lock in a price at the current time for a transaction that would take place
in the future so that the hedger can forecast the future cash flow with some certainty. Through hedging,

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 92   Financial Risk Management

Notes a hedger tries to reduce the risk of not knowing the future price or the future cash flow. A perfect hedge
is achieved when the risk is completely eliminated, that is, when the hedger knows for certain what the
future cash flow will be. A partial hedge is when the risk is reduced but not completely eliminated. This
means that the hedger will not be able to forecast the exact cash flow but will be able to get an idea as to
what the cash flow might be. In general, a perfect hedge is very difficult to achieve and the purpose of
using futures markets to hedge is to get as close to achieving a perfect hedge as possible.
The basic principle of hedging is that a party faces a loss when the price of some asset changes, and it
wants to reduce this loss by trading futures contracts. The various questions that need to be considered
while using futures to hedge are:
1.  What quantity of assets would be subjected to loss if the price changes?
2.  When would losses accrue, that is, when would the price increase or decrease?
3.  Which futures contract would provide a hedge against this loss?
4.  How many futures contracts should be used to hedge?

  Example 5.1
Consider a wholesale merchant who sells chana dal. In September, they have recognised a risk, namely,
the price at which they can buy the chana produced and harvested in the month of February. The mer-
chant enters the futures market to minimize the risk. For example, assume that the wholesaler has esti-
mated in September that they will buy 30 MT of chana when harvested in the month of February, next
year. This means that if the chana prices decrease by INR 1,000 per MT by February, they will need to pay
INR 30,000 less. On the other hand, if the chana prices increase by INR 1,000 per MT by February, they
will need to pay INR 30,000 more. Thus, the wholesaler faces a price risk. To offset this risk, they might
take a position in chana futures contracts by buying chana contracts for 30 MTMT. If the chana price
decreases by INR 1,000 per MT by February, the wholesaler will lose INR 30,000 in the chana futures
contract. However, this loss will be exactly offset by the gain the wholesaler would have made in the spot
market if they had not entered the futures market. This offsetting of gain in the spot market with loss in
the futures market will ensure that the price that the farmer gets for the chana will be the futures price at
which the contract was entered into.
This shows that the merchant can make certain that they will pay a particular price for chana in
February, irrespective of the price movements in the spot market for chana.

5.2 Long Hedges
A long hedge is when the hedger agrees to buy the asset in the future or takes a long position in the futures
market by buying futures contracts. A long hedge is appropriate when the hedger needs to buy the asset
in the future or has a short position in the asset. Example 5.1 illustrates a long hedge.
For example, traders who buy commodities from producers and sell them to other traders or con-
sumers could use a long hedge. Companies that need to buy materials for their operations also use long
hedges.
In currency futures markets, importers who need to pay in a foreign currency at a future time for
imported goods use long hedges. By taking a long position in foreign currency futures contracts, they fix
the exchange rate at which importers will buy the foreign currency.
It is very difficult to know when to go for a long hedge in hedging interest rate risk. Since
hedging is undertaken to reduce downside risk, the hedger tries to avoid the interest rate going against
him. Since a long hedge involves an agreement to buy at a future time and the long hedger gains only
when the price increases, they will undertake long hedges only when the asset price increases. The price
of any asset whose value is based on the interest rate will increase only when the interest rate decreases.
Thus, the risk for a long hedger is a possible decrease in the interest rate, which they would try to avoid.
Thus, in interest rate futures markets, long hedges are undertaken when an investor or a company expects
to invest money at a future time but is concerned that the interest rate may decrease. In this case, a long
position in interest rate futures contracts provides a known interest rate for an investment to be made in
the future.

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 Hedging Strategies Using Futures   93

Notes   Example 5.2

On September 10, a wholesale merchant estimates that his company will require 30 MT of chana
on February 20. The current spot price of chana is INR 1,912 per quintal (100 kg), and the price of a
February chana futures contract is INR 2,011 per quintal. Each contract is for 1 MT (1,000 kg or 10 quin-
tals) of chana. Note that the futures price is always specified in terms of the unit traded. In this example,
the futures price is always stated in terms of “per quintal”. Since the contract size is 10 quintals, contract
value will be the (futures price × 10).The wholesale merchant can hedge the price risk:
(i) by taking a long position in 30 chana futures contracts on September 10 at INR 2,011 per quintal,
i.e., INR 20,110 per contract, and
(ii)  by taking a short position in these contracts on February 20.
  This strategy will ensure that the company will pay a price of INR 2,011 per quintal of chana, irrespec-
tive of its price in the spot market on February 20, as the delivery of the chana contracts will be on
February 20.
Consider the case where the chana price in the spot market on February 20 is INR 2,561. Since the
delivery date is February 20, the futures price will be very close to the spot price in order to eliminate
arbitrage opportunities. Thus, the futures price will also be INR 2,561.
Since the wholesaler closes out the position on February 20 by agreeing to sell chana at INR 2,561, the
gain from the futures position will be (2,561 – 2,011) × 10 = INR 5,500 per contract or INR 165,000 for 30
contracts. However, they need to buy chana in the spot market at INR 2,561 per quintal, or INR 768,300
for the required 30 MT. The net price that the wholesaler pays for the chana, therefore, is INR 768,300 –
INR 165,000 = INR 603,300, or INR 2,011 per quintal. This is shown below:
Date: September 10
Action: Enter into 30 long chana futures contracts at a futures price of INR 2,011.
Date: February 20
Action: Close the long position by entering into 30 short futures contracts at INR 2,561, making a gain of
(2,561 – 2,011) × 10 × 30 = INR 165,000.
Action: Buy 30 MT of chana in the spot market at INR 2,561 for a total of 2,561 × 10 × 30 = INR 768,300.
Result: Net cost = Purchase price in the spot market – Gain from futures = INR 768,300 – INR 165,000 =
INR 603,300 for 30 MT or INR 2,011 per quintal.
If the spot market chana price on February 20 is INR 1,900, then the position of the hedger will be:
Date: September 10
Action: Enter into 30 long chana futures contracts at a futures price of INR 2,011.
Date: February 20
Action: Close the long position by entering into 30 short futures contracts at INR 1,900, making a loss of
(2,011 – 1,900) × 10 × 30 = INR 33,300.
Action: Buy 30 MT of chana in the spot market at INR 1,900 for a total of 1,900 × 10 × 30 = INR 570,000.
Result: Net cost = Purchase price in the spot market + Loss from the futures = INR 570,000 + INR 33,300 =
INR 603,300 for 30 MT or INR 2,011 per quintal.
This example shows that the wholesaler will pay INR 2,011 per quintal of chana, irrespective of its spot
market price on February 20. This happens because the gains from the futures position are exactly offset
by the losses in the spot market, and the losses in the futures position are exactly offset by the gains in the
spot market. Such hedges where the hedger is able to lock in a certain price for the future purchase of the
asset are called perfect hedges.

5.3  Short Hedges

A short hedge is undertaken when the hedger owns the asset or has a long position in the asset and
wants to sell it in the future. Since the hedger faces the risk of unknown future prices for the asset, they

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 94   Financial Risk Management

Notes will hedge this risk by agreeing to sell the asset at a future time for a price that is agreed upon today. This
means that the hedger will sell futures contracts or take a short position in the futures when they already
have a position in the underlying asset or expect to have a position in the underlying asset in the future.
In the commodity market, producers of commodities such as agricultural products and minerals un-
dertake a short hedge.
In the currency futures market, exporters who expect to receive foreign currency in the future for the
goods they have exported will undertake a short hedge.
In interest rate futures markets, short hedges are undertaken when a company is planning to borrow
at a future time and is concerned that the interest rate might increase.

  Example 5.3
Assume that today is September 10. A farmer producing chana estimates that their farm will produce
50 MT on February 20. The current spot price of chana is INR 1,912 per quintal (100 kg), and the price
of a February chana futures contract is INR 2,011 per quintal. Each contract is for 1 MT (1,000 kg or
10 quintals) of chana. The farmer can hedge price risk by:
(i) taking a short position in 50 chana futures contracts on September 10 at INR 2,011 per quintal, i.e.,
INR 20,110 per contract, and
(ii) taking a long position in 50 chana futures contracts on February 20.
  This strategy will ensure that the farmer will receive a price of INR 2,011 per quintal of chana, irrespec-
tive of its spot market price on February 20, as the delivery of chana contracts will be on February 20.
Consider the case where the spot market chana price on February 20 is INR 2,561. Since the delivery
date is February 20, the futures prices will be very close to the spot prices in order to eliminate arbitrage
opportunities. Thus, the futures price will also be INR 2,561.
Since the wholesaler closes out the position on February 20 by agreeing to buy chana at INR 2,561, the
loss from the futures position will be (2,561 – 2,011) × 10 = INR 5,500 per contract or INR 275,000 for 50
contracts. However, they need to sell chana in the spot market at INR 2,561 per quintal, or INR 1,280,500
for the 50 MT produced by them. The net price that the farmer receives for the chana, therefore, is
INR 1,280,500 – INR 275,000 = INR 1,005,500 or INR 2,011 per quintal.
Date: September 10
Action: Enter into 50 short chana futures contracts at a futures price of INR 2,011.
Date: February 20
Action: Close the short position by entering into 50 long futures contracts at INR 2,561, making a loss of
(2,561 – 2,011) × 10 × 50 = INR 275,000.
Action: Sell 50 MT of chana in the spot market at INR 2,561 for a total of 2,561 × 10 × 50 = INR 1,280,500.
Result: Net receipts = Sale price in the spot market – Loss from the futures = INR 1,280,500 –
INR 275,000 = INR 1,005,500 for 50 MT or INR 2,011 per quintal.
If the spot market chana price on February 20 is INR 1,900, then the position of the hedger will be:
Date: September 10
Action: Enter into 50 short chana futures contracts at a futures price of INR 2,011.
Date: February 20
Action: Close the short position by entering into 50 long futures contracts at INR 1,900, making a gain of
(2,011 – 1,900) × 10 × 50 = INR 55,500.
Action: Sell 50 MT of chana in the spot market at INR 1,900 for a total of 1,900 × 10 × 50 = INR 950,000.
Result: Net cost = Sale price in the spot market + Gain from the futures = INR 950,000 + INR 55,500 =
INR 1,005,500 for 50 MT or INR 2,011 per quintal.
  This example shows that the farmer will receive INR 2,011 per quintal of chana, irrespective of its spot
market price. This happens because the gains from the futures position is exactly offset by the losses in the
spot market, and the losses in the futures position is exactly offset by the gains in the spot market. This
hedge also results in a perfect hedge.

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 Hedging Strategies Using Futures   95

Notes Problem 5.1

Barley Mart produces barley and sells it to wholesalers. On September 1, the spot market price of Barley is INR 922
per quintal. Barley Mart wants to sell 50 MT of Barley in December and is concerned that the price of Barley might
fall in the period between September and December. In order to eliminate the risk of possible price decreases, Barley
Mart wants to hedge the position using futures. Barley futures are available in the NCDEX, with expiry on December
20 and a contract size of 10 MT. Barley futures are priced in Indian rupees per quintal. The December futures are
selling at INR 840. Show that Barley Mart can fix the selling price of barley by entering into a futures contract.
Solution to Problem 5.1
Step 1: Identify whether a long hedge or a short hedge is preferable.
A long hedge is preferable when a hedger would like to buy the asset at a future time and a short hedge would be
preferable when a person wants to sell the asset at a future time. In this problem, Barley Mart wants to sell the asset
at a future time and hence a short hedge is appropriate.
Step 2: Choose the appropriate futures and the number of contracts.
Since Barley Mart wants to sell in December, December futures will be used to hedge.
The number of contracts will be calculated as:

Position in the asset 50 MT

= = 5 contracts
Contract size of the futures 100 MT
Thus, Barley Mart will take a short position in five December barley contracts.
Step 3: Decide the actions to be taken to hedge.
September 1: Take a short position in five December barley futures at INR 840.
December 20: (i) Close out the short position in the futures by taking a long position in the five December barley
futures contracts; and (ii) sell 50 MT of barley in the spot market at the prevailing spot market price.
Step 4: Calculate the effective selling price for two different spot prices, one higher and one lower, to show that the
effective price is the same, irrespective of the spot market price.
Since the futures price contracted is INR 840, consider the case of (i) spot market price of INR 880 and
(ii) spot market price of INR 820.
  When the spot price is INR 880 on December 20, the futures price will also be INR 880. Thus, when you take a
long position at INR 880, you agree to buy barley at INR 880 per quintal; however, at the time of entering into the
contract on September 1, Barley Mart had agreed to sell at INR 840. Thus, when you close out the position, there will
be a loss of INR 40 per quintal.
Loss per quintal = Opening futures price – Closing futures price = INR 880 – INR 840 = INR 40
Since the contract size is 10 MT, and each MT is equal to 10 quintals, the contract size = 100 quintals.
Loss per contract = 100 × 40 = INR 4,000
Loss from five contracts = INR 20,000
Receipt from sales in the spot market = 500 × 880 = INR 440,000
Net receipt = Receipt from sales in the spot market – Loss from futures
= INR 440,000 – INR 20,000 = INR 420,000
420,000
Net receipt per quintal = = INR 840
50
When the spot price is INR 820 on December 20, the futures price will also be INR 820. Thus, when
you take a long position at INR 820, you agree to buy barley at INR 820 per quintal; however, at the time of entering
into the contract on September 1, you had agreed to sell at INR 840. Thus, when you close out the position, there will
be a gain of INR 20 per quintal.

Gain per quintal = Opening futures price – Closing futures price = INR 840 – INR 820 = INR 20
Since the contract size is 10 MT, and each MT is equal to 10 quintals, the contract size = 100 quintals.
Gain per contract = 100 × 20 = INR 2,000
Gain from five contracts = INR 10,000

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Receipt from sales in the spot market = 500 × 820 = INR 410,000
Notes
Net receipt = Receipt from sales in the spot market + Gain from futures
= INR 410,000 + INR 10,000 = INR 420,000
420,000
Net receipt per quintal = = INR 840
50
Thus, hedging would result in a price of INR 840 per quintal, irrespective of the spot price of barley in the market.

Problem 5.2
Indian Silver produces silver jewellery and sells all over India. On January 1, Indian Silver estimates that it will need
300 kg of silver on April 20 and is concerned that the silver prices may increase in the meantime. On January 1, the
spot market price of silver is INR 27,175 per kg. In order to eliminate the risk of possible price increases, Indian
Silver wants to hedge its position using futures. Silver futures are available in the NCDEX, with expiry on April 20
and contract size of 30 kg. The April futures are selling at INR 28,450. Show that Indian Silver can fix the buying price
of silver by entering into a futures contract.
Solution to Problem 5.2
Step 1: Identify whether a long hedge or a short hedge is preferable.
A long hedge is preferable when a hedger would like to buy an asset at a future time, and a short hedge is preferable
when a person wants to sell an asset at a future time. In this problem, Indian Silver wants to buy silver at a future time
and hence a long hedge is appropriate.
Step 2: Choose the appropriate futures and the number of contracts.
Since Indian Silver wants to buy silver in April, April silver futures will be used to hedge. The number of contracts
will be calculated as:

Position in asset 300 kg

= = 10 contracts
Contract size of futures 30 kg

Thus, Indian Silver will take a long position in 10 April silver futures contracts.
Step 3: Decide the actions to be taken to hedge.
January 1: Take a long position in 10 April silver futures at INR 28,450.

April 20: (i) Close out the long position in the futures by taking a short position in 10 April silver futures contract;
and (ii) buy 300 kg of silver in the spot market at the prevailing spot market price.

Step 4: Calculate the effective selling price for two different spot prices, one higher and one lower, to show that the
effective price is the same, irrespective of the spot market price.
Since the futures price contracted is INR 28,450, consider the case of (i) the spot market price of INR 29,000 and (ii)
the spot market price of INR 28,000.
  When the spot price is INR 29,000 on April 20, the futures price will also be INR 29,000. Thus, when you take a
short position at INR 29,000, you agree to sell silver at INR 29,000 per kg; however, at the time of entering into the
contract on January 1, you had agreed to buy at INR 28,450. Thus, when you close out the position, there will be a
gain of INR 550 per kg.

Gain per kg = Closing futures price – Opening futures price = INR 29,000 – INR 28,450 = INR 550

Since the contract size = 30 kg, gain per contract = 30 × 550 = INR 16,500.

Gain for 10 contracts = INR 165,000

Amount to be paid in the spot market to buy 300 kg of silver = 300 × 29,000 = INR 8,700,000
Net cost = Amount paid in the spot market – Gain from the futures
= INR 8,700,000 – INR 165,000 = INR 8,535,000
8,535,000
Net cost per kg = = INR 28,450
300

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When the spot price is INR 28,000 on April 20, the futures price will also be INR 28,000. Thus, when you take a short
Notes
position at INR 28,000, you agree to sell silver at INR 28,000 per kg; however, at the time of entering into the contract
on January 1, you had agreed to buy at INR 28,450. Thus, when you close out the position, there will be a loss of INR
450 per kg.

Gain per kg = Closing futures price – Opening futures price = INR 28,000 – INR 28,450 = INR 450; thus, the loss
made is also equal to INR 450 per kg.

Since the contract size = 30 kg, loss per contract = 450 × 30 = INR 13,500.

Gain for 10 contracts = INR 135,000

Amount paid to buy 300 kg of silver in the spot market = 300 × 28,000 = INR 8,400,000
Net cost = Amount paid in the spot market + Loss from futures
= INR 8,400,000 + INR 135,000 = INR 8,535,000
Net cost = 8,535,000/300 = INR 28,450

Thus, hedging would result in a price of INR 28,450 per kg, irrespective of the spot price of silver in the market.

5.4  Should Hedging be Undertaken?

Examples 5.2 and 5.3 show that hedging using futures contracts will lock in a known price for the future
purchase or sale of assets. However, is hedging really necessary?
Hedging is undertaken to reduce the downside risk. If a hedger owns some asset and wants to sell
the asset sometime in the future, the downside risk is that the future price of the asset may decrease. By
entering into a short futures contract, the hedger will gain from a futures contract if the price decreases,
whereas the hedger will make a loss from the position in the asset. The loss from the asset will be exactly
equal to the gain from the futures contract, so that the revenue for the hedged asset will be known at the
time of entering into a futures position and will be equal to the futures price prevailing at the time of en-
tering into the futures contract. However, if the price of the asset in the spot market increases, there will
be a loss in the futures position and again, the revenue will be fixed at the futures price prevailing at the
time of entering into the futures contract. If the hedger had not hedged the position and if the price had
not increased, the hedger would have been better off. Thus, hedging is preferable if the price is expected
to decrease and result in losses; on the other hand, hedging is not preferable if the price is expected to
increase. Therefore, the decision to hedge will depend on the expectations of possible price movements.

  Example 5.4
Consider the case where the chana spot price increased to INR 2,561. If the chana farmer had not hedged
the position with a chana futures contract, they could have realized INR 768,300, as opposed to a revenue
of only INR 603,300 with hedging. Thus, hedging with futures actually resulted in a loss for the farmer.
However, if the price had decreased to INR 1,900 instead, the chana farmer would have lost INR 33,300
without hedging. Thus, hedging was a better alternative when the price decreased, as the farmer was able
to lock in revenues of INR 603,300 for the chana produced.
However, if the farmer were to predict the direction in which the chana dal price was likely to move,
they could have decided whether they should hedge. If they believe that the price in the spot market is
likely to be more than the current futures price of INR 2,011, it is better not to hedge, and if the price does
go beyond INR 2,011, they would be better off by not hedging. However, this requires that the farmer is
able to predict the future price of chana dal at the contract expiry date.

One of the major factors that affect price risk is the price volatility. If the price shows very little volatil-
ity and remains in a narrow band, one can predict that the future price would be in that range. In that
case, hedging is not necessary. An example of this is shown Box 5.2. However, if the price moves out of
this range, there will be risks, and by not hedging, one may either lose—if the price moves against their
expectations—or gain—if the price moves in favour of their expectations.

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Notes
Box 5.2 Infosys and Currency Hedging

Infosys reduced its currency exposure hedging from USD reason cited for reducing the hedging amount was that the
932 million to USD 576 million because of the deprecia- company did not see much volatility in the exchange rate,
tion in the Indian rupee against the U.S. dollar. Another as it was expected to be in the range of INR 48 to INR 50.

Source: CommodityOnline, “Why Infosys Hates Hedging in Currency Futures,” commodityonline.com, January 13, 2009,
available online at http://www.commodityonline.com, accessed 10 May 2018 at 1pm IST.

5.5 Risks in Hedging
We have seen how perfect hedges have been achieved in Examples 5.2 and 5.3 of long and short hedges.
However, in reality, perfect hedges are very difficult to achieve because of the following reasons:
The asset that is to be hedged may not be exactly the same as the asset on which the futures contracts
 
are written. For example, a merchant may be interested in buying a particular grade of rice, but
the futures contracts may be written on another grade of rice. In this case, the price risk cannot be
completely eliminated.
The hedger may not know the exact date on which the asset may be bought or sold in the future. For
 
example, if the futures contract delivery date is on the 20th of the delivery month or later and the
hedger wants to buy or sell the asset before the delivery period, the futures price and the price in the
spot market may not coincide exactly, thus resulting in some risk.
The amount of asset to be bought or sold may be different from the futures contract size. For example,
 
if the chana futures contract is for 1 MT and a producer of chana wants to sell 3.5 MT, they cannot
achieve a perfect hedge, because they need to sell either three or four contracts. If they sell three
contracts, they still face price risk on the 0.5 MT of chana remaining with them, whereas if they sell
four contracts, they will be exposed to price risk on the 0.5 MT of chana that is not in their possession.
These problems relate to a risk in futures known as basis risk.

5.6 Basis Risk
A basis with respect to hedging using futures contracts is defined as:
Basis = Spot price of the asset to be hedged – Futures price of the contract used
The basis on the expiry date of a futures contract will be zero if the asset to be hedged is the same as the
asset underlying the futures contract. This happens because there will be arbitrage opportunities if the
spot market price is different from the futures price on the expiry date of a futures contract. However, if
the asset to be hedged is different from the asset underlying the futures contract, the basis on the expiry
date of the futures contract could be either positive or negative, because we will be comparing the spot
price of one asset with the futures price of some other asset.
The basis at times other than on the expiry date of a futures contract could be either positive or nega-
tive. When the underlying asset is a stock index, a low-interest-rate currency, gold, or silver, the futures
price is generally greater than the spot price and the basis is negative. For high-interest-rate currencies
and many commodities, the spot price is generally greater than the futures price and the basis is positive.
When the spot price increases more than the futures price, the basis will increase, whereas if the
futures price increases more than the spot price, the basis will decrease. This is called strengthening or
weakening of the basis.
Let S1 = spot price at time t1;
S2 = spot price at time t2;
F1 = futures price at time t1;

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Notes F2 = futures price at time t2;

b1 = basis at time t1; and
b2 = basis at time t2.
Assume that the hedge is placed at time t1 and closed out at time t2. Then,
b1 = S1 – F1
and
b2 = S2 – F2
Suppose the hedger enters into a short position at time t1 at F1, closes out the position by taking a long po-
sition in the futures contract at time t2 at F2, and sells the asset in the spot market at S2. Then the profit or
loss from the futures position is F1 – F2. Thus, the effective price for the hedger is S2 + (F1 – F2) = F1 + b2.
If the basis at time t2 is known with certainty at time t1, then the hedger will face no risk, because
they will know for certain what price they will receive for their commodity. However, b2 is known with
certainty to be equal to zero only if the asset being hedged is the same as the asset underlying the futures
contract, and the time t2 is the same as the expiry date or the delivery date of the futures contract when
the hedge is closed out. At other times, b2 is not known with certainty at the time of entering into the
futures contract. This uncertainty causes basis risk.
Basis risk is generally smaller for investment assets such as stock index futures, currency futures, gold,
and silver than it is for commodities. This happens because basis risk for investment assets mainly arises
from uncertainty of the level of risk-free interest rate in the future. For commodities, basis risk arises as a
result of imbalance between supply and demand and also from storage costs.
Basis risk does not mean that a hedger will be affected negatively. If it is a short hedge, the hedger’s
position will improve if the basis strengthens and will worsen if the basis weakens. On the other hand, a
long hedger’s position will improve if the basis weakens and worsen if the basis strengthens.

5.7  Factors Affecting Basis Risk

As was seen earlier, there is no basis risk only if:
1. the asset being hedged is the same as the asset underlying the futures contract;
2. the day on which the hedge is closed out matches the delivery date of the futures contract; and
3. the amount of asset being hedged is an integer multiple of the contract size of the futures contract
used to hedge.
Thus, basis risk arises if:
1. the asset being hedged is different from the asset underlying the futures contract;
2. the day on which the hedge is closed out is different from the delivery date of the futures contract; and
3. the amount of asset being hedged can be fully covered by an integer multiple of futures contracts.
This shows that if the asset being hedged exactly matches the asset underlying the futures contract, the
basis risk can be reduced. However, if there are no futures contracts on the asset being hedged, the hedger
will have to carry out a careful analysis of all available futures contracts in order to decide which of these
contracts have futures prices that are highly correlated with the price of the asset being hedged.
Basis risk generally increases as the time difference between the expiry date of the hedge and the
delivery date of the asset increases. Normally, the rule is to choose a date later in the delivery month but
as close as possible to the expiry date of the hedge. For example, if the delivery month is March, the de-
livery date according to the contract is March 20, and the date the exposure ends is March 27, it is better
to enter into an April contract rather than into a March contract. This is because, if one hedges using a
March contract, the position is not covered for a period of seven days from March 20 to March 27, and
the hedger faces the risk of unknown price movements in the spot market for these seven days. On the
other hand, if one hedges with an April contract, they can close the contract on March 27 at the futures
price as of March 27. Although there is a basis risk, given that the contract maturity is on April 20, it will
be smaller than the risk of spot price movement of the underlying asset.

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Notes   Example 5.5

Suppose today is January 1, and an Indian company expects to receive USD 5 million at the end of May.
The delivery date for U.S. dollar futures contracts is the 24th of every month. Each contract is for the
delivery of USD 1 million.
Step 1: Which contract should be used?
Since the exporter is receiving U.S. dollars on May 31 and contract delivery is on May 24, the hedger will
use a June contract.
Step 2: Should a long or short position be used to hedge?
The company will sell five June U.S. dollar futures contracts on January 1. When the U.S. dollars are
received on May 31, the futures contract will be closed out and the U.S. dollars will be exchanged at the
prevailing spot rate.
  Suppose the exchange rate on January 1 is USD 1 = INR 50 and the futures price is INR 51. Also assume
that the spot exchange rate and the futures price on May 31 are INR 49.40 and INR 50.50, respectively.
  The final basis is the difference between the spot price and the futures price on the day the contract is
closed out, i.e., INR 49.40 – INR 50.50 = INR –1.10. The gain from the futures contract is the difference
between the rate at which the contract is closed and the rate at which the contract was entered into, i.e.,
INR 50.50 – INR 51 = INR 0.50. This gain has been made because the company agreed to sell U.S. dollars
at INR 51 under the futures contract when it entered into the contract, and it agreed to buy U.S. dollars at
INR 50.50 at the time it closed the contract. Thus, the effective price obtained is
Effective price = Spot price + Gain on the futures contract
= INR 49.40 + INR 0.50
= INR 49.90
This can also be written as:
Effective price = Futures price contracted + Basis at the time the contract is closed out
= INR 51 – INR 1.10
= INR 49.90
The company will thus receive 5,000,000 × 49.90 = INR 249.5 million.

  Example 5.6
Consider a merchant dealing in aluminium; they are expecting to buy 10 MT of aluminium on
November 1. They enter into an October aluminium futures contract to hedge the price risk. The contract
size is 5 MT, and the price is specified in terms of Indian rupees per kg. On September 1, the futures price
is INR 91.90, and the merchant buys two contracts that require them to pay INR 91,900 per contract or
a total of INR 183,800 for the two contracts. Since they have entered into an aluminium futures contract,
the spot price of aluminium on October 31 will be the same as the futures price on that date, according
to the arbitrage principle. This means that the final basis will be zero. Hence, they are assured that they
need to pay exactly INR 183,800 for the 10 MT of aluminium that they would purchase on October 31.

  Example 5.7
Suppose they require 12 MT of aluminium on November 1; they will be able to enter into a futures con-
tract for covering only 10 MT of aluminium, as the contract size is 5 MT. Thus, they will be able to hedge
10 MT and be assured that they need to pay exactly INR 183,800 for these 10 MT. However, they will
not be able to hedge the exposure to the remaining 2 MT of aluminium that is not covered by the futures
contract. They will be exposed to price risk on these 2 MT. Thus, a perfect hedge is obtained only when
the amount of exposure in the underlying asset is the same as the amount of exposure under the futures
contract.

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Notes   Example 5.8

Suppose the aluminium merchant requires 10 MT of aluminium on November 10, rather than on
November 1. Since the contracts expire either on October 31 (for October contracts) or on November
30 (for November contracts), they will face price risk. Suppose they enter into an October contract, they
need to pay INR 183,800 for the 10 MT of aluminium they need and store this for 10 days. However, if
the price is lower than INR 91.90 per kg on November 10, they would incur a loss. If, on the other hand,
they enter into a November contract, say, at INR 92.50 per kg, they will need to close their position on
November 10 at the futures price prevailing on that day; however, this price is not known on September 1,
the day on which they enter into the futures contract. Thus, the hedger will face a price risk if the end-
of-exposure date is not the same as the futures contract maturity date. Typically, the hedger will use a
contract whose maturity date falls after the end-of-exposure date. This is because the volatility of futures
prices is relatively smaller when compared to the volatility of the price of the underlying asset. If they
enter into a futures contract whose maturity date is before the end-of-exposure date, they are exposed to
the price volatility of the underlying asset for that period. On the other hand, if they cover their exposure
with a longer maturity contract, they will be exposed only to the price volatility of futures prices, which
is relatively smaller.

In both the above examples, the hedger was exposed to the price risk of aluminium and they used alu-
minium futures contracts to hedge this risk. The underlying asset was the same as the asset to which they
were exposed to. However, there may be situations where one is exposed to risk in some asset in which no
futures contracts are available. In this case, it is still possible to hedge by using a futures contract on some
related assets; however, this hedge will not be a perfect hedge, as shown in the next example.

  Example 5.9
Consider the case of Kingfisher Airlines. One of the major expenses for Kingfisher is the aviation fuel.
The price of aviation fuel is highly volatile and Kingfisher would like to hedge the price risk of aviation
fuel. However, futures contracts are not available for aviation fuel. Kingfisher can still hedge its exposure
to some extent by entering into futures contracts written on related assets. A related asset is one whose
price changes are highly correlated with the price changes of the asset that is exposed to. For example, the
change in the price of aviation fuel is likely to be highly correlated with the change in the price of crude
oil, on which futures are available. Thus, Kingfisher will use crude oil futures to hedge against the risk of
price changes in aviation fuel. However, it is to be noted that it will not be a perfect hedge since the final
basis will be the difference between the spot price of aviation fuel and the price of crude oil futures, and
there is no need for these two prices to be the same; hence, the final basis will not be zero, causing the
hedge to be less than perfect.

When the asset being hedged is different from the asset underlying the futures contracts, the basis risk
will be different, as shown below:
Assume that the spot price of the asset being hedged is S1 at time t1 and S2 at time t2 and the spot price
of the asset underlying the futures contract is S2* 1 at time t1 and S2* at time t2. This means that the hedger
will be able to sell the asset at S2, and the profit from the futures position is F1 – F2. Thus,
Net price = S2 + F1 – F2
= (S2 – S2* ) + (S2* – F2) + F1
= (S2 – S2* ) + b2 + F1
Basis risk has two dimensions. The first is the basis risk on the asset underlying the futures contract, b2.
The second is the basis risk resulting from the price difference between the asset being hedged and the
asset underlying the futures contract.
Since the hedge is not perfect, the number of futures contracts that are needed to hedge the exposure
will not be equal to Amount of exposure/Futures contract size. The optimal number of contracts that are
needed to hedge the exposure will have to be calculated. This is explained in Examples 5.11 and 5.12.

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Notes 5.8  The Hedge Ratio

In hedging, the most important variable is the hedge ratio. This is defined as the ratio of the size of the
exposure to the size of the position taken in the futures contract. In order to minimize risk, the appropri-
ate hedge ratio needs to be determined.
The size of exposure is calculated as:
Size of exposure = Quantity of assets exposed × Spot price of the asset exposed
The size of position taken in futures is calculated as:
Size of position in futures = Contract size × Number of futures contracts
The hedge ratio is usually termed as the minimum variance hedge ratio and is calculated as shown below:
Let DS = change in spot price during a period of time equal to the life of the hedge;
DF = c hange in futures price during a period of time equal to the life of the hedge;
sS = standard deviation of DS;
sF = standard deviation of DF;
r = coefficient of correlation between DS and DF; and
h* = optimal hedge ratio.
Then,
sS
h* = r ×
sF

The hedge ratio is the product of the correlation coefficient and the ratio of the standard deviation of DS
to the standard deviation of DF.
If r = 1 and sS = sF, then h* = 1, which means that for each rupee exposed, one rupee must be invested
in the futures contract of the asset. This is very clear because the change in the price of the asset and the
change in futures price are exactly the same. If r = 1 and sF = 2sS, then h* = 0.5.
Hedging effectiveness is defined as the variance proportion eliminated by hedging and is given by:

sF 2
Hedging effectiveness = h*2 ×
sS 2

The values of r, sS, and sF are estimated from the historical data of DS and DF. A number of equal inter-
vals of time, usually the time for which the hedge is in effect, are chosen and DS and DF are observed for
each of these intervals.

  Example 5.10
On May 10, Meenakshi Rolling Flour Mills estimates that it will require 5 MT of wheat on June 20. It
wants to hedge the risk of increase in the price of wheat in the future and decides to hedge the price risk
using wheat futures in MCX India. Futures contracts are available with delivery on June 20, with a futures
price of INR 1,205. Since the hedge lasts from May 10 to June 20, for a period of 42 days, the manager of
the mills finds the following with respect to the spot price and futures price of wheat.
Standard deviation of changes in spot price = INR 105
Standard deviation of changes in futures price = INR 120
Correlation between the spot price and futures price changes = 0.96
The hedge ratio is calculated as:
sS 105
h* = r × = 0.96 × = 0.84
sF 120

This means that for each rupee exposed in wheat, the hedger should invest 84 paise in the futures contract.

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Notes Problem 5.3

On November 20, the spot price of jute is INR 2,198 per 100 kg and the price of December jute futures with expiry
on December 15 is INR 2,276. The standard deviation of the spot price change is estimated as INR 260, and the stan-
dard deviation of the futures price change is estimated as INR 248. The correlation coefficient between the spot price
change and the futures price change is estimated to be 0.99. What is the hedge ratio and the hedging effectiveness?

Solution to Problem 5.3

The hedge ratio is calculated as:
sS 260
h* = r × = 0.99 × = 1.0379
sF 248

This means that each rupee exposed in jute should be covered by futures worth INR 1.0379.

Hedging effectiveness is calculated as:

sF 2 2
 248 
Hedging effectiveness = h*2 × = (0.99)2 ×  = 0.8917
sS 2  260 

This shows that the hedge is able to cover 89.17 per cent of the variation in the spot price, and the hedger is exposed to
10.83 per cent of the variation in the spot price of jute.

  Example 5.11
The optimal number of contracts refers to the number of futures contracts that must be used to hedge the
exposure. This is calculated as shown below:
Let  NA = size of the position being hedged,
QF = size of the futures contract, and
N* = optimal number of futures contracts for hedging.
Then,
NA
N* = h* ×
QF

For example, if h* = 0.8, NA = 10,000, and QF = 1,000,

10,000
N* = 0.8 × =8
1,000
That is, eight futures contracts are needed to hedge so that the hedge effectively reduces the risk.

  Example 5.12
Kingfisher Airlines uses 20,000 barrels of aviation fuel every month. On January 1, Kingfisher would
like to hedge the price risk of aviation fuel for March and would like to enter into a futures contract with
expiry on February 28. Since there are no futures on aviation fuel, the chief financial officer of Kingfisher
decides to enter into February crude oil futures. The crude oil futures contract size is 100 barrels and the
price of these futures on January 1 is USD 72 per barrel. The standard deviation of the aviation fuel price
is USD 6, and the standard deviation of the crude oil futures price is USD 4. The correlation between the
aviation fuel price and the crude oil price is 0.90. How many futures contracts should Kingfisher Airlines
enter into and what will be the hedging effectiveness?
  Since Kingfisher would be buying aviation fuel on March 1, it should enter into a long hedge, that is, it
should buy February crude oil futures.
sS
Hedge Ratio = h* = r ×
sF

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 104   Financial Risk Management

Notes Since r = 0.9, sS = 6, and sF = 4,

6
h* = 0.9 × = 1.35
4
NA 20, 000
Number of contracts = h × = 1.35 × = 270 contracts
QF 100

sF 2
Hedging effectiveness = h*2 × = 0.81
sS 2

This means that 81 per cent of the variation in the aviation fuel price will be hedged, i.e., Kingfisher is still
exposed to 19 per cent of the variation in the aviation fuel price.

Problem 5.4
On May 10, Meenakshi Rolling Flour Mills estimates that it will require 50 MT of wheat on June 20. The spot price of
wheat on May 10 is INR 1,214. It wants to hedge the risk of increase in the price of wheat in the future and decides to
hedge the price risk using wheat futures in MCX India. Futures contracts are available with delivery on June 20, with a
futures price of INR 1,205. The contract size for wheat futures is 10 MT. Since the hedge lasts from May 10 to June 20,
for a period of 42 days, the manager of the mills finds the following with respect to the spot price and the futures price
of wheat.
The standard deviation of changes in spot price is INR 105. The standard deviation of changes in futures price is
INR 120. The correlation between the spot price and futures price changes is 0.96. How should Meenakshi Rolling
Flour Mills hedge this exposure?

Solution to Problem 5.4

Step 1: Calculate the hedge ratio.

The hedge ratio is calculated as:

sS 105
h* = r × = 0.96 × = 0.84
sF 120

This means that for each rupee exposed in wheat, the hedger should invest 84 p in the futures contract.

Step 2: Find the size of exposure to wheat.

Size of exposure = Quantity of assets exposed × spot price per MT

= Price per 100 kg × 10
= 1,214 × 10 = INR 12,140
Total exposure = 12,140 × 50 = INR 607,000

Step 3: Calculate the futures contract value.

Futures contracts value = Futures price × Contract size = 1,205 × 10 × 10 = INR 120,500

Step 4: Calculate the number of contracts.

Size of exposure to wheat
Number of contracts = h ×
Futures contract value
607,000
= 0.84 ×
120,500
= 4.23 contracts ≈ 5 contracts

This means that Meenakshi Roller Flour Mills should take a long position in five wheat futures contracts.

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 Hedging Strategies Using Futures   105

Notes Problem 5.5

On November 20, the spot price of jute is INR 2,198 per 100 kg and the price of December jute futures with expiry
on December 15 is INR 2,276. The standard deviation of the spot price change is estimated as INR 260, and the stan-
dard deviation of the futures price change is estimated as INR 248. The correlation coefficient between the spot price
change and the futures price change is estimated to be 0.99. The Bengal Jute Corporation is planning to sell 40 MT
of jute on December 15 and wants to hedge the price risk of jute. How should the corporation hedge its exposure?
Solution to Problem 5.5
Step 1: Calculate the hedge ratio as:
σS 260
h* = ρ × = 0.99 × = 1.0379
σF 248

This means that for each rupee exposed in jute, the hedger should invest INR 1.0379 in the futures contract.

Step 2: Find the rupee amount of exposure to jute.

Rupee exposure = Exposure × Spot price = 40 × Price per MT

Price per MT = Price per 100 kg × 10 = 2,198 × 10 = INR 21,980
Total exposure = 21,980 × 40 = INR 879,200

Step 3: Calculate the value of the futures contracts.

Value of the futures contracts = Futures price per MT × Contract size in MT = 2,276 × 10 × 10 = INR 227,600
Step 4: Calculate the number of contracts.

Rupee amount of exposure in wheat

Number of contracts = h* ×
Futures contract value
879,200
= 1.0379 ×
227,600
= 4.009 contracts
≈ 4 contracts

This means that the Bengal Jute Corporation should take a short position in four jute futures contracts.

5.9  Static and Dynamic Hedging

Hedging could be either static or dynamic. In static hedging, the company that is hedging the price risk
would enter the futures market and keep the contract till its maturity—if the end-of-exposure date is the
same as the maturity of the futures—or close to the end-of-exposure date—if the maturity falls after the
end-of-exposure date. The main idea in static hedging is to hedge the price risk so that the price and cash
flow are certain. Static hedgers do not worry about possible losses they may have made through hedging.
In dynamic hedging, the original hedge would be undertaken for a given maturity as desired. However,
as time passes by, the hedger will observe the price movements and make specific presumptions about
the future price movements on the basis of demand and supply, market conditions, etc., and would take
decisions periodically as to how long the position needs to be hedged and the extent to which the expo-
sure should be hedged. In dynamic hedging, the hedge position can change over time. This is appropriate
when the hedger has sophisticated knowledge of the underlying asset market. Dynamic hedging is much
riskier than static hedging, but if the hedger is knowledgeable about the market, they may be able to time
the hedges such that hedging losses can be minimized.

5.10  Strip Hedges and Stack Rolling Hedges

A hedger may have commitments to either buy or sell a commodity at different times during the year. For
example, WIPRO might be receiving USD 200,000 at the end of every month for the next six months. In
this case, WIPRO will enter into either a forward contract or a futures contract for USD 200,000, with
expiry every month. This is known as strip hedging. The total amount for the whole year is stripped into
periodic amounts and hedging is done for each stripped amount.

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 106   Financial Risk Management

Notes In a stack rolling hedge, the whole exposure will be hedged using the near-month contract. For exam-
ple, WIPRO will hedge the total amount of USD 1,200,000 that will be received over the next six months
with a forward or a futures contract with expiry in one month. When this contract expires, WIPRO will
roll over the remaining hedge amount of USD 1,000,000 with a forward or a futures contract with expiry
in one month. Since the amount hedged is different from the amount of exposure in any given month,
WIPRO is subject to basis risk if it follows a stack rolling hedge. A stack rolling hedge is usually employed
when the hedging horizon is larger than, or the end-of-exposure date is after, the maturity of the futures
contracts available.

5.11 Losses from Hedging Using Futures

The biggest problem in using futures to hedge is that the hedger will not know the direction in which
the asset price will move. If the price moves against the trader, there will be gains from futures that will
offset losses from the spot price movement. If the gains from futures exactly offset losses from spot price
movement, the hedge will be a perfect hedge and the trader can fix the price for future purchase or sale of
the asset. In this case, hedging is preferable. However, if the price moves in favour of the trader, the spot
price movement will provide gains. If the trader had used futures to hedge, hedging will lead to losses.
The trader would be better off without hedging if the price moves in favour of the trader. Hedging when
price moves in favour can lead to huge losses as it happened to Metallgesellschft, as explained in Box 5.3.

BOX 5.3 Derivatives Losses for Metallgesellschaft AG

Metallgesellschaft AG is a German conglomerate. In The hedging strategy would be a stack hedging strategy.
December 1993, the energy group of Metallgesellschaft This means that the entire hedge will be placed in short-dat-
declared that it had made losses of approximately USD 1.5 ed delivery months, instead of spreading into many long-
billion due to trading in derivatives. But how could Metallge- dated delivery contracts. At the maturity of a contract, a
sellschaft lose so much money? What was their strategy? position will be taken in the next near-month contract or the
Metallgesellschaft committed to sell a certain quantity of contracts will be rolled over every time a contract for one
petroleum every month for up to 10 years at prices fixed in month expires. This stack hedging strategy was adopted be-
1992. During the early days, the forward price was higher cause of the existence of the option provided, which was
than the spot price and the company was making up to USD based on the near-month futures. The company went into a
5 per barrel. In September 1993, the total number of barrels long futures contract. At the same time, it also entered into
under the forward contract amounted to 160 million barrels. a swap agreement through which it would pay fixed energy
These forward contracts also had an option clause attached prices and receive variable energy prices that were based
to them. According to this option, the counterparty had the on the spot price in the market. It held a futures position in
right to terminate the contract if the front-month New York about 55 million barrels of gasoline and heating oil.
Mercantile Exchange (NYMEX) futures price was greater than This hedging strategy would work as long as the price of
the forward price at which the company was selling the oil. oil increased. When one goes long in futures and if the price
If the counterparty exercised this option, the company would increase, the futures position would show a gain and the bal-
have to pay one-half of the difference between the futures ance in the margin account would increase. When the for-
price and the forward price multiplied by the volume remain- ward contracts mature, the forward will result in losses, but
ing to be delivered under the contract. The contract was struc- these losses would be offset by gains from the futures position.
tured such that the contract would be terminated automati- However, if the oil prices dropped, the long futures position
cally if the futures price increased beyond a specified price. would show a loss and the margin balance would decrease. If
By offering this type of a contract, the risk of fluctuating the oil prices dropped further, the margin balance could go be-
oil price was transferred from the customers to Metallgesells- low the variation margin and this would require Metallgesells-
chaft. However, the risk that had been transferred to Met- chaft to provide cash in order to bring it back to the original
allgesellschaft had to be managed. The risk management margin amount. This would cause a funding problem, because
strategy was as follows: the cash flow from forward contracts would come in only at the
Use front-month NYMEX futures contracts. The contracts time of maturity of the contract. This short-term funding problem
used were unleaded gasoline and No. 2 heating oil futures. became very serious in the case of Metallgesellschaft.

Continued

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 Hedging Strategies Using Futures 107

Continued

Another problem also arose during this period. The oil the market is in contango, stack hedging with rollover of
market shifted from normal backwardation to contango. In contracts would result in losses that cannot be recovered,
the oil market, the futures price is generally lower than the as the spot price drops below the futures price. Thus, as
spot price and the market is said to be in normal backwar- long as the market stayed in contango, the rollover losses
dation. When the market turns into contango, the futures would be heavy. This rollover loss is the real loss suffered
price would be higher than the spot price. In the oil market, by Metallgesellschaft.
backwardation can be considered as the market expecta- The case study shows that the hedge was undertaken in
tion that the spot prices will fall in the future, as the OPEC’s the belief that the oil price would increase and the market
cartel pricing will not be sustainable over the long run and would be in backwardation. However, the expectations did
hence collapse. In 1993, the expectation that the cartel not realize and the oil prices dropped; this resulted in margin
pricing would collapse was realized and the spot price calls on the futures position and the market went into contango,
decreased, causing the market to be in contango. When causing real losses because of the rolling over of the contracts.

CHapTEr SUmmarY
The major participants in a futures market are hedgers.
 If the price moves in favour of the hedger, they will not be able

A perfect hedge is achieved when the price risk is completely
 to take advantage of this favourable movement and might face
eliminated and the hedger is able to lock in a known price for the losses.
exchange of an asset at a future time. A long hedge is undertaken Basis is defined as the difference between the futures price and

when a person needs to buy the underlying asset in the future. the spot price.
A long hedge involves buying the futures at the current time.

For most assets, the basis on the maturity date will be zero, as

For a long hedger, the concern is that the price of the underly-

the futures price on the maturity date would converge to the
ing asset may increase in the future, thereby requiring them to spot price on that day.
pay a higher price when they need to buy the asset at a future
time. If the basis on the maturity date of the futures is not zero,

the hedger is said to face basis risk and the hedge will not be
By entering into a long hedge, any loss that the hedger will

perfect.
face in the spot market will be offset by the gains in the futures
market. Basis risk arises when the position in an asset has to be hedged

A short hedge is undertaken by a hedger when they need to sell
 using futures on another asset, when the size of the exposure
the underlying asset at a future time. in the asset is different from the contract size of the futures, or
A short hedge involves selling the futures at the current time.
 when the date on which the hedge needs to be lifted is different
A short hedge would result in gains from the futures when the

from the maturity date of the futures.
underlying asset price decreases. Hedge ratio indicates the ratio of the size of the position taken

Hedging through futures would lock in a known rate for the
 in the futures contracts to the size of risk exposure.
exchange of an asset at a future time, if the hedge is perfect. The optimal number of contracts that should be chosen to

Hedging using futures will protect the hedger if the price
 hedge the exposure depends upon the volatility of the asset
moves against them. price and the volatility of the futures price.

mUlTIplE-CHoICE QUESTIoNS
1. The basis is defined as spot minus futures. A trader is hedg- 2. Futures contracts trade with every month as a delivery month.
ing the sale of an asset with a short futures position. The basis A company is hedging the purchase of the underlying asset on
increases unexpectedly. Which of the following is true? June 15. Which futures contract should it use?
A. The hedger’s position improves. A. The June contract B. The July contract
B. The hedger’s position worsens. C. The May contract D. The August contract
C. The hedger’s position sometimes worsens and sometimes
3. On March 1 a commodity’s spot price is $60 and its August
improves.
futures price is $59. On July 1 the spot price is $64 and the
D. The hedger’s position stays the same.
August futures price is $63.50. A company entered into futures

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 108 Financial Risk Management

contracts on March 1 to hedge its purchase of the commod- tracts on $250 times the index can be traded. What trade is
ity on July 1. It closed out its position on July 1. What is the necessary to increase beta to 1.8?
effective price (after taking account of hedging) paid by the A. Long 192 contracts B. Short 192 contracts
company? C. Long 96 contracts D. Short 96 contracts
A. $59.50 B. $60.50
8. Which of the following is true?
C. $61.50 D. $63.50
A. The optimal hedge ratio is the slope of the best fit line
4. On March 1 the price of a commodity is $1,000 and the when the spot price (on the y-axis) is regressed against the
December futures price is $1,015. On November 1 the price futures price (on the x-axis).
is $980 and the December futures price is $981. A producer of B. The optimal hedge ratio is the slope of the best fit line
the commodity entered into a December futures contracts on when the futures price (on the y-axis) is regressed against
March 1 to hedge the sale of the commodity on November 1. the spot price (on the x-axis).
It closed out its position on November 1. What is the effective C. The optimal hedge ratio is the slope of the best fit line
price (after taking account of hedging) received by the com- when the change in the spot price (on the y-axis) is
pany for the commodity? regressed against the change in the futures price (on the
A. $1,016 B. $1,001 x-axis).
C. $981 D. $1,014 D. The optimal hedge ratio is the slope of the best fit line
when the change in the futures price (on the y-axis) is
5. Suppose that the standard deviation of monthly changes in
regressed against the change in the spot price (on the
the price of commodity A is $2. The standard deviation of
x-axis).
monthly changes in a futures price for a contract on commod-
ity B (which is similar to commodity A) is $3. The correla- 9. Which of the following describes tailing the hedge?
tion between the futures price and the commodity price is 0.9. A. A strategy where the hedge position is increased at the
What hedge ratio should be used when hedging a one month end of the life of the hedge
exposure to the price of commodity A? B. A strategy where the hedge position is increased at the
A. 0.60 B. 0.67 end of the life of the futures contract
C. 1.45 D. 0.90 C. A more exact calculation of the hedge ratio when forward
contracts are used for hedging
6. A company has a $36 million portfolio with a beta of 1.2. The
D. None of the above
futures price for a contract on an index is 900. Futures con-
tracts on $250 times the index can be traded. What trade is 10. A company due to pay a certain amount of a foreign currency
necessary to reduce beta to 0.9? in the future decides to hedge with futures contracts. Which
A. Long 192 contracts B. Short 192 contracts of the following best describes the advantage of hedging?
C. Long 48 contracts D. Short 48 contracts A. It leads to a better exchange rate being paid
B. It leads to a more predictable exchange rate being paid
7. A company has a $36 million portfolio with a beta of 1.2. The
C. It caps the exchange rate that will be paid
futures price for a contract on an index is 900. Futures con-
D. It provides a floor for the exchange rate that will be paid

Answer
1. A 2. B 3. A 4. D 5. A 6. D 7. C 8. C 9. D 10. B

rEVIEW QUESTIoNS
1. What is meant by basis and basis risk? (ii) A tyre manufacturer wants to reduce the price risk of
2. Under what conditions would a hedger not be able to get a rubber, which they use in the manufacture of rubber,
perfect hedge using futures? and rubber futures are available in MCX India.
3. What type of hedging would be undertaken under the follow- (iii) An oil producer would like to reduce the unknown price
ing circumstances? Explain. risk of crude oil. Crude oil futures are available in the
(i) An Indian company has exported products to the NCDEX.
USA and expects to receive USD 10 million from 4. Explain what happens to the position of a short hedger if the
the importer in the USA in three months’ time. basis strengthens and if the basis worsens.
Indian rupee futures are available through banks in 5. If the minimum variance hedge ratio is 1, does it mean that
India. you can completely eliminate price risk?

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 Hedging Strategies Using Futures 109

SElF-aSSESmENT TEST
1. Jet Airways requires 2,000,000 barrels of aviation fuel every 4. You are a gold jeweller, and you require 1.3 kg of gold on
month. Since the price of aviation fuel depends on the price March 12. Assume that you can enter into a futures contract to
of crude oil, Jet Airways faces price risk. At the beginning of buy gold at INR 1.25 million per kg, with expiry on March 20.
each month, Jet Airways goes for a long hedge in crude oil The contract size is 1 kg of gold.
futures contract for 2,000,000 barrels, with expiry by the end
of that month. (i) Explain how you can reduce the price risk of gold by
using the March futures contract.
(i) What is meant by a long hedge? (ii) Can you completely eliminate the price risk? Explain.
(ii) What is the purpose of the long hedge undertaken by
Jet Airways? 5. On November 20, the spot price of cardamom is INR 774.50
(iii) Would Jet Airways be able to completely eliminate the per kg, the price of December cardamom futures with expiry
price risk of aviation fuel? Explain. on December 15 is INR 773.00, and the price of January
2. In the above problem, assume that the standard deviation of cardamom futures with expiry on January 15 is INR 771.50.
the crude oil futures is USD 2.5 and the standard deviation The contract size of cardamom futures is 500 kg. The standard
of aviation oil price is USD 3.2. The correlation coefficient deviation of spot price change is estimated as 22, and the
between crude oil futures price and aviation oil price is 0.96. standard deviation of the futures price change is estimated
(i) Calculate the optimal hedge ratio. Explain what Jet as 20.2. The correlation coefficient between the spot price
Airways needs to do to hedge the price risk. change and the futures price change is estimated to be
(ii) What is the hedging effectiveness of this hedge under-taken 0.99. Indian Spice Corporation is planning to sell 1 MT of
by Jet Airways on the basis of the optimal hedge ratio? cardamom on December 25 and wants to hedge the price risk
(iii) If the size of a crude oil futures contract is 100 barrels, of jute.
calculate the number of contracts that Jet Airways
should enter into. (i) How should Indian Spice Corporation hedge this expo-
sure?
3. On May 10, Indian Aluminium Products Limited estimates (ii) If the spot price of cardamom on December 15 is INR
that it will require 60 MT of aluminium on June 5. The spot
773.75 and the spot price and January futures price of
price of aluminium on May 10 is INR 89.50. It wants to
cardamom on January 5 are INR 772.50 and INR 772.00,
hedge the risk of an increase in the price of aluminium in the
future and decides to hedge this price risk using aluminium respectively, calculate the result of hedging using January
futures in MCX India. The futures contracts are available with futures and December futures.
delivery on June 20, with a futures price of INR 90.90. The
6. On January 1, Ramesh Jewellers estimates that they would
contract size for the aluminium futures is 5 MT. The manager
has estimated that the standard deviation of changes in the require 250 kg of silver on March 1. The spot price of silver
spot price is 10, the standard deviation of changes in the on January 1 is INR 26,500, and futures are available on silver
futures price is 11, and the correlation between the changes with a contract size of 30 kg. The price of February futures
in the spot price and futures price is 0.96 with delivery on February 25 is INR 27,230, and the price
of March futures with delivery on March 28 is INR 28,320.
(i) How should Indian Aluminium Products Limited hedge
The standard deviation of spot prices changes is 940, and the
this exposure?
(ii) If the spot price of aluminium on June 5 is INR 91.25 standard deviation of futures price changes is also 940. The
and the futures price on June 5 is INR 92.40, what is the correlation of the price changes is 1. Calculate the result of
result of the hedge when compared to not hedging the hedging using February futures and March futures. How
exposure with futures? should Ramesh jewellers hedge the price risk?

CaSE STUDY

Sairam Metals are traders in metals. One of the products they trade at a markup of 15 to 20 per cent. Since the price of steel plates is
in is steel plates. They buy steel plates for inventory as well as on dependent on steel prices and the price of steel is very volatile in
order. Usually they buy steel plates on the first of every month the world market, Sairam Metals face a problem with regard to the
and the usual monthly demand is 320 MT. If they get an order projection of their cash outflows every month when they buy the
for steel, they require about three weeks to fulfil that order. They steel plates.
buy the steel plates at the prevailing market price and sell them

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 110   Financial Risk Management

  Sairam, the owner–manager of Sairam Metals has heard that one 2. I have been told that there are two types of hedges: long hedges
way to streamline the cash flow would be to enter into hedging and short hedges. What do they mean? Which one is appropri-
activity using futures markets. Since Sairam is just a trader, he is ate for Sairam metals?
not sure what hedging involves. However, he decides to see what 3. I understand that hedging is done to reduce price uncertainty.
futures contracts are available and finds that there are three futures Can I make certain that I will know the price that will be paid
contracts available in the Multi Commodity Exchange of India if I enter into a futures contract?
(MCX India): futures on steel ingots, steel flats, and sponge iron. 4. There are three different iron and steel contracts available in the
  The futures on steel ingots have a contract size of 15 MT, and market. Which of these contracts is the best for Sairam Metals?
the delivery date is on the 15th of the calendar month. Contracts 5. Our usual practice is to buy steel plates in the market on the
are available with a maturity of three months from the launch date, 1st day of every month. If I use futures to hedge, will this strat-
and they are launched on the 16th of each calendar month. The egy work, or should I change the timing of purchase?
current futures price on steel ingots is INR 24,170 per MT, with
6. Based on these questions, you decide to find the correlation
expiry next month.
between the market price of steel plates and the market price
  The futures on steel flats have a contract size of 25 MT, and the
of the futures on steel flats, steel ingots, and sponge iron. The
delivery date is 15th of the calendar month. Contracts are available
standard deviation of the market price of steel plates, futures
with a maturity of four months from the launch date, and they are
price on steel flats, futures price on steel ingots, and futures
launched on the 16th of each calendar month. The current futures
price on sponge iron is INR 450, INR 380, INR 520, and INR
price on steel flats is INR 30,880 per MTMT, with expiry next
420, respectively. The correlation between the price of steel
month.
plates and the futures price of steel flats is 0.87, that between
  The futures on sponge iron have a contract size of 15 MT, and
the price of steel plates and the futures price of steel ingots is
the delivery date is 15th of the calendar month. Contracts are
0.82, and that between the price of steel plates and the futures
available with a maturity of four months from the launch date, and
price of sponge iron is 0.65. Which of these contracts should
they are launched on the 16th of each calendar month. The current
Sairam use for hedging?
futures price on sponge iron is INR 16,110 per MTMT, with expiry
next month. 7. As his monthly demand is 320 MT a month, what will be his
  Since Sairam is not aware of how to go about hedging, he strategy of hedging? That is, how many contracts should he
has contacted you to answer some questions he has regarding enter into?
hedging. You are required to help him come up with a hedging 8. Suppose that he enters into a hedging contract today, with
strategy. expiry next month. On the expiry date, you find that the spot
prices of the various metals per MTMT are as follows: steel
plates, INR 28,780; steel flats, INR 31,450; steel ingots, INR
Discussion Questions 25,740; and sponge iron, INR 18,200. What is the effective cost
1. What is the purpose of hedging? What will it do for Sairam of steel plates for Sairam if he uses the various futures to hedge?
Metals?

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 6
Swaps

LEARNING OBJECTIVES

After completing this chapter, you On March 23, 2010, IFC, a member of the World Bank group
will be able to answer the following and the TBC Bank, the largest bank in Georgia, entered into inter-
questions: est rate swap contracts so that the TBC Bank could offer mortgage
 What are interest rate swaps, loans with 14.5% interest rate. This swap arrangement helped the
currency swaps, equity swaps, bank to hedge the U.S. dollar interest rate risk on long-term borrow-
and commodity swaps? ing. IFC entered into this contract to improve the risk management
capabilities of banks in Central and Eastern Europe.
 How are swaps priced?
 How can swaps be used to Source: International Finance Corporation, “IFC Helps TBC Bank
Strengthen Georgian Financial System by Reducing Interest Rate Risk,”
hedge risks?
Press Release, March 23, 2010.

BoX 6.1 IFC Helps TBC Bank Reduce Interest Rate Risks

In the earlier chapters, we discussed how forward contracts and futures contracts can be used to hedge
the risks of changes in commodity prices, interest rates, currency exchange rates, and portfolio values.
However, all these contracts are generally short-term contracts and help individuals and institutions to
hedge risk in the short term. They can be used to hedge long-term risk by rolling over the contracts from
one short term to another, but this strategy can result in losses if the underlying asset prices move against
the hedger. Therefore, there was a need for developing an instrument that could be useful in hedging over
a long term. The instrument created for this purpose was the swap contract. Box 6.1 illustrates how inter-
est rate risk faced by the TBC Bank was mitigated by the use of interest rate swaps.

6.1 What Are Swaps?

Swaps are private agreements between two parties to exchange one stream of future cash flows for an-
other stream of cash flows in accordance with a pre-arranged formula. The agreement provides details
of how the cash flows will be calculated and the dates on which the cash flows will be exchanged. At the
time the contract is entered into, at least one of these cash flows will be determined on the basis of an
uncertain variable such as interest rate, exchange rate, equity price, or commodity price, while the other
could either be a fixed payment or be determined on the basis of another uncertain variable.

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 112   Financial Risk Management

Notes Swap contracts are private, OTC agreements, and no exchange exists for swap contracts. There are no
regulations governing swap contracts, and they can be customized to the needs of the parties.

6.2  Types of Swaps

There are many types of swaps that are used to hedge risks. Most commonly used swaps are interest rate
swaps, currency swaps, commodity swaps, and equity swaps which are defined as follows:
Interest Rate Swaps: In interest swaps, one party agrees to exchange interest payments based on a fixed
rate with another party for interest payments based on a floating rate.
Currency Swaps: In a currency swap, one party agrees to exchange payments based on one currency with
another party for payments based on another currency.
Commodity Swaps: In a commodity swap, the floating market price is exchanged for a fixed price over a
certain period.
Equity Swaps: The underlying asset in an equity swap could be a single stock, a basket of stocks, or a stock
index. One leg of the swap would involve cash flows based on the performance of the underlying equity,
while the other leg could be based on a floating interest rate.
The first swap transaction was between IBM and the World Bank in 1981—a currency swap to swap
cash flow denominated in Swiss francs and Deutschmarks. Since then, the swap market has grown con-
siderably, with hundreds of billions of dollars worth of contracts currently negotiated each year. Table 6.1
shows the notional value as well as the gross market values of different swaps at the end of June 2009.

6.3  Terminologies in Swaps

A number of terminologies are used in the design and operation of swaps. These terminologies are de-
scribed below:
Swap: An agreement between two parties to exchange cash flows over a fixed period of time.
Counterparties: The two participants in the swap
Notional Principal: A monetary figure that is used as a part of the calculation to determine the payment
amounts.
Tenor: The length of time for which these payments will be exchanged is known as the tenor, term, ma-
turity, or expiration of the swap.
Swap Facilitators: They are specialists in the swap market who help clients find ways, via the swap mar-
ket, to alter or avoid unwanted risks. They are like financial engineers who design swaps to solve client
problems.
Swap Brokers: Swap brokers bring swap counterparties together so that a swap can be arranged between
them.

Table 6.1  Market Values of Swaps as of June 2009

  (Figures in billion U.S. dollars)

Type of Swap Notional Value Gross Market Value

Interest Rate Swap 341,886 13,934

Currency swap 15,072 1,211

Equity Swap 1,709 225

Commodity Swap 1,772 -

Source: Bank of International Settlements, “Table 19: Amounts Outstanding of Overt-the-counter (OTC) Derivatives,” BIS
Quarterly Review, June 2010, A121.

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 Swaps  113

Notes Swap Dealers: Swap dealers, in addition to acting as facilitators or brokers, also enter into swaps on their
own behalf as one of the parties to the swap.
Swap facilitators and swap brokers receive commission or fees for their services. Swap dealers become
parties to the swap, and they stand ready to take the risks associated with the swap. Facilitators can also
be brokers and/or dealers.
Swap dealers typically engage in an offsetting swap so that their net risk exposure is kept at a minimum
level.
Dealers price the swaps in which they are principals so as to earn a bid–asked spread on their overall
book of business, so that they earn a positive income even if their net position is zero. They also manage
their portfolio so that they earn a positive income by accepting a net exposure when they consider the
potential returns to outweigh the risks.

6.4  Interest Rate Swaps

Box 6.1 shows that banks face interest rate risk and need to manage this risk to provide better loan rates
to consumers. This can be done through interest rate swaps.
The most common form of swap is the interest rate swap. In an interest rate swap, a fixed interest rate
loan is exchanged for a floating interest rate loan. Figure 6.1 illustrates the basic design of this form of a
swap when one company transacts a swap in order to hedge its floating-rate loans. The company takes
out a floating-rate loan with the base rate adjusted to the three-month bill rate. Since the actual interest
amount will depend on the three-month bill rate, the interest amount will vary. To hedge this variability
in the interest payments, the company swaps the floating-rate loan with a swap counterparty for a fixed-
rate loan, which would provide a constant interest rate during the life of the loan.
Suppose the swap has a two-year maturity; then, an exchange of the current two-year swap rate for the
market’s three-month bill rate will occur every three months for the next two years.
For example, assume that the two-year swap rate is 9% at the start of the swap arrangement and the
three month bill rate is 8%. This means that the company will pay 0.25% on the notional principal at
the end of the first three months. Note that the principal is not exchanged in an interest rate swap. Since
the company is swapping a floating-rate loan for a fixed-rate loan, the company will need to pay at 9%
for the three-month loan under the swap, whereas the floating-rate loan would have cost only 8%. Thus,
the company has to pay 1% higher interest on a yearly basis, or 0.25% on a three-month basis to the swap
counterparty.
After three months, assume that the three-month bill rate increases to 10%. Since the fixed rate is 9%,
the swap counterparty will pay the company 0.25% of the notional principal at the end of six months.
This additional payment from the swap counterparty will provide sufficient funds to pay the interest on
the floating-rate loan at 10%.

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Figure 6.1  Example of an Interest Rate Swap

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 114   Financial Risk Management

Notes 6.5  Swap Rates

The fixed rate at which the swap is transacted is known as the swap rate. In an interest rate swap, one
party borrows at a fixed rate and another party borrows at a floating rate, and then they swap their obliga-
tions. Thus, the party that borrowed at the fixed rate will pay a floating rate to the swap counterparty and
the party that borrowed at the floating rate will pay a fixed rate to the swap counterparty. The rate, either
fixed or floating, paid by one party to the other in a swap transaction is called the swap rate. The swap rate
is determined in the market on the basis of the demand for such a swap and is related to the interest rates
in the derivatives market. The floating rate is usually the most widely used benchmark for any currency,
and in international markets, it is usually the London interbank offer rate (LIBOR) for that currency.

6.6  Rationale for Swap Arrangements

One of the major reasons for the growth in popularity of swap arrangements is that a swap reduces the
borrowing costs for both the parties. This reduction in borrowing costs is achieved by exploiting the
comparative advantages of the borrowers in different markets.

  E x am p l e 6 . 1
Company A is seeking to raise funds for a three-year period. In the floating-rate market, it can borrow at
LIBOR + 70 points, or it can borrow in the fixed-rate market at 9%. Company B can borrow at LIBOR +
20 points in the floating-rate market, or it can borrow at 8.2% in the fixed-rate market.
This difference in borrowing costs for different parties arises because of different credit ratings. In this
example, Company B has a better credit rating than Company A in both markets and hence it can bor-
row at a cheaper rate in both markets when compared to Company A. However, Company B can do even
better through a swap arrangement. The swap arrangement will be based on the comparative advantage
that a company has over the other in a particular market. In this example, Company B has a comparative
advantage over Company A in the fixed-rate market, while Company A has a comparative advantage over
Company B in the floating-rate market, as shown in the Table below:
Comparative Advantage

Market Company A Company B Margin

Floating Rate points LIBOR + 70 points LIBOR + 20 points 50

Fixed Rate points 9% 8.2% 80

Company B has an advantage of 80 points over Company A in the fixed-rate market, whereas it has an
advantage of only 50 points in the floating-rate market, for a net difference of 30 points.
  By transacting in the market that provides the comparative advantage, Company A and Company B
can enter into an interest rate swap agreement and both can achieve a better rate than by sticking to the
market that offers them the best rates. In this swap, Company A will borrow at a floating rate of LIBOR +
70 points, while Company B will borrow at the fixed rate at 8.2%. The two companies will then enter into
a swap agreement whereby Company B will agree to pay a floating swap rate to Company A and Com-
pany A will agree to pay a fixed swap rate to Company B. The swap rates will be negotiated between the
two parties. In this case, assume that the two parties agree to share the benefit equally. Since the total gain
is 30 points, which is the difference between the comparative advantages, each party will gain 15 points.
This means that company A will pay a swap rate of 8.2 % to Company B, while Company B will pay a
swap rate of LIBOR + 5 points to Company A. This will result in the following rates for the two parties:
  The net rate for Company A will be 8.85%, fixed rate, and that for Company B will be LIBOR + 5 points,
floating rate. This is 15 points cheaper than what the companies would have borrowed directly from these
markets.
Company A:
Borrow at a floating rate of LIBOR + 70 points = LIBOR + 0.7%
Receive floating rate from Company B LIBOR + 5 points = LIBOR + 0.05%
Pay Company B a fixed rate of 8.2%

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 Swaps  115

Notes Net Rate for Company A = [(8.2% + LIBOR + 0.7%) – (LIBOR + 0.05%)] = 8.85%
Net savings for Company A = (9% – 8.85%) = 0.15% or 15 points
Company B:
Borrow at a fixed rate of 8.2%
Receive fixed rate from Company A 8.2%
Pay Company a floating rate of  LIBOR + 5 points (= LIBOR + 0.05%)
Net Rate for Company B = [8.2% – (8.2% + LIBOR + 0.05%)] = LIBOR + 0.05% = LIBOR + 5 points
Net savings for Company B = [(LIBOR + 20 points) – (LIBOR + 5 points)] = 0.15% or 15 points



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Figure 6.2  Structure of the Interest Rate Swap Between Two Parties

This example shows that both parties gain 15 points through an interest rate swap.

The comparative advantage and hence the opportunity for both parties to enter into a swap to achieve
lower interest rates arises because of different credit ratings assigned to various borrowers. When a bor-
rower wishes to borrow, a borrowing rate is set for that borrower depending upon the borrower’s credit
rating. Thus, when different borrowers enter the market to borrow, they will face different borrowing
rates. In addition to the different credit rating assigned to the borrowers, the other reason for the exist-
ence of comparative advantage is yield compression.
Yield compression refers to the difference between the borrowing rates for two different borrowers in
the long-term and the short-term markets. Typically, the difference in the borrowing rates will be higher
in the long-term market than in the short-term market. The reason for the larger difference in the long-
term market can be attributed to the higher risk the lender faces when lending to a party with a lower
credit rating as compared to the risk undertaken in the short term. For example, the rates for the two
borrowers in the long-term market could be 9% and 8%, or a yield difference of 1% or 100 basis points,
whereas the borrowing rates for the same two borrowers in the short-term market could be BR + 50 points
and BR + 10 points, resulting in a yield difference of 40 basis points. Thus, there is a yield compression
of 60 points for the two borrowers in the two markets, resulting in comparative advantage situations.

6.7  Swap with Intermediaries

In Example 6.1, it was assumed that companies A and B entered into a swap agreement directly. In prac-
tice, a financial intermediary is usually involved in bringing the parties together. This intermediary will
be, in effect, engaging in two different swaps with the two companies. For example, the intermediary
will engage in a swap with Company A, whereby the intermediary will provide a fixed rate borrowing to
Company A in exchange for a floating-rate loan from Company A. Then the intermediary will arrange
a swap with Company B, whereby the intermediary will provide a floating-rate loan to Company B in
exchange for a fixed-rate loan from Company B. As compensation, the intermediary will charge some
interest from the two parties.

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 116   Financial Risk Management

Notes   E x am p l e 6 . 2
Consider the situation in Example 6.1. Assuming that the intermediary charges 8 points from each of the
parties, the total gain of 30 points is shared as 16 points to the intermediary, 7 points to Company B, and
7 points to Company A, and the swap design will be as shown in Fig. 6.3.

 

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Figure 6.3  Structure of an Interest Rate Swap through an Intermediary

Company A
Pay LIBOR + 70 points in the bill market
Pay 8.28% to the intermediary
Receive LIBOR + 5 points from the intermediary
Net rate for Company A: [(LIBOR + 0.7%) + 8.28 – (LIBOR + 0.05%)] = 8.93%
Net gain to Company A: 9% – 8.93 % = 0.07% or 7 points
Company B
Pay 8.2% in the bond market
Receive 8.2% from the intermediary
Pay LIBOR + 13 points to the intermediary
Net rate for Company B = (LIBOR + 0.13% + 8.2% – 8.2%) = LIBOR + 0.13%
Net gain for Company B = (LIBOR + 20 points) – (LIBOR + 13 points) = 7 points
Intermediary
Pay 8.2% to Company B
Receive 8.28% from Company A
Pay LIBOR + 0.05% to Company A
Receive LIBOR + 0.13% from Company B
Net Receipt = (LIBOR + 0.13%) – (LIBOR + 0.05%) + 8.28% – 8.2% = 0.16% = 16 points

6.8  Forward Swaps

A forward swap is a swap that commences at a future date. It is designed the same way as a swap that
begins today. The fixed interest rate is set today, but it will not be compared with the floating-rate bench-
mark until the first period commences at a delayed start date.
For example, a company may be planning to undertake an investment after six months for which it
needs to borrow INR 20 million. It finds that a swap arrangement will provide a better rate than borrow-
ing directly in the fixed-rate market. However, an immediate swap agreement is of no use as the money

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 Swaps  117

Notes is needed only after six months. Therefore, the company will enter into an agreement to enter into a swap
with the swap counterparty after six months. This is known as a forward swap.
The main problem in forward swaps is to find the fixed rate for the delayed swap. It is usually deter-
mined on the basis of the current yield curve. For example, assume that an investor expects to receive
some funds after one year and plans to invest these funds for two years after receiving the funds. The
investor is uncertain about the future interest rates and would like to lock in a known return for this
investment right now, even before the investment is undertaken.

  E x am p l e 6 . 3
Assume the current yield curve is:
Term Yield
90 days 5%
1 year 6%
2 years 7%
3 years 8%
The forward swap rate for a swap starting one year from today and continuing for two years will be esti-
mated from the current yield curve as:
1/2
 (1 + 3 − year yield )3 
f =  −1
 1 + 1 − year yield 
 
If we assume quarterly compounding, the forward swap rate will be determined as:
1/ (2 × 4 )
   3 − year yield   3× 4 
 1 +   
f    4  
=  −1
4    1 − year yield  1× 4 
 1 +  4   
  
1/8
  0.08 12 
f  1 + 4  

9
= −1 =
4   0.06  4  4
 1 + 
  4  
f = 9%
The fixed rate component for the forward swap is calculated as the implied forward rate from the yield
curve.

  E x am p l e 6 . 4
Assume that a corporation wants to enter into a two-year swap commencing in one month’s time. To find
the appropriate forward swap rate, the swap rates for two-year maturity and for one-month maturity will be
used. Since the two-year yield is 7% and the three-year yield is 8%, the yield for a bond maturing in two years
and one month will be 7 + (8 – 7)/12 = 7.08%. If the one-month rate is 5%, the forward swap rate is given by

 1 
1/8 
   7.08%  212 × 4  
  1 +   
 4  
f =  1  − 1 × 4 = 7.16%
   5  12 × 4  
  1 +   
   4   

This example shows that the forward rate will be 7.16%.

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 118   Financial Risk Management

Notes 6.9 Swaptions
A swaption is an option to enter into a swap. A swaption gives the buyer the right to enter into a swap at
a future date. From this definition, it is clear that the buyer of the swaption will exercise the right to enter
into a swap only if it is advantageous to do so. Swaptions are used to:
1.  Bring a swap into place when hedging becomes necessary.
2.  Remove an existing swap when it becomes unattractive.
3.  Enhance the yield on an underlying position by selling a swaption.
4. Obtain access to a swap when borrowers are uncertain of the funding that will be required or when
they are unwilling to forego the benefit of an interest rate decrease prior to drawing the funds.

  E x am p l e 6 . 5
A borrower is planning a possible project whose funding is uncertain. A corporation may be tendering
for a large project. If the project goes ahead, it would be funded at the prevailing interest rate, but there
is a risk that the interest rates may increase in the interim period. A standard swap is not appropriate,
because there would be large speculative gains or losses from unwinding the swap if the project does not
go ahead and the interest rate changes significantly. The appropriate action is to enter into a swaption.
  In a swaption, the buyer pays a premium upfront and is assured of a swap and locks in a certain fund-
ing cost if the project goes ahead and the interest rate increases. In this case, the cost of borrowing will be
equal to Swap rate + Option premium. The various alternatives available to the option buyer and possible
actions depending on the project’s success and interest rate changes are shown below:
If the interest rate decreases and the project is successful, the corporation will let the option expire and
borrow the funds in the market at the market rate. In this case, the cost of funding will be equal to
Market rate + Option premium.
If the interest rate decreases and the project is unsuccessful, the corporation will let the option expire and
will lose the premium paid on the option.
If the interest rate increases and the project is successful, the corporation will exercise the option and the
cost of funding will be equal to Swap rate + Option premium.
If the interest rate increases and the project is unsuccessful, the corporation will still exercise the option,
because the market rate will be higher than the swap rate and the company will gain the difference
between the two rates.
This is shown in Fig. 6.4.

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Figure 6.4  Decisions in Swaptions based on

Project Success and Interest Rate

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 Swaps  119

Notes   E x am p l e 6 . 6
A swaption can be used to remove an existing swap. Assume that a corporation has entered into a swap
to lock in its borrowing cost. However, the corporation is concerned that the interest rates may decrease
significantly in the next six months and would like to take advantage of the benefits of lower interest rates.
Then, the corporation can enter into a swaption to remove this swap in case the interest rate decreases.
If the interest rate does not decrease as expected, the swaption will be allowed to expire and the original
swap will continue. If the interest rate decreases as expected, the corporation will exercise the option,
which will remove the original swap, and the corporation can get a lower borrowing cost as a result of the
lower interest rates.

6.10  Uses of Interest Rate Swaps

Interest rate swaps can be used for hedging purposes as well as for speculation. Many non-financial cor-
porations use interest rate swaps to reduce the funding cost through interest rate swaps, as was explained
earlier. Financial institutions such as banks use interest rate swaps to reduce the duration gap.
Many financial institutions such as banks have assets with a longer duration and liabilities with a
shorter duration. When the interest rate changes, there will be a higher change in the value of assets when
compared to the change in the value of liabilities. One way to manage this duration gap is to use interest
rate futures. Interest rate swaps can also be used to manage this duration gap. Since the liabilities have
a shorter duration, one can enter into an interest rate swap to convert this floating rate into a long-term
fixed rate so that the duration of the liabilities can be increased to match the duration of the assets.
TBC Bank’s U.S. dollar loans were floating-rate loans, and TBC Bank was giving mortgage loans with
fixed rates. Through interest rate swaps, TBC Bank was able to convert the floating-rate U.S. dollar loan
into a fixed-rate loan so that TBC Bank can offer a better rate on mortgage loans.
Interest rate swaps can also be used for speculation. If the interest rate is expected to decrease, one can
buy the bonds in the market and sell them at a higher price when the interest rate decreases. However, it
requires immediate investment. Alternatively, one can speculate by going long in bond futures contract.
A swap provides another opportunity to speculate on interest rates. One can enter into a floating-for-
fixed interest rate swap. If the interest rate decreases, the speculator needs to pay a lower floating rate for
the same fixed rate.

6.11  Valuation of Interest Rate Swaps

An interest rate swap can be considered as a series of forward contracts. Consider the example whereby
a financial institution has entered into an interest rate swap with its customer. According to the swap
agreement, the notional principal is INR 100 million, the fixed rate that the customer would swap their
9% fixed-rate loan with a floating-rate loan is based on MIBOR + 100 basis points. The payments would
be exchanged every six months. In this case, the financial institution would receive interest at an annual
rate of MIBOR + 1% every six months and pay interest at the annual rate of 9% to the customer.
At the first payment date, the cash flow to the financial institution would be:
100 million × [0.5 × (MIBOR + 1%) − 0.5 × 9%] = 50 million × (MIBOR − 8%)

This can be considered to be the pay-off from a forward contract on the MIBOR with a delivery rate of
8% and a notional principal of INR 50 million.
One difference between a regular forward contract on the MIBOR and this forward contract implied
by the swap should be noted. In a regular forward contract, the pay-off is based on the MIBOR, which is
likely to be on the maturity date of the contract, whereas in the forward contract implied by the swap, the
MIBOR is the rate six months prior to maturity.
Since pay-off at any time can be considered as a forward contract, the value can be easily determined.
If Fi is the forward interest rate for the six-month period prior to the payment date, the value of a long
forward contract will be the present value of the amount by which the current forward rate differs from
the delivery price.

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 120   Financial Risk Management

Notes The value of the forward contract corresponding to a particular payment i for the party receiving a
fixed and paying a floating interest rate can be written as:
Vi = (FP − 0.5 × Fi × NP ) × exp(−ri × ti )
where, FP is the payment of interest based on the fixed interest rate,
NP is the notional principal,
Fi is the forward interest rate,
ri is the market interest rate, and
ti is the time at which payment will be made.
A factor of 0.5 is used because payments are made every six months.
At the time of first payment exchange, an amount based on the floating rate (FP*) will be paid and an
amount based on the fixed interest rate (FP) will be received. The value of this exchange will be:
(FP − FP *) × exp(−ri × ti )
The total value of the swap would be:
(FP − FP *) × exp(−ri × ti ) + Σ(FP − 0.5 × Fi × NP ) × exp(−ri × ti )
For the party that is receiving a floating and paying a fixed interest rate, the value of the swap would be:
(FP * − FP ) × exp(−ri × ti ) + Σ(0.5 × Fi × NP − FP ) × exp(−ri × ti )

  E x am p l e 6 . 7
A financial institution has agreed to enter into a swap agreement for INR 100 million with payment at a
floating rate of the MIBOR and receipt based on 10% per annum (based on semi-annual compounding).
The swap has a remaining life of two years. The relevant fixed interest rates based on the yield curve are
10%, 10.2%, 10.5%, and 11%, respectively. The MIBOR for the last payment date was 10.4%.
In this example: 
FP = 100 × 10% × 0.5 = INR 5 million
FP* = 100 × 10.4% × 0.5 = INR 5.2 million
r1 = 10%
r2 = 10.2%
r3 = 10.5%
r4 = 11%
From this we can calculate the forward rates for the remaining three periods as:

(1.102)2
F1 = − 1 = 10.4%
1.10
(1.105)2
F2 = − 1 = 10.8%
1.102
(1.11)2
F3 = − 1 = 11.5%
1.105
These forward rates can be converted to the rate based on semi-annual compounding as:
2
 10.4% 
F1 =  1 + − 1 = 10.67%
 2 
2
 10.8% 
F2 =  1 + − 1 = 11.09%
 2 

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 Swaps  121

2
Notes  11.5% 
F3 =  1 + − 1 = 11.83%
 2 
The value of the swap is given by:
V = (FP − FP *) × exp(−ri × ti ) + Σ(FP − 0.5 × Fi × NP ) × exp(−ri × ti )
= (5 − 5.2) × exp (−0.104 × 0.5) + (5 − 0.5 × 0.1067 × 100) × exp(−0.10 × 1)
+ (5 − 0.5 × 0.1109 × 100) × exp(−0.102 × 1.5) + (5 − 0.5 × 0.1183 × 100) × exp(−0.105 × 2)
= INR 1.86977 million
Note that the value of a swap is zero at the time the swap is entered into. Some of these forward contracts
will have a positive value while others will have a negative value and the sum of all these would be zero at
the start of the swap. The value of the swap can change over time depending on the direction in which the
interest rates go. If the floating interest rate is equal to the fixed interest rate, the value of forward contract
will be zero. If the floating rate is more than the fixed rate, the value of forward contract will be negative
for the party that receives fixed and pays floating. If the floating rate is less than the fixed rate, the value of
the forward contract will be positive for the party that receives fixed and pays floating.

6.12  Currency Swaps

The first currency swap was between the World Bank and IBM in which IBM swapped a U.S. dollar loan
with the World Bank’s Swiss francs and Deutschemarks in 1981 for a notional amount of USD 210 million
over 10 years. Box 6.2 illustrates a currency swap between the U.S. dollar and the Colombian peso.
Suppose a company in India wants to borrow U.S. dollars to pay for its oil imports. It has to borrow at
U.S. dollar interest rates, which would be different from Indian rupee interest rates. In a currency swap,
one party borrows U.S. dollars at U.S. dollar interest rates and swaps the U.S. dollar loan with a loan based
on Indian rupee interest rates.

6.12.1  Differences Between an Interest Rate Swap and a Currency Swap

The following are the differences between an interest rate swap and a currency swap:
 The cash flows exchanged are in two different currencies.
 There are two notional principal amounts and they are also exchanged (though there are currency
swaps where notional principals are not exchanged).

6.12.2  Basic Structure of Currency Swaps

In an interest rate swap, the party that has fixed rate obligations will swap this fixed rate with another
party that has a floating rate obligation and therefore, one party will be paying fixed and receiving floating
rate of interest while the other party will be paying floating and receiving fixed rate of interest. However,
in a currency swap there could be a number of different structures with either party having either fixed or
floating obligations. There are four possible swap structures as shown in Table 6.2.

BOX 6.2 Norfund Facilitates a USD 4 million Swap Transaction

The Norwegian Investment Fund for Developing Countries be extended to Fundacion Mundo Mujer, one of the most
(NORFUND) entered into a cross-currency swap transac- efficient and successful MFIs in Latin America. Fundacion
tion with MicroVest I, LP, a Washington, DC-based micro- Mundo Mujer targets low-income micro-businesses, and
finance investment fund. The swap will have a principal of 60% of its clients are female entrepreneurs.
USD 4 million and a three-year loan in Columbian pesos to

Source: Press release, Norfund, November 16, 2009.

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Notes Table 6.2  Basic Structure of Currency Swaps

Party A Party B

Pay floating in U.S. dollars Pay fixed in Indian rupees

Pay floating in U.S. dollars Pay floating in Indian rupees

Pay fixed in U.S. dollars Pay floating in Indian rupees

Pay fixed in U.S. dollars Pay fixed in Indian rupees

A standard currency swap will require three transactions:

1.  An initial exchange of notional principals
2.  Periodic exchange of coupon payments
3.  Return of notional principals at the termination of the swap

  E x am p l e 6 . 8
Party A has just borrowed USD 10,000,000 for five years on which it is making floating rate payments
every six months. The company would have preferred to borrow in Indian rupees. To do this, the com-
pany engages in a currency swap with another party as follows:
Tenor 5 years
Party A Pay fixed interest in Indian rupees at 6%
Party B Pay floating interest in U.S. dollars at the LIBOR flat rate
Payments Every six months
Notional USD 10,000,000/INR 400,000,000 at the exchange rate of USD 1 = INR 40
At the initiation of the swap, Party A delivers USD 10,000,000 notional amount to Party B and Party B
delivers INR 400,000,000 to Party A. The initial notional amounts are determined on the basis of the
exchange rate prevailing at the initiation of the swap. The net value of this exchange will be zero. This is
equivalent to Party A borrowing INR 400,000,000 and Party B borrowing USD 10,000,000.
Periodic payments:
Assuming the LIBOR for the first period is 4%, Party B must pay to Party A half (six months’ interest) of
4% on the USD 10,000,000 notional, or USD 200,000.
  Party A will pay to Party B a fixed rate of 3% (half of 6% fixed) on INR 400,000,000 notional, or INR
12,000,000.
  Note that these payments are not netted as in interest rate swaps, because they are in different curren-
cies, as Party A needs to receive U.S. dollars to pay its U.S.-dollar-denominated interest payments and
Party B needs Indian rupees to pay its Indian-rupee-denominated interest payments.
  At swap termination, the counterparties will exchange the notional principals again. Party A will pay
Party B INR 400,000,000 and Party B will pay Party A USD 10,000,000.
  Note that the notional principal is exchanged at the initiation of the swap at the prevailing exchange
rate. Similarly, the notional principals are exchanged at the termination of the swap on the basis of the
exchange rate prevailing at the time of initiating the contract. If the currency values have changed in
the meantime, one party will need more of its own currency to pay the notional principal. For example,
if the rate has changed to USD 1 = INR 41 at the termination of the contract, Party B will receive INR
400,000,000 from the swap but will need INR 410,000,000 to pay USD 10,000,000 to Party A. Thus, a cur-
rency swap involves currency risk.

By using currency swaps, a party is able to synthetically convert a debt in one currency into a debt in
another currency. Example 6.8 shows how a company that has just issued a floating-rate bond denomi-
nated in U.S. dollars uses a currency swap to replicate what would have happened if the company had
borrowed in Indian rupees.

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 Swaps  123

Notes 6.13  Currency Risk in Currency Swaps

Since periodic payments as well as final payments are paid in foreign currency, this type of currency swap
entails currency risk. Then why would anyone enter into a currency swap?
For an Indian corporation, there is no reason to enter into a USD–INR swap unless the Indian busi-
ness has a U.S. dollar cash flow. Thus, currency swaps are undertaken only when the periodic payment
and terminal payments can be made using the foreign currency cash flow. Otherwise, currency swaps will
lead to currency risk.
Consider the case of IT solutions companies such Infosys, WIPRO, or Tata Consultancy Services. They
provide IT solutions to businesses all over the world and specifically to those in the USA. This results in
periodic cash flow in U.S. dollars to these companies. In order to provide efficient service, these compa-
nies also have offices in the USA, and these may require initial funding. In this case, it will be prudent for
these companies to enter into currency swaps. They would borrow in the Indian market in Indian rupees
and then swap it with U.S. dollar loans. At each period, they can make swap payments using the U.S.
dollar cash flow and also return the original principal in U.S. dollars at the termination of the contract,
again by using the U.S. dollar cash flow. In this case, there will be no currency risk for these companies.
Thus, currency swap will make sense only when a company entering into a currency swap in a foreign
currency has cash inflows in that currency. Otherwise, currency swaps will entail currency risk.

6.14  Comparative Advantages of Currency Swaps

When currency swaps were introduced, the main motivation was to exploit the comparative advantage
whereby a company faced relatively lower borrowing costs in one country (and currency) than in another
country (and currency).

  E x am p l e 6 . 9
Rajesh wants to borrow Singapore dollars (SGD) 20,000,000 at a fixed interest rate for five years. Rakesh
wants to borrow INR 560,000,000 in India at a fixed interest rate for five years. Investment bankers are ap-
proached for advice as to the likely borrowing rates for a new bond issue, and the projected interest rates are:
In Singapore In India
Rajesh 12% 8%
Rakesh 9% 9%
In this example, it is clear that Rakesh has a comparative advantage of borrowing in Singapore as it can
borrow at 9%, while Rajesh will have to pay 12% if it borrows in Singapore.
  Similarly, Rajesh has a comparative advantage in India, as it can borrow at 8% while Rakesh can borrow
at 9% in India.
  Therefore, the best strategy is for Rajesh to borrow in Indian rupees at 8% in India and Rakesh to borrow
in Singapore dollars at 9% in Singapore and then swap. This will result in a fixed-fixed swap. Assume that
the swap rates are as follows: Rajesh to pay Rakesh Singapore dollars at 10% and Rakesh to pay Rajesh
Indian rupees at 8%.
Mechanics of the swap:
At initiation:
Assume the exchange rate between the Indian rupee and Singapore dollar is SGD 1 = INR 28.
Rakesh borrows SGD 20,000,000 at a fixed rate of 9% for five years.
Rajesh borrows INR 560,000,000 at a fixed rate of 8% for five years.
Rajesh pays Rakesh INR 560,000,000 and Rakesh pays Rajesh SGD 20,000,000.
For the next 41/2 years, the two companies will exchange interest payments as follows:
 0.10 
Rajesh will pay Rakesh SGD 1,000,000  20, 000, 000 ×
 2 
 0.08 
Rakesh will pay Rajesh INR 22,400,000  560, 000, 000 ×
 2 

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Notes At termination, the companies will exchange the notional principal plus the interest for the last six
months.
Rajesh will pay Rakesh SGD 21,000,000 and Rakesh will pay Rajesh INR 592,400,000. These funds are
used by these two companies for the repayment of the principal and for the last interest payment.
We can calculate the cost to Rajesh and Rakesh from the currency swap as follows:
Rajesh borrows at 8% in India and agrees to swap with Rakesh, receiving 8% in Indian rupees and pay-
ing 10% in Singapore dollars. The net cost to Rajesh would be:
Pay interest in the Indian debt market 8% Indian rupees
Pay interest to Rakesh (swap rate) 10% Singapore dollars
Receive interest from Rakesh (Swap rate) 8% Indian rupees
Net rate for Rajesh 10% Singapore dollars
This rate is less than the 12% rate if Rajesh had borrowed in Singapore directly.
Rakesh borrows at 9% in Singapore and agrees to swap with Rajesh, receiving 10% Singapore dollars
and paying 8% Indian rupees. The net cost to Rakesh would be:
Pay interest in the Singapore debt market 9% Singapore dollar
Pay interest to Rakesh (swap rate) 8% Indian rupee
Receive interest from Rajesh (Swap rate) 10% Singapore dollar
Net rate 8% Indian rupee – 1% Singapore dollar
This rate is less than the 9% rate if Rakesh had borrowed in India directly. Also note that there is a cur-
rency risk in this swap as the net rate is based on the interest rates in the two currencies. However, if the
swap is undertaken such that the payments can be made using foreign currency cash flows, the currency
risk is not important.

6.15  Uses of Currency Swaps

A currency swap can be used to hedge currency risk and reduce the funding cost when a company needs
to borrow in another currency. It can also be used to reduce currency risk while making investment in
securities that provide cash flow in a foreign currency. For example, consider a non-resident financial in-
stitution that is investing in Indian securities. It requires Indian rupees in order to make investments, and
all its cash flows will be in Indian rupees as along as it keeps its position in the Indian securities. If it tries
to repatriate the Indian rupee cash flow to its country of origin, it will face currency risk. Instead, it can
enter into a currency swap whereby the Indian rupee cash flow can be used to make the swap payments.
In this way, currency risk can be reduced.

6.16  The Valuation of a Currency Swap

A currency swap can be valued as a series of forward contracts. However, to value this currency swap,
we need two yield curves. Since the forward exchange rate is determined on the basis of the interest rate
parity condition, we need to know the yield curves of both currency interest rates.

  E x am p l e 6 . 1 0
Suppose that the term structure of interest rates in Singapore and India are as given below. Currently, the
interest rate in India is 9% and that in Singapore is 4%. A financial institution has entered into a currency
swap whereby it receives 5% per annum in Singapore dollars and pays 8% per annum in Indian rupees. The
principal in the two currencies are SGD 10 million and INR 280 million (at the current exchange rate of
SGD 1 = INR 28).The swap will last for another three years. The interest will be paid at the end of each year.
Under the swap contract, payments would be as follows:
On each payment date, the financial institution would receive SGD 500,000 (SGD 10 million × 5%)
and pay INR 22.4 million (280 million × 8%). At maturity, it would receive INR 280 million and pay SGD
10 million.
This can be considered as a series of four forward contracts.
The value of the forward contract with respect to interest payment can be written as:
Vi = (500, 000 × Fi − 22, 400, 000) × exp(ri × ti )

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 Swaps  125

Notes The value of the forward contract with respect to the exchange of the principal would be:
Vp = (10, 000, 000 × Fn − 280, 000, 000) × exp(rn × tn )
The value of the swap is then the sum of all these forward contracts.
In this example, assume the term structure is as follows:
Year    India    Singapore
  0  9.0% 4.0%
  1  9.6% 4.8%
  2 10.2% 5.7%
  3 10.6% 6.5%
The corresponding forward rates can be calculated as:
F1 = 28 × exp(0.04 − 0.09) = 26.63
F2 = 26.63 × exp(0.048 − 0.096) = 25.382
F3 = 25.641 × exp(0.057 − 0.102) = 24.265
Value of the swap for the Indian party = (500,000 × 26.63 – 22,400,000) × exp(–9.6% × 1)
+ (500,000 × 25.382 – 22,400,000) × exp(–10.2 × 2)
+ (500,000 × 24.265 – 22,400,000) × exp(–10.6% × 3)
+ (10,000,000 × 24.265 – 280,000,000) × exp(–10.6% × 3)
= INR – 50,817,346
The value of the swap is negative for the Indian party because of the substantial depreciation of the Indian
rupee and hence the Indian party will need to pay more Indian rupees in order to make future interest and
principal payments.

When interest rates in the two countries are significantly different, the payer of the lower interest rate
currency will have the value of the forwards contracts to be positive, while the principal payment at the
maturity of the swap will have a negative value at maturity of the swap will have a negative value.
For the payer of the lower interest rate currency, the swap will have a tendency to have a negative value
during most of its life, whereas the swap for the payer of the higher interest rate currency will have a posi-
tive value during most of its life.

6.17  Equity Swaps

An equity swap is a transaction in which one party agrees to make a series of payments determined by
the return on a stock, a group of stocks, or a stock index to another party in return for a cash flow that
could be based on a fixed rate, a floating rate, or a return on another stock or stock index. For example,
one party can promise to receive the return on the CNX Nifty index to another party in return for paying
12% fixed.
An equity swap can be considered as follows: Suppose you want to buy the CNX Nifty index stocks. You
want to buy these stocks by borrowing at 12%. When you borrow money at 12% and invest in CNX Nifty
stocks, your return will be the return on the CNX Nifty index and you would be paying 12% on the loan you
took to buy the index stocks. You can also use an equity swap to remove exposure to a stock or a group of
stocks and replace the exposure with the exposure to another risk. For example, your portfolio contains IT
stocks and you are not sure about the performance of these stocks. When you enter into an equity swap, you
would pay the other party whatever return you receive from the stocks and the party will pay you a fixed rate.
By entering into an equity swap transaction, you can get an exposure to the stock without actually
owning the stocks. In a similar manner, by entering into an equity swap, you can avoid exposure to stock
price volatility. However, if you own the stocks and enter into an equity swap, you would be receiving
dividends, but you would show only the payments received from the other party. This is what is consid-
ered as tax evasion as pointed out in Box 6.3.
An equity swap is different from an interest rate swap, because the stock returns can be negative and
the party that receives the payments based on equity returns may have to make payments if the stock

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Notes
Box 6.3 IRS Directs Agents to Focus on Equity Swaps

The Internal Revenue Service in the USA has asked its agents the IRS, equity swaps are equivalent to owning shares and
to concentrate on equity swaps that are entered into by off- are entered into to avoid taxes on dividends, as these funds
shore hedge funds and private equity firms. According to need not have to report the stake to regulators.

Source: Kim Dixon, “IRS Directs Agents to Focus on Equity Swaps,” www.reuters.com, January 21, 2010

return is negative. Thus, it is possible that one party may be making payments in both the legs of the swap
transaction, which is not the case in an interest rate swap. In an interest rate swap, the floating rate is set
at the beginning of the period, whereas in an equity swap, the return on the stock is known only at the
end of the period.

6.18  The Valuation of an Equity Swap

In an equity swap with a fixed notional principal, one party pays the return on the equity index and the
other party pays a fixed interest rate.
Assume that a swap is entered into at time 0. Let the fixed rate of interest be R and the value of the
index at time t be given by I(t).
Consider a party that pays a fixed rate R and receives stock return. At time 1,
I (1)
Return from the index = −1
I (0)
which will be received and a rate of R will be paid.
If the notional principal is NP:
 I (1) 
Payment received = NP ×  − (1 + R)
 I (0) 
Similarly,
 I (2) 
payment received at time 2 = NP ×  − (1 + R)
 I (1) 
Assume that zero-coupon bonds with face value of INR 1 are available with varying maturities and the
value of the zero-coupon bonds with maturity at time t is given by D(t).
In order to value these cash flows, consider the following strategy.
At time 0, we invest [I(1)/I(0)] in the index and borrow (1 + R) × D(1). At time 1, the cash flow would be
I (1)
Cash flow = – (1 + R)
I (0)
which is the cash flow at time 1 of the swap for each Indian rupee.
At time 0, we borrow (1 + R) × D(2) and invest D(1) in the zero-coupon bond with maturity at time 1.
At time 1, we would receive INR 1 from the bond, and we can invest this in the index. At time 2, the value
of our index portfolio will be I(2)/I(1) and we need to repay 1 + R. Thus, cash flow at time 2 will be:
I (2)
Cash flow = – (1 + R)
I (1)
This process will continue to get cash flows for other periods. Since our investment in index with bor-
rowed funds provides the same cash flow as the swap, the value of the swap at time 0 should be equal to
the amount of net investment at time 0, or
I (1)
Value of swap at time 1 = – D(N) – R × SD(t)
I (0)

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 Swaps  127

Notes Swap rate is given by:

1 − D(N )
R=
∑ D(t )
Note that the level of interest rates at the start of the swap, and not the level of stock prices, determines
the swap rate.

  E x am p l e 6 . 1 1
Assume the following term structure: r1 = 8%, r2 = 9%, and r3 = 10% .
Then, the prices of zero-coupon bonds can be calculated as:
1
D(1) = = 0.9259
1.08
1
D(2) = = 0.8417
(1.09)2
1
D(3) = = 0.7513
(1.10)3
Forward prices are calculated as:
0.8417
D(1, 2) = = 0.9090
0.9259
0.7513
D(2, 3) = = 0.8926
0.8417
1− D(N ) 1 − 0.7513
Swap rate R = = = 9.8734%
∑ D(t ) 0.9259 + 0.8417 + 0.7513

6.19  Commodity Swaps

Commodity swaps are designed to hedge the risk associated with the prices of input resources such
as energy, precious metals, and agricultural products. However, most of the commodity swaps involve
energy-related products such as crude oil. A commodity swap transaction involves exchange of payments
between two parties at set time periods. One leg of the swap is determined by the price of the commodity,
and the other leg of the swap usually involves a fixed rate. As an example, consider Air India, which uses
aviation fuel. If it has estimated the need as 2 million barrels, it can enter into a commodity swap with a
counterparty. Under this swap, Air India will pay a fixed rate and the counterparty will provide the pay-
ment on the basis of the price of aviation fuel.
Since the commodity price is highly volatile, the usual practice is to use the average price over a set pe-
riod of time rather than the price of the commodity on the day of the settlement. Thus, the performance of
the swap is related to the average performance of the asset, and this is what is usually desired by companies.

6.20  Risks While Entering into Interest Rate Swaps

While entering into a swap, one party transfers the risk to another party, especially if it is a pay-floating,
receive-fixed swap. For example, Rajesh Corporation will take a floating-rate loan, which exposes it to
interest rate risk. By swapping this with Rakesh Corporation, Rajesh will receive a fixed rate, thus elimi-
nating interest rate risk, while Rakesh will face the risk of paying a floating interest rate. If the interest
rate increases substantially, the pay-floating party can incur huge losses. Therefore, it is important to have
some expectations of the interest rate movement before entering into an interest rate swap.
One of the examples of incurring heavy losses through the use of interest rate swaps is that of Long-
Term Capital Management (LTCM). This is explained in Box 6.4.

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Notes
BOX 6.4 LTCM and Interest Rate Swap

LTCM was a hedge fund located in Greenwich, Connecticut, price slightly higher than the theoretical price. Off-the-
USA. It was founded in 1993 by John Meriwether, and he run bonds are those that were issued at an earlier period
was able to get two Nobel laureates, Myron Scholes and and which would be selling at a price lower than the
Robert Merton, to be part of the fund. Since hedge funds were theoretical price as a result of poor liquidity. The expec-
unregulated, LTCM was free to operate in many markets. Be- tation is that in a short period of time, new issues will be
cause of its good reputation, it was able to engage with auctioned and these original on-the-run bonds will be-
many respectable counterparties. It could enter into interest come off-the-run bonds, causing the price of these bonds
rate swaps at the market rate without any margin. This meant to decrease and thereby providing gains to LTCM.
LTCM was a hedge fund located in Greenwich, Connecticut, 3. Enter into interest rate swaps betting that the spread be-
USA. It was founded in 1993 by John Meriwether, and he tween the swap rates and the most liquid treasury bonds
was able to get two Nobel laureates, Myron Scholes and would narrow. In an efficient market, the spread be-
Robert Merton, to be part of the fund. Since hedge funds tween the fixed rate under the interest rate swap and the
were unregulated, LTCM was free to operate in many mar- yield on the reference bond should be small. Whenever
kets. Because of its good reputation, it was able to engage LTCM thought that this spread was high and is expected
with many respectable counterparties. It could enter into in- to decrease, it would enter into an interest rate swap and
terest rate swaps at the market rate without any margin. This make money.
meant that LTCM could borrow 100% of the value of any col- 4. Buy mortgage-backed securities. Mortgage-backed se-
lateral, and with that cash, it could buy more securities and curities are based on pools of mortgages and the hold-
post them as collateral for further borrowing. During 1994 ers of these securities will be paid on the basis of the
and 1995, LTCM was able to provide a return of 43% and amount paid by the mortgage holders. Since mortgage
41%, respectively, and its total investment was USD 7 billion. payment includes both interest payments and principal
The strategy that LTCM used was a very simple strategy payments, some of these mortgage-backed securities
called relative-value strategy. According to relative value are divided into interest-only and principal-only securi-
theory, any two assets which are similar in characteristics ties. Using econometric models, LTCM was able to pre-
should sell at similar prices and one can earn money with dict prepayment of mortgages under various conditions
very little risk by taking a long position in one asset and a of interest rate movements. In case the actual rates dif-
short position in a similar asset or its derivatives. If these fered from the rates calculated from the model, LTCM
two assets are selling at slightly different prices, then these would enter into interest rate swaps to manage this risk.
prices should converge soon, and taking a long position in 5. Trade interest rate futures to take advantage of inconsist-
the asset that has a slightly lower price and a short posi- ent dips and spikes in the yield curve.
tion in the asset with a slightly higher price would lead to 6. Get involved in buying and selling volatility using options.
arbitrage profit. This strategy was employed by LTCM ef-
fectively. However, the profit per transaction would be very All these strategies were simple strategies, and with
small and in order to provide large gains, the fund has to Merton’s mathematical models, LTCM was doing well in
be leveraged, so that the equity holders would get a much spite of its high leverage. However, in September 1998,
larger return. LTCM employed a very high leverage. LTCM these strategies collapsed, leading to losses. What was the
was operating at a leverage ratio of about 30%. cause for the collapse?
The major strategies used by LTCM were as follows: On August 17, 1998, Russia devalued the Russian ruble
and declared a moratorium on Russian rubles 281 billion
1. Buy Italian government bonds and sell German Bund bonds; of its treasury debt. Investors who were already spooked
Italian bonds were selling at a slightly lower price than the by the Asian financial crisis were further alarmed when the
German Bund bonds, and under this strategy, LTCM Russian crisis occurred. The investors decided to get out
would make money when the price of the Italian bonds of risky investments and fled to safe investments such as
would increase to match that of the German Bund bonds. treasury bonds. The spreads widened between on- and off-
2. Buy off-the-run U.S. Treasury bonds and go short in on- run government securities and between the swap rate and
the-run treasury bonds. On-the-run treasury bonds are treasury bonds. Since all trades of LTCM was based on
the bonds issued at the most recent auction for which convergence of rates and since the actions of the traders
the liquidity is higher, causing these bonds to sell at a caused huge divergence, the counterparties started asking

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 Swaps 129

LTCM to provide additional collaterals. This additional col- Finally, the Federal Reserve Bank of New York brought
lateral could be provided only by liquidating the positions the lenders together and brokered a bailout. Around 14
held by LTCM, realizing losses. On a single day, August banks contributed approximately USD 300 million each
21, 1998, LTCM lost USD 550 million. In August alone, to raise a USD 3.65 billion loan fund. This amount, along
LTCM lost USD 2.1 billion, and its equity capital base went with the equity that was still held by LTCM, was sufficient to
down to USD 2.3 billion. LTCM had done swap transac- withstand the crisis. LTCM was reorganized and continued
tions with 36 different counterparties, and many of these to operate. By early 2000, LTCM paid off all its loans and
swaps were revering the original swap transaction. The effectively liquidated.
notional principal was around USD 1 trillion. During this This episode clearly indicates that swaps are risky, and
period, LTCM had approximately 2.5% of all the swaps companies could collapse if interest rates move against ex-
traded on the global market. pectations.

CHApTER SUMMARy
 Swaps were developed for the purposes of hedging risks.  A forward swap and swap futures are contracts to enter into a
 In comparison to forwards and futures, swap contracts have swap at a future time.
longer maturity.  A swaption is an options contract to enter into a swap contract
 Swaps are over-the-counter contracts between private parties. in the future. A swaption can also be used to remove an existing
These are facilitated by swap intermediaries. swap.
 In an interest rate swap, one party agrees to exchange interest  Interest rate swaps and currency swaps can be valued on the
payments based on a fixed interest rate with another party for basis of the principle that any swap contract can be considered
interest payments based on a floating rate. as a series of forward contracts. The value of the swap at any
 In a currency swap, one party agrees to exchange payments time would then be the sum of the values of each such forward
based on one currency with another party for payments based contract for periodic payment.
in another currency. Currency swaps are interest rate swaps,  Equity swaps are used to get exposure to equity or remove
where the interest rates are based on the currencies of the two exposure from equity.
countries.
 In equity swaps, counterparties exchange payments with
 The swap rate is the rate at which the party that has a fixed-
payments on one leg based on the performance of equity
interest-rate obligation pays the party that has a floating-rate
while the payments on the other leg could be either fixed rate
obligation, and vice versa. There is an active swap market and
or floating rate or based on the performance of another stock
the swap rates are determined in the market.
or index
 The major reason for the use of interest rate swaps and
 Commodity swaps are used to hedge commodity price
currency swaps is the comparative advantage whereby one
risk.
party has an advantage over the other party in arranging a
particular loan. The two parties then share this comparative  In a commodity swap, one leg of payments requires payment
advantage through a swap so that they can get a lower interest based on the price of the commodity and the other leg of
rate through the swap agreement. payments is usually fixed.

MUlTIplE-CHOICE QUESTIONS
1. A company can invest funds for five years at LIBOR minus 30 swap and in the same direction as interest payments at the
basis points. The five-year swap rate is 3%. What fixed rate of end of the swap.
interest can the company earn by using the swap? C. The principal amounts usually flow in the same direction
A. 2.4% B. 2.7% as interest payments at the beginning of a currency swap
C. 3.0% D. 3.3% and in the opposite direction to interest payments at the
end of the swap.
2. Which of the following is true?
D. Principals are not usually specified in a currency swap
A. Principals are not usually exchanged in a currency swap
B. The principal amounts usually flow in the opposite direc- 3. Which of the following is a way of valuing interest rate swaps
tion to interest payments at the beginning of a currency where LIBOR is exchanged for a fixed rate of interest?

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 130 Financial Risk Management

A. Assume that floating payments will equal forward LIBOR 7. Which of the following describes an interest rate swap?
rates and discount net cash flows at the risk-free rate A. A way of converting a liability from fixed to floating
B. Assume that floating payments will equal forward OIS B. A portfolio of forward rate agreements
rates and discount net cash flows at the risk-free rate C. An agreement to exchange interest at a fixed rate for
C. Assume that floating payments will equal forward LIBOR interest at a floating rate
rates and discount net cash flows at the swap rate D. All of the above
D. Assume that floating payments will equal forward OIS 8. Which of the following is true for an interest rate swap?
rates and discount net cash flows at the swap rate A. A swap is usually worth close to zero when it is first nego-
tiated
4. Which of the following describes the five-year swap rate?
B. Each forward rate agreement underlying a swap is worth
A. The fixed rate of interest which a swap market maker is close to zero when the swap is first entered into
prepared to pay in exchange for LIBOR on a 5-year swap C. Comparative advantage is a valid reason for entering into
B. The fixed rate of interest which a swap market maker is pre- the swap
pared to receive in exchange for LIBOR on a 5-year swap D. None of the above
C. The average of A and B
9. Which of the following is true for the party paying fixed in an
D. The higher of A and B
interest rate swap?
5. Which of the following is a use of a currency swap? A. There is more credit risk when the yield curve is upward
A. To exchange an investment in one currency for an invest- sloping than when it is downward sloping
ment in another currency B. There is more credit risk when the yield curve is down-
B. To exchange borrowing in one currency for borrowings in ward sloping than when it is upward sloping
another currency C. The credit exposure increases when interest rates decline
D. There is no credit exposure providing a financial institu-
C. To take advantage situations where the tax rates in two
tion is used as the intermediary
countries are different
D. All of the above 10. Since the 2008 credit crisis
A. LIBOR has replaced OIS as the discount rate for non-
6. Which of the following is usually true collateralized swaps
A. OIS rates are less than the corresponding LIBOR rates B. OIS has replaced LIBOR as the discount rate, but only for
B. OIS rates are greater than corresponding LIBOR rates non-collateralized swaps
C. OIS rates are sometimes greater and sometimes less than C. LIBOR has replaced OIS as the discount rate for collater-
LIBOR rates alized swaps
D. OIS rates are equivalent to one-day LIBOR rates D. OIS has replaced LIBOR as the discount rate for swaps

Answer
1. B 2. B 3. A 4. C 5. D 6. A 7. D 8. A 9. A 10. D

REVIEW QUESTIONS
1. What is the motivation behind an interest rate swap? 7. Since exchange of payments takes place in different curren-
2. What is a currency swap? cies in a currency swap, a currency swap involves currency
3. What is a swaption? What are the uses of swaptions? risk. Then why would anyone enter into currency swaps?
4. What are the major differences between an interest rate swap 8. Explain the rationale behind using a commodity swap.
and a currency swap? 9. Explain the rationale behind using an equity swap.
5. Under what circumstances would you enter into a forward swap? 10. Explain how banks can manage their gap using interest rate
6. A swap contract can be considered as a series of forward con- swaps.
tracts. Explain why.

SElF-ASSESMENT TEST
1. Company A wants to borrow at a fixed rate while Company B 2. ABC Corporation can borrow at 6% fixed rate or at a
wants to borrow at a floating rate. Company A can borrow at floating rate of LIBOR + 50 basis points. GH Corporation
a fixed rate of 8% or at a floating rate of MIBOR + 150 basis can borrow at 8% fixed rate or at a floating rate of LIBOR
points. Company B can borrow at a fixed rate of 9% or at a + 100 basis points. Show that these two corporations can be
floating rate of MIBOR + 50 basis points. Show that these two better off by entering into an interest rate swap. Assume
companies can improve their position through an interest that the comparative advantage is equally shared by the two
rate swap. What would be the gain to the two parties? parties.

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 Swaps  131

3. Figment Corporation wants to enter into a three-year swap 6. Calculate the value of the following interest rate swap for the
commencing in three months’ time. The current yield curve floating-rate payer:
for interest rate is given below:
Notional principal USD 100 million
Term Yield Fixed swap rate 8%
90 days 4.6% Floating swap rate LIBOR + 200 bps
180 days 4.9% Payment exchange every six months
1 year 5.2% The tenure of swap remaining 24 months
2 years 5.7%
3 years 6.5% The yield curve for interest rate is as follows:
Calculate the forward swap rate for the fixed rate. Term Yield
Current 7%
4. BHP, Australia, can borrow at 8% fixed rate in Australia and 180 days 7.6%
at 9% fixed rate in India. Tata Steel can borrow at a fixed rate 1 year 8.4%
of 7% in India and a fixed rate of at 11% in Australia. The 11/2 years 8.7%
current exchange rate is AUD 1 = INR 36. Explain how the 2 years 9.0%
two companies can engage in a five-year currency swap with
payments every six months. 7. Calculate the value of the following currency swap for the
Australian-dollar payer:
5. Tata Motors would like to invest in developing a new truck
in its Korean plant and would like to engage in a currency Current exchange rate AUD 1 = INR 36.00
swap for two years. It needs Korean won (KRW) 1 billion for Principal exchanged AUD 10 million = INR 360 million
the same. Samsung, Korea, is willing to engage in a currency Swap rates AUD 8% and INR 9%
swap to provide capital for its operations in India. The swap Payment exchange every six months
rates are: Korean won 7% fixed and Indian rupees MIBOR Tenure of swap 18 months
+ 150 basis points. The payments would be made every six remaining
months. The current exchange rate between the Korean won The yield curves for interest rate in the two countries are as
and the Indian rupee is INR 1 = KRW 24.65. The expected follows:
MIBOR rates for the next 24 months are:
Term Yield in Australia Yield in India
Current  9.5% Current   8%  9.3%
Six months later   9.8% 180 days 8.4%   9.7%
One-year later 10.1% 1 year 8.7% 10.2%
One-and-a-half year later 10.4% 11/2 years 9.0% 10.5%
Calculate the various exchanges that would take place under 2 years 9.4% 11.0%
this swap.

   C ase S tud y

Aviatronics is a private airline that rents aircrafts and helicopters to   Ravi, the manager of Aviatronics, is interested in hedging the
corporations in India. It has estimated its demand for aviation fuel fuel price risk and has approached you for advice. Since there are
as shown in Table 1. no futures contracts available on aviation fuel and the use of crude
  The price of aviation fuel has been highly volatile, with a price oil futures would lead to basis risks, you suggest that he can use a
range of USD 64 to USD 96 per barrel, during the past year. Cur- commodity swap for hedging the price risk of aviation fuel. Since
rently, aviation fuel is selling at USD 68 per barrel. the price of fuel is based on the U.S. dollar, you tell Ravi that he
can use a number of hedges to hedge interest rate risks also. Your
Table 1  Demand for Aviation Fuel (in barrels) suggestion is as follows:
  Enter into a commodity futures contract that would result in the
Year Demand for Fuel payment of a fixed interest rate in U.S. dollars and receipt of fuel
prices in U.S. dollars. Since this would result in currency risk, he
1 300,000 can enter into a currency swap whereby he will receive in U.S.
dollars and pay floating rate in Indian rupees. As a floating-rate
2 370,000
loan in India would result in interest rate risk, he can hedge this
3 400,000 risk by entering into an interest rate swap whereby he will pay a
fixed and receive a floating rate. Further, you suggest that he may

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 132   Financial Risk Management

also use an equity swap whereby he can receive a fixed rate and   Table 3 shows the actual price of the aviation fuel and the actual
pay the return on the stock index. values of the CNX Nifty index at the end of the next three years.
  In order to help him, you have collected the following infor-
mation: Table 3  Actual Price of Fuel and the Nifty Index
  Term structures in the USA and India are shown in Table 2.

Table 2  Term Structure of Interest Rates Fuel Price per

End-of-year Index Value
(in percentage) Barrel (USD)
1 82 5,328
Spot Rate with 2 91 5,642
India USA
Maturity Year
3 98 5,975
1 8% 5%
Discussion Questions
2 9% 6%
1. Explain to Ravi how each of these swaps will reduce the risk
3 10% 7% and show the mechanism of entering into each of these swaps
using diagrams.
The exchange rate between the U.S. dollar and the Indian rupee is 2. Calculate the payments that need to be made for each of these
USD 1 = INR 45.2432 and the CNX Nifty index is at 4,942 at the swaps at the end of each year for the next three years.
current time. 3. Show him the benefit of hedging using swaps as compared to
not hedging.

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 7
Fundamentals of Options

LEARNING OBJECTIVES

After completing this chapter, you In order to help Indian companies to reduce currency derivatives
will be able to answer the following losses, Reserve Bank of India (RBI) has suggested that companies
questions: should be allowed to write currency options. According to RBI
What
 is an options contract? guidelines, importers and exporters with foreign currency expo-
sures will be permitted to write covered call and put options as
What are call options and put


these would protect them from making losses while using currency
options?
derivatives.”
What is an option premium,

exercise price, and exercise Source: ET Bureau, “Cos May Get to Write Currency Options,”
The Economic Times, 13 November 2009.
date?
What are American and

European options?
What are the uses of options?
 boX 7.1 Companies May Get to Write Currency Options
How to trade options on

exchanges and over-the-
counter markets?
What are the protections

for corporate actions for
exchange-traded options?

In Chapters 3 to 6, we discussed forward contracts, futures contracts, and swap contracts. One of the
problems with these contracts is that these contracts will provide gains if the underlying asset price moves
against the hedger but they would result in losses when the underlying asset price moves in favour of the
hedger. These contracts can also lead to huge speculative losses if the speculator does not guess the direc-
tion of movement of the prices of the underlying assets correctly. That is where options come in. As will
be explained later in this chapter, options will provide gains if the underlying asset price moves against
the hedger and the losses will be limited if the underlying asset price moves in favour of the hedger.
Similarly, a speculator can make gains if they guess the direction of price movement correctly and their
losses will be small if they guess the direction wrongly. Box 7.1 explains this rationale of reducing losses
by allowing companies with foreign currency exposure to write options. In this chapter, we will discuss
what options are, understand the various terminologies used in options, and how they are traded.

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Notes As was shown in Chapter 1, an options contract gives the buyer of the option the right to either buy
the underlying asset or sell the underlying asset at a specified price on or before a specified date. Since
the option gives the right to the buyer, there is no obligation for the buyer to buy or sell the asset at that
specified price. The buyer will exercise the option and either buy or sell the option only if such an exercise
is beneficial to the option buyer. This concept is explained in detail in Section 7.1.1.
Options have been in existence for a long time. Options can be classified into three categories:
1. Options issued by corporations
2.  Options between private parties in over-the-counter (OTC) markets
3.  Options that are traded on exchanges

7.1  Options Issued by Corporations

The options issued by corporations could be warrants, employee stock options, or options that are em-
bedded in either debt securities or equity securities. The options that are embedded in corporate securi-
ties are convertible bonds, callable bonds, and put bonds. In all these options, the issuer becomes one of
the parties to the options contract.

7.1.1 Warrants
Warrants are issued by corporations to increase their equity capital base. The company may feel that the
stock price is slightly suppressed and that the share price would increase in a short time. Instead of is-
suing the additional shares at the current time, it may decide to issue additional shares only if the share
price increases to a certain level. To accomplish this, the company may issue warrants. Warrants provide
the buyer the right to purchase a given number of shares at a specified price on or before a specified time.
Thus, warrants are options given to the buyer of warrants. Although warrants can be issued separately,
they are usually issued as a sweetener for a debt issue. Warrants are issued along with bonds, and they
provide the right to buy the shares of the company at a specified price within a specified period. When a
warrant is issued, there is no cash payment involved. The issuer of the warrant does not receive any cash
from the person to whom the warrant is issued, and the person who receives the warrant does not pay any
money for the warrant. Since a warrant is usually issued along with a debt issue of which the warrant is a
part, the yield on the bond that has a warrant attached may be slightly lower than a similar bond that has
no warrant attached. Therefore, there could be an implicit cost for the warrant in terms of a lower yield;
however, the buyer of the bond does not pay an explicit amount for the warrant.
Once the warrant that is attached to a bond is issued, the warrant can be detached from the bond. At
the time of issue, the bond may have a five-year maturity and the warrant may have a six-month maturity.
During the first six months in which the warrant exists, the bond can be traded either as a bond with the
warrant attached or as a bond with the warrant detached. Once the warrants expire, they will trade as
ordinary bonds. In general, the holder of the bond will detach the warrant from the bond, trade the bond
as an ordinary bond, and trade the warrant separately. When the holder of the warrant sells the warrant,
the seller of the warrant will receive money from the buyer of the warrant.
The holder of the warrant, at any time during the life of the warrant, has the right to buy the specified
number of shares from the issuer of the warrant at the specified price. If the warrant gives the right to
buy 100 shares of the issuing company at INR 220, the holder of the warrant is eligible to pay INR 22,000
and receive 100 shares from the issuer. The holder of the warrant has two ways in which they can get 100
shares of the company:
1.  Use the warrants and pay INR 22,000 and get 100 shares.
2.  Buy 100 shares of the issuing company in the share market at the prevailing market price.
Since 100 shares can be owned through either of these two strategies, it is obvious that the holder of
the warrant will choose the cheaper alternative. This means that if the market price is lower than the
specified price of INR 220, then it would be cheaper to buy the shares in the market at the lower market
price rather than using the warrants to get the shares by paying INR 220 each. On the other hand, if the

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 Fundamentals of Options   135

Notes market price is higher than the specified price of INR 220 in the warrant, it would be cheaper to use the
warrant and buy the shares at INR 220. The price specified in the warrant issue is known as the “exercise
price” of the warrant, and the act of using the warrant to buy the shares at the exercise price of INR 220 is
known as “exercising” the warrant. If the warrant holder decides not to use the warrant, they are said “not
to exercise” the warrant. The time period within which the warrant gives the right to exercise is known as
the “exercise date” or warrant “expiration date.”
If the warrant holder decides to exercise the warrant, they need to pay INR 22,000 to the company
issuing the shares and they will receive 100 shares from the company. Thus, upon exercising the warrant,
the issuing company receives money and issues additional shares, causing an increase in the number of
outstanding shares.

  Example 7.1
Metro Chemicals issues five-year 8% coupon bonds with a face value of INR 1,000 each on March 1. Each
bond has three warrants attached to it. The current share price of Metro Chemicals is INR 125. The terms
of each warrant are:
Number of shares for each warrant 200
Exercise price INR 140
Exercise period June 1 to September 30
On September 30, the share price of Metro Chemicals is INR 148. Should the warrant holder exercise the
warrant? What would happen if the warrant is exercised?
  Since the market price of a share is INR 148 and the exercise price under the warrant is INR 140, it is
cheaper to get the shares by exercising the warrant. Therefore, the warrant holder will exercise the war-
rant. When a warrant is exercised, the warrant holder needs to pay INR 28,000 (Exercise price × Number
of shares) to Metro Chemicals and receive 200 shares of Metro Chemicals from the company.
  If the share price was less than INR 140, say, INR 135, the warrant holder will not exercise the warrant
and there will be no transaction between the warrant holder and Metro Chemicals.

Problem 7.1
Chennai Metals has 10,000,000 shares outstanding. Its shares are priced at INR 205 on January 1, 2010. It is planning
to increase its equity base. It plans to issue 3-year, 10% coupon bonds with a face value of INR 1,000 each with
warrants attached to the bond issue. The terms of the warrant are:
Number of shares for each warrant 100
Exercise price of the warrant INR 250
Exercise period April 1 to June 30, 2010

(i)  When would the warrant be exercised?

(ii)  If the market price on June 30, 2010 is INR 265, what events would take place on June 30, 2010:
Solution to Problem 7.1
(i) Warrants would be exercised only if the market price of the shares is greater than INR 250 during the exercise
period of April 1 to June 30, 2010.
(ii) Since the share price is INR 265 which is higher than the exercise price of INR 250, the warrants will be
exercised. The holders of the warrant will pay INR 25,000 for the 100 shares they are entitled to buy at the
exercise price and the company will issue them 100 shares.

7.1.2  Employee Stock Options

Employee stock options are issued by a company to its employees as a part of their compensation. These
options will specify the number of shares the employees are eligible to receive if they exercise the option
and the price they have to pay to get these shares. These employee stock options are not negotiable in
the sense that the employees cannot sell these options to somebody else. If an employee leaves the job,

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Notes these options will expire. If the employee decides to exercise the option, they need to pay the company
the exercise price of each share and will receive the shares from the company. The company will then have
to issue additional shares. Thus, when an employee exercises their employee stock option, the issuing
company will receive cash and the number of outstanding shares will increase.

  Example 7.2
Infosys issues employee stock options to Ramesh when he joins Infosys on April 1, 2009. According to
the terms of the contract, he will receive 10 options. Each option will give Ramesh the right to buy
50 Infosys shares at INR 1,800 each. The option cannot be exercised during the first two years, or
until March 31, 2011. The life of the option is two years from April 1, 2011, i.e., the option expires on
March 31, 2013.
If the market price of Infosys on the expiry date of March 31, 2013, is INR 1,900, exercising the
option is beneficial, as Ramesh can buy the shares at INR 1,800 each and sell them in the market
immediately at INR 1,900, making a gain of INR 100 per share. Since he has 10 options and each option
gives him the right to buy 50 shares, by exercising the 10 options, he has the right to by 500 shares
of Infosys at INR 1,800 each. On March 31, 2013, he needs to pay INR 900,000 for which he will receive
500 shares of Infosys. If he decides to sell them immediately at the price of INR 1,900, he will gain
INR 50,000.

7.1.3 Convertible Bonds

Convertible bonds are issued by corporations. When a bond is issued as a convertible bond, the holder
has the right to convert the bond into a specified number of shares of the company during a specified time
period. Typically, conversion will be allowed only after a few years after the issue. The issuer will have to
state the conversion provisions, which include:
1. Conversion ratio: the number of shares one bond can be converted into.
2. Conversion period: the period in which the bondholder can convert the bonds into shares.
In the Tata Power example shown in Box 7.2, the conversion price is 1,323.75 × 1.1 = INR 1,456.125,
and the conversion can take place over the next five years.
A convertible bond can be considered as a combination of two securities, namely, a normal bond
and an option to buy shares. If the option is exercised, the status of the bondholder will change from a
bondholder to a shareholder. If the option is not exercised, the option will expire and the bondholder will
continue to be a bondholder and receive the promised payments.
When the convertible bondholder exercises the option, there is no cash transaction. The bondholder
does not pay any cash to the issuer. However, the issuer will write off the bonds in the balance sheet, and
in its place, increase the number of shares and the amount of share capital. Thus, when the convertible
bondholder converts the bonds into shares, the total debt for the company decreases and the amount of
equity increases, and so does the number of outstanding shares.

BOX 7.2 Tata Power Issues Convertible Bonds

On November 6, 2009, Tata Power started selling foreign Power at a price which is 10% premium over the closing
currency convertible bonds for USD 250 million with a ma- price on the National Stock Exchange on November 5,
turity of five years and one day and with a coupon rate of 2009, which was INR 1,323.75. The yield to maturity will be
1–1.75%. These bonds are convertible into shares of Tata 3.5% p.a. on a semi-annual basis.

Source: Tata Power, Press Release, November 6, 2009.

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 Fundamentals of Options   137

Notes   Example 7.3

On January 1, 2006, Neptune Shippers issues convertible bonds with the following provisions:
Maturity 10 years
Face value INR 1,000
Coupon payments 9% of face value payable semi-annually
Conversion ratio 1:5, i.e., one bond can be converted into five shares
Conversion period After January 1, 2008, till December 31, 2010
This means that a person who buys the bond will have the right to surrender the bond to Neptune
Shippers and receive five shares from them during the period from January 1, 2008, to December 31,
2010. It is clear that the bondholder would convert the bonds only if the share price in the market is more
than INR 200, because he already has the alternative of converting the bond and receiving five shares,
which have an effective price of INR 200.

Problem 7.2
Chennai Metals has 10,000,000 shares outstanding. Its shares are priced at INR 205 on January 1, 2010. It plans to
issue 3-year, 10% coupon convertible bonds with a face value of INR 1,000 each. The terms of the convertible bond
issue are:

Conversion ratio 1:4

Conversion period January 1 to June 30, 2011

(i)  When would conversion take place?

(ii)  If the market price on June 30, 2011 is INR 265, what events would take place on June 30, 2011?
Solution to Problem 7.2
(i) Since the conversion ratio is 1:4, the bondholder is eligible to receive four shares for each bond, the conversion
price is equal to (Face value of the bond / Conversion ratio) = (1000/4) = INR 250. This means that the
bondholder will effectively pay INR 250 per share. Conversion would take place only if the market price per
share is more than INR 250 during the conversion period of January 1 to June 30, 2011.
(ii) If the market price on June 30, 2011 is INR 265, the bondholders would decide to convert the bond into shares.
The bondholders would surrender their bonds and would receive 4 shares for each bond surrendered. There
will be no cash paid by the bondholders.

7.1.4  Callable Bonds

A bond with a call provision attached to it is called a callable bond. Under the call provision, the is-
suer has the right to purchase the bond from the bondholders at a fixed price, known as the call price.
Callable bonds are issued when the interest rates are high and are expected to decrease in the future.
When interest rates decrease, the bond’s market price will increase. If the price increases to a level
higher than the call price, the issuer can call the bond, i.e., buy them back from the bondholders at
the lower call price and refinance the existing loan at a lower cost. Thus, the call option embedded in a
callable bond is beneficial to the issuer, as the total cost of refinancing will be lower. When a callable
bond is exercised, there is no impact on the shares issued by the company. Thus, a callable bond can
be considered to be a combination of a normal bond and an option to buy the bonds back from the
bondholders. The exercise date of the call option will also be specified; this date will be a few years after
the issue so that the bond is non-callable for some time after the issue. This is called the date of first call.
Some bonds are callable only on that date, and once that date is passed and if the bond is not called, it
cannot be called back afterwards. There are some bonds that can be called anytime after the first call
date until their maturity. In that case, the call price, if called at various times, will be mentioned at the
time of bond issue. When a bond is called back, the issuer will pay the bondholders the call price and
the amount of debt will be reduced. There will be no effect on the number of outstanding shares or the
share capital.

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Notes   Example 7.4

Greater India Corporation issued a bond on June 5, 2007, with a coupon rate of 8% and a maturity of
10 years. The face value of the bond was INR 1,000, and it had a call provision as follows:
Call price INR 1,060
Date of first call: January 1, 2010, and callable only on that date
This means that the Greater India Corporation has the option to buy the bonds back from the bondhold-
ers by paying INR 1,060 per bond on January 1, 2010. In this option, the exercise price is INR 1,060 and
the exercise date is January 1, 2010.

7.1.5 Put Bonds
A bond with a put provision attached to it is called a put bond. Under the put provision, the holder of the
bond has the right to sell the bond to the issuer at its face value, at fixed periods of time before maturity.
Put bonds are issued when interest rates are low and are expected to increase in the future. When interest
rates increase, the bond’s market price will decrease. If the price decreases significantly, the bondholder can
sell the bond to the issuer at its face value and reinvest the proceeds at a higher interest rate. Thus, the put
option embedded in a put bond is beneficial to the holder of the bond. However, the yield on a put bond
will be lower than that on a bond that has no put provision, as the put option provides value to the bond-
holders. When a put bond is exercised, there is no impact on the shares issued by the company. Thus, a put
bond can be considered to be a combination of a normal bond and an option given to the bondholders to
sell the bonds to the issuer at its face value. The exercise date of the put option will also be specified; this
will be a few years after the issue so that the bond is non-puttable for some time after issue. This is called
the date of first put. Most put bonds are puttable on specific dates, after the first put date until maturity.

  Example 7.5
Haryana Corporation issued a bond on September 1, 2007, with a coupon rate of 8% and a maturity of
10 years. The face value of the bond was INR 1,000 and it had a put provision as follows:
Put price INR 1,000
Dates of exercise Every September 1 and March 1, starting September 1, 2009, until March 1, 2017
This means that the bondholders of Haryana Corporation have the option to sell the bonds back
to Haryana Corporation at a price of INR 1,000 per bond starting from September 1, 2009, on
September 1 and March 1 every year until March 2017. The bondholders will sell the bond at INR 1,000
to Haryana Corporation only if the market price of the bond is less than INR 1,000. In this put option,
the exercise price is INR 1,000 and the exercise date is every September 1 and March 1, starting from
September 1, 2009, and ending at March 1, 2017.
One of the examples of a callable bond and a put bond is the bond issued by the ICICI Bank. In 1996,
ICICI made a public issue of unsecured redeemable bonds for INR 10 billion. There were four bonds is-
sued: Aashirwad Deep Discount Bonds, Akshay Monthly Income Bonds, Suvidha Regular Return Bonds,
and Shubh Laabh Money Back Plus Bonds. The Aashirwad Deep Discount Bond having a face value of
INR 200,000 with maturity on July 15, 2021, was sold at INR 5,200 and had the provision that both the
bondholders and ICICI have the option of redeeming the bonds. The redemption prices were stated as:
INR 11,000 (after five years), INR 24,000 (after 10 years); INR 50,000 (after 15 years), and INR 100,000
(after 20 years). ICICI decided to redeem the bonds after five years at INR 11,000, since an option was
given to the issuer (the ICICI Bank) and the bondholders. The Aashirwad Deep Discount Bond was both
a callable bond as well as a put bond. However, when the interest rate decreased in 2005, the ICICI Bank
decided to call the bonds back at INR 11,000.
In warrants, convertible securities, callable bonds, and put bonds, the issuer is one of the parties and
the holder of these securities is another party. Moreover, when an option is exercised, it will have an im-
pact on the balance sheet of the issuer, affecting either the equity or debt, depending on the security in
which the option is embedded.

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Notes
BOX 7.3 Hindalco Announces Rights Issue

On August 14, 2008, Hindalco announced that it is issu- day. The right will entitle the existing shareholder to receive
ing additional 520 million shares at a share price of INR three additional shares for every seven shares owned. The
96 through a rights issue. The exercise price for the right rights were issued to the holders of shares as of September
was set at a discount of 29% to its market price on that 5, 2008.

Source: Hindalco, Press Release, August 14, 2008

7.1.6 Rights
When a company decides to increase its share capital, it may want to issue additional shares. It is common
for these companies to offer them first to the existing shareholders. Since the company cannot force the
shareholders to buy additional shares, it would provide options to the existing shareholders to buy the
additional shares on the basis of their current ownership in the company. These options are called rights
and the issue of additional shares using rights is called rights issue.
The terms of right issue will state the number of new shares that can be bought by using one right, the
price that is to be paid to the company per share if the rights are used to buy the shares, and the period
within which the rights have to be exercised. These rights can be used by the existing shareholders who
receive the right to buy the additional shares, or the rights can be sold to other parties who will then get
the right to buy the shares at the price specified in the right.
Thus, rights are options issued by a company to its existing shareholders to buy the shares offered at a
specified price on or before the specified dates.
In the Hindalco example shown in Box 7.3, each right allowed the existing shareholders to buy
three additional shares for every seven shares owned, and the price at which the shares can be bought
was INR 96.

  Example 7.6
Krishna Textiles has 1,000,000 outstanding shares on January 1, selling at INR 135.60. Krishna Textiles is
planning to issue additional 100,000 shares through a rights issue. The rights issue terms are as follows:
Number of rights issued 1,000
Each shareholder will receive one right for every 100 shares they own.
The price at which the shares can be bought using the right is INR 130.
The rights will have to be exercised on or before February 28.
This is an option to buy the shares at an exercise price of INR 130 on the exercise date of February 28, and
each option provides the right to buy 100 shares.

Problem 7.3
Chennai Metals has 10,000,000 shares outstanding. Its shares are priced at INR 205 on January 1, 2010. It is planning
to increase its equity base. It plans to issue additional 2,000,000 shares through rights issue. The terms of the rights
issue are:

Number of rights issued 5,000

Exercise price of the right INR 250
Exercise period April 1 to June 30, 2010

(i)  When would the rights be exercised?

(ii)  If the market price on June 30, 2010 is INR 265, what events would take place on June 30, 2010?

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Notes Solution to Problem 7.3

(i) Rights would be exercised only if the market price of the shares is greater than INR 250 during the exercise
period of April 1 to June 30, 2010.
(ii) The number of rights issued is 5,000 and the number of shares issued is 2,000,000. This means that by exercising
each right, the holder of the right can buy 400 shares at the exercise price. Since the share price is INR 265
which is higher than the exercise price of INR 250, the rights will be exercised. The holders of the right will pay
INR 100,000 for the 400 shares they are entitled to buy at the exercise price and the company will issue them
400 shares for each right exercised.

In all these options in which the issuer is a party to the option, the option holder will have to exercise
the option to get the benefit from the option. In case the option holder does not exercise the option even
if the exercising will be profitable, the option will become worthless on the expiry date.

7.2  Options Contracts Between Private Parties

The various options discussed above are not direct options but options embedded in other securities.
Convertible bonds, callable bonds, and put bonds have an option embedded into the security, and the op-
tion cannot be separated from the security. Warrants and rights are not directly embedded in any security
and hence can be traded separately. Employee stock options are embedded with the employment contract
and can be exercised only by that particular employee and hence cannot be traded.
In addition to these corporate options, options are also created between private parties. Earlier, op-
tions were contracts between private parties. The options that are contracts between two private parties
are said to be OTC options. In India, currency options and interest rate options are usually created in
OTC markets. These OTC options on currency and interest rate are used by corporations for managing
their risks, and banks are authorized by the Reserve Bank of India to provide these options for genuine
and contingent exposures.
There are also exotic options traded on OTC markets. Exotic options are options that have pay-offs
based on different conditions. Credit options are also usually traded on OTC markets. Credit options
are based on the credit risk of a party, and this credit risk is transferred to another party through credit
options.

7.3  Exchange-traded Options

Official trading in options began in 1848, with the founding of the Chicago Board of Trade (CBOT).
Later, other exchanges such as the Kansas City Board of Trade, Minneapolis Grain Exchange, and New
York Cotton Exchange started to trade options. Options trading, however, was not popular, and the an-
nual trading volume was less than 300,000 contracts. In 1968, the Chicago Board of Options Exchange
(CBOE) was opened for options trading. From 911 contracts traded on April 26, 1968, which was the
first day of trading, the number of traded contracts increased to 200,000 a day by the early 1970s. With
the increase in liquidity, speculators were lured into options contracts. In 1977, put options, which pro-
vided opportunities to hedge both in the bull and bear markets, were introduced. Options on index were
introduced in the CBOE in 1983.
In India, exchange-traded options are available at the NSE and the BSE and contracts are available on
single stocks and stock indexes. It is quite likely that currency options may be started in the near future.

7.4  Options Contracts: An Example

You are interested in buying a house now. You have looked at a number of houses and have decided on
a particular house. However, you do not have the sufficient financial resources now and you expect to
receive a bonus in three months’ time. The owner of the house is willing to provide you with an option to
buy the house during the next three months. Suppose that you enter into a three-month options contract
to buy this house for INR 5,000,000. You are aware that the price of the house may change during the next

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Notes three months. The price may increase or decrease. It is up to you to decide whether you pay the required
INR 5,000,000 over the next three-month period and buy that house. If the price of the house increases in
the next three months such that the market price of this particular house is INR 6,000,000, it is advanta-
geous to buy the house using the option and pay only INR 5,000,000. On the other hand, if the price of
the house does not appreciate in the next three months and the value of the house is only INR 4,500,000,
you can let the options contract expire and buy the house at the market price of INR 4,500,000, which is
less than INR 5,000,000, which you must pay under the options contract.
However, the seller of the options contract has an obligation to sell you the property at INR 5,000,000
if you decide to exercise your right under that contract, even if the market price has increased to INR
6,000,000 in the intervening time. Since the seller of the house is providing you with an option, the seller
would require the buyer to pay some money for giving the option to the buyer.
Compare the strategy of buying the house through options with the strategy of using futures for the
same purpose. Suppose the seller of the house is willing to enter into a forward contract to sell the house
at INR 5,000,000. Under this contract, you agree to buy the house at INR 5,000,000, irrespective of the
market price after three months. If the market price increases to INR 6,000,000, you benefit as you need to
pay only INR 5,000,000. This is similar to using options. In case the price falls to INR 4,500,000, you need
to pay INR 5,000,000 under the futures contract, which is higher than the market price. If you had used
an options contract, you would have had the option to not enforce the right to buy at INR 5,000,000 and
buy the house at INR 4,500,000 instead. Thus, options are better if the price moves in favour of the hedger.

7.5  What Is an Options Contract?

An options contract conveys the right to buy or sell a specified asset at a fixed price for a fixed length
of time. The important thing in an options contract is that the purchaser of the options contract has the
right, but not an obligation, to sell or buy the asset. This distinction separates an options contract from
other derivatives contracts such as futures and forward contracts.
In the case of futures and forward contracts, the holder of the contract has an obligation to fulfil the
terms of the contract, while the holder of an options contract is not legally obliged to take any further
action. Thus, the holder of an options contract may wish to fulfil their contractual right to buy or sell
the asset only if it is economically advantageous to do so. On the other hand, the holders of forward and
futures contracts will have to fulfil their obligations even if it is disadvantageous to them. This difference
is very important, because both futures and options are used for hedging downside risk or for hedging
the situation where the price is expected to move against the hedger. In case the price moves against the
hedger, both futures and options will provide protection. When the price moves in favour of the hedger,
hedging through options will be beneficial as compared to hedging through futures.

7.6  Options Terminologies

Options are complicated instruments with different terminologies associated with them. This section
explains these terminologies:

7.6.1  The Underlying Asset

An options contract provides the buyer of an option with the right to buy or sell a specified asset. The
asset on which the option is written is known as the underlying security or asset.
Currently, in most countries, options are available for trading the following:
1. Commodities
2. Individual stocks
3. Stock indexes
4. Foreign currencies
5. Futures contracts
6. Bonds

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Notes 7. Interest rates

8. Credit
However, in India, options are available only on individual stocks and stock indexes that are traded on
the BSE and NSE and on foreign currencies and interest rates that are created on OTC markets.

7.6.2  Call and Put Options

In the case of futures, you are agreeing to either buy or sell the underlying asset at a future time at a price
determined at the current time. As both parties are obligated to fulfil the contract, there is only one speci-
fication of a futures contract. On the other hand, in the case of an options contract, only one party has the
obligation and the other party has the right to decide whether they want to fulfil the contract. Because
of this distinction, an options contract has to state whether the seller of the options contract is obligated
to sell the underlying asset or buy the underlying asset if the option is exercised. Therefore, it becomes
necessary to have two types of options contracts: one indicating that the option buyer has the right to buy
(or the option seller has the obligation to sell), and the other indicating that the option buyer has the right
to sell (or the option seller has the obligation to buy). Thus, in the options markets, there are two types
of options, depending on whether the purchaser of the option has the right to buy or sell the underlying
asset; these are called call options and put options.
A call option gives the purchaser of the option the right to buy the underlying asset at a fixed price at
a future time.
A put option gives the purchaser of the option the right to sell the underlying asset at a fixed price at
a future time.

7.6.3  The Option Premium

In the case of a futures contract, both the buyer and the seller have risks they want to hedge. If the actual
market price at the expiry of futures is higher than the agreed futures price, the buyer of the futures con-
tract will benefit and the seller of the futures contract will lose. On the other hand, if the market price on
the expiry date of the futures is less than the agreed futures price, the seller of the futures will gain and
the buyer of the futures will lose. The amount of loss for one party will be equal to the amount of loss
for the other party. Thus, a futures market exhibits the principle of a “zero-sum” game. That is, no single
party will make gain beyond the loss of the other party. For example, if the futures price of the house is
INR 5,000,000 and the market price is INR 6,000,000, the buyer gains INR 1,000,000 and the seller loses
INR 1,000,000. If the market price is INR 4,500,000, the buyer loses INR 500,000 and the seller gains INR
500,000.
However, in an options contract, the buyer of the option will benefit whenever the price moves in their
favour, and this benefit is not shared with the seller of the option. If the price moves against the buyer of
the option, the buyer gains and the seller loses. For example, if the option exercise price for the house is
INR 5,000,000 and the market price is INR 6,000,000, the buyer gains INR 1,000,000 and the seller loses
INR 1,000,000. If the market price is INR 4,500,000, the buyer gains INR 500,000 and the seller loses INR
500,000, as compared to a futures contract. Thus, in an options contract, the buyer always gains and the
seller always loses when compared to a futures contract, which is based on the price of the underlying
asset on the date of exercise.
Since the buyer of an option gets a greater benefit, the seller would enter into an options contract only
if the buyer compensates the seller for the potential loss that the seller would incur. This is similar to an
insurance contract, whereby the insurance company takes the risk of loss from the insured party. In an
insurance contract, the insured pays a premium to the insurance company to transfer the risk. Similarly,
in an options contract, the seller of the options contract would demand that the buyer of the options pay
a premium at the time the options contract is entered into, as the seller is taking the risk of price changes.
This amount that the option buyer needs to pay to the option writer is known as the option premium.
If options are traded on the options exchanges, the buyer of the option will have to pay this premium to
the seller of the option and thus this becomes the price at which the options are traded on the exchanges.
Thus, the price that the buyer of the option pays the seller of the option is known as the option price or
option premium.

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Notes 7.6.4  Exercising Options

In the case of a call option, the option holder has the right to buy the underlying asset at a fixed price and
they will buy the underlying asset using the options contract only if it is economically advantageous to
do so. When an option holder decides to buy the underlying asset under the options contract, they are
said to exercise the call option. If the option holder finds that exercising the option will be economically
disadvantageous, they will not exercise the option. In that case, the option is said to expire without exer-
cise. For example, the buyer with an option to buy the house at INR 5,000,000 will exercise the option and
buy the house at INR 5,000,000 if the market price of the house after three months is INR 6,000,000, as it
is beneficial to exercise. If the market price is INR 4,500,000, the option holder will let the option expire
without exercise, because they will lose if they exercise the option and buy the house at INR 5,000,000
when the market price is INR 4,500,000.
Similarly, in a put option, the option holder has the right to sell the asset at a fixed price, and they
will sell the asset under the options contract only if it is economically advantageous to do so. When an
option holder decides to sell the property under the options contract, they will exercise the put option.
If the option holder finds that exercising the option will be economically disadvantageous, they will not
exercise the option and it will expire without exercise. If the house owner had entered into a put option
to sell the house at INR 5,000,000, they will exercise the option when the market price is INR 4,500,000.
This is because they can sell the house at INR 5,000,000, while the market price is INR 4,500,000. In case
the market price is INR 6,000,000, the put option holder will let the put option to sell at INR 5,000,000
expire, and instead sell it at INR 6,000,000, which is the market price.

7.6.5  The Exercise Price or the Strike Price

All options contracts provide the price at which the asset will be bought or sold if the option is exercised.
This price is fixed and the seller of the option will have to either sell the asset at this fixed price to the
holder of the option (in a call option) or buy the asset at this fixed price from the holder of the option (in
a put option). This fixed price at which the asset will be traded under the options contract is known as the
exercise price or strike price of the option. In the above examples, the exercise price was INR 5,000,000.
In a futures contract, the price at which the underlying asset will be exchanged for cash is known as
the futures price, and this futures price is determined in the market. As the price of the underlying asset
changes in the spot market, the futures price will also change. Thus, two persons who hold futures con-
tracts for delivery that were purchased at different times may pay different prices for the same asset on the
delivery date. However, in an options contract, the price at which the underlying asset is exchanged for
cash is known as the exercise price, and this price does not change over the life of the contract, except in
special circumstances, which are discussed in Section 7.8. Thus, all buyers of a given call options contract
will pay the same price for buying the asset even if the options were bought at different times. The price
that is determined in the options market is the option premium or the option price, which provides the
right to the option buyer.

7.6.6  The Exercise Date or the Strike Date

All options contracts have a fixed maturity. That is, the option holders will have to make a decision as to
whether they are going to exercise the option and either buy the underlying asset at the exercise price (if
it is a call option) or sell the underlying asset at the exercise price (if a put option), by this fixed maturity
date. The fixed maturity date of an options contract is known as the exercise date or strike date.

7.6.7 American and European Options

Options contracts are classified as either American options or European options, depending on when the
holders of the options contracts can exercise their right to buy or sell the asset during the maturity of the
option.
If the options contract stipulates that the holder can exercise the right to buy or sell the asset at the
fixed exercise price only on the fixed maturity date or exercise date, the option is referred to as a European
option.

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Notes If the options contract stipulates that the holder can exercise the right to buy or sell the asset at the
fixed exercise price at any time from the time of purchasing the option until and including the fixed maturity
date or exercise date, the option is referred to as an American option.

  Example 7.7
Consider a call option on the house with an exercise price of INR 5,000,000 and an exercise date of March
31. On March 3, the market price of the house is INR 5,500,000. On that date, if you can exercise the op-
tion, you can buy the house at INR 5,000,000 while the market price is INR 5,500,000. However, if it was
a European option, you can exercise only on March 31. If the price decreases and reaches INR 5,000,000
by that date, you will not be able to gain through the option. On the other hand, if it was an American
option, you could exercise on March 3 and buy the house worth INR 5,500,000 at INR 5,000,000.

Thus, American options are more valuable than European options because American options provide
more choices to the buyer.

7.6.8 Buyers and Writers of Options

The person who purchases the option (whether it is a call option or a put option) is called an option buyer
and they are said to hold the option long.
The person who sells the option (whether it is a call option or a put option) is called an option writer
and they are said to have sold the option short.
In the options market, anyone can be either an option buyer or an option writer. An individual may
find opportunities to buy options to make profits at some time and to write options to make profits at
some other time. In some instances, the same individual may write as well as buy options for different
purposes.
The distinction between the option writer and buyer is important, because the right to exercise rests
only with the option buyer. The option writer has the obligation to fulfil the terms of the contract in case
the option buyer exercises their right under the options. Since the option buyer will exercise the right
only if it is economically advantageous and a profit will result from exercising the option, it is clear that
the writer of the option will always realize a loss when an option is exercised.

7.6.9  The Contract Size

The options contract also needs to specify the number of units of the underlying asset that can be bought
or sold using the option. This is known as the contract size or market lot size. In case of exchange-traded
stock options, the lot size is determined by the exchange. In case of an index option, the exchange will
determine the dollar value of the contract, which is known as the contract multiplier. In the case of OTC
contracts, the two parties will decide on the contract size through negotiation.

7.6.10  In-the-money, At-the-money and Out-of-money Options

Whenever the price of the underlying asset is such that exercising the option will provide a gain, the
option is said to be in-the-money, and if exercise is likely to result in a loss, the option is said to be out-
of-money. If the price of the underlying asset is very close to the exercise price, the option is said to be
at-the-money.

  Example 7.8
Call options and put options are available on the Bank Nifty index on September 1 with expiry on
September 24. The spot value and the exercise price of Index options are always quoted in index points.
The spot value of the Bank Nifty index on September 1 is 7,377.20 points. The call option premium is
INR 153 and the put option premium is INR 361 for a Bank Nifty options with an exercise price of 7,600
points.

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Notes Since the exercise price is 7,600 and the value of the index is 7,377.20, exercising the call will result
in a loss and hence the call is out-of-money. On the other hand, exercising a put will result in a gain and
hence the put is in-the-money. In general, for the same exercise price, if the call is in-the-money, the put
will be out-of-money, and vice versa.
If the value of the index were 7,700 on September 1, the call option will be in-the-money and the put
option will be out-of-money. If the value of the index were 7,600, it is close to the exercise price and both
the call and the put are said to be at-the-money.

7.7  Exchange-traded and OTC Options: A Comparison

Options are traded on organized exchanges or on OTC markets. In OTC trading, the options brokers
and dealers bring together buyers and writers and arrange the contract terms. The volume of transactions
in the OTC market is comparatively low and commission expenses are high. There is transparency in
exchange-traded contracts, as all the details of the trades are posted by the exchange and hence it is easy
to regulate the activity in exchanges. On the other hand, OTC transactions are not transparent and it is
very difficult to regulate the activity in OTC markets.
Most of the OTC options are either interest rate options or currency options. There is no standardiza-
tion of options contracts and, therefore, OTC options are not generally tradable. Hence, the OTC market
is suitable only for individuals and financial institutions that are looking for a particular contract to suit
their purpose. In many cases, OTC market options are European style options. This is because options
transfer the risk of price movement from the option buyer to the option writer. Thus, it becomes neces-
sary for an option writer in OTC contracts to manage this risk. If it were a European option, the option
writer will know exactly when the option will be exercised and hence manage the risk more efficiently.
However, if it were an American option, the option writer will not know when the option may be exer-
cised and hence will find it difficult to manage the risk. In the case of an exchange-traded option, it is not
a concern because the option writer can take an opposite position in the contract in case they believe that
the option may be exercised, creating a loss for the writer of the option.
The major disadvantage of OTC options is the existence of counterparty risk. Counterparty risk arises
whenever there is a possibility that one of the participants in the contract may default on the contract
terms if the contract goes against that person. For example, assume that Prime Fund has written 10 call
options contracts on the S&P CNX Nifty index with an exercise price of 5,200 and Mega Fund has pur-
chased this contract. The multiplier for this contract is 50. If the S&P CNX Nifty index goes up to 7,200
by the maturity date of the option, Prime Fund will decide to exercise the option, because they can gain
INR 100,000 per options contract (2,000 × 50) under the terms of the option. This means that Prime Fund
will have to give Mega Fund an amount of INR 1,000,000 on the 10 contracts that have been written. In
OTC contracts, Prime Fund may be able to escape from the contract by defaulting. Of course, Mega Fund
can take legal actions to recover the money, but this could be costly and time-consuming. This is known
as counterparty risk.
Although it is unlikely that all the option writers will renege upon their contracts, option buyers always
face a counterparty risk when entering into an options contract in the OTC market. Note that counterparty
risk is faced only by option buyers and not by sellers. This is because option buyers have an option and not
the obligation, while option writers have the obligation to fulfil their contract terms. Counterparty risk
arises only when the person who has the obligation to perform does not fulfil the contract terms.

7.7.1  Guarantee of Performance in Exchange-traded Options

Earlier, we saw that OTC options contracts involve counterparty risk and as far as the option buyers are
concerned, there is no guarantee of performance. However, in organised options exchanges such as the
BSE and the NSE, such non-performance of contracts is not possible, because each exchange has its own
clearing corporation. The existence of the clearing corporation and its role in each options contract are
the major reasons for the rapid growth of the options market.
In each options contract, a clearing corporation interposes itself between the buyer and the writer.
For example, if Prime Fund is the writer and Mega Fund is the buyer and the actual contract is between
Prime Fund and Mega Fund, the books of the clearing corporation will show that there were actually two
transactions, as shown below:

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Notes Writer Buyer

Prime Fund Clearing Corporation
Clearing Corporation Mega Fund
Since performance guarantee in options contracts is only from the writer, Mega Fund is guaranteed by the
clearing corporation that it will meet the obligation through performance. Thus, there is no counterparty
risk present when trading in exchange-traded options.

7.7.2 Margin Requirements
Options trading on exchanges also require that the writer of the options put up a margin, similar to the
margin in futures trading. The margin amount is usually calculated on the basis of the variability in stock
price movements. Similar to futures trading, there will be initial margin requirements as well as a vari-
ation margin. The margin account will be marked-to-market every day, and in case the margin amount
goes below the variation margin requirement, the writer of the option will get a margin call. On receipt
of a margin call, the writer of the option will have to provide additional cash to reach the initial margin
amount, or the broker has the right to offset the contract. Similar to futures trading, the margin amount
can be in cash or securities that are allowed by the exchange clearinghouse.
Note that the margin needs to be posted only by the writer of the option, and not by the buyer. This is
different from futures trading, where both the buyers and the sellers of futures need to post margin. In the
case of futures, both the buyers and the sellers of futures have obligations to fulfil at the time of maturity
of the contract and, therefore, both need to post the margin. However, in the case of options, only the
writer of the option has obligations and the buyer gets the right to exercise. Since options buyers do not
have an obligation to fulfil their contract unless they exercise the option, they do not need to post any
margin. On the other hand, options writers have an obligation to either buy the security (in the case of
put options) or sell the security (in the case of call options) if they are exercised, and they need to post the
margin to show good faith that they are willing to fulfil their obligations if called to do so.

7.7.3 Margin Calculation

The margin amount in options trading is to cover the financial loss due to an adverse market movement.
Margins are paid to cover the obligations to the broker, who, in turn, will pay the amount to the clearing-
house through the clearing member (CM). The margins will be calculated at the end of each day in order
to ensure that adequate margin cover is maintained at all times. The margin account will be marked-to-
market every day, and if there is a shortfall, the clearinghouse will issue a margin call, which requires that
the amount is paid within 24 hours. When the position is closed out or when the option is exercised, the
final settlement will take place and the balance in the margin account will be paid to the account holder.
Only the writers of the options need to post margins, as they are the only ones who have to fulfil the
obligations. Only the buyers of the options have the rights and hence need not have to post any margin.
The obligations will arise if one writes a call option or a put option. In the case of a call option, the writer’s
risk of financial loss increases if the price of the underlying asset increases, and in the case of put options,
the risk of financial loss to the writer decreases if the price of the underlying stock decreases. Since the
loss and gains are difficult to estimate in the case of options, the financial risk is estimated by the clear-
inghouse by using a computer software known as standard portfolio analysis of risk (SPAN). The basic
methodology is to estimate the loss for a given range of possible prices on the next day, given the current
day’s price of the underlying asset. This margin is known as the risk margin, and the clearinghouse will
calculate the risk margin amount every day on the basis of the closing price of the underlying asset on
that day and the variability estimated from historical data.
In addition to the risk margin, the option writers need to post a margin known as the premium mar-
gin. The premium margin is the amount of premium the writer would receive for the options they have
written. Thus, when a writer sells an option, the amount that the writer receives as premium will be de-
posited with the clearinghouse as the margin. If the underlying asset price changes, the premium would
also change and hence the premium margin will be adjusted daily on the basis of the option premium
every day. If the option premium increases, the writer would face a loss on the option premium. This
happens because the writer can close out the position only by buying the options, and if the premium
increases, the writer will have to pay more than what they had received when they sold the option. On the
other hand, if the premium decreases, the option writer will gain on the premium margin.

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 Fundamentals of Options   147

Notes The writer will also need to post a margin called the assignment margin. In the case of European
options, the option can be exercised only on the exercise date. On the exercise date, the number of long
positions in the options will be equal to the number of short positions. All writers willingly hold the
open short position, and if the options are in-the-money on the exercise date, the clearinghouse will
automatically exercise the options, calling all the writers to pay the “in-the-money” value of the option
to the clearinghouse. The clearinghouse will credit the account of the buyers with that value. Since the
writers may hold the open position on the exercise date, they would face a loss in the case of exercising
the option and hence they would be required to pay a margin for possible loss, called the assignment
margin.
In the case of American options, there is a possibility that some option buyers may exercise the option
before expiry. Since the contract is considered as a contract between the buyer of the option and the clear-
inghouse, the clearinghouse will randomly assign the option to a writer who has an open short position
in the option on that day. Since all writers have equal probability of being selected for this assignment, all
writers would face a loss in case the option is exercised before maturity. The clearinghouse will impose a
margin for such possible assignment in case the option is exercised before the maturity date. This margin
is known as the assignment margin. The assignment margin will be calculated every day by the clearing-
house. The assignment margin is levied only on the CMs by the exchange.
The risk margin as well as the assignment margin can either increase or decrease on the basis of the
price of the underlying asset in the market relative to the exercise price of the option. The total margin
amount is the sum of the premium margin, risk margin, and assignment margin. The margin account will
be marked-to-market every day.

  Example 7.9
Call options are available on the Bank Nifty index on September 1 with expiry on September 24. The
value of the Bank Nifty index on September 1 is 7,377.20. The option premium is INR 153 for the Bank
Nifty call option with an exercise price of 7,600. You write five options. The margin account will be as
shown below, assuming that you would close out the position on September 5. Since the multiplier is 50,
the total premium is Market premium × 50. All numbers used in this example are assumed numbers.

Premium Margin (in Indian rupees)

Day 1 2 3 4 5

Option premium 153 185 210 245 318

Premium per contract 7,650 9,250 10,500 12,250 15,900

Premium margin for 5 contracts 28,250 46,250 52,500 61,250 79,500

Risk margin and Total margin (in Indian rupees)

Day 1 2 3 4 5

Option premium 153 185 210 245 318

Upside theoretical price 162 197 225 270 350

Downside theoretical price 141 168 195 208 286

Risk margin per contract 450 600 750 1,250 1,600

Risk margin for 5 contracts 2,250 3,000 3,750 6,250 8,000

Premium margin for 5 contracts 28,250 46,250 52,500 61,250 79,500

Total margin 30,500 49,250 56,250 67,500 87,500

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Notes The upside theoretical price is calculated as follows.

Using the current price of the underlying asset and its variability, find the possible prices, both upside
as well as downside for the variation allowed for margin calculation. Using these prices, calculate the
theoretical value of the option premium using the option pricing models discussed in Chapters 10 and
11. For a call writer, the upside movement in the underlying security will result in a loss, while any
downside movement will result in a gain. Thus, the risk margin is calculated as (Upside theoretical price –
Current option premium) × Contract multiplier. For the first day, risk margin = (162 – 153) × 50 = 450
The premium margin is calculated as Current option premium × Contract multiplier, and the total
margin is the sum of the premium margin and the risk margin. Note that the total margin is the total
option premium per contract for the theoretical premium for upside risk. For day 1, the upside theoretical
price is 162 and the total premium for this theoretical price = 162 × 50 = INR 8,100, which is the total
margin for that day.

  Example 7.10
Put options are available on the Bank Nifty index on September 1 with expiry on September 24. The value
of the Bank Nifty index on September 1 is 7,377.20. The option premium is INR 361 for the Bank Nifty
call option with an exercise price of 7,600. You write one option. The margin account will be as shown
below, assuming that you would close out the position on September 5. Since the multiplier is 50, the total
premium is Market premium × 50. All numbers used in this example are assumed numbers.
  Since index options are European options, there will be no early assignment and hence the total margin
will be the sum of the premium margin and the risk margin only.

Premium Margin (in Indian rupees)

Day 1 2 3 4 5

Option premium 361 330 395 380 425

Premium per contract 18,050 16,500 19,750 19,000 21,250

Premium margin 18,050 16,500 19,750 19,000 21,250

Risk margin and Total margin (in Indian rupees)

Day 1 2 3 4 5

Option premium 361 330 21,000 380 425

Upside theoretical price 345 322 19,750 362 395

Downside theoretical price 385 348 1,250 404 462

Risk margin 1,200 900 420 1,200 1,850

Premium margin 18,050 16,500 376 19,000 21,250

Total margin 19,250 17,400 395 20,200 23,100

The upside theoretical price is calculated as follows.

Using the current price of the underlying asset and its variability, find the possible prices, both upside
as well as downside for the variation allowed for margin calculation. Using these prices, calculate the
theoretical value of the option premium. For a put writer, the downside movement in the underlying
security will result in a loss, while any upside movement will result in a gain. Thus, the risk margin is
calculated as (Downside theoretical price – Current option premium) × Contract multiplier. For the first
day, risk margin = (385 – 361) × 50 = INR 1,200.
The premium margin is calculated as Current option premium × Contract multiplier, and the total
margin is the sum of the premium margin and risk margin. Note that the total margin is the total option

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 Fundamentals of Options   149

Notes premium per contract for the theoretical premium for downside risk. For day 1, the downside theoretical
price is INR 385 and the total premium for this theoretical price = 385 × 50 = INR 19,250, which is the
total margin for that day.
In case a writer has a portfolio of options, both written and bought, the margin will be calculated for
each option separately and the margin will be added to get the total margin.

Problem 7.4
On March 1, call options are available on SBI shares with expiry on March 27 and exercise price of INR 2,600. SBI
shares are priced at INR 2,500 on March 1. The contract size for SBI options is 132. Ravi writes 10 call options and
the option premium is INR 170. Option premium, upside theoretical price and downside theoretical price for SBI call
option on March 1, March 2, and March 3 are given below.
March 1 March 2 March 3
Option premium 70 78 85
Upside theoretical price 67 74 79
Downside theoretical price 74 82 88

Calculate premium margin, risk margin, and total margin for the three days.
Solution to Problem 7.4

Premium Margin (in Indian rupees)

Day 1 2 3

Option premium 70 78 85

Premium per contract 9,240 10,296 11,220

Premium margin for 10 contracts 92,400 102,960 112,200

Risk margin and Total margin (in Indian rupees)

Day 1 2 3

Option premium 70 78 85

Upside theoretical price 67 74 79

Downside theoretical price 74 82 88

Risk margin per contract 528 528 396

Risk margin for 10 contracts 5,280 5,280 3,960

Premium margin for 10 contracts 92,400 102,960 112,200

Total margin 97,680 108,240 116,160

7.7.4  Standardization of Contracts

The success of options contracts in organized exchanges depends on how well the options are standard-
ized. Standardization requires that all parties know exactly what they are contracting for, and the ex-
change should clearly specify the following:
The option type: call or put option
 

The name of the underlying security

 

The contract size, that is, the number of underlying shares in the case of a stock option and the mul-
 
tiplier in the case of index options

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 150   Financial Risk Management

The exercise date or strike date

 
Notes
The exercise price or strike price
 

The rule for exercise: European or American

 

Furthermore, since the investors want to use options to hedge and speculate, the exchange should
provide a sufficient number of options on each stock, with different exercise prices and exercise dates.

7.7.5  Exercise Dates

Typically, the exercise date is stated in terms of the month in which the contract expires. For example,
a January call on Reliance is a call option on Reliance shares that expires in the month of January. The
precise expiration date, the last trading date on the option, and the latest time by which the investor can
exercise the option will have to be clearly given by the options exchange. The expiry date in Indian ex-
changes is the last Thursday of the month, and if the last Thursday of the month is a trading holiday, the
expiry date will be the preceding trading day.
Stock options have a three-month trading cycle, namely, the near month (one), the next month (two),
and the far month (three). This means that there will be three expiry dates for each option at any given
time. For example, in the month of January, there will be three options with expiry dates in January,
February, and March. When the January option expires, the April option will be introduced. Thus,
options can be used for hedging over three months.
Stock index options can be regular index options or long-term index options. In regular index options,
there will be three expiry dates, the near month, the next month, and the far month, as in individual stock
options. In long-term options, there will be three quarterly expiry dates on a March, June, September, and
December cycle and five half-yearly expiry dates, namely, a June and a December cycle. For example, in
the month of January 2010, index options will be available for expiry dates in January, February, March,
June, September, and December 2010; June and December 2011; and June and December 2012. Thus, one
can use index options to hedge over a three-year period.

7.7.6 Exercise Prices

The exercise prices at which options can be written are chosen by the exchange.

Exercise Prices for Stock Options.  For stock options, exercise prices might be spaced at different
ranges depending upon the price of the underlying security.
Indian exchanges provide a minimum of seven strike prices for each option type (call and put) for
individual stock options during the trading month. There will be three contracts in-the-money, three
contracts out-of-money, and one contract at-the-money. The exercise price interval is based on the price
of the underlying stock as follows see Table 7.1.
New contracts can be created by the exchange with the same expiration date but with different exercise
prices when the underlying security price changes.

Table 7.1

Stock price Exercise Price Interval

Less than INR 50 INR 2.50

INR 50 to INR 250 INR 5
INR 250 to INR 500 INR 10
INR 500 to INR 1,000 INR 20
INR 1,000 to INR 2,500 INR 30
More than INR 2,500 INR 50

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 Fundamentals of Options   151

Notes Example 7.11

Suppose the stock price of Reliance is INR 2,800 when the trading in July options starts. Seven call op-
tions and seven put options would first be offered with exercise prices of INR 2,650, INR 2,700, INR
2,750, INR 2,800, INR 2,850, INR 2,900, and INR 2,950.
If the stock price increases to INR 2,850, new options (both call and put) with an exercise price of INR
3,000 will be offered on the next working day.
If the stock price decreases to INR 2,750, new options (both call and put) with an exercise price of INR
2,600 will be offered on the next working day.

Strike Prices of Index Options.  In the case of index options in the NSE, the strike price intervals
and the number of options will depend on the expiry date. The following table shows the details of the
number of options and the strike price intervals for index options see Table 7.2.

Table 7.2

1,2,3 months’ Expiry Quarterly Expiry Half-Yearly Expiry

Index Level
Interval Number Interval Number Interval Number

> 2,000 25 4-1-4 25 6-1-6 50 4-1-4

2,001–4,000 50 4-1-4 50 6-1-6 100 4-1-4
4,001–6,000 50 5-1-5 50 8-1-8 100 5-1-5
>6,000 50 5-1-5 50 8-1-8 100 5-1-5

  Example 7.12
If the CNX Nifty index value is 5,300 on January 1, 2010, there will be 11 index options (both call and
put) with expiry dates in January, February, and March 2010; 17 index options with expiry dates in June,
September, and December 2010; and 11 index options with expiry dates in June and December 2011 and
June and December 2012. For the 11 options with expiry dates in January 2010, the exercise prices would
be 5,050, 5,100, 5,150, 5,200, 5,250, 5,300, 5,350, 5,400, 5,450, 5,500, and 5,550, with five of them in-the-
money, five of them out-of-money, and one at-the-money.

7.7.7  Options Classes and Options Series

For a given stock at any given time, there may be many different options contracts traded. If there are four
expiration dates and seven exercise prices and the puts and calls trade for each of these exercise prices for
each of these expiration dates, there will be 56 options traded on the same stock. All options of the same
type (puts or calls) are called an option class. For example, Reliance calls are one class and Reliance puts
are another class.
An option series consists of all options in a given class with the same exercise date and exercise price.
An option series refers to a particular contract that is traded. For example, a Reliance 2,800 October call
refers to a call option on Reliance shares with an exercise price of INR 2,800 with expiry in October.

7.8  Trading of Options

Trading of options is similar to the trading of securities in derivatives exchanges, as explained in
Chapter 2. Trading will involve the following steps:
1.  Contact the broker to place the order.
2.  The broker fulfils the order.

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Notes 3.  The broker contacts a CM to clear the order

4. Once the order is cleared, the writer of the options needs to post the margin. The buyer of the option
will have to pay the option premium to the broker, and this will be transferred to the writer of the
option. For the buyer of the option, the broker will just maintain an account showing the position of
the buyer.
5.  The option writer’s margin account is marked to market daily.
6. If the margin account balance goes below the variation margin, the writer of the option may get a
margin call, which would require the writer to post additional margin.
7. On the exercise date, the option will be exercised if it is advantageous for the option holder, and if it
is not advantageous to the option holder, the option will expire without exercise. The option buyer
does not have to indicate to the broker that they plan to exercise. The balance in the margin account
will be paid to the writer of the option. The buyer will receive the positive difference between the
exercise price and the market price of the underlying asset. If the difference is negative, there will be
no exercise, and the buyer will have no cash flow.
All options exchanges also allow online trading by individual traders directly. In order to do online
trading, the trader needs to register and open an account with an authorized broker. The broker will
provide the software that needs to be used in order to do online trading. Once the trader is registered
with the broker, the trader will have access to online quotes from the exchange and can place orders by
themselves. The traders are also required to provide a link to a bank account so that all the amounts relat-
ing to online transactions will be directly debited from or credited to that bank account. The broker will
maintain the margin account, and any amount due from the trader for the margin account will be directly
taken from the bank account.

7.8.1  Types of Orders

Many types of orders can be placed by an investor while directing their broker to trade in options. The
simplest type of order is a market order. A market order means that a trade must be carried out at the best
prevailing market price, whatever that may be.
1. A limit order specifies a particular price. The order can be executed only at this price or at a price
that is favourable to the buyer. For example, if the limit price is INR 15 for buying a call option on
Allahabad Bank stock, the order can be executed and the call bought only for a price of INR 15 or
less. Of course, there is no guarantee that this order will be executed at all, since the limit price may
never be reached.
2. A stop order also specifies a particular price, and the order becomes a market order as soon as
the stop price is reached. For example, if the stop price is INR 15 for the Allahabad Bank call,
the order will become a market order as soon as the call price reaches INR 15. Since it is a
market order, it will be executed at the best available price at that time. If the best price is INR 15.50,
then the order will be executed at INR 15.50. The purpose of the stop order is generally to close
out a position if unfavourable price movements take place, thereby limiting the amount of loss that
is incurred.
3. A stop–limit order is a combination of a stop order and a limit order. The order becomes a limit order
as soon as there is a bid or offer at a price equal to or less than the stop order price. Two prices must be
specified in a stop–limit order: the stop price and the limit price. For example, an investor may place
a stop–limit order with a stop price of INR 15 and a limit price of INR 15.30. When the market price
reaches INR 15, the order becomes a limit order with a limit price of INR 15.30.
The orders can also specify time limits. Generally, an order is a day order, unless otherwise stated, and
expires at the end of the day. A time-of-day order specifies a particular period of time during the day at
which the order can be executed. An open order or a good-till-cancelled order is in effect until executed or
until the end of trading in that contract. A fill-or-kill order must be executed immediately when received,
or not at all.

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Notes 7.8.2  Offsetting Orders

An investor who has purchased an option can close out their position by issuing an offsetting order to
sell the same option. Similarly, a person who has written an option can close out their position by issuing
an offsetting order to purchase the same option.

7.9 Price Quotes
Table 7.3 shows the price quotes for selected S&P CNX Nifty index options and Bharti Airtel options as
of September 1, 2009, obtained from the NSE.
Symbol: This is the symbol under which the option is traded on the NSE.
 

Expiry
  Date: This is the expiry date of the option. For Nifty index options, the expiry dates are
in September 2009, October 2009, November 2009, December 2009, March 2010, June 2010,
December 2010, June 2011, December 2011, June 2012, and December 2012. For Bharti Airtel
options, the expiry dates are in September 2009, October 2009, and November 2009.
Strike
  Price: Both calls and puts are available for various strike prices for each expiry date.
Table 7.3 shows the quotes only for a few of the exercise prices.
Option
  Type: This shows whether the option is a call or a put as well as whether it is American or
European. CE refers to a European call, PE refers to a European put, CA refers to an American call,
and PA refers to an American put. All index options are European options, and all stock options are
American options.
Open,
  High, Low, Close, and Settle: These are the data regarding the option premium, which is
determined in the exchange. They refer to the details of the opening price, highest price during the
day, lowest price during the day, closing price of the day, and settlement price of the contract on that
day. The settlement price is calculated by the exchange by taking the average of the prices during the
last 30 minutes if there is trading in the options, and if there is no trading, the settlement price is
calculated using a theoretical model.
Contracts: This shows the number of contracts that were traded that day.
 

Value (in lakh): This shows the total value of all contracts traded during the day.
 

Open Interest: This shows the number of outstanding contracts that require settlement on the expiry
 
date.
Change in Open Interest: This shows the number of new contracts initiated that day.
 

Open interest is very important in options trading. Open interest is the number of open contracts, that
is, the number of contracts that have been traded but not liquidated by an offsetting trade or exercise. This
shows the liquidity of the market. If the open interest is high, there are a large number of contracts that
need to be closed or exercised in the future and hence if one wants to close the existing position, it would
be easier to do so. The change in the open position also provides information as to whether new contracts
were opened during the day. If it is positive, it means that the interest in the option is high, whereas if the
change in open position is negative, it means that the traders are closing their position and the interest in
the option is decreasing. Typically, the number of contracts, and thus the open interest, is high and low
for the near-month and far-month contracts, respectively.

7.10 Protection Against Corporate Actions

Options trading is based on the exercise price. For a call option on individual stocks, the exercise will take
place only if the stock price is above the exercise price. However, the exercise price is fixed at the time the
contract starts, whereas the stock price can change during the period of the options contract. The stock
price change can be due to the general market movement or due to some actions taken by the corpora-
tion that has issued the stock. Options are traded to hedge the price changes due to the general market

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 Notes

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Table 7.3  Sample Quotes for S&P CNX Nifty Index Options and Bharti Airtel Options

Expiry Strike Option Value in Open Change in

Symbol Open High Low Close Settle Contracts
Date Price Type Lakh Interest Open Interest

NIFTY 26-Mar 4900 CE 56 82 49 52 52 83500 200150 3528325 185670

NIFTY 26-Mar 5000 CE 47.8 59.5 32 34 34 87354 220567 3235687 275400

NIFTY 26-Mar 4900 PE 272.5 346 248 339.5 339.5 1352 3367.5 147500 10940

NIFTY 26-Mar 5000 PE 342.5 435.6 302.5 409.5 409.5 1645 4465.6 194350 -7890

NIFTY 30-Apr 5200 CE 68 81.5 56.3 64.2 64.2 1225 3356.4 72456 44300

NIFTY 30-Apr 4600 PE 198 264 192 252.5 252.5 2470 6023.7 428547 56890

BHARTIARTL 26-Mar 440 CA 14.8 15.25 11.35 12.15 12.15 182 365.87 438890 37600

BHARTIARTL 26-Mar 450 CA 12.2 12.95 9.2 9.8 9.8 78 167.85 74698 7400

BHARTIARTL 26-Mar 430 PA 18.2 25.4 17.6 22.8 22.8 14 28.56 8200 -4750

BHARTIARTL 26-Mar 440 PA 22.8 28.6 21.6 28.6 28.6 3 8.75 4800 -1200

BHARTIARTL 30-Apr 440 CA 22.2 22.2 21.25 21.25 21.25 6 10.15 3600 1600

BHARTIARTL 30-Apr 400 PA 19.8 20.75 19.65 20.75 20.75 2 8.52 2700 700

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Notes movement, and if the stock price changes as a result of unforeseen corporate actions, the options traders
should not be affected because of these actions.
For example, if a corporation pays huge dividends, it is seen that the stock price decreases by the
amount of dividends. To illustrate this, consider the shares of Infosys. They are currently selling at INR
2,130. There is a call option traded on the exchange with maturity in 30 days and exercise price of INR
2,200. The buyers of call options would benefit if the market price increases from INR 2,130 to INR 2,200
within the next 30 days. Suppose Infosys decides to pay a dividend of INR 200 on the next day. In that
case, the stock price will decrease to INR 1,930 and the option holders will be affected because of this
dividend, as they can benefit only if the price moves from INR 1,930 to INR 2,200 within the next 30 days.
This will reduce the attractiveness of options if the option holders are not protected against the actions
taken by corporations that can directly affect the option holders.
Both the BSE and the NSE have provisions to protect the option holders in case of corporate actions.
These are explained in this section.
The idea behind protection is that there should be adjustments to the terms of the options con-
tract such that the value of the option holder’s position remains the same as far as possible even under
the actions taken by corporations. The various actions by corporations for which adjustments are
made are:
  1. Issue of bonus shares
  2. Issue of rights
  3. Merger/demerger
  4. Amalgamation
  5. Stock splits
  6. Consolidation of stock
  7. Hive-offs
  8. Warrants
  9. Secured premium notes
10. Cash dividends
Adjustment for corporate actions will be carried out on the last day on which a stock is traded on a
cum-basis in the stock market, after the close of trading. When any corporate action that will have an
impact on the share price and shareholder right is taken, it is important to decide when this effect will
take place. Since shares are traded continuously on the stock market, a person who buys the share at
a particular time needs to know whether the corporate action will have any impact on the new share-
holder. For example, if a company announces that it will pay dividends of INR 100 and if Ramesh sells
the stock to Gopal, the question arises as to who should get the dividend. In order to clarify this, the
company will announce a holder-of-record date. This means that the company will pay dividend to all
shareholders who are in their record as on that day. Assume that the holder-of-record date is June 10.
Since the settlement in the Indian Stock Exchanges is on T + 1 day, it will take one day after the trade for
the new shareholder to be recorded as a shareholder in the books of the company. If Ramesh sells the
shares to Gopal on or before June 9, Gopal will receive the dividends, as the records in the books of the
company will show Gopal as the shareholder. On the other hand, if Ramesh sells the shares on June 10
or later, Ramesh will still get the dividend, as his name will be in the records of the company. Thus, any
buyer of shares until June 9 is eligible to receive the dividends, whereas any buyer on June 10 is ineligible
to receive dividends. Thus, the share will sell at the cum-dividend on June 10 and the ex-dividend date
will begin on June 11. Therefore, it is important to know when the last day on which the stock is traded
on a cum-basis is.
Adjustment will be made to the strike price, market lot size, or multiplier.
In the case of bonus shares, stock splits, and consolidation, adjustment will be made as follows. The
strike price will be changed by dividing the old strike price by the adjustment factor. If the bonus shares
ratio is A:B, the adjustment factor will be (A + B) / B.

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Notes   Example 7.13

Assume that the number of outstanding shares is 10,000 and the company issues 100 bonus shares. Then
the ratio will be 100:10,000, and the adjustment factor would be (10,100 / 10,000) = 1.01.
If the original strike price was INR 1,000, the new strike price would be 1,000 / 1.01 = INR 990.
If the original market lot was 500 shares, the new market lot would be 500 × 1.01 = 505.
Thus, the original call options contract to buy 500 shares at INR 1,000 each would be changed to buying
505 shares at INR 990. Both would have a cash outlay of INR 500,000, but under the revised contract, the
option holder will be able to get 505 shares instead of 500 shares and the exercise price would be INR 990
instead of INR 1,000.
In the case of stock splits, the adjustment factor is calculated as: If the ratio is A:B, the adjustment
factor will be A / B.

Example 7.14
If a company announces a stock split of 2:5, it means that every two shares currently existing will become
five shares in the future. The strike price of INR 1,000 will be adjusted as: 1,000 × 2 / 5 = INR 400. The
contract market lot will become Old market lot × A / B, or a market lot of 500 will become 500 ×5 / 2 =
1,250. The total amount to be paid is the same at INR 500,000, but the number of shares that a person
receives on exercise will be 1,250 at INR 400, instead of 500 shares at INR 1,000.
In the case of cash dividends, if the dividend amount is less than 10 per cent of the market value of
the underlying stock, it will be considered as ordinary dividend and no adjustments will be made. If the
dividend is extraordinary, the strike price will be adjusted. The total per-share dividend amount (both
ordinary and extraordinary) will be deducted from the strike price to arrive at the new strike price. The
revised strike prices will be applicable from the ex-dividend date. For example, if the call option has a
strike price of INR 1,000 and an extraordinary dividend of INR 200 per share is made, the new strike
price of INR 800 will become operational from the ex-dividend date.
In the case of mergers, the company will make an announcement of the record date for the merger.
Once the announcement is made, no further options contracts will be introduced on that stock. All
unexpired contracts on the last cum date will be compulsorily settled at the closing price on the last cum
date. All orders that are good-till-cancelled will be cancelled by the exchange.

Problem 7.5
A company has 1,000,000 shares outstanding and issues 50,000 bonus shares on January 10. The share price of
this company on January 10 is INR 300. Call and put options are available on this company shares with expiry on
January 31 and exercise price of INR 315. The contract size for the options is 500. How would the terms of the options
change on issue of bonus shares?
Solution to Problem 7.5
Since the number of bonus shares is 50,000 and the number of shares outstanding is 1,000,000, the ratio of shares
outstanding including bonus shares to the shares outstanding without bonus shares is (1,050,000 / 1,000,000) = 1.05.
This is known as the adjustment factor.
The contract size as well as the exercise price for the option will be adjusted as follows:

New contract size for option = Original contract size × Adjustment factor = 500 × 1.05 = 525
Old exercise price 315
New exercise price = = = INR 300
Adjustment factor 1.05

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 Fundamentals of Options 157

CHapTEr SUmmarY
An options contract provides the right to buy or sell a

Th
e option buyer gets the right to exercise, whereas the

specified asset at a fixed price for a fixed length of time. option writer has the obligation to fulfil the contract if the
In the case of futures and forward contracts, both the

option is exercised by the buyer.
buyer and the seller have obligations to fulfil, whereas in an O
ptions are available on individual stocks, stock indexes,

options contract, the buyer of the option has the right and foreign currencies, futures contracts, bonds, and interest
not the obligation to fulfil the contract. rates.
A call option gives the buyer the right to buy the underlying

Options can be traded on organized exchanges or on OTC

security at a fixed price at a future time. markets as a private contract between two parties.
A put option gives the buyer the right to sell the underlying


Interest rate options and currency options are available

security at a fixed price at a future time.
in OTC markets, and in India, banks generally act as a
Since the buyer of the option gets the right to exercise, they

counterparty to corporate customers who have a known
will have to pay a price to buy the option. This is known as risk exposure.
the option premium.
The clearinghouse of an exchange guarantees performance

The option buyer will exercise the option only if it is


through margins.
economically advantageous to do so. If not, the option will
not be exercised and will expire worthless on the expiry Margins in options are provided by the option writers, as

date. only the writers have obligations to fulfil. Buyers of options
need not have to provide margins.
The exercise price is the price at which the underlying asset


can be bought or sold if the option is exercised. Margin comprises premium margin, risk margin, and


The exercise date is the last date on which the option can be


assignment margin.
exercised. There will be options available with a number of exercise

A European option can be exercised only on the exercise

dates and exercise prices, and these details will be decided
date, whereas an American option can be exercised at any by the exchange.
time before, or on, the exercise date. Most exchange-traded options on stocks are not protected

The person who buys the option is called an option buyer

against payment of cash dividends but are protected against
or holder, while the person who sells the option is called an payment of extraordinary dividends, bonus shares, and
option writer. stock splits.

mUlTIplE-CHOICE QUESTIONS
1. Which of the following is true? 4. Which of the following are true of employee stock options?
A. An employee stock option is usually held to maturity A. They are commonly valued as though they are regular
B. An employee stock option tends to be exercised earlier American options
than an OTC option with the same terms B. They are commonly valued as though they are regular
C. An employee stock options tends to be exercised later American options, but with a reduced life.
than an OTC option with the same terms C. They are commonly valued as though they are regular
D. Employee stock options are usually exercised as early as
European option
possible
D. They are commonly valued as though they are regular
2. Which of the following is NOT usually true about employee European options but with a reduced life.
stock options?
A. There is a vesting period 5. Which of the following was true about employee stock options
B. They can be sold to other employees prior to 1995?
C. They are often at-the-money when issued A. The options never had any affect on a company’s financial
D. Their value is currently a charge to the income statement statements
B. The value of options which were at-the-money when
3. What term is used to describe losses shareholders experience
issued had to be expensed on the income statement
because the interests of managers are not aligned with their
own? C. The value of options which were at-the-money when
A. Agency costs issued had to be reported in the notes to the financial
B. Backdating scandals statements
C. Dilution D. Options which were at-the-money when issued did not
D. Income statement expense affect a company’s financial statements

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 158 Derivatives and Risk Management

6. Which of the following was true about employee stock options 8. Which of the following is true about employee stock options
between 1996 and 2004? after they have been issued?
A. The options never had any affect on a company’s financial A. They have to be revalued every year
statements B. They have to be revalued every quarter
B. The value of options which were at-the-money when C. They have to be revalued every day like other derivatives
issued had to be expensed on the income statement D. They never have to be revalued
C. The value of options which were at-the-money when
9. Which of the following is true about the practice of backdating
issued had to be reported in the notes to the financial
a stock options grant?
statements
A. It is illegal
D. Options which were at-the-money when issued did not
B. It is illegal in the majority of states in the U.S., but not all
affect a company’s financial statements
states
7. Which of the following was true after 2005? C. It is illegal in roughly half the states in the U.S.
A. The options never had any affect on a company’s financial D. It is unethical, but not illegal
statements
10. A company surprises the market with an announcement that
B. The value of options which were at-the-money when
it has granted stock options to senior executives. The options
issued had to be expensed on the income statement
are exercised four years later. When does dilution take place?
C. The value of options which were at-the-money when
A. Dilution takes place when the options are exercised
issued had to be reported in the notes to the financial
B. Dilution takes place on the announcement date
statements
C. Dilution takes place gradually over the four years
D. Options which were at-the-money when issued did not
D. There is no dilution
affect a company’s financial statements

Answer
1. B 2. B 3. A 4. D 5. D 6. C 7. B 8. D 9. A 10. B

rEVIEW QUESTIONS
1. What is the difference between options issued by corporations (v) Exercise price
and options entered into between two private parties? (vi) Exercise date
2. What is a warrant? What would be the effect of warrant exer- (vii) Option premium
cise on the financial statements of the company? 9. Explain the difference between an options contract and a fu-
3. Why is a convertible bond considered as an option? When tures contract.
would a convertible bond be exercised? 10. Explain the difference between the positions of an option
4. Why is a callable bond considered to have an embedded op- buyer and an option writer.
tion? Under what conditions would a callable bond be called? 11. Explain the circumstances under which an option would be
5. Why is a put bond considered to have an embedded option? exercised.
Under what conditions would a put bond be redeemed? 12. In options trading, the margin needs to be posted only by an
6. What is a rights issue? How is it comparable to an option? option writer. Why is an option buyer not required to post
7. What is the difference between exchange-traded options and margin?
OTC options? 13. Explain what is meant by premium margin, risk margin, and
8. Explain the following terms: assignment margin.
(i) Call option 14. Why do exchanges allow a number of options with different
(ii) Put option exercise prices and exercise dates?
(iii) European option 15. What is the rationale behind adjusting option terms for vari-
(iv) American option ous corporate options?

SElF-aSSESmENT TEST
1. Indian Textiles issued three-year 10% coupon bonds with a Number of shares for each warrant 100
face value of INR 1,000 each on January 1, 2008. Each bond Exercise price INR 260
has two warrants attached to it. The share price of India Exercise period March 1 to June 30, 2008.
Textiles on January 1, 2008, was INR 240. The terms of
warrant issue are: On June 30, the share price of Indian Textiles is INR 268.

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 Fundamentals of Options   159

(i) Should the warrant holder exercise the warrant? rights issue. Each right will allow the shareholders to buy 100
(ii)  If the warrants are exercised, what will happen? shares at INR 260 each. The rights will expire on July 31.
  (i)  How many rights will be issued?
2. Mumbai Computers issues employee stock options to new   (ii) What will be the adjustments to the balance sheet on
employees. Mukesh joins this company on March 1, 2008, for July 31, assuming all rights are exercised.
a salary of INR 45,000 a month and is also issued 50 employee
stock options. According to the terms of the contract, the   6. On July 1, call options are available on the CNX Nifty index
exercise price of these options is INR 250 and each option with expiry on September 30. The exercise price of this
is based on 100 shares. During the first two years, Mukesh option is 4,200. On July 1, the CNX index is at 4,080. At what
cannot exercise these options, but he can exercise them value of index would the call options be in-the-money, out-
anytime during the third year. of-money, and at-the-money?
(i) What will be the position of Mukesh if he leaves the job
with Mumbai Computers on December 31, 2009.   7. On September 1, put options are available on the Bank Nifty
(ii) If Mukesh continues in his job and the share price of index with expiry on September 30. The exercise price of the
Mumbai Computers on December 31, 2010, is INR 275, put option is 7,480. On September 1, the Bank Nifty index is
should Mukesh exercise the option? If he exercises, what at 7,350. At what value of the index would the put option be
will be the position of Mukesh? in-the-money, out-of-money, and at-the-money?

3. On July 1, 2005, Assam Tea Company issues convertible bonds   8. Call options are selling at INR 120 on State bank of India
with the following provisions: shares with exercise price of INR 1,850 and exercise date of
October 31. SBI shares are selling at INR 1,780 on September
Maturity 10 years 1. The SBI options contract size is 132 shares. You write 10
Total issue INR 10 million options on SBI shares. On September 1, the upside theoretical
Face value INT 1,000 price of the option is INR 135 and the downside price is INR
Coupon payments 8% of face value payable semi-annually 112. The assignment margin is INR 8,000. Calculate the
Conversion ratio 1:4, i.e., one bond can be converted into initial margin payable.
four shares
Conversion period After July 1, 2009, till December 31, 2009   9. Put options are selling at INR 80 on Tata Steel shares with
exercise price of INR 400 and exercise date of September 29.
On December 31, 2009, the share price of Assam Tea is INR 310. Tata Steel shares are selling at INR 430 on September 1. The
(i)  Should the bondholders convert the bonds? options contract size is 764 shares. You write five options on
(ii) What will be the adjustment in the balance sheet of Tata Steel shares. On September 1, the upside theoretical
Assam Tea on December 31 if all the bondholders decide price of the option is INR 88 and the downside price is INR
to convert these bonds? 74. The assignment margin is INR 12,000. Calculate the
initial margin payable.
4. Prime Fund invests in bonds of various companies. Two major
10. Tata Steel shares are selling at INR 430 on July 1 and new
investments on July 1, 2009, are:
options contracts will be introduced that day.
(a)  Ten-year 8% coupon callable bond issued by Metro
Chemicals on July 1, 2006, for INR 5 million to yield 12%   (i) How many options contracts will be introduced on
at the time of issue, with a call price of INR 1,040. July 1, and at what exercise prices and exercise dates?
(b) Six-year 10% coupon put bond issued by Hindustan   (ii) On July 5, Tata Steel price increases to INR 444. How
Textiles on March 1, 2008, for INR 3 million to yield 8% many new contracts will be introduced on July 5?
at the time of issue.
11. The CNX Nifty index is at 4,600 on November 1, and new
  (i) Assume that the yield to maturity on both these bonds options contracts will be introduced that day.
is 10% on July 1, 2009. Since the yield to maturity on the   (i) How many options contracts will be introduced on
callable bond has decreased, Metro Chemicals decides November 1, and at what exercise prices and exercise
to call the bond. What will be the cash flow to Prime dates?
Fund if Metro Chemicals calls the bonds?   (ii) On November 10, the CNX Nifty index decreases to
  (ii) Assume that the yield to maturity on both these bonds INR 4,440. How many new contracts will be introduced
is 10% on July 1, 2009. Since the yield to maturity on the on July 5?
put bond has increased, Prime Fund decides to redeem
the bond. What will be the cash flow to Prime Fund if 12. Indian Textiles has 1 million outstanding shares and the
Prime Fund redeems the bonds? share price on September 1 is INR 560. Call options with
expiry on November 28 are available with an exercise price
  5. Indus Valley Corporation has 25 million outstanding shares of INR 600 and are selling at INR 35. The contract size is 950.
on July 1, 2009, and these are selling at INR 278 each. Indus On October 1, Indian Textiles announces a bonus issue of
Valley is planning to issue additional 1 million shares through additional 200,000 shares with the holder-of-record date of

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 160   Derivatives and Risk Management

October 5. What will be the adjustment to option terms on option has an exercise price of INR 2,400 and an exercise date
October 5? of March 31 and is priced at INR 68.

13. 
Bharat Chemicals has 2 million outstanding shares, and   (i) On March 1, the State Bank of India announces a cash
these shares are selling at INR 1,480 each on July 1. Call dividend of INR 500 with the stock going ex-dividend
options are available on Bharat Chemicals with exercise on March 15. It is expected that the ex-dividend stock
price of INR 1,500 and exercise date of September 30. The price would decrease by INR 500, which is the amount
call options are selling at INR 80. The contract size is 600. of cash dividend. What would be the adjustment in
Bharat Chemicals announces a cash dividend of INR 300 on option terms when the State Bank of India pays cash
August 1 with a holder-of-record date of August 8. What will dividends?
be the adjustment to option terms?   (ii) On March 1, the State Bank of India announces that
it would have a three-for-one stock split with effect
14. On January 1, you buy a call option on the shares of the State from March 15. What would be the adjustment in
Bank of India. The share price is INR 2,350 on January 1. The option terms when the State Bank of India splits its
option is written on 132 shares of the State Bank of India. The stock?

   C a se S tudy

Ram entered the Indian government service and was working in In early 2009, Ram’s brother Raj, who lives in the USA and
Tamil Nadu for over 20 years. He held a number of important po- is a professor of finance, visited Ram. When Ram explained his
sitions such as the Chairman of Tamil Nadu Corporations. After predicament, Raj told Ram that he should have gone into options
20 years of service, he decided to retire from government service rather than futures, as futures were comparatively more risky and
and start his own business. Journalism was always his passion can lead to huge losses.
and he was looking for an opportunity to enter into journalism. Ram had a number of questions for Raj, and Raj told him that
When he visited his brother in the USA, he came across a neigh- all these questions can be easily answered by his students who take
bourhood newspaper that reported various happenings in that his course on derivatives.
neighbourhood as well as the details of the various businesses
operating in that neighbourhood. The newspaper was funded by Discussion Questions
advertisements. This appealed to Ram, and he decided to start a
1. Why is trading in futures more risky when compared to trad-
similar venture in Chennai.
ing in options?
This venture turned out to be a huge success. Financed through
2. If I buy a November futures contract on the ICICI Bank at
advertisements from the local businesses, this weekly newspaper INR 1,250, I agree to buy ICICI Bank shares at INR 1,250.
contained articles highlighting the achievements of local families The contract size for ICICI futures and options is 350. How-
and children and details of local events. This newspaper was ever, when I look at the option, there are a number of options
distributed to all the households in that area. trading in the market, some are called call options and some
With the profits earned through this venture, Ram decided are called put options, and their prices are very low. For ex-
to make investments. Originally, most of his investments were ample, the November call at INR 1,250 is selling for INR 70
in mutual funds, and when the Indian market was doing well, and the November put at INR 1,250 is selling for INR 140.
he was getting a high return on these investments. He was not The contract size for ICICI futures and options is 350 shares.
satisfied with this investment performance and decided to trade in What do these mean? What will be the price at which I can
derivatives. Since options sounded very complicated, he went on buy the ICICI Bank shares? At what price can I sell them?
to trade in futures. 3. In the case of futures, I need to post a margin. Do I need to
Even though he did not know much about futures, he post a margin in the case of options?
formulated a simple rule. He would take a long position in the 4. In the case of futures, I have a strategy of closing the posi-
futures on a single stock, which he believed would increase in tion whenever I make INR 1,000. Can I also do the same with
price. Then he would close the position if the future prices move options?
up, so that he can make at least INR 1,000 and take the profits. In 5. I enter into a long November futures contract at INR 1,250. I
case the price does not increase as expected, he would close the also enter into an options contract to buy ICICI Bank shares
position after two days and take whatever be the result, even if it is at INR 1,250. The option price is INR 70. On November 28,
ICICI Bank shares sell at INR 1,300. What will be my gain or
a loss. From 2004 to 2007, this worked when the market was doing
loss from futures? What will be my gain or loss from options?
well and most stocks were increasing in prices. However, when the
6. In case the ICICI Bank announces a stock split of 5:2, that is,
market started doing poorly from the middle of 2008, this strategy
for every two shares currently owned, five new shares will be
resulted in huge losses, and at one point of time, he had lost more
issued. Will the options contract remain the same or will it
than INR 1.5 million in a month. change? How will the option terms change?

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 8
Call and put Options

LEARNING OBJECTIVES

After completing this chapter, you In April 2008, STC entered into an agreement on behalf of the
will be able to answer the following Government of India to purchase a call option on 180,000 MT of
questions: wheat from Cargill International at an exercise price of USD 406
What

are call options? per MT with an exercise date of July 15 to hedge the uncertainty
in the domestic production of wheat. The call premium paid was
What is meant by the in-the-

USD 35 per MT. In case the Government does not take delivery
money value and the time
using the call option, it will forfeit the USD 6.3 million paid for
value of a call option?
the call option. The exercise date of July 15 was chosen so that
Would an American call
 the government will be reasonably certainty about the domestic
option be exercised before production by that time. If the delivery is taken, wheat would arrive
maturity? within 75 days.
When would a trader buy or

Source: G. Chandrashekhar, “Govt Buys Wheat on ‘Call Option’ from
write a call option? Cargill at USD 406/tonne,” The Hindu Business Line, April 6, 2008.
What are put options?

What is meant by the in-the-

money value and the time BOX 8.1 Government Uses a “Call Option” to Buy Wheat
value of a put option?
Would an American put

option be exercised before
maturity?
When would a trader buy or

write a put option?

In Chapter 7, the basics of options, options terminologies, and the procedure to trade options were
discussed. The details of what call and put options are and how these options derive value are discussed
in this chapter.

8.1 What are Call Options?

A call option provides the right to buy the underlying security at a fixed price, known as the exercise
price, at a specified future time, known as the exercise date. Call options can be of either the American
type or the European type.

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 162   Financial Risk Management

Notes An American call option can be defined as the right to buy the underlying asset at the exercise price
on or before the exercise date. A European call option can be defined as the right to buy the underlying
asset at the exercise price on the exercise date only.
Thus, American options provide the call buyer with more choices in terms of when the option can be
exercised, as opposed to European options, which can be exercised only on the exercise date.
While exchange-listed call options on stocks are of the American type, exchange-traded index options
and most of the over-the-counter options are usually of the European type.
In the case of call options on individual stocks, the underlying asset is a fixed number of shares, and in
the Indian exchanges, the contract size for call options on different stocks are specified by the exchange.
For example, the call options contract size for ONGC stock is 225, while the call options contract size for
Hindustan Unilever stock is 1,000. However, when talking about options, it is customary to talk in terms
of a single share. Thus, a Hindustan Unilever call option price of INR 12.65 means that it costs INR 12.65
to purchase an option for each share of Hindustan Unilever, and since each option is written on 1,000
shares, the actual cost of buying the option is INR 12,650. Call options are settled in cash. For example, if
you buy a call option on Hindustan Unilever at an exercise price of INR 265 and if on the maturity date,
the Hindustan Unilever stock price is INR 300, you would receive an amount of (300 – 265) × 1,000 =
INR 35,000.
STOCK index call options are settled in cash. However, the pay-off for stock index options typically
involves a multiplier. For example, the multiplier for an S&P CNX Nifty index option is 50. Assume that
the value of a CNX Nifty index on January 1 is 5,000 and there is a March call option on this index with an
exercise price of 5,400. In March, if the actual index value is 5,800, it will be profitable to exercise. Upon
exercise, the buyer will receive (5,800 – 5,400) × 50 = INR 20,000 and the call writer will pay INR 20,000
and the settlement will be in cash.
It is important to know why call options exist. As discussed in Chapter 1, all business organizations
face commodity price risk, currency exchange rate risk, interest rate risk, and risk of changes in the prices
of securities in the security market. In order to hedge this risk, derivative securities have been developed.
Futures and forwards help to hedge the downside risk, but if the price moves in favour of the hedger,
futures and forwards would result in a notional loss. On the other hand, options would help the hedger
to hedge the downside risk and at the same time allow the hedger to benefit if the price moves in favour
of the hedger. Depending upon the nature of exposure to the risk, the hedger will face risk under both
scenarios, increase in the price in the market as well as decrease in the price in the market. For example,
if a person is planning to invest in a stock at a future time, they face the risk of not knowing what price
they may have to pay for the stock. Here, they are concerned with increases in price, as they will be forced
to pay a higher price for the stock. On the other hand, if the stock price decreases, they would be able to
buy the stock at a lower price. Thus, they would make a loss if the price increases and make a gain if the
price decreases. To hedge this risk of increase in prices and at the same time benefit from falling prices,
they can enter into a call options contract. Buying a call option provides the hedger the right to buy the
stock at a fixed price. If the actual market price is higher than this fixed exercise price, they would exercise
and buy the stock at the exercise price. Since the exercise price is known at the time of entering into a call
option contract, there is no risk for the hedger, as the maximum price they would pay for the stock would
be the exercise price. In the case where the market price is lower than the exercise price, the hedger will let
the call expire without exercise and buy the stock at the lower market price. Thus, the buyer a call option
can fix the maximum price that he will pay for the stock.
Call options are also available on interest rates, currency exchange rates, commodities, and futures
contracts. Interest rate call options are used by hedgers who plan to borrow in the future, and these pro-
vide the maximum interest rate that the hedger will pay on future borrowings; currency call options are
used by hedgers who are exposed to foreign currency risk at a future time, and these can fix the maximum
exchange rate through currency options. Box 8.1 shows an options contract on wheat entered into by the
Government of India.

  Example 8.1
Assume that on January 1, the price of Ashok Leyland shares is INR 39. If you buy 9,550 shares of Ashok
Leyland today, your investment would be INR 372,450. You are not sure of what the share price of

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 Call and Put Options   163

Notes Ashok Leyland will be on March 31. Let us consider two scenarios, the first where the price increases to
INR 55 and the second where it drops to INR 25. The gain and loss are given in Table 8.1.

Table 8.1  Gains and Losses from Buying a Share

Stock Price of INR 25 Stock Price of INR 55

Price paid for the share INR 39 INR 39

Gain per share –INR 14 +INR 16

Gain for 9,550 shares –133,700 +152,800

Return on Investment over three months –35.9% 41.0%

  Suppose there exists a call option on Ashok Leyland with an exercise price of INR 45 and it costs INR
2.35 to buy that option. When buying a call with an exercise price of INR 45, the call buyer can use the
option and buy the shares at INR 45. It is clear that the call buyer will exercise the option only when the
share price is more than INR 45. If the share price is more than INR 45, the option buyer will gain INR 1
for each INR 1 increase in the share price beyond INR 45. On the other hand, if the share price is less than
INR 45, the call buyer will not exercise the option and let it expire, because it will be cheaper to buy the
share in the market instead of exercising the option and buying it at the exercise price of INR 45. In this
example, the call option will be exercised when the share price is INR 55 and the gain will be INR 10 per
share. However, the actual gain is only INR 7.65, as the buyer would have paid INR 2.35 per share while
purchasing the option. The total gain will be INR 73,057.50 (7.65 × 9,550). When the share price is INR
25, the call option will not be exercised and the call buyer will have lost the total amount paid to buy the
call option, which would be INR 22,422.50 (2.35 × 9,550). In this case, the pay-off from the call option
position will be as shown in Table 8.2.

Table 8.2  Gains and Losses from Buying a Call Option

Stock Price of Stock Price of

INR 25 (in INR) INR 55 (in INR)

Price paid for the call option 22,422.50 22,422.50

Gain per share –2.35 7.65

Net gain or loss –22,422.50 73,057.50

Return on investment –100% 325.5%

Example 8.1 shows that investing in call options provides leverage and it is possible to achieve higher
returns by investing in options when compared to investing directly in shares. However, if the share price
decreases, the total investment will be lost.
Thus, from the buyers’ point of view, call options are good if the prices of the underlying assets are
likely to increase beyond the sum of the exercise price and the premium paid for buying the option.
From the writers’ point of view, the writer would receive the option price upon writing the option. If
there is no exercise, the call option writers will gain the option premium they received. If there is exercise,
writes will face a loss which will equal (exercise price – stock price – option premium received). This is
shown in Table 8.3.
Tables 8.2 and 8.3 shows that a call option is a bet between the buyer and the writer of the call option.
The buyer of the option is betting that the share price on the expiration date of the option will be beyond
the sum of the exercise price and the option premium, so that they can make money. The writer, on the
other hand, is betting that the share price will not go beyond the sum of the exercise price and the option
premium on the expiration date.

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Notes Table 8.3  Gains and Losses from Writing a Call Option

Stock Price of INR 25 (in INR) Stock price of INR 55 (in INR)

Price received 22,422.50 22,422.50

Gain 22,422.50 –73,057.50

In Example 8.1, the buyer of an Ashok Leyland call option is betting that the price of Ashok Leyland
shares will go beyond INR 47.35, which is Exercise price + Option premium paid = INR 45 + INR 2.35 =
INR 47.35, while the writer is betting that the price will not go beyond INR 47.35.

8.2  The Terminal Value of a Call Option

The value of a call option on the exercise date is known as its terminal value. Consider a European option
on the date of maturity. Since it is a European option, it can be exercised only on the exercise date, and
in order to decide whether the buyer should exercise or not, it is important for them to know the value
of the call option at that time. Thus, the terminal value of a call option is important from that point of
view. When an investor buys a call option, they get the right to buy the underlying share and there is no
obligation on their part to exercise the right to buy the share. Thus, the buyer will exercise the option and
buy the share at the fixed price only if it is profitable.
When will a call option be exercised? It is clear that a call option will never be exercised as long as the
market price of the share is less than the exercise price. This is because the buyer of the call option needs
to pay the exercise price to buy the share if they exercise, whereas the share can be purchased for a lower
price in the market without exercising the option.
In Example 8.1, if the exercise price is INR 45 and the market price of Ashok Leyland is less than INR
45, say, INR 41, the holder of the option will have to pay INR 45 if they exercise the option and buy the
share. On the other hand, they can buy the share in the market for INR 41. Thus, it is not profitable to
exercise the option if the share price is less than the exercise price.
If the share price is higher than the exercise price, it is advisable to exercise the option and buy the
share at the exercise price, rather than to buy it at a higher market price. If the option holder does exercise
this option, they will gain the difference between the share price and the exercise price.
For example, if the market price of Ashok Leyland is INR 50, the holder of the call option can exercise
and buy an Ashok Leyland share at INR 50 from the option writer and sell this share at INR 50 in the
market to make a gain of INR 5. Since there is only cash settlement, the buyer of the call option would
receive INR 5 per share of Ashok Leyland or INR 47,750 per contract of 9,550 shares.
This shows that the terminal value of a call option depends upon the relationship between the share
price and the exercise price on the terminal date or expiry date.
Case 1: If the exercise price (SX) > terminal stock price (ST), do not exercise; the value of the call option
is zero.
Case 2: If the exercise price (SX) < terminal stock price (ST), exercise; the value of the call option is (ST – SX).
Since exercise takes place only when it is profitable to the holder, (if it is not profitable to exercise,
the holder will let the call option expire without exercise), the minimum value of the call option is zero
and the maximum value will be the difference between the share price and the exercise price. Thus, the
terminal value can be written as follows:
Terminal value = (ST – SX) if ST > SX
and
Terminal value = 0  if  ST < SX
This can be shortened to:
Terminal value of a call = Max (ST – SX, 0)

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Notes This shows that when ST is greater than SX , the option will be exercised and the value will be the difference
between ST and SX, which is positive. However, if ST is less than SX, then (ST – SX) will be negative, but the
option will not be exercised. This leaves the value of the option to be zero, which is greater than (ST – SX ).

  Example 8.2
Assume that the price of a share of Maruti Udyog stock is INR 1,470 on January 1 and there is a call op-
tion with maturity in January with a maturity date of January 31 and an exercise price of INR 1,500. Even
though a call option is written on 200 shares of Maruti, we will calculate the terminal value on a per-share
basis. We can calculate the terminal value of the call option for different prices of Maruti Udyog shares on
the option expiration date. This is shown in Table 8.4 and Fig. 8.1.

Table 8.4  Terminal Value of a Call Option (SX = INR 1,000)

Terminal Stock Option Value

Action
Price (ST) (INR) Max (ST – SX , 0)

1,340 Do not exercise 0

1,380 Do not exercise 0

1,420 Do not exercise 0

1,460 Do not exercise 0

1,500 Exercise/Do not exercise 0

1,540 Exercise 40

1,580 Exercise 80

1,620 Exercise 120

1,650 Exercise 150


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Figure 8.1  Terminal Value of a Bought Call

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Notes 8.3  Gains and Losses from Purchasing Call Options

When one purchases a European call option, they would like to know the profit or loss that will be made
on the exercise date, when the call option is exercised, and when it is not exercised. In this section, we will
discuss how the profit or loss from buying a call option can be calculated in both cases, namely, when the
call is exercised and when it is not exercised.
Earlier, we saw that the terminal value of a call option is:
CT = Max (ST – SX, 0)
The terminal value shows the worth of the call option on the exercise date. However, the buyer of a call
option will have to pay the price of the option at the time of buying. Therefore, the gain from buying a
call would be the difference between the terminal value and the price paid for the option. Thus, gains and
losses from buying a call option can be written as:
GC = Max [(ST – SX – C0), –C0],
where C0 is the price paid for the option.
This shows that the gain for the option buyer is the difference between the terminal value of the call
option and the price paid for the option. If the option is exercised, the share price will be higher than
the exercise price and the gain would depend on the extent to which the share price is higher than the
exercise price. If the difference between the share price and the exercise price is less than the price paid
for the option, the call buyer would still make a loss, but it would be less than the price paid for the call.
If the difference between the share price and exercise price is more than the price paid for the option, the
call buyer will start making profits. If the option is not exercised, the call buyer will lose the entire amount
they paid for buying the call option, which is C0. Therefore, the maximum loss for the option buyer will
be C0, which is incurred only upon failure to exercise.
Thus, if the option is exercised, there could be a loss or gain to the person who exercises this option,
and this loss or gain is based on the price of the underlying asset. There will be a loss if the stock price is
between SX and (SX + C0). If the stock price at maturity is more than (SX + C0), then the option buyer will
make a positive gain. However, the maximum loss would be the amount paid for the option, C0.

  Example 8.3
Assume that the price of a share of Maruti Udyog stock is INR 1,470 on January 1 and there is a call option
with maturity in January with a maturity date of January 31 and an exercise price of INR 1,500. The call op-
tion is selling at INR 84.75. Even though a call option is written on 200 shares of Maruti, we will calculate
the terminal value on a per-share basis. We can calculate the gains and losses from buying a call option for
different prices of Maruti Udyog shares on the option expiration date. This is shown in Table 8.5 and Fig. 8.2.

Table 8.5  Gains and Losses from Buying Call Options (SX = INR 1,000)

Option Value Max Option Premium Gain Max [(ST –

Stock Price (INR)
(ST – SX , 0) (INR) Paid C0 (INR) SX – C0), –C0] (INR)
1,340 0 84.75 –84.75
1,380 0 84.75 –84.75
1,420 0 84.75 –84.75
1,460 0 84.75 –84.75
1,500 0 84.75 –84.75
1,540 40 84.75 –44.75
1,580 80 84.75 –4.75
1,620 120 84.75 35.25
1,650 150 84.75 65.25

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 Call and Put Options   167


Notes


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Figure 8.2  Gains and Losses from a Bought Call

8.4  Value of a Call Option Before Maturity

In Sections 8.2 and 8.3, we discussed the value of a European call option on the exercise date and gains
and losses from buying a call option if the option is held till the exercise date. Since options exist from
the time they start trading till their maturity, one would like to know the possible values of a call prior to
their maturity dates. In this section, we would discuss the factors that affect the value of a European call
option before its maturity.
Consider a January call option on Maruti Udyog stock with an exercise price of INR 1,500 and an
expiry date of January 31. The stock price on January 1 is INR 1,470. During the 30-day period before the
expiration date, the price of a Maruti Udyog share can move in either direction, going below INR 1,470
or above INR 1,500.
Suppose on January 7, the Maruti Udyog share price is INR 1,520. On this date, the share price is
above the exercise price. Whenever the stock price is above the exercise price, the call option is said to
be in-the-money and such options are called in-the-money call options. The in-the-money value of a
call option is calculated as the difference between the share price and the exercise price. The in-the-
money value of a call option is also called the intrinsic value of the call option. In our example, the
in-the-money value or the intrinsic value of the Maruti Udyog call on January 7 is INR 20 (INR 1,520 –
INR 1,500).
What happens if the share price of Maruti Udyog on June 7 is INR 1,470? Now, the share price is below
the exercise price and the call option is said to be out-of-money and such options are called out-of-money
options. When the option is out-of-money, its intrinsic value is zero, as the value of an option can never
be negative.
If the stock price is close to the exercise price, the option is said to be near-the-money or at-the-money.
Thus, the option will be at-the money if the Maruti Udyog stock price is around INR 1,500.
If the difference between the share price and exercise price is very large, then the options are said to
be either deep-in-the-money or deep-out-of-money, depending on whether the share price is higher or the
exercise price is higher. For example, if the exercise price is INR 1,500 and the share price is INR 1,600,
the option is deep-in-the-money, as the share price is higher than the exercise price. If the share price is
INR 1,400 instead, the call option will be deep-out-of-money.
We have seen that the intrinsic value of a call option is equal to the difference between the share price
and the exercise price if the option is in-the-money and is equal to zero if it is out-of-money. What would
be the actual value of the call option on that day?
The intrinsic value of a call option at any time t, can be written as,
Intrinsic value of a call = Max (St – SX , 0)

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Notes



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Figure 8.3  Value of a Call Option Before Expiry

What will be the price of the call option on January 7 when the share price is INR 1,520? As we saw earlier,
the intrinsic value of the call is INR 20. That is, if the call option is American, an investor can exercise
the call to gain INR 20 per share. However, the price of the call option will be higher than INR 20 in the
market. Why is this so?
The option expires on January 31, and it is just January 7. Since the option has a life of another 24
days till January 31, there is a good chance that the share price might exceed the current price of INR
1,520. The purchasers of the call options will consider this possibility of higher share prices by January 31
and, therefore, would be willing to pay some amount for this possibility. The amount the option buyers
are willing to pay for the possible increase in the stock price over time is called the time value of the call
option.
Thus, the value of the call option before maturity is made of two components:
1. the intrinsic value of the call option, and
2. the time value of the call option.
Value of the call before maturity = Intrinsic value + Time value
This relationship shows that a call option will always have a positive value, as the time value is always
positive, except on the maturity date of the option, when the time value will be zero.
Note that the time value of a call depends on the probability of an increase in the share price and is
dependent on the variability of the stock price and time remaining until maturity. The call value before
maturity can be shown diagrammatically, as shown in Fig. 8.3.
In Fig. 8.3, the inner curve shows the actual value of the call, while the outer line shows the intrinsic
value of the call. This diagram shows that the time value of a call is maximum when the call is at-the-
money and it is near zero for deep-in-the-money and deep-out-of-money options.

8.5 Minimum and Maximum Values of a Call

As was shown earlier, the minimum value of a call at any time can be written as,
Ct = Max (St – SX, 0)
This is because the minimum value expressed above is the intrinsic value of the call. This is also known as
the lower bound of the call option value.

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Figure 8.4 Lower and Upper Bounds for a Call Option

The maximum value of a call is the stock price, because the maximum an option buyer will be willing
to pay for the option is the price of the stock. This is because a call option gives the right to buy the stock
at the exercise price and no one would be willing to pay more than the stock price for buying that option.
This is known as the upper bound of the call option value.
The lower and upper bounds of the call option are shown in Fig. 8.4.

8.6  When to Exercise an American Call Option

If the call option is a European option, there is a simple rule to decide whether the option should be
exercised or not. Since a European call can be exercised only upon maturity, this rule can be stated as:
Exercise if ST > SX
Do not exercise  if  ST ≤ SX
However, in the case of an American option, should a call option be exercised whenever the stock price is
greater than the exercise price? In Example 8.3, suppose that on January 7, the Maruti Udyog share price
is INR 1,550, should you exercise the call?
If you exercise, you would gain INR 50, which is the difference between the share price of INR 1,550
and the exercise price of INR 1,500. This is the intrinsic value of the call option. However, consider what
you would receive if you decided to sell the call option, instead of exercising it.
We saw earlier that the call price comprises two values, namely, intrinsic value and time value, and
the price of the call option before maturity will always be greater than its intrinsic value. On maturity,
the price of the option will be equal to the intrinsic value, as the time value is zero. Thus, the price of this
call option will be greater than INR 50, and an option holder will be better off selling the option than
by exercising it. Suppose that the time value of this option is INR 20, so that the call option is selling for
INR 70 in the market. If the option holder exercises the option, they will receive INR 50, whereas if they
sell the call option, the cash inflow will be INR 70. Thus, it is not advantageous to exercise the call option
before maturity.
Does this mean that you should never exercise an American call option before maturity? No! If the
company pays a substantial cash dividend, the ex-dividend price of the share is likely to decrease by the
amount of dividend. This would reduce the intrinsic value, and thus, the value of the option. It would also
reduce the time value of the option, as the share price will have to increase substantially in order to be
in-the-money at the expiry date. In this case, it is likely that the time value of a call option may become
negative. Therefore, it would be appropriate to exercise an American call option that is in-the-money
just before the ex-dividend date. Thus, the rule for exercising an American call option can be written as:

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Notes 1. Do not exercise before maturity if the share does not pay any cash dividend.
2. Exercise the call option if it is in-the-money just before the ex-dividend date if the company pays
substantial cash dividends and the time value of the option is negative.
However, a few cautions are in order.
1. Even though the call option is in-the-money at present, there is no guarantee that the call option
would be in-the-money on the exercise date. If the investors believe that the share price is likely to
decrease because of some reason, it is quite likely that the call option is priced such that it has a nega-
tive time value, that is, the market price of the call is less than its intrinsic value. In that case, it would
be better to exercise the option, rather than sell it.
2. If the cash dividend is substantially large, the exchange may decide to change the specifications of the
options contract by altering the exercise price. In that case, one has to recalculate the intrinsic value
of the option on the basis of the new exercise price for the share price after the dividend is announced
and compare this intrinsic value with the option price in the market. One would exercise the call
option before maturity only if the option price is less than the new intrinsic value or when the call
option has a negative time value.

8.7  From a Call Option Writer’s Point of View

In call options, the decision to exercise the option lies with its buyer. The writer has the obligation to sell
the share at the exercise price if the option buyer exercises their right. Thus, the terminal value of a writ-
ten call as well as the gains and losses from a written call depend upon the action of the buyer.

8.7.1  The Terminal Value of a Written Call

If the buyer does not exercise the call, the writer has no obligation to sell the share and hence the writer
is not affected. Thus, the value of a written call is zero as long as it is not exercised.
If the call is exercised, it is clear that the call is in-the-money. Thus, the share price in the market is
higher than the exercise price. When the writer is writing a call, it is possible that they own the underly-
ing share at the time of writing, but it is also possible that they do not. If they do not already own the
underlying share, they are said to have written a naked call. If they write a call on the shares they already
own, they are said to have written a covered call.
If they write a naked call, it means that they have to buy the underlying shares at the market price and
then sell to the option buyer at the exercise price if the call is exercised. Since the market price is higher
than the exercise price at the time of exercise, the value of the written call will be the difference between
SX and ST , which will be negative.
If they write a covered call, it means that although they could have sold the underlying shares at the
market price, they are forced to sell it at the lower exercise price. Again, the value of the written call will
be the difference between SX and ST , which will be negative.
Regardless of whether the writer has written a naked call or a covered call, the value of the written
call will always be negative and will be equal to the difference between the share price and the exercise
price if the call is in-the-money and is exercised. On the other hand, if the call is out-of-money and is not
exercised, the value of the written call will be zero.
Thus, the terminal value of the written call can be written as:
CW,T = Min (SX – ST , 0)

  Example 8.4
Consider the case of writing call options on Cipla shares. Each option is based on 1,250 shares of Cipla.
Assume that on July 1, the Cipla share price is INR 270 and you are writing a call option with an exercise
price of INR 300 and an exercise date of September 28. The option premium for this call option is INR
6.40. The terminal value of a written call for this example is shown in Table 8.6 and Fig. 8.5.

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Notes Table 8.6  Terminal Value of a Written Call Option (SX = INR 260)

Terminal Stock Price (ST) (INR) Option Value Min (SX – ST , 0) (INR)

230 0
250 0
270 0
290 0
300 0
310 –10
330 –30
350 –50
370 –70


       
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Figure 8.5  Terminal Value of a Written Call 

  In Table 8.6, the option value is zero when the stock price is less than the exercise price, because the
option buyer would not exercise the option. When the stock price is above the exercise price, the option
buyer will exercise the option and hence the value of the written call option will be negative.

8.7.2 Gains and Losses for a Call Writer

When the call writer writes a call, they receive the option price immediately. The gain or loss on the exer-
cise date will depend on whether the call buyer exercises the call or not. The gain or loss on the terminal
date is given by the terminal value of the written call. The net gain or loss would be the sum of the option
price received and the terminal value. Thus, the gains and losses for a call writer can be written as
GWC = Min [C0, C0 – (SX – ST) ]

  Example 8.5
Consider the case of writing call options on Cipla shares. Each option is based on 1,250 shares of Cipla.
Assume that on July 1, the Cipla share price is INR 270 and you are writing a call option with an exercise
price of INR 300 and an exercise date of September 28. The option premium for this call option is INR 6.40.
Table 8.7 and Fig. 8.6 show the gains for a call writer.

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Notes Table 8.7  Gains and Losses from Writing Call Options

Option Value Min Gain Min

Stock price (ST) (INR)
(SX – ST , 0) (INR) [C0, C0 – (SX – ST )] (INR)

230 0 6.4

250 0 6.4

270 0 6.4

290 0 6.4

300 0 6.4

310 –10 –3.6

330 –30 –23.6

350 –50 –43.6

370 –70 –63.6




       
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Figure 8.6  Gains and Losses to the Call Writer

This shows that the maximum gain for a call writer is C0, which is the option price received at the time
of writing the call. However, the losses could be high if the stock price increases substantially.

Prob l e m 8 . 1
SBI shares are selling on January 1 at INR 2,500. Call options are available on SBI shares with expiry on January 29
and exercise price of INR 2,600. These options are priced at INR 70. The contract size is 132. These are American
options and these options are not expected to pay any dividends during January.

(i) At what share price on January 29 would you exercise these call options?
(ii) Would you exercise these call options if the share price on January 17 is INR 2,640?
(iii) Calculate the terminal value of these call options (in terms of per share) for SBI share prices of INR 2,400,
INR 2,500, INR 2,600, INR 2,700 and INR 2,800.
(iv) Calculate the gains and losses for the call buyer if SBI share prices of INR 2,400, INR 2,500, INR 2,600,
INR 2,700, and INR 2,800.
(v) Calculate the gains and losses for the call writer if SBI share prices of INR 2,400, INR 2,500, INR 2,600,
INR 2,700, and INR 2,800.

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 Call and Put Options   173

Notes Solution to Problem 8.1

(i) Since the exercise price of the call option is INR 2,600, call option will be exercised only if the SBI share price
is more than INR 2,600.
(ii) Since SBI is not expected to pay dividends during January, the option price on January 17 would be more than
its in-the-money value of INR 40. Therefore, it is better to sell the option rather than exercise the option. Thus,
the option will not be exercised on January 17.
(iii) The terminal values of call are shown below:

Terminal Share Price Action Terminal Value of Option

2,400 Do not exercise   0

2,500 Do not exercise   0

2,600 Exercise/Do not exercise   0

2,700 Exercise 100

2,800 Do not exercise 200

(iv) Gain to Call Buyer

   Since the contract size is 132, gain will have to be calculated for 132 shares. Gain for the call buyer is (–132 ×
call premium) if call is not exercised and [(Share price – Exercise price – Call premium) × 132] if call is exercised.

Terminal Share Price Action Gain (in INR)

2,400 Do not exercise –132 × 70 = –9240

2,500 Do not exercise –132 × 70 = –9240

2,600 Exercise/ Do not exercise –132 × 70 = –9240

2,700 Exercise 132 × (2700 – 2600 – 70) = 3,960

2,800 Exercise/Do not exercise 132 × (2800 – 2600 – 70) = 17,160

(v) Gain to Call Writer

   Since the contract size is 132, gain will have to be calculated for 132 shares. Gain for the call writer is (132 × call
premium) if call is not exercised and –[(Share price – Exercise price – Call premium) × 132] if call is exercised.

Terminal Share Price Action Gain (in INR)

2,400 Do not exercise 132 × 70 = 9240

2,500 Do not exercise 132 × 70 = 9240

2,600 Exercise/Do not exercise 132 × 70 = 9240

2,700 Exercise –132 × (2700 – 2600 – 70) = –3,960

2,800 Exercise –132 × (2800 – 2600 – 70) = –17,160

8.8 Comparison Between the Gains Made by a Call Buyer

and a Call Writer
For an option buyer, the maximum loss is the option price that they paid for buying the option, and the
gain is unlimited (in the sense that it depends on how high the share price can go at the time of maturity).

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Notes

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Figure 8.7  Terminal Value of a Bought and Written Call

For the option writer, the gain is the maximum option price that they received at the time of writing
the call, but the loss can be quite high.
Figure 8.7 shows the terminal value of a bought call and a written call and Fig. 8.8 shows the gains for
a call option buyer and for a call option writer for Example 8.5.
From these figures, it can be seen that the terminal value of a bought call is the mirror image of that
for a written call and the gains to the call option buyer is the mirror image of the gains to the call writer.
This shows that a call option results in a zero-sum game between the call option buyer and the call option
writer. This is because the total loss borne by the call option buyer forms the gain for the call option writer
and all the gains made by the call buyer are equal to the loss for the call option writer.

8.9  When to Buy and When to Write a Call Option?

When a person buys a call option, they gain only if the share price is expected to increase. However, the
call buyer would make a positive gain only when the share price is more than the sum of the exercise price
and the price paid for the option. If SX is the exercise price and C0 is the price paid for the option, a call
option would be bought only when the share price ST is expected to be more than (SX + C0). For example,






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Figure 8.8  Gains and Losses to a Call Buyer and a Call Writer

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 Call and Put Options   175

Notes if the exercise price is INR 260 and the call option price is INR 30, a person will buy a call option only
when they expect the share price to go beyond INR 290 (INR 260 + INR 30).
A call writer gains as long as the share price does not go beyond the sum of the exercise price and the
option price, or as long as ST is less than (SX + C0). Thus, a person will write a call only when they believe
that the share price will not increase beyond INR 290 (INR 260 + INR 30).
Note that the belief about the movement of stock prices could be different for the call option writer
and the call option buyer. While the call option buyer always believes that the stock price would increase
and go beyond (SX + C0), the call option writer believes that the stock price may either decrease or even
increase and that if it increases, it will not go beyond (SX + C0).

8.10 Put Options
So far we looked at the factors that influence the value of call options. In the next sections, we will discuss
the factors that affect the value of put options.

8.10.1  What Are Put Options?

A put option provides the right to sell the underlying security at a fixed price, known as the exercise price,
at a specified time in the future, known as the exercise date. Put options can be of either the American
type or European type.
An American put option can be defined as the right to sell an underlying asset at the exercise price on
or before the exercise date.
A European put option can be defined as the right to sell an underlying asset at the exercise price on
the exercise date only.
Thus, American options provide the put buyer with more choices as to when the option can be exer-
cised, as opposed to European options, which can be exercised only on the exercise date.
Typically, with put options on individual stocks, the underlying asset is a fixed number of shares, and
in Indian exchanges, the contract size for put options on different stocks are specified by the exchange.
For example, the put options contract size for Bank of India stock is 950, while the contract size for put
options on Bharti Airtel stock is 250. However, while talking about options, it is customary to talk in
terms of a single share. Thus, a Bank of India put option price of INR 14 means that it costs INR 14 to pur-
chase the option for each share of Bank of India, and since each option is written on 900 shares, the actual
cost of buying the option is INR 12,600. The settlement of put options is in terms of cash. For example, if
you buy a put option on the Bank of India at an exercise price of INR 340 and if on the maturity date, the
Bank of India stock price is INR 320, you would receive an amount of (340 – 320) × 950 = INR 19,000.
In the case of stock index put options, the settlement will be in terms of cash. However, the pay-off of
the stock index put options typically involves a multiplier. For example, the multiplier for the Bank Nifty
index options is 50. Assume that the value of the Bank Nifty index is 7,400 on January 1 and there is a
March put option on this index with an exercise price of 7,500. In March, if the actual index value is 7,200,
it is profitable to exercise. Upon exercise, the buyer will receive (7,500 – 7,200) × 50 = INR 15,000 and the
put writer will pay INR 15,000 and the settlement will be in cash.
While exchange-listed put options on stocks are American, most over-the-counter options are
European. Index put options traded on exchanges are also European.

8.10.2 Rationale for Put Options

Call options are useful for hedgers who are concerned about an increase in price in the future. In the case
of commodities or stocks, the hedger is planning to acquire them in the future and hence wants to fix the
maximum price that they would be willing to pay. In the case of interest rate call options, the hedger is
planning to borrow in the future and hence would like to fix the highest interest rate that they would be
willing to pay for the loans. In the case of currency call options, the hedger would be paying or receiving
foreign currency in the future and would like to get the best exchange rate possible. What would be the
rationale for the existence of put options?
Put options are useful when a hedger is concerned with a decrease in prices. Consider a hedger who
owns a stock and plans to sell it in the future. Their concern is that the price of the stock may decrease.

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 176   Financial Risk Management

Notes If the price increases, they would like to sell at the higher market price. However, if the price decreases, they
would like to fix the minimum price they would receive by selling the stock in the future. This would be
accomplished by buying a put option on the stock. Since the put option provides the right to sell the stock at
the exercise price, the hedger would exercise only if the exercise price is more than the market price. If the
market price is higher than the stock price, the hedger will not exercise, but will sell the stock at the higher
market price. Thus, irrespective of the price movement of the stock, the hedger is assured of the minimum
price they would receive, which would be the exercise price, through the purchase of a put option.
Put options are also available on interest rates, currency exchange rates, commodities, and futures
contracts. Interest rate put options will be used by hedgers who plan to invest in the future and these op-
tions provide the minimum interest rate that the hedger will receive on future investments. Currency put
options will be used by hedgers who are exposed to future foreign currency risk and these options provide
the minimum exchange rate.

  Example 8.6
Assume that on January 1, the State Bank of India (SBI) share price is INR 2,400. If you buy one share of
SBI at INR 2,400 today, your investment is INR 2,400, but you are not sure of what the SBI share price will
be on March 31. Let us consider two scenarios, the first where the price increases to INR 2,500, and the
second, where it drops to INR 2,250. Suppose there is a put option on the SBI with an exercise price of
INR 2,450 and it costs INR 100 to buy that option. In this case, the pay-off from the put option position
will be as shown in Table 8.8.

Table 8.8  Gains and Losses from Buying the Put Option

Stock Price of INR 2,250 Stock price of INR 2,500

Price paid for the put option INR 100 INR 100

Gain or loss INR 200 0

Net gain or loss INR 100 –INR 100

  If you had invested in the stock directly, you would have paid INR 2,400 today and would have gained
INR 100 when the price moves to INR 2,500 and would have lost INR 150 if the price moves to INR 2,250.
If the investment was in put options, you would gain INR 100 when the price is INR 2,250 and lose INR
100 if the share price was INR 2,500. However, the amount of investment in the stock is INR 2,400, while
the amount of investment in the put option is only INR 100. This example shows that investing in put op-
tions provides leverage and you get a much higher return by investing in options than you do by investing
directly in shares. However, if the stock price increases, your total investment will be lost.
Thus, from the buyers’ point of view, put options are good if the price of the underlying asset is likely
to decrease below the exercise price and the premium paid for the put.
From the writers’ point of view, the writer would receive the option price upon writing the option.
The gain or loss will be zero if there is no exercise, and the loss will be the difference between the stock
price and exercise price less the price they received upon writing the contract. This is shown in Table 8.9.

Table 8.9  Gains and Losses from Writing the Put Option

Stock Price of INR 2,250 Stock price of INR 2,500

Price received   INR 100 INR 100

Gain –INR 200 0

Net gain –INR 100 INR 100

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 Call and Put Options   177

Notes This example shows that a put option is a bet between the buyer and the writer of a put option. The
buyer of the put option is betting that the share price will go below the value of the exercise price less the
option premium, so that they can make money. The writer, on the other hand, is betting that the share
price will not go below the value of the exercise price less the option premium.
In Example 8.6, the buyer of the SBI option is betting that the SBI share price will go below INR 2,350,
while the writer is betting that the share price will not go below INR 2,350.

8.11 The Terminal Value of a Put Option

Consider a European put option on the date of maturity. When an investor buys a put option, they get the
right to sell the underlying share and there is no obligation on their part to exercise the right. Thus, the
buyer will exercise the option and sell the share at the fixed price only if it is profitable for them to do so.
When will a put option be exercised? It is clear that a put option will never be exercised as long as the
market price of the share is more than the exercise price. This is because the share can be sold for a much
higher price in the market than through exercising the option.
For example, if the exercise price is INR 2,450 and the market price of an SBI share is more than INR
2,500, say, INR 2,550, the holder of the option will receive INR 2,450 if they exercise the option and sell
the share. On the other hand, they can sell the share in the market for INR 2,550. Thus, it is not profitable
to exercise the option if the share price is more than the exercise price.
If the share price is lower than the exercise price, it is advisable to exercise the option and sell the share
at the exercise price, rather than to sell it at the lower market price. If the option holder does exercise this
option, they will gain the difference between the exercise price and the market price.
For example, if the market price of an SBI share is INR 2,300, the holder of the put option can buy this
share at INR 2,300 in the market and then exercise and sell the SBI share at INR 2,450 to the option writer
in order to make a gain of INR 150.
This shows that the terminal value of a put option depends upon the relationship between the share
price and the exercise price.
Case 1: If the exercise price (SX) < terminal stock price (ST), do not exercise; the value of the put option
is zero.
Case 2: If the exercise price (SX) > terminal stock price (ST), exercise; the value of the put option is
(SX – ST).
The put holder will let the put option expire without worth if it is not profitable to exercise and, therefore,
the minimum value of the put option will be zero and the maximum value will be the difference between
the exercise price and the stock price. Thus, the terminal value can be written as follows:
Terminal value = (SX – ST) if ST < SX,
and
Terminal value = 0  if  ST > SX
where ST represents the share price on the option expiration date and SX represents the exercise price of
the option. In shortened form, we can write this as:
Terminal value = Max (SX – ST , 0)
This shows that when ST is less than SX , the option will be exercised and the value will be the difference
between SX and ST , which is positive. However, if ST is greater than SX , then (SX – ST) will be negative,
but the option will not be exercised, thus leaving the value of the option to be zero, which is greater than
(SX – ST) .

  Example 8.7
Assume that the price of Tata Motor stock is INR 490 on January 1 and there is a put option with a ma-
turity of 90 days and an exercise price of INR 520. The contract size for a Tata Motor put option is INR
850. We can calculate the terminal value of the put option for different prices of Tata Motor shares on the
option expiration date. This is shown in Table 8.10 and Fig. 8.9.

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 178   Financial Risk Management

Notes Table 8.10  Terminal Value of a Put Option (SX = 520)

Terminal Stock Option Value Max

Action
Price (ST) (INR) (SX – ST , 0) (INR)

440 Exercise 80

460 Exercise 60

480 Exercise 40

500 Exercise 20

520 Do not exercise/Exercise 0

560 Do not exercise 0

580 Do not exercise 0

600 Do not exercise 0

620 Do not exercise 0




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Figure 8.9  Terminal Value of the Bought Put

8.12  Gains and Losses from Purchasing Put Options

Earlier, we saw that the terminal value of a put option is given by:
PT = Max (SX – ST  , 0)
However, the buyer of the put option will have to pay the price of the option at the time of purchase. Thus,
gains and losses from buying a put option can be written as
GP = Max (–P0 , SX – ST – P0)
where P0 is the price paid for the option.
This shows that the maximum loss for the option buyer is P0, i.e., the price paid for the option, which
occurs when there is no exercise. When the option is exercised, it will be in-the-money and, hence, the
loss will be less than P0 if the stock price is between SX and (SX – P0). If the stock price at maturity is less
than (SX – P0), then the option buyer will have a positive gain.

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 Call and Put Options   179

Notes   Example 8.8

Assume that the price of Tata Motor stock is INR 490 on January 1 and there is a put option with a
maturity of 90 days and an exercise price of INR 520. The put option is selling for INR 78.40. The
contract size for a Tata Motor put option is 850. We can calculate the terminal value of the put option
for different prices of Tata Motor shares on the option expiration date. This is shown in Table 8.11 and
Fig. 8.10.

Table 8.11  Gains and Losses from Buying Put Options (SX = 520)

Stock
Option Value Max Option Premium Gain Max (–P0 ,
Price
(SX – ST , 0) (INR) Paid P0 (INR) SX – ST – P0) (INR)
(ST) (INR)

360 160 78.4 81.6

380 140 78.4 61.6

400 120 78.4 41.6

420 100 78.4 21.6

440 80 78.4 1.6

460 60 78.4 –18.4

480 40 78.4 –38.4

500 20 78.4 –58.4

520 0 78.4 –78.4

560 0 78.4 –78.4

580 0 78.4 –78.4

600 0 78.4 –78.4






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Figure 8.10  Gains and Losses from the Bought Put

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 180   Financial Risk Management

Notes 8.13  Value of a Put Option Before Maturity

Consider a March put option on Tata Motor stock with the exercise price of INR 520. The current stock
price is INR 490. During the three-month period before the March expiration date, the Tata Motor share
price can move in either direction, above INR 520 or below INR 490.
Suppose on January 31, the Tata Motor stock price is INR 470. On this date, the share price is below
the exercise price. Whenever the stock price is below the exercise price, the put option is said to be
in-the-money, and such put options are called in-the-money put options. The in-the-money value of
a put option is calculated as the difference between the exercise price and the share price. The in-the-
money value of a put option is also called the intrinsic value of the put option. In our example, the in-the-
money value or the intrinsic value of the Tata Motor put on January 31 is INR 50 (INR 520 – INR 470).
What happens if the share price of Tata Motor on January 31 is INR 530? Now, the share price is above
the exercise price, and the put option is said to be out-of-money. When the option is out-of-money, its
intrinsic value is zero, as the value of an option can never be negative.
If the stock price is close to the exercise price, the option is said to be near-the-money or at-the-
money. Thus, the option will be at-the-money if the Tata Motor stock price was around INR 520.
The intrinsic value of a put option at any time t can be written as:
Intrinsic value of a put = Max (SX – St, 0)
What will be the price of the put option on January 31 when the share price is INR 470? As we saw earlier,
the intrinsic value of the put is INR 50. That is, if the option is an American put option, an investor can
exercise the put and make INR 50 per share. However, the price of the put option will be higher than
INR 50 in the market. Why?
The option matures in the month of March and it is only January 31. Since the option has a life of around
two months on January 31, there is a good chance that the share price can go below the current price of
INR 470. The purchasers of the put options will consider this possibility of lower share prices by March 31
and, therefore, would be willing to pay some amount for this possibility. The amount the option buyers are
willing to pay for the possible decrease in the stock price over time is called the time value of the put option.
Thus, the value of the put option before maturity is made of two components:
1. 
the intrinsic value of the put option
2. 
the time value of the put option
Price of put = Intrinsic value + Time value
This relationship shows that a put option will always have a positive value, as the time value is always
positive as long as maturity is not on the same date.
Note that the time value depends on the probability that the price of the share will decrease, and it is
dependent on the variability of the stock price and time remaining until maturity.
The put value before maturity is shown in Fig. 8.11.
In Fig. 8.11, the inner curve shows the actual value of the put, while the outer line shows the intrinsic
value of the put. When the stock price is above INR 520, the intrinsic value is zero, but the time value is
positive, thus giving a positive value to the put. It is also seen that the time value is very high when the
put option is near-the-money and the time value is close to zero for both deep-in-the-money and deep-
out-of-money put options.

8.14 Minimum and Maximum Values of Put

As was shown earlier, the minimum value of the put at any time can be written as:
Pt = Max (SX – St, 0)
This is because the minimum value expressed above is the intrinsic value of the put. This is also known as
the lower bound of the put option value.
The maximum value of a put is the exercise price of the option, because the maximum an option buyer
will be willing to pay for the put option is the exercise price. This is because a put option gives the right

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 Call and Put Options   181


Notes




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Figure 8.11 Put Value Before Maturity

to sell the stock at the exercise price and no one would be willing to pay more than the exercise price for
buying that option, as the maximum gain from the put is the exercise price when the stock price is close
to zero. This is known as the upper bound of the put option value.
The lower and upper bounds of the put option are shown in Fig. 8.12.

8.15  When to Exercise a Put Option

If the put option is European, there is a simple rule to determine whether the option should be exercised
or not. Since a European put can be exercised only on the maturity date, the rule can be stated as:
Exercise if SX > ST
Do not exercise  if SX ≤ ST
However, in the case of an American option, should a put option be exercised whenever the stock price
is below the exercise price? In the Tata Motor example, suppose that on January 31, the Tata Motor share
price is INR 470, should you exercise the call?




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Figure 8.12 Lower and Upper Bounds of Put Option Value

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 182   Financial Risk Management

Notes If you exercise, you would gain INR 50, which is the difference between the exercise price of INR 520
and the stock price of INR 470. This is the intrinsic value of the call option. However, consider what you
would receive if you decided to sell the put option, instead of exercising it.
We saw earlier that the put price comprises two values, namely, the intrinsic value and time value, and
the price of the put option before maturity will always be greater than its intrinsic value. On maturity,
the price of the option will be equal to the intrinsic value, as the time value is zero. Thus, the price of this
put option will be greater than INR 50 and an option holder will be better off selling the option than by
exercising it. Suppose that the time value of this option is INR 28.40, so that the put option is selling for
INR 78.40 in the market. If the option holder exercises the option, they will receive INR 50, whereas if
they sell the put option, the cash inflow will be INR 78.40. Thus, it is not advantageous to exercise the put
option before maturity.
Does this mean that you should never exercise an American put option before maturity? No! It may
be better to exercise rather than sell the put option when the share price is considerably low and the put is
deep-in-the-money. When the option is deep-in-the-money, the gain from the exercise of the put option
will be the exercise price, and the probability of the stock price decreasing further could be very small.
Because the probability of the stock price increasing is higher than the probability of it decreasing, it is
possible that the time value is negative and the price of the put is less than the intrinsic value. In such
a case, it is advisable to exercise the put option, rather than to sell it in the market. Thus, there may be
circumstances where it is optimal to exercise the put option before maturity.
Thus, the rule for exercising an American put option can be written as:
1. Do not exercise before maturity if the option is not deep-in-the-money.
2. Exercise the put option if it is in deep-in-the-money and the time value of the option is negative.

8.16  From a Put Option Writer’s Point of View

In put options, the decision to exercise the option lies with the buyer of the option. The seller has the ob-
ligation to buy the share at the exercise price if the option buyer exercises their right. Thus, the terminal
value of a written put as well as the gains and losses from a written put depend on the action of the option
buyer.

8.16.1  The Terminal Value of a Written Put

If the put is not exercised by the buyer, the writer has no obligation to buy the share and hence is not af-
fected. Thus, the value of a written put is zero as long as it is not exercised.
If the put is exercised, it is clear that the put is in-the-money. Thus, the share price in the market is
lower than the exercise price. The put writer will be forced to buy the stock from the option buyer at a
price higher than what it would have cost if the stock were bought in the market. Thus, the value of the
written put will be the difference between ST and SX.
Hence, the value of the written put can be written as:
PW,T = Min (ST – SX, 0)
This shows that the terminal value of a written put will be negative if the put is exercised and the value
will be the difference between the stock price and the exercise price. In case the put is not exercised, the
value of the written put will be zero, as the writer has no obligation. The value of the written put will be
the minimum of zero and the difference between the stock price and exercise price. This is shown in the
above equation.

  Example 8.9
Assume that the price of Tata Motor stock is INR 490 on January 1 and there is a put option with maturity
of 90 days and an exercise price of INR 520. The contract size for the Tata Motor put option is 850. We
can calculate the terminal value of the written put option for different prices of Tata Motor shares on the
option expiration date.

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 Call and Put Options   183

Notes Table 8.12  Terminal Value of a Written Put Option (SX = 70)

Terminal Stock Price Option Value Max

Action
(ST) (INR) (SX – ST , 0) (INR)

440 Exercise –80

460 Exercise –60

480 Exercise –40

500 Exercise –20

520 Do not exercise/Exercise 0

560 Do not exercise 0

580 Do not exercise 0

600 Do not exercise 0

620 Do not exercise 0

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Figure 8.13  Terminal Value of the Written Put

  The terminal value of the written put is shown in Table 8.12 and Fig. 8.13.
  In Table 8.12, the option value is zero when the stock price is more than the exercise price, because the
option buyer would not exercise the option. When the stock price is below the exercise price, the option
buyer will exercise the option and hence the option writer will lose and the value of the written put option
will be negative.

8.16.2  Gains and Losses for a Put Writer

When a put writer writes a put, they receive the option price immediately. Thus, their gains or losses from
the written put are the difference between the option price they receive and the terminal value of the writ-
ten put. The gains and losses for a put writer can be written as:
GWP = Min [P0, P0 – (ST – SX)]

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 184   Financial Risk Management

Notes This shows that the maximum gain for a put writer is P0, which is the option price received at the time
of writing the put. However, the losses could be high if the stock price decreases substantially. The maxi-
mum loss, however, is limited to the exercise price, because the lowest stock price is zero.

  Example 8.10
Assume that the price of Tata Motor stock is INR 490 on January 1 and there is a put option with a matu-
rity of 90 days and an exercise price of INR 520. The contract size for a Tata Motor put option is 850. We
can calculate the gains of the put option for different prices of Tata Motor shares on the option expiration
date. Table 8.13 and Fig. 8.14 show the gains for a put writer.

Table 8.13  Gains and Losses from Writing Put Options (SX = 520)

Stock Price Option Value Max Option Premium Gain Max (–P0 ,
(ST) (INR) (SX – ST , 0) (INR) Received (P0) (INR) SX – ST – P0) (INR)

360 –160 78.4 –81.6

380 –140 78.4 –61.6

400 –120 78.4 –41.6

420 –100 78.4 –21.6

440 –80 78.4 –1.6

460 –60 78.4 18.4

480 –40 78.4 38.4

500 –20 78.4 58.4

520 0 78.4 78.4

560 0 78.4 78.4

580 0 78.4 78.4

600 0 78.4 78.4






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Figure 8.14  Gains and Losses from a Written Put

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 Call and Put Options   185


Notes

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Figure 8.15  Gains from the Bought and Written Put

8.17 Comparison Between the Gains Made by

a Put Buyer and a Put Writer
For an option buyer, the maximum loss is the option price paid by them for buying the option and the
maximum gain is the exercise price when the stock price is close to zero. For the option writer, the gain
is the maximum option price received by them at the time of writing the call, but the loss can be as high
as the exercise price. However, the gains of the writer are the losses of the buyer, and vice versa. Thus, an
option is a zero-sum game between the option writer and the option buyer. In addition, it can be seen
that the terminal value of a bought put is the mirror image of the terminal value of a written put, and the
gains to the put option buyer are the mirror image of the gains to a put writer (see Fig. 8.15).

8.18  When to Buy and When to Write a Put Option

When a person buys a put option, they make gains only if the share price is expected to decrease. How-
ever, the put buyer would make positive gain only when the share price is less than the sum of the exercise
price and the price paid for the option. If SX is the exercise price and P0 is the price paid for the option,
the put option would be bought only when the share price ST is expected to be less than (SX – P0). For
example, if the exercise price is INR 520 and the put price is INR 78.40, a person will buy the put when
they expect the stock price to be less than INR 441.60 (INR 520 – INR 78.40). A put writer gains as long
as the share price does not go below the exercise price less the option price and hence a person will write
a put only if they believe that the terminal stock price ST will not go below (SX – P0). For example, if the
exercise price is INR 520 and the put price is INR 78.40, a person will write a put when they expect that
the stock price will not go below INR 441.60 (INR 520 – INR 78.40).
Note that the belief about the movement of stock prices could be different for the put option writer and
the put option buyer. While the put option buyer always believes that the stock price would decrease and
go below (SX – P0), the put option writer believes that the stock price may either increase or even decrease,
but if it decreases, it will not go below (SX – P0).

Prob l e m 8 . 2
SBI shares are selling on January 1 at INR 2,500. Put options are available on SBI shares with expiry on January 29
and exercise price of INR 2,600. These options are priced at INR 160. The contract size is 132. These are American
options and these options are not expected to pay any dividends during January.

(i) At what share price on January 29 would you exercise these put options?
(ii) Would you exercise these put options if the share price on January 17 is INR 2,540?

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 186   Financial Risk Management

(iii) Calculate the terminal value of these put options (in terms of per share) for SBI share prices of INR 2,400,
Notes
INR 2,500, INR 2,600, INR 2,700 and INR 2,800.
(iv) Calculate the gains and losses for the put buyer if SBI share prices of INR 2,400, INR 2,500, INR 2,600,
INR 2,700, and INR 2,800.
(v) Calculate the gains and losses for the put writer if SBI share prices of INR 2,400, INR 2,500, INR 2,600,
INR 2,700, and INR 2,800.
Solution to Problem 8.2
(i) Since the exercise price of the put option is INR 2,600, put option will be exercised only if the SBI share price
is less than INR 2,600
(ii) Since SBI is not expected to pay dividends during January, the option price on January 17 would be more than
its in-the-money value of INR 40. Therefore, it is better to sell the option rather than exercise the option. Thus,
the option will not be exercised on January 17.
(iii) Terminal values of put are shown below:

Terminal Share Price Action Terminal Value of Option

2,400 Exercise 200

2,500 Exercise 100

2,600 Exercise/Do not exercise   0

2,700 Do not exercise   0

2,800 Do not exercise   0

(iv) Gain to Put Buyer

  Since the contract size is 132, gain will have to be calculated for 132 shares. Gain for the put buyer is (–132 ×
Put premium) if put is not exercised and [(Exercise price – Share price – Put premium) × 132] if put is exercised.

Terminal Share Price Action Gain (in INR)

2,400 Exercise 132 × (2600 – 2400 – 160) = 5,280

2,500 Exercise 132 × (2600 – 2500 – 160) = –7,920

2,600 Exercise/Do not exercise –132 × 160 = – 21,120

2,700 Do not exercise –132 × 160 = – 21,120

2,800 Do not exercise –132 × 160 = – 21,120

(v) Gain to Put Writer

  Since the contract size is 132, gain will have to be calculated for 132 shares. Gain for the put writer is (132 × Put
premium) if put is not exercised and –[(Exercise price – Share price – Put premium) × 132] if put is exercised.

Terminal Share Price Action Gain (in INR)

2,400 Exercise 132 × (2,600 – 2400 – 160) = –5,280

2,500 Exercise –132 × (2,600 – 2500 – 160) = 7,920

2,600 Exercise/Do not exercise 132 × 160 = 21,120

2,700 Do not exercise 132 × 160 = 21,120

2,800 Do not exercise 132 × 160 = 21,120

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 Call and Put Options   187

Notes 8.19  Comparison Between Calls and Puts

It was seen earlier that
1. a person would buy a call option when the stock price is expected to increase; their gain would be
the difference between the stock price at maturity and the exercise price less the premium paid for
buying the call option, and
2. a person would buy a put option when the stock price is expected to decrease; their gain would be
the difference between the exercise price and the stock price at maturity less the premium paid for
buying the put option.
Since buying a call is appropriate when the stock price is expected to increase, it is often erroneously
assumed that writing a call would be appropriate when the stock price is expected to decrease. However,
we saw that buying a put is the appropriate strategy while the expectation is that the stock price will de-
crease. What is the difference between the two strategies, namely, writing a call and buying a put?

  Example 8.11
Consider a stock that is currently trading at INR 68. Call options and put options on this stock are avail-
able with maturity in three months. The exercise price of the call as well as that of the put is INR 70. The
price of the call option is INR 3, and the price of the put option is INR 2.73. The gain from buying a put
and writing a call is shown in Table 8.14.

Table 8.14  Gains and Losses from a Bought Put and a Written Call

Terminal Stock Gain from a Gain from a

Price (INR) Bought Put (INR) Written Call (INR)

61 6.27 3
64 3.27 3
67 0.27 3
70 –2.73 3
73 –2.73 0
76 –2.73 –3
79 –2.73 –6

  Figure 8.16 shows the gain from the bought put and the written call.

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Figure 8.16  Gains from the Bought Put and the Written Call

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 188   Financial Risk Management

Notes This comparison shows that the gain is different for the two strategies. When a call is written,
the maximum gain is the call option premium received by the call writer, but they can also incur
considerable losses in case the stock price increases substantially. On the other hand, buying a put will result
in a maximum loss that is equal to the put option premium paid; this situation will arise in case the stock
price increases beyond the exercise price. In case the stock price decreases, the put buyer will gain INR 1
each time the stock price decreases by INR 1. Thus, when the stock price is expected to decrease, it is
better to buy a put, rather than to write a call. The decision as to whether one should buy a put or write
a call depends on the expectation of the stock price at maturity. If the stock price is not expected to
decrease below INR 64.27, writing a call provides more gain, and if the stock price is expected to decrease
below INR 64.27, buying a put is better.
Similarly, when the stock price is expected to increase, one can either buy a call or write a put. How-
ever, the gain would be different for the two strategies. Buying a call will result in a maximum loss that is
equal to the call option premium paid, in case the stock price decreases below the exercise price. How-
ever, a call option buyer can make a huge gain if the stock price increases substantially. On the other hand,
writing a put will result in a maximum gain that is equal to the put option premium received at the time
of writing the put, in case the stock price increases beyond the exercise price. The put writer can incur
substantial losses in case the stock price decreases below the exercise price. Thus, it is appropriate to buy
a call when the stock price is expected to increase. This is explained in Example 8.12.

  Example 8.12
Consider a stock that is currently trading at INR 68. Call options and put options on this stock are
available with maturity in three months. The exercise price of the call as well as that of the put is INR 70.
The price of the call option is INR 3, and the price of the put option is INR 2.73. The gain from buying a
call and writing a put is shown in Table 8.15 and Fig. 8.17.

Table 8.15  Gains from Buying a Call and Writing a Put (SX = 70)

Terminal Stock Gain from a Written Gain from a Bought

Price (INR) Put (INR) Call (INR)

61 –6.27 –3

64 –3.27 –3

67 –0.27 –3

70 2.73 –3

73 2.73 0

76 2.73 3

79 2.73 6

  Thus, it is clear that one should buy call options when the stock price is expected to increase and one
should buy put options when the stock price is expected to decrease. Under what circumstances should
a call or a put be written? To understand this, a comparison between the gains from the four strategies,
namely, buy call, buy put, write call, and write put for the example are shown in Table 8.16.
Table 8.16 shows that the strategy of buying a call and that of writing a put provide positive gains when
the stock price increases. However, the gain for the strategy of writing a put is higher until the stock price
reaches INR 75.73. The strategy of buying a call provides a higher gain when the stock price increases
beyond INR 75.73. Therefore, one would buy calls only when the stock price is expected to be above
INR 75.73.

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 Call and Put Options   189


Notes

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Figure 8.17

Table 8.16  Comparison between Gains for Different Strategies

Terminal Stock Bought Call Written Call Bought Put Written Put
Price (INR) (INR) (INR) (INR) (INR)

61 –3 3 6.27 –6.27
62 –3 3 5.27 –5.27
63 –3 3 4.27 –4.27
64 –3 3 3.27 –3.27
65 –3 3 2.27 –2.27
66 –3 3 1.27 –1.27
67 –3 3 0.27 –0.27
68 –3 3 –0.73 0.73
69 –3 3 –1.73 1.73
70 –3 3 –2.73 2.73
71 –2 2 –2.73 2.73
72 –1 1 –2.73 2.73
73 0 0 –2.73 2.73
74 1 –1 –2.73 2.73
75 2 –2 –2.73 2.73
76 3 –3 –2.73 2.73
77 4 –4 –2.73 2.73
78 5 –5 –2.73 2.73
79 6 –6 –2.73 2.73
80 7 –7 –2.73 2.73

The strategy of writing a put provides the highest gain for a stock price range of INR 70.27 to INR
75.73. Thus, one would write puts if the price is expected to be in the range of INR 70.27 to INR 75.73.

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 190   Financial Risk Management

Notes The strategy of writing a call provides the highest gain for a stock price in the range of INR 64.27 to
INR 70.27 and hence one would write calls when the price is expected to be in that range.
The strategy of buying a put provides the highest gain when the price is below INR 64.27, and one
would buy puts if the price is expected to decrease below INR 64.27.
This can be summarized as:
 Buy a put if ST is expected to be below INR 64.27.

 Write a call if ST is expected to be between INR 64.27 and INR 70.27.

 Write a put if ST is expected to be between INR 70.27 and INR 75.73.

 Buy a call if ST is expected to be above INR 75.73.

On the basis of the call price, put price, and exercise price, the above rule for different expected termi-
nal stock prices can be written as follows:
Buy a put if:
ST < (SX – C0 – P0)
Write a call if:
(SX – C0 – P0) < ST < (SX + C0 – P0)
Write a put if:
(SX + C0 – P0) < ST < (SX + C0 + P0)
Buy a call if:
ST < (SX + C0 + P0)
When the price decreases, both the written call and the bought put will provide gains. However, the
gain is constant and equal to the call price received for the written calls. For a bought put, the put buyer
makes gains only when the share price is below (Exercise price – Put price). The gain for the put buyer
will be INR 1 each time the stock price decreases by INR 1. Thus, the gain from a bought put will be
more than the gain from a written call only when the stock price decreases below [(Exercise price – Put
price) – Call price], because the gain from a written call will be equal to the call price when the stock price
decreases. Thus, a person will buy puts only when the stock price is expected to be lower than (Exercise
price – Call price – Put price).
When the price increases, both the written put and the bought call will provide gains. However, the gain
is constant and equal to the put price received for written puts. For a bought call, the call buyer makes gains
only when the share price is above (Exercise price + Call price). The gain for the call buyer will be INR 1
each time the stock price increases by INR 1. Thus, the gain from a bought call will be more than the gain
from a written put only when the stock price goes above (Exercise price + Call price + Put price), because
the gain from a written put will be equal to the put price when the stock price increases. Thus, a person
will buy calls only when the stock price is expected to be above (Exercise price + Call price + Put price).
To decide between the strategy of writing a call and that of writing a put, we have to decide which of
the two provides better gains for various stock prices. A written call will provide constant gains, equal to
the call price, as long as the stock price is below the exercise price, and the call buyer starts to make losses
if the stock price is above (Exercise price + Call price). For a written put, the gain is constant and equal to
the put price as long as the stock price is above the exercise price, and the put writer will make losses only
when the stock price is below (Exercise price – Put price). Thus, if the stock price is expected to decrease,
it is better to write a call, and if the stock price is expected to increase, it is better to write a put. If the call
price is more than the put price, the call writer will gain more than the put writer for a stock price is less
than (Exercise price + Call price – Put price). Thus, a written call is preferable for a stock price in the range
of (Exercise price – Call price – Put price) to (Exercise price + Call price – Put price). Writing a put will
be preferable for a stock price in the range of (Exercise price + Call price – Put price) to (Exercise price +
Call price + Put price).

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 Call and Put Options   191

Notes The above discussion shows that different options strategies, involving calls and puts, can lead to dif-
ferent gains. The appropriate strategy should be chosen on the basis of the expected value of the stock
price at maturity. However, at any given time, there are a large number of options with different exercise
prices and exercise dates and one can combine these options in order to make profits from the options.
Such combinations of options will be discussed in Chapter 9.

Prob l e m 8 . 3
SBI shares are selling on January 1 at INR 2,500. Call options are available on SBI shares with expiry on January 29
and exercise price of INR 2,600. Call options are priced at INR 70. Put options are available on SBI shares with expiry
on January 29 and exercise price of INR 2,600. These options are priced at INR 160. The contract size is 132. These
are American options and these options are not expected to pay any dividends during January. Under what price
expectations would one engage in (i) buy call, (ii) write call, (iii) buy put, and (iv) write put?
Solution to Problem 8.3
The results of gains and losses for these four strategies for various terminal share prices are shown below:

Gain for call buyer = 132 × Call premium  if call is not exercised
and

Gain for call buyer = –[(Share price – exercise price – Call premium) × 132]  if call is exercised
Gain for call writer = 132 × Call premium  if call is not exercised
and

Gain for call writer = –[(Share price – exercise price – Call premium) × 132]  if call is exercised
Gain for the put buyer = –132 × Put premium  if put is not exercised
and
Gain for put buyer = [(Exercise price – share price – Put premium) × 132]  if put is exercised
Gain for the put writer = 132 × Put premium  if put is not exercised
and
Gain for put writer = –[(Exercise price – share price – Put premium) × 132]  if put is exercised

Terminal Gain from Gain from Gain from Gain from

Share Price Buying Call Writing Call Buying Put Writing put

2300 –9,240 9,240 18,480 –18,480

2370 –9,240 9,240 9,240 –9,240

2400 –9,240 9,240 5,280 –5,280

2440 –9,240 9,240 0 0

2500 –9,240 9,240 –7,920 7,920

2600 –9,240 9,240 –21,120 21,120

2670 0 0 –21,120 21,120

2700 3,960 –3,960 –21,120 21,120

2800 17,160 –17,160 –21,120 21,120

2830 21,120 –21,120 –21,120 21,120

2900 30,360 –30,360 –21,120 21,120

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 192 Financial Risk Management

From the above table, it can be seen that appropriate strategies would be:

 Buy Put if share price is expected to be less than INR 2,370.

 Write Call if share price is expected to be in the range INR 2,370 and INR 2,440.

 Write Put if share price is expected to be in the range INR 2,440 and INR 2,830.

 Buy Call if share price is expected to be above INR 2,830.

CHapTER SUmmaRy
Investing in call options provides leveraged gains when
 An option is a zero-sum game in the sense that the gains made

compared to investing in the underlying security, if the by the option buyer would be equal to the loss incurred by the
price of the underlying security increases. option writer, and vice versa.
The terminal value of a call option is given as:
 The value of an option prior to maturity is the sum of its

intrinsic value and time value. The intrinsic value of a call at
CT = Max (0, ST – SX)
a particular time is the difference between the stock price at
and the terminal value of a put option is given as: that time less the exercise price or zero, whichever is greater;
the intrinsic value of a put at a particular time is the difference
PT = Max (0, SX – ST)
between the exercise price and the stock price at that time or
The gain to a European call option buyer is:
 zero, whichever is greater.
GC = Max (–C0, ST – SX – C0) Intrinsic value is either zero or positive. If the intrinsic value is

positive, the option is said to be in-the-money. If it is zero, the
and the gain to a European put option buyer is: option is said to be out-of-money. The time value is the option
GP = Max (–P0, SX – ST – P0) value that arises because the option can be in-the-money by
the time the option maturity is reached.
The option buyer will have a maximum loss that is equal to

It is not optimal to exercise an American call option on a

the premium paid for the option, if the underlying asset price stock that does not pay dividends, as selling the option would
moves against the option buyer. However, if the price moves provide a relatively higher cash flow. If the underlying security
in favour of the option buyer, the gains can be large. pays dividends, it may be optimal to exercise the option before
The option writer has the maximum gain that is equal to the
 the stock goes ex-dividend.
premium they receive from writing the option. However, their It may be optimal to exercise a put option on a stock that

losses can be huge if the underlying asset price increases, in the pays no dividends, if the option is deep-in-the-money and the
case of call options, and if the underlying asset price decreases, option premium is less than its intrinsic value.
in the case of put options, and the option is exercised by the A call option is bought when the investor believes that the stock

option buyer. price would increase beyond (Exercise price + Call option
A call option contract is a bet between the option buyer
 premium + Put option premium), while a put option is bought
and option writer with the option buyer betting that when the investor believes that the stock price would go below
the underlying asset price would increase beyond the sum (Exercise price – Call option premium – Put option premium).
of the exercise price and option premium and the writer A call option will be written when the stock price is expected

betting that the underlying asset price will not increase to that to be in the range of (Exercise price – Call option premium
level. – Put option premium) to (Exercise price + Call option
A put option contract is a bet between the option buyer and the
 premium – Put option premium).
option writer with the option buyer betting that the underly- A put option will be written when the stock price is expected

ing asset price would decrease below (SX – ST – P0)and the to be in the range of (Exercise price + Call option premium –
option writer betting that the underlying asset price will not Put option premium) to (Exercise price + Call option premium
decrease to that level. + Put option premium).

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 Call and Put Options 193

mUlTIplE-CHOICE QUESTIONS
1. A one-year forward contract is an agreement where C. The exchange-traded market is ten times as big as the
A. One side has the right to buy an asset for a certain price in over-the-counter market.
one year’s time. D. The over-the-counter market is ten times as big as the
B. One side has the obligation to buy an asset for a certain exchange-traded market.
price in one year’s time. 6. Which of the following best describes the term “spot price”
C. One side has the obligation to buy an asset for a certain A. The price for immediate delivery
price at some time during the next year. B. The price for delivery at a future time
D. One side has the obligation to buy an asset for the market C. The price of an asset that has been damaged
price in one year’s time. D. The price of renting an asset
2. Which of the following is NOT true 7. Which of the following is true about a long forward contract
A. When a CBOE call option on IBM is exercised, IBM A. The contract becomes more valuable as the price of the
issues more stock asset declines
B. An American option can be exercised at any time during B. The contract becomes more valuable as the price of the
its life asset rises
C. An call option will always be exercised at maturity if the C. The contract is worth zero if the price of the asset declines
underlying asset price is greater than the strike price after the contract has been entered into
D. A put option will always be exercised at maturity if the D. The contract is worth zero if the price of the asset rises
strike price is greater than the underlying asset price. after the contract has been entered into

3. A one-year call option on a stock with a strike price of $30 8. An investor sells a futures contract an asset when the futures
costs $3; a one-year put option on the stock with a strike price price is $1,500. Each contract is on 100 units of the asset. The
of $30 costs $4. Suppose that a trader buys two call options contract is closed out when the futures price is $1,540. Which
and one put option. The breakeven stock price above which of the following is true
the trader makes a profit is A. The investor has made a gain of $4,000
A. $35 B. $40 B. The investor has made a loss of $4,000
C. The investor has made a gain of $2,000
C. $30 D. $36
D. The investor has made a loss of $2,000
4. A one-year call option on a stock with a strike price of $30
9. Which of the following describes European options?
costs $3; a one-year put option on the stock with a strike price
A. Sold in Europe
of $30 costs $4. Suppose that a trader buys two call options
B. Priced in Euros
and one put option. The breakeven stock price below which
C. Exercisable only at maturity
the trader makes a profit is D. Calls (there are no puts)
A. $25 B. $28
C. $26 D. $20 10. Which of the following is NOT true
A. A call option gives the holder the right to buy an asset by
5. Which of the following is approximately true when size is a certain date for a certain price
measured in terms of the underlying principal amounts or B. A put option gives the holder the right to sell an asset by a
value of the underlying assets certain date for a certain price
A. The exchange-traded market is twice as big as the over- C. The holder of a call or put option must exercise the right
the-counter market. to sell or buy an asset
B. The over-the-counter market is twice as big as the D. The holder of a forward contract is obligated to buy or sell
exchange-traded market. an asset
Answer
1. B 2. C 3. A 4. C 5. D 6. A 7. C 8. C 9. D 10. D

REVIEW QUESTIONS
1. Explain when a call option would be exercised. 7. Under what circumstances would you write a call option?
2. Explain when a put option would be exercised. 8. Under what circumstances would you write a put option?
3. What is meant by the intrinsic value of an option? 9. An option contract is a zero-sum game between the option
4. What is meant by the time value of an option? buyer and the option writer. Explain this statement.
5. Under what circumstances would you buy a call option? 10. What are the minimum and maximum values of a call option
6. Under what circumstances would you buy a put option? and a put option?

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 194 Financial Risk Management

SElF-aSSESmENT TEST
1. A State Bank share is selling for INR 2,500 on January 1. It (ii) If on September 30, the value of the CNX Nifty index
has a call option with maturity on March 31 with an exercise is 4,260, what will be the gain or loss for the put option
price of INR 2,700. This option is selling for INR 85. Draw a buyer?
diagram showing the terminal value of this option as well as (iii) If on September 30, the value of the CNX Nifty index
the gains from buying this option for possible stock prices of is 4,260, what will be the gain or loss for the call option
INR 2,300 to INR 3,000. writer?
(iv) If on September 30, the value of the CNX Nifty index
2. A State Bank share is selling for INR 2,500 on January 1. It is 4,260, what will be the gain or loss for the put option
has a put option with maturity on March 31 with an exercise writer?
price of INR 2,700. This option is selling for INR 160. Draw a (v) On September 12, the CNX Nifty index is at 4,220 and
diagram showing the terminal value of this option as well as the call option is selling at INR 135. What is the intrinsic
the gains from buying this option for possible stock prices of value of the call option and the time value of the call
INR 2,300 to INR 3,000. option?
(vi) Can you exercise the call option on the CNX Nifty index
3. A State Bank share is selling at INR 2,500 on January 1. It has on September 12 when the index is at 4,220?
a call option with maturity on March 31 with an exercise price
of INR 2,700. This option is selling for INR 85. 7. On September 1, call and put options are available on the Bank
(i) On February 14, the State Bank share price is INR 2,540. Nifty index with expiry on September 30. The exercise price of
What is its intrinsic value? Is the option in-the-money? these options is INR 7,480. On September 1, the Bank Nifty
Would you exercise this option on February 14? Explain. index is at 7,350. The call is priced at INR 100, and the put
(ii) On February 14, the State Bank share price is INR 2,820. option is priced at INR 240. The contract multiplier for the
What is its intrinsic value? Is the option in-the-money? Bank Nifty index is 50.
Would you exercise this option on February 14? Explain. (i) If on September 30, the value of the Bank Nifty index
is 7,450, what will be the gain or loss for the call option
4. A State Bank share is selling at INR 2,500 on January 1. It has buyer?
a put option with maturity on March 31 with an exercise price (ii) If on September 30, the value of the Bank Nifty index
of INR 2,700. This option is selling for INR 160. is 7,450, what will be the gain or loss for the put option
(i) On February 14, the State Bank share price is INR buyer?
2,540. What is its intrinsic value? Is the option in-the- (iii) If on September 30, the value of the Bank Nifty index
money? Would you exercise this option on February 14? is 7,450, what will be the gain or loss for the call option
Explain. writer?
(ii) On February 14, the State Bank share price is INR (iv) If on September 30, the value of the Bank Nifty index
2,820. What is its intrinsic value? Is the option in-the- is 7,450, what will be the gain or loss for the put option
money? Would you exercise this option on February 14? writer?
Explain. (v) On September 12, the Bank Nifty index is at 7,320 and
the put option is selling at INR 250. What is the intrinsic
5. A State Bank share is selling at INR 2,500 on January 1. It has value of the put option and the time value of the call
a call and a put option with maturity on March 31 with an option?
exercise price of INR 2,700. The call is priced at INR 85 and (vi) Can you exercise the put option on the Bank Nifty index
the put is priced at INR 160. on September 12 when the index is at 7,320?
(i) If you believe that the price of the State Bank share would
be INR 2,750 on March 31, what action would you take? 8. On September 1, call options are selling at INR 70 on ICICI
(ii) If you believe that the price of the State Bank share would Bank shares with an exercise price of INR 800 and an exercise
be INR 2,650 on March 31, what action would you take? date of October 31. ICICI Bank shares are selling at INR 750
(iii) If you believe that the price of the State Bank share would on September 1. The ICICI option contract size is 350 shares.
be INR 2,530 on March 31, what action would you take? (i) If the share price of ICICI Bank is INR 860 on October
(iv) If you believe that the price of the State Bank share would 31, what will be the gain or loss for the call option
be INR 2,400 on March 31, what action would you take? buyer?
(ii) If the share price of ICICI Bank is INR 860 on October
6. On July 1, call and put options are available on the CNX Nifty 31, what will be the gain or loss for the call option writer?
index with expiry on September 30. The exercise price of this (iii) On September 30, the share price of ICICI Bank is INR
option is INR 4,200. The call option is priced at INR 120 and 840 and the call option is selling at INR 135. What is the
the put option is priced at INR 220. On July 1, the CNX Nifty intrinsic value of the call option and the time value of
index is at 4,080. The contract multiplier is 50. the call option?
(i) If on September 30, the value of the CNX Nifty index (iv) Can you exercise the call option on ICICI stock on
is 4,260, what will be the gain or loss for the call option September 30 when the shares of ICICI Bank are selling
buyer? at INR 840?

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 Call and Put Options   195

9. On September 1, put options are selling at INR 140 on ICICI 10. On September 1, call and put options are selling at INR 70
Bank shares with an exercise price of INR 800 and an exercise and INR 140 on ICICI Bank shares with an exercise price
date of October 31. ICICI Bank shares are selling at INR 750 of INR 800 and an exercise date of October 31. ICICI Bank
 on September 1. The ICICI Bank option contract size is 350 shares are selling at INR 750 on September 1. The ICICI Bank
shares. option contract size is 350 shares. You can either buy/write a
  (i) If the share price of ICICI Bank is INR 860 on October call or buy/write a put.
31, what will be the gain or loss for the put option (i) What is the price range in which buying a call is
buyer? superior to the other strategies?
  (ii) If the share price of ICICI Bank is INR 860 on October (ii) What is the price range in which buying a put is
31, what will be the gain or loss for the put option writer? superior to the other strategies?
  (iii) On September 30, the share price of ICICI bank is INR (iii) What is the price range in which writing a call is
700 and the put option is selling at INR 165. What is superior to the other strategies?
the intrinsic value of the put option and the time value (iv) What is the price range in which writing a put is
of the put option? superior to the other strategies?
 (iv) Can you exercise the put option on ICICI stock on
September 30 when the shares of ICICI Bank are
selling at INR 700?

   C a se S tud y

Ram, who has been trading in futures that resulted in huge losses, 4. If he purchases a put option, what will be the initial outlay for
is now convinced that trading in options is a better alternative to him?
trading in futures when the direction of price movement is uncer- 5. If he writes a put, what will be the initial receipt for him?
tain. However, he would like to know what gains he can make if he
enters into options contracts. He has collected the following details 6. What will be the initial premium margin for (i) if he buys a put
on options on Tata Steel stock. and (ii) if he writes a put?
  On September 1, Tata Steel shares are selling at INR 430. Call 7. Show diagrammatically what will be Ram’s gains for the price
options and put options are available on Tata Steel with an exercise range of INR 380 to INR 520 on the exercise date if:
price of INR 450 and an exercise date of October 28. A call is (i) he buys a call
priced at INR 30, and a put is priced at INR 50. The contract size is (ii) he buys a put
764. The analysts have estimated that the share price of Tata Steel (iii) he writes a call
could be anywhere in the range of INR 380 to INR 520. Ram wants (iv)  he writes a put
answers to the following questions: 8. Which of these four strategies—buying a call, writing a call,
buying a put, and writing a put—will be appropriate for differ-
Discussion Questions ent price ranges?
1. If he purchases a call option, what will be the initial outlay for 9. 
Suppose Tata Steel announces a dividend of INR 15 on
him? October 10 with a holder-of-record date of October 15, so that
2. If he writes a call, what will be the initial receipt for him? the stock will go ex-dividend on October 16. On October 15, the
3. What will be his initial premium margin (i) if he buys a call share price of Tata Steel is INR 462. Should Ram exercise the
and (ii) if he writes a call? call option? Should he exercise the put option?

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M08 Financial Risk Management 01 XXXX.indd 196 6/27/2018 10:56:53 AM
 9
Combinations of Options:
Trading Strategies

LEARNING OBJECTIVES

After completing this chapter, you Nicholas Leeson, a trader of Barings Bank in Singapore, earned
will be able to answer the following substantial profits by trading straddles on the Nikkei 225 index
questions: from 1992 to 1995 when Nikkei 225 Index was in the range of
 What is the rationale for 16,000 to 20,000. A straddle involves trading in calls and puts
combining options and the at the same time, and as long as the price volatility is not high,
underlying security? a straddle can result in profits. However, when an earthquake hit
Japan, the stock index moved away from the range, causing huge
 What is meant by covered
losses from the written straddles. By January 1, 1995, Leeson was
call writing?
short in 37,925 Nikkei calls and 32,967 Nikkei puts.
 What is meant by a protective
put?
 What is meant by spread
BoX 9.1 Dealing in Straddles
trading using options?
 What is meant by straddle
trading using options?
 What are strips, straps and
strangles?

In Chapter 8, we saw the factors that affect the values of calls and puts and the price expectations under
which one would buy calls, write calls, buy puts, and write puts. In Chapter 7, we saw that there will be a
large number of calls and puts available in the market at the same time with different exercise prices and
exercise dates. In this chapter, we will discuss how one can combine options with the underlying stocks
or combine options such that one can make money.
Box 9.1 shows one combination of options, known as straddles, whereby one can make either a profit
or a loss depending on the movement of the price of the underlying asset. There are many other combi-
nations of calls, puts, and underlying stock, which can be used to hedge as well as make money. In this
chapter, we will discuss these combinations and show the price ranges in which the various combinations
would provide gains and losses.

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Notes While discussing the rationale of call and put options, it was shown that call options are good if
the price of the underlying security is expected to increase, while put options are good if the price of
the underlying security is expected to decrease. However, if an investor is not too sure of how the price
of the underlying securities may change, they can use a combination of different options to get the maxi-
mum benefit out of them. At any given time, there will be a number of options available for trading with
different exercise prices and different exercise dates. On the basis of the price expectations, a trader could
use various combinations of calls and puts available in the market to make money.
Four types of strategies can be used when the only available securities are puts and calls on the same
underlying security and the underlying security itself. They are:
1. Naked positions
2. Hedge positions
3. Spread positions
4. Combinations

9.1  Naked or Uncovered Positions

Naked positions are strategies involving only a single security such as the underlying security, call option,
or put option, either purchased or sold. They could be long stock or short stock, long call or written call,
or long put or written put. These strategies are also referred to as uncovered positions.

9.1.1  Naked Long Stock Positions

Long stock means that the investor buys the shares of a stock at the current time and holds them till the
exercise date of the options written on that stock. When you buy a share of a stock, the profit is a function
of the stock price at the expiration date of the options, ST.
If the stock was bought at the current price of S0, the profit is (ST – S0) if the stock price, ST increases
beyond S0 and the loss is (S0 – ST) if the price decreases below S0. The maximum loss is S0, as you can
lose the full investment if S0 is close to zero. The maximum gain can be high if the stock price increases
considerably by the exercise date of the option. Each time the stock price changes by INR 1, the gain or
loss also changes by INR 1.

  E x a m ple 9 . 1
The share price of Bank of Baroda on January 1 is INR 430. An investor has bought a share of this
stock. The profit and loss for various stock prices on a March expiration date are shown in Table 9.1 and
Fig. 9.1.

Table 9.1  Profit and Loss from a Naked Long Stock Position

Stock Price at Expiration (INR) Gains (INR)

400 –30

410 –20

420 –10

430 0

440 10

450 20

460 30

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 Combinations of Options: Trading Strategies   199


Notes






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Figure 9.1  Gains from a Long Stock Position

9.1.2  Naked Short Stock Positions

When an investor takes a short position in the stock, the investor sells the stock they do not own. In
essence, the investor borrows the stock, usually from a broker, and sells it. When the investor wants to
close the short position, they purchase the stock in the market and return it to the lender. The investor
makes a profit if the share price decreases from the time they sell it short to the time they close out the
position, because they can buy the stock at a lower price in the market.

  E x a m ple 9 . 2
The share price of Bank of Baroda on January 1 is INR 430, and an investor has short-sold the stock
on January 1. The profit and loss for various stock prices on the March expiration date are shown in
Table 9.2 and Fig. 9.2.

Table 9.2  Profit and Loss from a Naked Short Stock Position

Stock Price at Expiration (INR) Gains (INR)

400 30

410 20

420 10

430 0

440 –10

450 –20

460 –30

The profit diagrams for long stock and short stock show that an increase in the share price provides a
profit for a long stock position and a loss for a short stock position. Any decrease in the stock price pro-
vides a loss for the long stock position and a profit for the short stock position. Moreover, the loss for the
long stock position is exactly the same as the profit for the short stock position, and vice versa. The profit
or loss is INR 1 each time the stock price changes by INR 1.

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Figure 9.2  Gains from a Short Stock Position

9.1.3  Naked Bought Calls

A naked position in a bought call means that the investor has bought a call option on the underlying stock
and has not taken a position in either the underlying shares or the put options on the underlying shares.
Since the option holder of a bought call will exercise the call only if the stock price at the expiration date
(ST) is greater than the exercise price (SX), the profit from the bought call can be written as
ST − S X − C if ST > S X
Profit for call buyer = 
−C if ST < S X
where C is the price paid for buying the call.

  E x a m ple 9 . 3
Suppose that call and put options are available on Bank of Baroda stock with an expiration date in March.
Call and put options have an exercise price of INR 440, and the prices of the call and put are INR 20 and
INR 38, respectively. The profit/loss from bought call positions for various stock prices on the expiration
date is shown in Table 9.3 and Fig. 9.3.
  This profit diagram shows that the buyer of the call option loses the full amount paid for the option if
the stock price at the expiration date is less than the exercise price and they gain INR 1 for each INR 1
increase in the stock price at expiration when the stock price is greater than the exercise price. Thus, the
loss is known with certainty, as the price paid for the option and the profit is unlimited.

Table 9.3  Profit and Loss from Bought Call Positions

Stock Price on Terminal value Call Price Gains from the

Expiration Date (INR) of the Call (INR) Paid (INR) Bought Call (INR)

400 0 –20 –20

420 0 –20 –20
440 0 –20 –20
460 20 –20 0
480 40 –20 20
500 60 –20 40
520 80 –20 60

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 Combinations of Options: Trading Strategies   201


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Figure 9.3  Gains from Bought Call Positions

However, if we look at the returns from buying an option, the option buyer can incur a maximum loss
of 100%, but the gain could be very high depending upon the stock price at expiration.

9.1.4  Naked Written Calls

A naked written call position means that an investor has written a call option on a stock without taking
any position in the stock or in a put option on the stock. When an investor writes a call, they receive the
call price at the time the call is written. They are required to fulfil the obligation of selling the stock at the
exercise price if the buyer does exercise the call. Since the buyer will exercise the call only when it is in-
the-money, that is, when the stock price at expiration is greater than the exercise price, the profit or loss
for a call writer can be written as:
C − (ST − S X ) if ST > S X
Profit for a call writer = 
C if ST < S X

  E x a m ple 9 . 4
Suppose that call and put options are available on Bank of Baroda stock with an expiration date in March.
Call and put options have an exercise price of INR 440, and the prices of the call and put are INR 20 and
INR 38, respectively. The profit/loss from written call positions for various stock prices on the expiration
date is shown in Table 9.4 and Fig. 9.4.

Table 9.4  Profit and Loss from Written Call Positions

Stock Price on Terminal value Call Price Gains from the

Expiration Date (INR) of the Call (INR) Received (INR) Written Call (INR)

400 0 20 20

420 0 20 20

440 0 20 20

460 –20 20 0

480 –40 20 –20

500 –60 20 –40

520 –80 20 –60

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Notes





      
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Figure 9.4  Gains from Written Call Positions

  The call writer will make a maximum gain, equal to the option price they received at the time of writing
the call. This happens when the stock price on the expiration date is less than the exercise price. However,
the loss could be high if the stock price increases considerably beyond the exercise price.

The profit and loss tables and diagrams for the call buyer and the call writer show that the profit for a
naked call buyer is the negative of the profit for a naked call writer. In fact, if the profit and loss diagram
is drawn such that the profit and loss for both the buyers of the call and the writers of the call are drawn
in the same diagram (as shown in Fig. 9.5), the profit for the call buyer is seen to be the mirror image of
the profit for the call writer, and vice versa.
This diagram shows that the maximum profit for a call writer is INR 20, which is the price at which
the call was written, while the maximum loss for a call buyer is INR 20, the price paid for buying the
call. The maximum profit for the call buyer is unlimited in the sense that it depends on how high the price
of the stock can increase. This also determines the amount of loss a call writer will incur.






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Figure 9.5  The Gain for the Call Buyer and the Call Writer

9.1.5  Naked Bought Puts

A naked position in a bought put means that the investor has bought a put option on the underlying
security without taking a position in either the underlying shares or the call options on the underlying

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 Combinations of Options: Trading Strategies   203

Notes shares. Since the option holder of a bought put will exercise the option only if the stock price on the
expiration date (ST) is less than the exercise price (SX), the profit from the bought put can be written as:

(S X − ST ) − P if ST < S X
Profit for the put buyer = 
− P if ST > S X

where P is the price paid for buying the put.

  E x a m ple 9 . 5
Suppose that call and put options are available on Bank of Baroda stock with an expiration date in March.
Call and put options have an exercise price of INR 440, and the prices of the call and put are INR 20 and
INR 38, respectively. The profit and loss from bought put positions for various stock prices are shown in
Table 9.5 and Fig. 9.6.
  The profit diagram shows that the buyer of a put option loses the full amount paid for the option if the
stock price at expiration is more than the exercise price and that they gain INR 1 for each INR 1 decrease
in the stock price below the exercise price at expiration. The maximum loss is known with certainty, and
this is equal to the price paid for the put. The maximum profit from the bought put position will be the
exercise price, since the stock price cannot go below zero.

Table 9.5  Profit and Loss from Bought Put Positions

Stock Price on Terminal value Put Price Paid Gains from the
Expiration Date (INR) of the Put (INR) (INR) Bought Put (INR)

280 160 –38 122

320 120 –38 82

360 80 –38 42

400 40 –38 2

440 0 –38 –38

480 0 –38 –38

520 0 –38 –38








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Figure 9.6  The Gain to a Put Option Buyer

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 204   Financial Risk Management

Notes 9.1.6  Naked Written Puts

A naked written position means that the investor has written a put option on a stock without taking any
position in the underlying stock or in the call option on the stock. When an investor writes a put, they will
receive the put price and they are required to fulfil the obligation of buying the stock at the exercise price
if the buyer of the put exercises the option, but they have no obligation if the put buyer does not exercise
the option. Since the put buyer will exercise the option only when it is in-the-money, that is, when the
stock price at expiration is less than the exercise price, the profit for a put writer can be written as:
−(S X − ST ) + P if ST < S X
Profit for put writer = 
− P if ST > S X
  E x a m ple 9 . 6
Suppose that call and put options are available on Bank of Baroda stock with an expiration date in March.
Call and put options have an exercise price of INR 440, and the prices of the call and put are INR 20 and
INR 38, respectively. The profit and loss from written put positions for various stock prices are shown in
Table 9.6 and Fig. 9.7.

Table 9.6  Profit and Loss from Written Put Positions

Stock Price on Terminal value Put Price Gains from the

Expiration Date (INR) of the Put (INR) Received (INR) Written Put (INR)

280 160 38 –122

320 120 38 –82

360 80 38 –42

400 40 38 –2

440 0 38 38

480 0 38 38

520 0 38 38

  When an investor writes a put, the maximum profit is the option price they received at the time of
writing the put. The maximum loss is the exercise price, as the stock price can never go below zero.








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 Combinations of Options: Trading Strategies   205


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Figure 9.8  Gain to the Put Buyer and the Put Writer

This diagram shows that the maximum profit for the put writer is INR 38, which is the price at which
the put was written. The maximum loss for the put buyer is INR 38, the price paid by the put buyer. The
maximum profit for the put buyer is INR 402 (Exercise price – Put price), as the stock cannot have a price
of less than zero. This will also be the maximum loss for the put writer.
The profit and loss table and diagram show that the profit for a naked put buyer is the negative of the
profit for a naked put writer. In fact, if the profit diagram for both the put buyer and the put writer are
shown in the same figure (as shown in Fig. 9.8), the profit for the put buyer is seen to be the mirror image
of the profit for the put writer.

9.2  Hedge or Covered Positions

When an investor uses a portfolio of the underlying security and one or more of the options such that the
options protect the investor from unfavourable outcomes of the stock price movements, the position is
said to be a hedged position. The most common hedge is known as covered call writing, which involves
writing a call option on a stock that the investor already owns. Other possible hedge positions are short
stock and long calls, known as reverse hedge, long stock and long puts, known as purchasing protective
puts, and short stock and short puts.
Box 9.2 indicates a combination of stock and written call known as a covered call position. Stock can
be combined with either calls or puts in order to hedge risks. These combinations of stocks with either a
call or a put are discussed in this section.

BOX 9.2 Covered Call Funds as an Alternative to Bonds

The major advantage of investing in bonds is the steady gives up possible upside potential from the stock markets
stream of income. However, there is an alternative to bond in- but provides a steady income. Although these funds under-
vestment which can be accomplished at a lower cost, known perform in the market during bullish periods, during the
as investing in “covered call funds.” A covered call fund buys other periods, these funds do better.
shares and sells call options on the stocks owned. This fund

Source: Brett Arends, “As Bonds Look Risky, Finding Shelter in Covered Calls,” The Wall Street Journal,
October 8, 2009.

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Notes 9.2.1  Covered Call Writing

In naked call writing, a trader writes call option on a stock and he does not own the shares on which the
call is written. In covered call writing, the trader owns the shares on which the call is written. When a call
writer writes a naked call, they incur a loss when the price of the underlying share increases, because they
will have to purchase the underlying share at the market price and sell it to the call buyer at the exercise
price, which is lower than the market price. However, if the call writer already owns the shares of the
underlying stock, they do not have to buy the share at the higher market price and hence no loss is in-
curred. Of course, they could have sold the stock at the higher market price, instead of selling at the lower
exercise price. Thus, there is only an implicit cost of writing a covered call and there is no explicit loss.
Covered calls are used when the price is not expected to increase beyond the exercise price of the call. By
writing a covered call, the holder of a stock is able to reduce the losses on their stock position through the
price of the call received, in case the stock price decreases.
The risk while writing naked calls is that the call writer can lose an unlimited amount of money if the
stock price increases. However, this loss can be reduced by writing a covered call, as shown in Problem 9.1.

P r oble m 9 . 1
Suppose that an investor writes a call option on Bank of Baroda stock with an exercise price of INR 440 for INR 20.
He already owns the shares of Bank of Baroda. Show that writing a covered call will provide a lower loss than writing
a naked call.
Solution to Problem 9.1
The terminal value of this covered call position and the profit are shown in Table 9.7 and Fig. 9.9.

Table 9.7  Terminal Value and Profit from a Covered Call Position

Stock Price on Value of the Profit from

Gain from Call Price
Expiration date Written Call the Covered
Stock (INR) Received (INR)
(INR) (INR) Call (INR)

320 –120 0 20 –100

360  –80 0 20 –60
400  –40 0 20 –20
440     0 0 20 20
480   40 –40 20 20
520 80 –80 20 20






 
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Figure 9.9  The Gain from Covered Call Writing

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 Combinations of Options: Trading Strategies   207

  This diagram shows that the maximum profit for the covered call writer is INR 20, which is the price of the
Notes
call option received by the writer, and the maximum loss is the difference between the exercise price and the price
of the call.

Covered call writing changes all favourable stock outcomes into a constant hedge profit and the un-
favourable stock outcomes are improved upon the receipt of the call option price. A covered call will be
used when an investor owns the stock and is concerned about a decrease in the price of the stock. If they
had not written a call, their loss would have been the total amount of decrease in the price. When they
write a call, they would receive the call price and hence their loss would reduce by the amount of price
they had received for the call. In case the stock price decreases such that the decrease in the price is less
than the call price, the covered call writer will also make a gain. For example, an investor buys Bank of
Baroda stock when the price is INR 430 and writes a covered call with an exercise price of INR 440 and a
call price of INR 20. If the stock price decreases to INR 420, the investor would incur a loss of INR 10 if
they had not written a call; with the written call, they would actually gain INR 10 as they would receive
INR 20 from the call buyer. Of course, if the price increases, a covered call writer will have to sell the
stock at the exercise price and incur losses only if the stock price moves higher than Exercise price + Call
option price. Thus, a covered call provides better returns in case the stock price is below Exercise price
+ Call option price.
It is interesting to note that the profit from the covered call position has the same pattern as the profit
for a naked put writer although the maximum loss and maximum profit are different. In the case of a
naked put writer, the maximum profit is the put price received and the maximum loss is the difference
between the exercise price and the put price.

9.2.2 Reverse Hedges
A reverse hedge means that an investor short-sells the stock and buys a call option on the stock. When
a stock is sold short, the short-seller is affected when the stock price increases. To hedge the risk of an
increase in the stock price, the investor purchases a call option that gives the investor the right to buy the
stock at the exercise price. Thus, the investor is protected from unfavourable outcomes when the stock
price increases.

  E x a m ple 9 . 7
Assume that the investor sells the stock short when the price is INR 440 and buys a call option on the
stock with an exercise price of INR 440. Table 9.8 shows that the investor incurs a maximum loss of INR
20, which is the price paid for the call option. When the stock price increases beyond the exercise price,
the investor is able to exercise the option and pay only the exercise price for acquiring the stock. Thus,
unfavourable outcomes of share prices are offset by the purchase of call options. Fig. 9.10 shows the profit
from a reverse hedge.

Table 9.8  Terminal Value and Profit from a Reverse Hedge Position

Stock Price Gain from the Value of the Profit from

Call Price
on Expiration Short Stock Bought Call the Reverse
Paid (INR)
date (INR) (INR) (INR) Hedge (INR)

280 160 0 –20 140

320 120 0 –20 100
360 80 0 –20 60
400 40 0 –20 20
440 0 0 –20 –20
480 –40 40 –20 –20
520 –80 80 –20 –20

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Figure 9.10  Gains from a Reverse Hedge

A reverse hedge changes all unfavourable stock outcomes into a constant hedge loss, and the gains
from favourable stock outcomes are decreased by price paid for buying the call option. A reverse hedge
will be used when an investor short-sells the stock and is concerned about an increase in the price of
the stock. If they had not bought a call, their loss would have been the total amount of increase in price.
When they buy a call, any loss from the short stock position will be offset by the gain from the call and
the maximum loss would be the call price paid. However, in case the stock price decreases, the gain from
a decrease in prices would be reduced by the call price paid. For example, suppose the investor short-sells
Bank of Baroda stock when the price is INR 430 and buys a call with an exercise price of INR 440 and a
call price of INR 20. If the stock price increases to INR 480, the call will be exercised and the gain from
the call will be offset by the loss from short-selling the stock. The maximum loss will be INR 20, which is
the price paid for the call. Of course, if the price decreases, the reverse hedger will gain by the amount of
decrease in the stock price, and this gain will be reduced by the call price paid.
It can be seen that the profit diagram for the reverse hedge position is very similar to the profit diagram
for a naked put buyer, except that the maximum profit and the maximum loss are different for the two strat-
egies. This indicates that a put option can be created by a suitable combination of the stock and a call option.

9.2.3  Protective Puts

Put options can be combined with a long stock position to provide a hedge. When an investor buys
a stock, they benefit if the share price increases, but they face a loss if the stock price decreases. If they
wish to maintain the profit position when the stock price increases and want to reduce losses if the stock
price decreases, a combination of a bought put with the long stock would provide the desired outcome.
Box 9.3 explains the use of a protective put when one expects that the price of a stock may decrease
because of a rally on a Friday, before a long weekend, with a trading holiday on Monday.

BOX 9.3 Mobile Telesys Ojsc Ads (MBT) Protective Put

When the stock price increases by a large percentage on value can be maintained at a minimum, which is the exer-
Friday, before a long weekend, it is likely that the price may cise price of the put option. For example, the stock of MBT
fall heavily on Tuesday morning, when trading in the stock had increased by 9.99%, with late-day selling activity on
begins again. If you are bullish about the stock and want Friday indicating that the price may drop by Tuesday. Buy-
to hedge the weekend risk, you can enter into a protective ing a June put option at USD 1.70 per share will protect the
put transaction. By entering into a protective put, the stock investor from weekend surprises for a total of three weeks.

Source: Jason Ng, “Mobile Telesys Ojsc Ads (MBT) Protective Put,” International Business Times, May 23, 2009.

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 Combinations of Options: Trading Strategies   209

Notes P r oble m 9 . 2
Suppose that call and put options are available on Bank of Baroda stock with an expiration date in March. Call and
put options have an exercise price of INR 440, and the prices of the call and put are INR 20 and INR 38, respectively.
Assume that you buy Bank of Baroda shares at INR 440 and a put option on bank of Baroda stock to form a protective
put strategy. What will be the terminal value and profit from this strategy for various terminal stock prices?
Solution to Problem 9.2
Table 9.9 and Figure 9.11 illustrate the profit from a protective put strategy.

Table 9.9  Profit from a Protective Put Strategy

Stock Price Terminal value Profit from

Gain From Value of the
on Expiration of the Protective the Protective
Stock (INR) Bought Put (INR)
date (INR) Put (INR) Put (INR)

280 –160 160 440 –38

320 –120 120 440 –38

360 –80 80 440 –38

400 –40 40 440 –38

440 0 0 440 –38

480 40 0 480 2

520 80 0 520 42

Table 9.9 shows that the minimum value of the portfolio is INR 440 even when the share price
decreases below INR 440. This is because the bought put with an exercise price of INR 440 is able to
provide a hedge for a decrease in the share price below INR 440. Thus, a bought put is able to protect
the portfolio from deceasing below the exercise price of the put option. This strategy is also known as a
portfolio insurance strategy, the cost of insurance being the price paid for the put option.
When a person employs a protective put strategy, their initial outlay is the sum of the stock price
and the put price. If the stock price is INR 440 and the put price is INR 38, the total outlay will be
INR 478. If the stock price decreases to INR 430, the investor would lose INR 10 on the stock investment.
At the same time, they can exercise the put option and sell the stock at INR 440. This would provide a
gain of INR 10 from the bought put. The net gain from the bought stock and bought put will be zero,
as losses from the stock position are exactly offset by the gains from the bought put position. This










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Figure 9.11  Gains from a Protective Put Strategy

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 210   Financial Risk Management

Notes will be true for all stock prices below INR 440. Thus, a protective put strategy provides a minimum
value for the portfolio of a stock and a bought put, and this value is the exercise price of the put op-
tion. In case the stock price increases, the put will not be exercised and the value of the portfolio will
be the same as the value of the stock. However, the gain from the portfolio when the stock price increases
will be reduced by the put price paid. For example, if the stock price increases to INR 480, the gain from
the stock is INR 40 and the gain from portfolio will be only INR 2 (INR 40 – INR 38), as the put price
is INR 38.
Since this strategy results in a minimum value for the stock portfolio, one can say that this strategy
insures that the value of the portfolio will not go below this value. Because of this property of insuring a
minimum value, this strategy is also known as a portfolio insurance strategy.

9.2.4  Short Stocks and Short Puts

When an investor writes a put, they agree to buy the share at the exercise price and they are obligated to
buy it at the exercise price only if the market price is below the exercise price. Thus, the put writer will
incur a loss if the stock price decreases. However, if they cover the short put position by selling the stock
short, losses from the short put position will be offset by gains from the short stock position. This happens
because the investor will receive the full share price while selling the stock short and will then replace the
stock at a later date, when the price is lower. Thus, a short stock position will provide a hedge for a short
put position.

  E x a m ple 9 . 8
Suppose that call and put options are available on Bank of Baroda stock with an expiration date in March.
Call and put options have an exercise price of INR 440, and the prices of the call and put are INR 20 and
INR 38, respectively. Assume that you short-sell Bank of Baroda shares at INR 440 and write a put option
on Bank of Baroda stock. The profit from the short-put–short-stock strategy is shown in Table 9.10 and
Fig. 9.12. In this example, it is assumed that the stock is sold short at INR 440.
When the stock price is below the exercise price, the put writer will lose the difference between the
exercise price and the stock price; however, a short stock position will provide an identical gain and
hence the profit will be the put price received. When the stock price is above the exercise price, the put
will not be exercised and the short stock position will result in losses, but the loss will be reduced by the
put price received. In Table 9.10, when the stock price is less than the exercise price, say, INR 400, the
investor gains from the short stock position of INR 40. However, the put will be exercised and the put
writer will have to buy the stock from the put buyer at INR 440 while the stock price is INR 400. Thus, the

Table 9.10  Profit from a Short Stock and Short Put Position

Terminal Terminal Value Profit from the

Stock Price Gain from
Value of the of the Short Short Stock
on Expiration the Short
Written Put Stock and Short and the Short
Date (INR) Stock (INR)
(INR) Put (INR) Put (INR)

280 160 –160 0 38

320 120 –120 0 38
360 80 –80 0 38
400 40 –40 0 38
440 0 0 0 38
480 –40 0 –40 –2
520 –80 0 –80 –42

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 Combinations of Options: Trading Strategies   211


Notes







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Figure 9.12  Gains from a Short Stock and Short Put

short put position will result in a loss of INR 40. The portfolio of a short stock (which provides a gain of
INR 40) and a short put (which provides a loss of INR 40) will provide neither a gain nor a loss. However,
the investor earns a profit of INR 38, which is the put option price they received. This is true for any stock
price below the exercise price. Therefore, this strategy will provide a sure profit that is equal to the put
option price in case the stock price decreases below the exercise price. In case the stock price increases,
the investor will lose from shorting the stock, but there will be no impact from the option position, as
the put option will not be exercised. However, the loss from shorting the stock will be reduced by the put
price received.

It is to be noted that the profit diagram for a protective put is similar to the profit diagram for a bought
call and the profit diagram for a short put and short stock is similar to the profit diagram for a written call
position, except for the maximum profit and maximum loss.

9.2.5  Partial Hedges

It was shown earlier that the writing of covered calls involves writing a call for each stock purchased.
However, partial hedges, wherein the number of calls written is different from the number of shares
of stock purchased, can also be used. The number of calls that one wants to write depends on their
expectations about the stock price movement. If the investor believes that the probability of a decrease in
the stock price is low, they would write a fewer number of calls per share bought. However, if they believe
that the probability of a decrease in the stock price is large, they would write a large number of calls per
share bought.

P r oble m 9 . 3
Assume that the share price of Hindustan Unilever is INR 295, the call option exercise price is INR 300, and the
call option premium is INR 10. Calculate the profits for the following partial hedging strategies for various possible
terminal stock prices:

(i) Buy 1 stock and write 1/2 call

(ii) Buy 1 stock and write 1 call
(iii) Buy 1 stock and write 2 calls
(iv) Buy 1 stock and write 4 calls
Solution to Problem 9.3
The profit from partial hedges is shown in Table 9.11 and Fig. 9.13.

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 212   Financial Risk Management

Notes Table 9.11  Profits from Partial Hedges

1 Stock 1 Stock 1 Stock +

Stock 1 Stock +
ST (INR) 1/2 Call + 2 Calls 4 Calls Call (INR)
(INR) 1 Call (INR)
(INR) (INR) (INR)

270 –30 –25 –20 –10 10 10

280 –20 –15 –10 0 20 10
290 –10 –5 0 10 30 10
300 0 5 10 20 40 10
310 10 10 10 10 10 0
320 20 15 10 0 –20 –10
330 30 20 10 –10 –50 –20




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Figure 9.13  The Gain from Partial Hedges

The profits from partial hedges are derived as follows: When the hedge is one stock and half a written
call, we can consider it to be half of two stocks and one written call. This means that when the stock price
increases and the call buyer exercises the call option, the writer will have to give up only one share and
the gains from another share still belong to the hedger. Thus, when the share price is INR 310, the hedger
will lose the gain on one share, but retain the INR 10 they received for the call on that share, and they will
make a gain of INR 10 on the other share. Thus, the profit for two shares and one call will be INR 20 when
the share price is INR 310 or INR 10 for one share and half a call.
When the strategy is one stock and two calls, we will have to add the pay-off from one call to the port-
folio of one stock and one call; this will give the profit for one stock and two calls.
It can be seen from the diagram that, as the number of calls included in the portfolio decreases per
share of the underlying security, the portfolio performs as the underlying security, while, on the other
hand, as the number of calls per share of the underlying security increases, the portfolio performs as a
written call.

9.2.6  Summary of Hedged Positions

Hedged positions using the underlying security and any one type of option, that is either a call or a put,
provide for a hedge against unfavourable movement in one of the two securities. However, the resulting

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 Combinations of Options: Trading Strategies   213

Notes pattern can be arrived at by naked trading in another option. For example, the profit pattern from covered
call writing, involving a long stock and a written call, can be arrived at by writing a put.
This indicates that only one type of option exists. An investor can include a call option in their portfo-
lio or just as easily create the option position by investing in the underlying security and a put. Of course
the profits will vary for the two strategies, but they can be made equal by including risk-free securities.
This relationship between a call and a put is known as the put–call parity, which will be discussed in detail
in Chapter 8.

9.3  Spread Positions

A portfolio of two or more options of different series belonging to the same class, with some options held
long and some held short, is known as a spread position. Two options are in the same class if both are calls
or puts, and two options are in the same series if they have the same exercise price and date.
The most common spreads are money spreads (where the options have the same expiration dates
but different exercise prices), time spreads (where the options have the same exercise price but different
exercise dates), and butterfly spreads.

9.3.1 Money Spread Using Calls

A money spread is also known as a vertical or price spread. It refers to a portfolio that contains the same
type of option with the same expiration date but different exercise prices. One can form a money spread
by using either call options or put options.
A money spread has two forms, bullish and bearish, depending on the expectation about the stock
price movement. If an investor is bullish about the stock and expects the stock price to go higher than the
low exercise price but remain lower than the higher exercise price, they will write a call with the higher
exercise price and buy a call with the lower exercise price. On the other hand, if the investor is bearish
about the share price and expects the share price to decrease, they will write a call with the lower exercise
price and buy a call with the higher exercise price. Since the call option with the lower exercise price will
be priced higher than the call option with the higher exercise price, this strategy would provide an im-
mediate cash flow to the investor.

  E x a m ple 9 . 9
Assume that the Tata Motor share price on January 1 is INR 725 and call options and put options are
available with maturity in March. Option series A has an exercise price of INR 740 (SL), while series B
has an exercise price of INR 760 (SH) for both calls and puts. The price of a call option with an exercise
price of INR 740 is INR 35 (CL), and the price of a call option with an exercise price of INR 760 is INR
20 (CH). The put prices are INR 48 (PL) and INR 60 (PH) for options with exercise prices of INR 740 and
INR 760, respectively. Table 9.12 and Fig. 9.14 show the profit from a bullish spread, and Table 9.13 and
Fig. 9.15 show the profit from a bearish spread using call options. ST refers to the stock price at maturity.
Initial investment and the value of the bullish money spread on the expiration date are calculated as
follows:
Initial investment = Call price received for higher exercise price – Call price paid for lower exercise price call
= INR 20 – INR 35
= –INR 15
On the exercise date, when ST < SL, both options will not be exercised and hence the profit is given by
CH – CL = INR 20 – INR 35 = –INR 15. When SL < ST ≤ SH , the low-exercise-price options will be
exercised, but the high exercise price option will not be exercised; hence:
Profit = (ST – SL) + (CH – CL)
= ST – 740 – 15
= ST – 755

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Notes Table 9.12  Profit from a Bullish Money Spread Using Call Options

Bought Call Value Written Call Value Value of the Money

ST (INR)
(SX = 740) (INR) (SX = 760) (INR) Spread (INR)

600 –35 20 –15

640 –35 20 –15

680 –35 20 –15
700 –35 20 –15
720 –35 20 –15
740 –35 20 –15
760 –15 20 5
800 25 –20 5
840 65 –60 5
880 105 –100 5






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Figure 9.14  Gain from a Bullish Money Spread Using Calls

Thus, when ST = INR 755,

profit = INR 755 – INR 755 = 0,
and when ST = INR 757,
Profit = INR 757 – INR 755 = INR 2
When ST > SH , both options will be exercised. Hence:
Profit = (ST – SL) – CL – [(ST – SH) – CH] = (SH – SL) + (CH – CL)

Thus, the profit when ST = INR 800 is given by:

Profit = (INR 760 – INR 740) + (INR 20 – INR 35) = INR 5
This shows that the profit from the bullish spread using calls can be written as:
Profit = CH – CL when ST ≤ SL
Profit = (ST – SL) + (CH – CL) when SL < ST ≤ SH
Profit = (SH – SL) + (CH – CL) when ST > SH

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 Combinations of Options: Trading Strategies   215

Notes This shows that an investor with a bullish money spread using calls will make a profit as long as ST >
(SL + CL – CH), or ST > INR 755, and this profit is constant at (SH – SL) + (CH – CL) = INR 5 after ST crosses
INR 760.
This also shows that a bullish money spread using calls results in a maximum profit of [(SH – SL) +
(CH – CL)] when both the options are in-the-money and results in a maximum loss of (CH – CL) when
both the options are out-of-money.
In other words, if an investor believes that the stock price is likely to exceed INR 755, they would
engage in a bullish spread using calls, and this will result in a constant profit of INR 5 for any stock price
beyond INR 760. It can also result in a maximum loss of INR 15 for any stock price below INR 740. If they
had bought just the low-exercise-price call paying INR 35, they would have made a gain only if the price
went beyond INR 775, whereas the spread provides INR 5 for a price between INR 755 and INR 775.
The profit for a bearish money spread using calls can be calculated as follows:
  In a bearish money spread, one would buy a call with the higher exercise price and write a call with the
lower exercise price. A bearish money spread will result in profits if the stock price decreases.
Initial investment = Premium received for the low-exercise-price call
– Premium paid for the high-exercise-price call
= INR 35 – INR 20
= INR 15

Table 9.13  Profit from a Bearish Money Spread Using Call Options

Written Call Value Bought Call Value Value of Money

ST (INR)
(SX = INR 740) (SX = INR 760) Spread (INR)

600 35 –20 15

640 35 –20 15

680 35 –20 15

700 35 –20 15

720 35 –20 15

740 35 –20 15

760 15 –20 –5

800 –25 20 –5

840 –65 60 –5




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Figure 9.15  Gain from a Bearish money Spread Using Calls

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Notes On the expiry date, when ST < SL, both the options will not be exercised; hence:
Profit = CL – CH = INR 35 – INR 20 = INR 15
When SL < ST ≤ SH, the low-exercise-price option will be exercised but the high-exercise-price option will
not be exercised; hence:
Profit = (CL – CH) – (ST – SL) = 755 – ST
Thus, when ST = 755,
Profit = INR 755 – INR 755 = 0,
and when ST = INR 760,
Profit = INR 755 – INR 760 = –INR 5
When ST > SH, both the options will be exercised:
profit = CL – (ST – SL) + [(ST – SH) – CH]= (SL – SH) + (CL – CH)
Thus, the profit when ST = INR 780 is given by:
Profit = (INR 740 – INR 760) + (INR 35 – INR 20) = –INR 5
This shows that the profit from a bearish spread using calls can be written as:
Profit = (CL – CH) when ST ≤ SL
Profit = (CL – CH) – (ST – SL) when SL < ST ≤ SH
Profit = (CL – CH) + (SL – SH) when ST > SH

Thus, an investor with a bearish money spread using calls will make a profit as long as the share price is
not expected to exceed SL + CL – CH = INR 755.
This also shows that a bearish money spread using calls results in a maximum profit of (CL – CH) when
both the options are out-of-money, and it results in a maximum loss of [(CL – CH) + (SL – SH)] when both
the options are in-the-money.
  In other words, if an investor believes that the stock price is not likely to exceed INR 755, they would
engage in a bearish spread using calls, and this will result in a constant profit of INR 15 for any stock price
below INR 740.
Thus, an investor will enter into a bearish money spread using calls if the expected stock price is less
than (SL + CL – CH) and an investor will enter into a bullish money spread using calls if the expected stock
price is more than (SL + CL – CH).

9.3.2 Money Spreads Using Puts

An investor can create money spreads using put options. A bullish spread means that the investor expects
the stock price to increase. When the stock price is expected to increase, it makes sense to buy a put with
the lower exercise price and write a put with the higher exercise price. This will result in immediate cash
inflow, because a put with a higher exercise price will have a higher value. On the other hand, if the inves-
tor is bearish on the stock and expects the stock price to decrease, they would buy a put with a higher
exercise price and write a put with a lower exercise price.

  E x a m ple 9 . 1 0
Assume that the Tata Motors share price on January 1 is INR 725 and call options and put options
are available with maturity in March. Option series A has an exercise price of INR 740 (SL), while series
B has an exercise price of INR 760 (SH) for both calls and puts. The price of a call option with an exercise
price of INR 740 is INR 35 (CL), and the price of a call option with an exercise price of INR 760 is INR
20 (CH). The put prices are INR 48 (PL) and INR 60 (PH) for options with exercise prices of INR 740 and
INR 760, respectively. Tables 9.14 and Fig. 9.16 show the profits for a bullish money spread using puts,
and Table 9.15 and Fig. 9.17 show the profits for a bearish money spread using puts.

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 Combinations of Options: Trading Strategies   217

Notes Table 9.14  Profit from a Bullish Money Spread Using Put Options

Bought Put Value Written Put Value Value of Money

ST (INR)
(SX = INR 740) (SX = INR 760) Spread (INR)

600 92 –100 –8
640 52 –60 –8
680 12 –20 –8
700 –8 0 –8
720 –28 20 –8
740 –48 40 –8
760 –48 60 12
800 –48 60 12

840 –48 60 12

The profit is arrived at as follows. When ST ≥ SH, both the put options will not be exercised, and
Profit = PH – PL = INR 60 – INR 48 = INR 12
When SL < ST < SH, the high-exercise-price put will be exercised and the low-exercise-price put will not
be exercised and, therefore:
profit = (PH – PL) – (SH – ST) = (60 – 48) – (760 – ST) = ST – 748
When the stock price is INR 748, the profit will be INR 0, and when the stock price is INR 750, the profit
will be INR 2. When ST ≤ SL, both the options will be exercised and:
profit = (SL – SH) + (PH – PL)
= (INR 740 – INR 760) + (INR 60 – INR 48)
= –INR 8
This shows that the profit from a bullish spread using puts can be written as:
Profit = (SL – SH) + (PH – PL) when ST ≤ SL
Profit = (PH – PL) – (SH – ST) when SL < ST ≤ SH
Profit = (PH – PL) when ST > SH

This shows that an investor with a bullish money spread using puts will earn profit as long as the share
price is expected to exceed SH – (PH – PL) = INR 748.




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Figure 9.16  Gain from a Bullish Money Spread Using Puts

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 218   Financial Risk Management

Notes   In other words, if an investor believes that the stock price is likely to exceed INR 748, they will engage
in a bullish spread using puts, and this will result in a constant profit of INR 12 for any stock price above
INR 760. This also shows that a bullish money spread using puts results in a maximum profit of (PH – PL)
when both the puts are out-of-money, and it results in a maximum loss of [(SL – SH) + (PH – PL)] when
both the puts are in-the-money.
The profit for a bearish money spread using puts is calculated as follows: When ST ≥ SH, both the put
options will not be exercised, and:
Profit = PL – PH = –INR 48 + INR 60 = INR 12
When SL < ST < SH, the high-exercise-price put will be exercised and the low-exercise-price put will not
be and, therefore:
Profit = (PL – PH) + (SH – ST)
= (48 – 60) + (760 – ST)
= 748 – ST 
When the stock price is INR 742, the profit is INR 6, and when the stock price is 756, the profit is
–INR 8. When ST ≤ SL, both the options will be exercised, and:
Profit = (SH – SL) + (PL – PH)
= (INR 760 – INR 740) + (INR 48 – INR 60)
= INR 8

Table 9.15  Profit from a Bearish Money Spread Using Put Options

Written Put Value Bought Put Value (SX Value of Money

ST (INR)
(SX = INR 740) = INR 760) Spread (INR)

600 –92 100 8

640 –52 60 8

680 –12 20 8

700 8 0 8

720 28 –20 8

740 48 –40 8

760 48 –60 –12

800 48 –60 –12

840 48 –60 –12

  This shows that the profit from a bearish spread using puts can be written as:
Profit = (SH – SL) + (PL – PH) when ST ≤ SL
profit = (PL – PH) + (SH – ST) when SL < ST ≤ SH
profit = (PL – PH) when ST > SH

This shows that an investor with a bearish money spread using puts will make a profit as long as the share
price is expected to not exceed SH – (PH – PL) = INR 748
In other words, if an investor believes that the stock price is not likely to exceed INR 748, they will
engage in a bearish spread using puts, and this will result in a constant profit of INR 8 for any stock price
below INR 740. This also shows that a bearish money spread using puts results in a maximum loss of
(PL – PH) when both the puts are out-of-money, and it results in a maximum gain of [(SH – SL) – (PH – PL)]
when both the puts are in-the-money.

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 Combinations of Options: Trading Strategies   219


Notes

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Figure 9.17  Gains from a Bearish Money Spread Using Puts

It can be noted that the bullish money spread using calls and the bullish money spreads using
puts have identical profit patterns; however, the maximum profit and maximum loss can differ, as seen
in Table 9.16.
However, when a bullish money spread is entered into using calls, it requires an investment of
(CL – CH) , but the bullish money spread using puts provides a cash inflow of (PH – PL) at the time of
entering into the contract.
Similarly, the bearish money spread using calls and the bearish money spread using puts have similar
profit patterns; however, the profit amount will differ, as seen in Table 9.17.
However, when a bearish money spread is entered into using calls, it provides a cash inflow of
(CL – CH), but the bearish money spread using puts requires an investment of (PH – PL) at the time of
entering into the contract.
Since spreads using calls and puts provide similar profit patterns and since the profits depend on the
relationship between the prices of high-exercise-price options and low-exercise-price options, the inves-
tor can choose whether to use calls or puts on the basis of the difference in the prices of the options and
by determining the strategy that provides a higher profit.

9.3.3  Box Spreads

A box spread is a combination of a bullish money spread, calls with exercise prices SL and SH and, a bear-
ish money spread using puts with the same exercise prices (SL and SH). The pay-off from a box spread
is given in Table 9.18. A bullish money spread using calls requires buying a call with the lower exercise
price SL and writing a call with the higher exercise price SH. A bearish money spread using puts requires
buying a put with the higher exercise price SH and writing a put with the lower exercise price SL. Thus, a
box spread includes:
1. Buying a call at CL with the low exercise price SL
2. Writing a put at PL with the low exercise price SL

Table 9.16  Profit from Bullish Spreads Using Calls and Puts

Stock Price Profit using Calls Profit Using Puts

ST ≤ SL (CH – CL) (PH – PL) – (SH – SL)

SL < ST ≤ SH (CH – CL) + (ST – SL) (PH – PL) – (SH – ST)

ST > SH (CH – CL) + (SH – SL) (PH – PL)

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Notes Table 9.17  Profit from Bearish Spreads Using Calls and Puts

Stock Price Profit Using Calls Profit Using Puts

ST ≤ SL (CL – CH) (PL – PH) + (SH – SL)

SL < ST ≤ SH (CL – CH) – (ST – SL) (PL – PH) + (SH – ST)

ST > SH (CL – CH) – (SH – SL) (PL – PH)

3. Buying a put at PH with the high exercise price SH

4. Writing a call at CH with the high exercise price SH
The value of this box spread = CL – PL + PH – CH = (CL – CH) – (PL – PH)
where, CL and CH represent the price of the call options with the low exercise price and high exercise
price, respectively, and PL and PH represent the price of put options with the low exercise price and high
exercise price, respectively.
Table 9.18 shows that the terminal value of a box spread is equal to the difference in the exercise prices,
irrespective of the stock price in the market. The current value of the box spread should therefore be equal
to the present value of this constant pay-off of (SH – SL), which equals e–rt × (SH – SL). If the actual current
value of the box spread is different from this value, there will be arbitrage opportunities.
If the market price of the box spread is below this value, it is better to buy the box. This means that the
investor would buy a call with an exercise price of SL, buy a put with an exercise price of SH, write a call
with an exercise price of SH , and sell a put with an exercise price of SL; therefore, the current investment
would be [(CL – CH) – (PL – PH)].
If the market price of the box spread is above this value, it is better to sell the box. This means that the
investor would buy a call with an exercise price of SH , buy a put with an exercise price of SL, write a call
with an exercise price of SL, and sell a put with an exercise price of SH.
Constant pay-off from a box spread is possible only in the case of European options. A box spread us-
ing American options can give rise to variable pay-offs, as they could be exercised early and hence cause
losses.

9.3.4  Butterfly Spreads

A butterfly spread involves positions in options with three different exercise prices but with the same
exercise date. It can be created by buying a call option with the high exercise price SH , buying a call
option with the low exercise price SL, and writing two call options with the medium exercise price SM.
Creating a butterfly spread can also be considered as forming a portfolio comprising a bullish mon-
ey spread created by using a high-exercise-price call and a medium-exercise-price call and a bearish
money spread created by using a medium-exercise-price call and a low-exercise-price call. Typically,
the medium exercise price SM is the average of the other two exercise prices and is also close to the
current stock price.

Table 9.18  Pay-off from a Box Spread

Terminal Value of a Terminal Value of a

Terminal Value
Stock Price Bullish Spread Bearish Spread
of a Box Spread
Using Calls Using Puts

ST ≤ SL 0 (SH – SL) (SH – SL)

SL < ST ≤ SH (ST – SL) (SH – ST) (SH – SL)

ST > SH (SH – SL) 0 (SH – SL)

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 Combinations of Options: Trading Strategies   221

Notes   E x a m ple 9 . 1 1
Assume there are three call options on ICICI Bank stock with exercise prices of INR 1,200 (SL), INR 1,250
(SM), and INR 1,300 (SH) with the same exercise date. The ICICI Bank stock is currently selling at INR
1,225. Assume that the call prices are INR 80 (CL) for SL, INR 50 (CM) for SM , and INR 30 (CH) for SH.
Then, the butterfly spread involves the following:
1. Buying a call with an exercise price of INR 1,200
2. Buying a call with an exercise price of INR 1,300
3. Writing two calls with an exercise price INR 1,250
The initial cost of this portfolio is:
Cost = (CH + CL) – (2 × CM) = (80 + 30) – (2 × 50) = INR 10
The profit from a butterfly spread using calls can be summarized as shown in Table 9.19.

Table 9.19  Profit from a Butterfly Spread Using Calls

Stock Price Profit

ST ≤ SL (2 × CM) – (CH + CL)

SL < ST ≤ SM (ST – SL) + [2 × CM – (CH + CL)]

SM < ST < SH (SH – ST) + [2 × CM – (CH + CL)]

ST ≥ SH (2 × CM) – (CH + CL)

When ST ≤ SL, none of the calls will be exercised and the portfolio value will be zero. The profit will
be the initial cash flow, which is equal to the difference between the amount received from writing the
medium-exercise-price call and the amount paid to purchase the high-exercise-price call and the low-
exercise-price call, which is [(2 × CM) – (CH + CL)]. In this example, when ST ≤ INR 1,200,
Profit = (2 × 50) – (80 + 30) = –INR 10
When SL < ST ≤ SM, the call with the low exercise price will be exercised and the other calls will not be
exercised, resulting in a portfolio value of ST – SL. Therefore,
Profit = (ST – SL) + [(2 × CM) – (CH + CL)]
= ST – 1,200 – 10
= ST – 1,210

If the stock price is INR 1,230, the profit will be INR 10, and if the stock price is INR 1,245, the profit will
be INR 35.
When SM < ST < SH, the low-exercise-price option and the medium-exercise-price option will be
exercised. The portfolio value of the low-exercise-price option is (ST – SL) and the portfolio value of the
written medium-exercise-price option is –(ST – SM). Since two calls are written on the medium-exercise-
price option, the portfolio value of the options is
Value = (ST – SL) – [2 × (ST – SM)] = (SH – ST)   since 2 × SM = SL + SH
Therefore,
Profit = (SH – ST) + [(2 × CM) – (CH + CL)]
= (1,300 – ST) – 10
= 1,290 – ST

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Notes When the stock price is INR 1,270, the profit will be INR 20, and when the stock price is INR 1,285, the
profit will be INR 5.
 When ST ≥ SH, all the three options will be exercised, and:
Portfolio value = (ST – SH) + (ST – SL) – [2 × (ST – SM)] = 0  since 2 × SM = SH + SL
Thus,
Profit = (2 × CM) – (CH + CL)
= –INR 10
The profit from the butterfly spread is shown in Table 9.20 and Fig. 9.18.
  The profit diagram shows that the position results in a constant loss if the stock price is above the high
exercise price or below the low exercise price or when all the three options are either in-the-money or
out-of-money. In the range of stock prices from {SL + [(2 × CM) – (CH + CL)]} to {SH – [(2 × CM) – (CH +
CL)]}, the butterfly position will show a profit, and the maximum profit is made when the stock price is
equal to the medium exercise price. Here, profit arises when the stock price is in the range of (1,200 + 10,
1,300 – 10), i.e., in the range of INR 1,210 to INR 1,290.

Table 9.20  Profit from the Butterfly Spread Using Calls

Value of the
Bought Call Bought Call Value of the
Two Written
ST (INR) Value (SX = INR Value (SX = INR Butterfly
Calls (SX = INR
1,200) (INR) 1,300) (INR) Spread (INR)
1,250) (INR)

1,000 –80 –30 100 –10

1,050 –80 –30 100 –10

1,100 –80 –30 100 –10

1,150 –80 –30 100 –10

1,200 –80 –30 100 –10

1,250 –30 –30 100 40

1,300 20 –30 0 –10

1,350 70 20 –100 –10

1,400 120 70 –200 –10

1,450 170 120 –300 –10

1,500 220 170 –400 –10

A butterfly spread leads to a profit if the stock price stays close to the medium exercise price, which is
usually close to the current stock price. Thus, a butterfly spread strategy will result in a profit if the stock
price is not expected to move substantially from the current stock price in either direction.
A butterfly spread can also be created using put options. In this case, puts with high and low exercise
prices will be bought and two puts with medium exercise prices will be written. We will assume that
put option prices for low-, medium-, and high-exercise-price options are INR 30 (PL), INR 50 (PM), and
INR 100 (PH), respectively.
The profit from a butterfly spread using puts can be worked out as follows: When ST ≥ SH, none of the
options will be exercised and, therefore, the portfolio value will be zero and:
Profit = (2 × PM) – (PH + PL)
= (2 × 50) – (30 + 100) = –INR 30

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 Combinations of Options: Trading Strategies   223


Notes






*DLQ



      
6WRFN3ULFHDW0DWXULW\
±

±

Figure 9.18  The Gain from a Butterfly Spread Using Calls

When SM < ST < SH, only the put option with the high exercise price will be exercised:
Profit = (SH – ST) + [(2 × PM) – (PH + PL)] = 1,300 – ST – 30 = INR 1,270 – ST
If the stock price was INR 1,270, the profit would have been zero, and if the stock price was INR 1,260,
profit would have been INR 10.
When SL < ST ≤ SM, the high-exercise-price put and the medium-exercise-price put will be exercised
and:
Profit = (SH – ST) – 2 × (SM – ST) + [(2 × PM) – (PH – PL)]
= (ST – SL) + [(2 × PM) – (PH – PL)]  since 2 × SM = SH + SL
Profit = ST – 1,200 – 30 = ST – 1,230

If the stock price was INR 1,230, the profit would have been zero, and if the stock price was INR = 1,240,
the profit would have been INR 10.
When ST ≤ SL, all options will be exercised:
Profit = (SH – ST) + (SL – ST) + 2 × (SM – ST) + [(2 × PM) – (PH – PL)]
= [(2 × PM) – (PH – PL)]  since 2 × SM = SH + SL

Thus, the profit will be –INR 30. The profit diagram shows that the put option butterfly spread is similar
to the call option butterfly spread, except that the profit is different.
Reverse butterfly spreads can be used when the stock prices are expected to move substantially from
the current stock price or the medium exercise price. This strategy will result in moderate profit if the
stock price moves outside the range of SL to SH, and it will result in a loss if the stock price stays in the
range of SL to SH. Reverse butterfly spreads can be created by writing either calls (or puts) with high and
low exercise prices and buying two calls (or puts) with medium exercise prices. The maximum profit will

Table 9.21  The profit from a Butterfly Spread Using Puts

Stock Price Profit

ST ≤ SL [(2 × PM) – (PH – PL)]

SL < ST ≤ SM (ST – SL) + [(2 × PM) – (PH – PL)]

SM < ST < SH (SH– ST) + [(2 × PM) – (PH – PL)]

ST ≥ SH [(2 × PM) – (PH – PL)]

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Notes Table 9.22  Profit from a Butterfly Spread Using Puts

Value of the Two Value of

Bought Put Bought Put Value
Written Calls (SX Butterfly
ST (INR) Value (SX = INR (SX = INR 1,300)
= INR 1,250) Spread
1,200) (INR) (INR)
(INR) (INR)

1,000 170 200 –400 –30

1,050 120 150 –300 –30

1,100 70 100 –200 –30

1,150 20 50 –100 –30

1,200 –30 0 0 –30

1,250 –30 –50 100 +20

1,300 –30 –100 100 –30

1,350 –30 –100 100 –30

1,400 –30 –100 100 –30

1,450 –30 –100 100 –30

1,500 –30 –100 100 –30








*DLQ

 

± 6WRFN3ULFHDW0DWXULW\

±

±

±

Figure 9.19  The Gain from a Butterfly Spread Using Puts

be the cash inflow at the time of entering into the contract, which is [(CH + CL) – (2 × CM)] in the case of
calls and [(PH + PL) – (2 × PM)] in the case of puts.

9.3.5  Calendar Spreads

Money spreads and butterfly spreads are created using calls and puts with different exercise prices but
with expiry on the same date. We can also combine calls or puts with the same exercise price but with
different exercise dates. Such a combination is called a calendar spread.
A calendar spread can be created by writing a call option with a certain exercise date and buying a call
option with the same exercise price but with a longer maturity. Since a call option with a longer maturity
will be priced higher than a call option with a shorter maturity, a calendar spread will require an initial
investment of CL – CS, where the subscripts denote the maturity, long and short, respectively.

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 Combinations of Options: Trading Strategies   225


Notes



 
± 6WRFN3ULFHDW0DWXULW\

*DLQ ±

±

±

±

Figure 9.20  The Gain from a Reverse Butterfly Spread Using Calls

Since the two options do not expire on the same date, it is difficult to directly calculate the profit with
a calendar spread. Only an intuitive explanation will help in understanding the profit from a calendar
spread.

  E x a m ple 9 . 1 2
Assume that Ranbaxy Laboratories stock has two call options with the same exercise price of INR 420
but with a three-month and a six-month maturity. Assume that the option premium for the three-month
option is INR 25 and that for the six-month option is INR 60. Let us look at the value of the spread at the
end of three months, when the short maturity option expires. Since the value of a call option comprises
intrinsic value and time value and since the time value of a call option is the highest when the stock price
is close to the exercise price, we can consider the value of the spread for different stock prices at the expi-
ration of the short option. This is shown in Table 9.23.

Table 9.23  Value of a Calendar Spread at the Maturity of the Short-Maturity Option

Value of the Value of the Value of the

Stock Price
Short-Maturity Long-Maturity Calendar
(INR)
Written Call (INR) Bought Call (INR) Spread (INR)

390 0 Time Value Time Value

400 0 Time Value Time Value

410 0 Time Value Time Value

420 0 Time Value Time Value

430 –10 10 + Time Value Time Value

440 –20 20 + Time Value Time Value

450 –30 30 + Time Value Time Value

This shows that the investor with the calendar spread can sell the long-maturity call at the maturity
of the short-maturity call and receive the time value of the call option. Since the time value is highest
when the stock price is close to the exercise price, it is possible that this time value is greater than the
cost of the calendar spread for a range of stock prices that are close to the exercise price. Thus, a calendar
spread can provide profit for a range of stock prices. If the stock price moves away from this range, the
calendar spread will result in losses.

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Notes A calendar spread can also be created using put options by buying long-maturity put options and writ-
ing short-maturity put options. This strategy will also result in profits for a range of stock prices close to
the exercise price.
Calendar spreads are useful if the investor believes that the stock price at the maturity of the short-
maturity option is not likely to move substantially from the exercise price.
A reverse calendar spread is one in which an investor buys a short-maturity option and writes a long-
maturity option. This will create a small profit if the stock price at the expiration of the short-maturity
option moves substantially from the exercise price. If it is close to the exercise price, it can result in con-
siderable losses.

9.3.6  Iron Condor Spreads

An iron condor spread strategy has limited risk and is independent of the expectations about the direc-
tion of movement of the price of the underlying security. This strategy has a high probability of making
small profits from stocks that have very low volatility. This strategy can be considered as a combination of
a bullish spread using puts and a bearish spread using calls.
An iron condor spread involves buying and selling puts and calls with the same exercise date, as shown
below:
1. Buy an out-of-money put with a very low exercise price.
2. Sell an out-of-money put with a slightly higher exercise price.
3. Sell an out-of-money call with a high exercise price.
4. Buy an out-of-money call with a slightly higher exercise price.
Since this strategy involves selling a put with a higher exercise price and buying a put with a lower
exercise price, it would provide a positive cash flow, as a put with a higher exercise price will have a higher
option premium. Similarly, a call with a lower exercise price will have a higher option premium than a call
with a higher exercise price and hence investing in calls will also provide a positive cash flow. Thus, the
iron condor strategy will provide a positive cash flow, which will provide a credit to the margin account.
When the stock price at maturity is between the high exercise price of the put and the low exercise
price of the call, none of the four options will be exercised and the initial cash flow received will be the
gain from the iron condor spread. Thus, the gain will be small, and in order to make this small profit, all
that is required is that the stock price remains in the range of the low exercise price of the call and the
high exercise price of the put.

  E x a m ple 9 . 1 3
Assume there are four options, two calls and two puts, on ICICI Bank stock with exercise prices of INR
1,100 (SL), INR 1,150 (SM), INR 1,300 (SH), and INR 1,350 (SH) with the same exercise date. The ICICI
Bank stock is currently selling at INR 1,225. Assume that the call option with the exercise price of INR
1,300 is selling for INR 80 and the call option with the exercise price of INR 1,350 is selling for INR 35.
The put option premium for the put with the exercise price of INR 1,150 is INR 120 and that for the put
with the exercise price of INR 1,100 is INR 160. Then, the iron condor spread involves the following:
1. Buying a call with an exercise price of INR 1,350 at a price of INR 35
2. Writing a call with an exercise price of INR 1,300 at a price of INR 80
3. Writing a put with an exercise price of INR 1,150 at a price of INR 120
4. Buying a put with an exercise price of INR 1,100 at a price of INR 160
At the time of entering into the iron condor spread, the cash flow will be:
Cash flow = (Value of written call with SX of INR 1,300 + Value of written put with SX of INR 1,150)
– (Value of bought call with SX of INR 1,350 + Value of bought put with SX of INR 1,100)
= (INR 80 + INR 120) – (INR 35 + INR 160)
= INR 5 per share

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 Combinations of Options: Trading Strategies   227

Notes Since the contract size for ICICI Bank options is 350, the total cash flow = 5 × 350 = INR 1,750.
The gain from the iron condor spread for various stock prices at maturity is given in Table 9.24 and
Fig. 9.21.

Table 9.24  Gains from the Iron Condor Strategy

Gain from Gain from Gain from Gain from Gain from
the Written the Bought the Bought the Written the Iron
Stock
Call (SX = Call (SX = Put (SX = Put (SX Condor
Price (INR)
INR 1,300) INR 1,350) INR 1,100) = 1,150) Strategy
(INR) (INR) (INR) (INR) (INR)

750 80 –35 190 –280 –45

800 80 –35 140 –230 –45

850 80 –35 90 –180 –45

900 80 –35 40 –130 –45

950 80 –35 –10 –80 –45

1,000 80 –35 –60 –30 –45

1,050 80 –35 –110 20 –45

1,100 80 –35 –160 70 –45

1,150 80 –35 –160 120 5

1,200 80 –35 –160 120 5

1,250 80 –35 –160 120 5

1,300 80 –35 –160 120 5

1,350 30 –35 –160 120 5

1,400 –20 15 –160 120 –45

1,450 –70 65 –160 120 –45

1,500 –120 115 –160 120 –45




    
6WRFN3ULFHDW0DWXULW\
±
*DLQ

±

±

±

±

Figure 9.21  Gains from an Iron Condor Spread

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 228   Financial Risk Management

Notes The iron condor strategy provides a constant gain of INR 5 for a share price in the range of INR 1,150
to INR 1,300, which are the high put exercise price and low call exercise price, respectively. For any stock
price below INR 1,145 or for any stock price above INR 1,305, the iron condor strategy will result in a
loss. However, the maximum loss is capped at INR 45, and this loss arises when the stock price is below
INR 1,100, which is the low exercise price of the put, and when the stock price is above INR 1,350, which
is the high exercise price of the call. The maximum gain from the contract is given by [(Premium on the
written put at the low put exercise price + Premium on the written call at the high call exercise price)
– (Premium on the bought put at the high put exercise price + Premium on the bought call at the low
call exercise price)]. The iron condor strategy is commonly used with index options, rather than with
individual stocks; this is because the index tends to stay in a particular range for a longer time period,
whereas individual stocks can have sudden movements that may often cause them to move away from a
given range.

9.4  Combinations of Puts and Calls

Spreads are created by combining the same type of options with different exercise prices or exercise dates.
One can also combine calls and puts together. These combinations are portfolios that comprise different
types of options traded on the same underlying security, with all the options either held long or written.
A number of combinations of options are possible, but only four of the combinations have special names.
These are straddles, strips, straps, and strangles.

9.4.1 Straddles
A straddle strategy involves a put and a call with the same exercise price and exercise date and on the
same underlying security. When a straddle strategy is undertaken, the gains from the straddle depend on
whether the share price is expected to stay within a given range or not. There are two types of straddles,
a long straddle and a short or written straddle, which are explained below.

Bought or Long Straddles.  A long straddle involves buying one call and one put on an underly-
ing security with the same exercise price and the same exercise date. When a long position is taken in a
call, there will be gains if the price increases beyond Call premium + Exercise price, while it will result
in a constant loss equal to the call premium if the share price is below the exercise price. On the
other hand, when a long position is taken in a put, there will be gains if the price decreases beyond
Exercise price – Put premium, while it will result in a constant loss equal to the put premium if the share
price is above the exercise price. Thus, a long straddle will provide a gain if the price moves in either
direction and when the investor is not sure about the direction of movement of the price. The further
the price moves from the call exercise price or the put exercise price, the higher are the gains from a
long straddle.

  E x a m ple 9 . 1 4
Assume that an Infosys share is currently selling for INR 1,770 and has a call as well as a put option on it
with an exercise price of INR 1,750 and expiry of 90 days. The price of the call is INR 60, and the price of
the put is INR 25. The profit from the long straddle is shown in Table 9.25 and Fig. 9.22.
This strategy shows that the investor with the long straddle will make a loss as long as the Infosys
share price is within The range of INR 1,665 to INR 1,835. If the price is below INR 1,665 or above INR
1,835, this strategy will result in a profit. The more the price moves away from INR 1,665 or INR 1,835,
the higher are the gains.

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 Combinations of Options: Trading Strategies   229

Notes Table 9.25  Profit from the Long Straddle Position

Gain from Gain from the

Gain from the
Stock Price (INR) the Put Straddle
Call (INR)
(INR) (INR)

1,550 –60 175 115

1,600 –60 125 65

1,650 –60 75 15

1,700 –60 25 –35

1,750 –60 –25 –85

1,800 –10 –25 –35

1,850 40 –25 15

1,900 90 –25 65

1,950 140 –25 115






*DLQ


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0DWXULW\

    
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±
9DOXHRI/RQJ6WUDGGOH
*DLQIURP%RXJKW&DOO
±

Figure 9.22  The Gain from a Long Straddle Position

A bought straddle strategy is appropriate if an investor expects a large movement in the stock price but
is not sure of the direction of movement of the stock price.

Written Straddles.  If an investor writes a call as well as a put, it is called a written straddle strategy.

  E x a m ple 9 . 1 5
Assume that an Infosys share is currently selling for INR 1,770 and it has a call as well as a put option
on it with an exercise price of INR 1,750 and an expiry of 90 days. The price of the call is INR 60,
and the price of the put is INR 25. The profit from a written straddle is shown in Table 9.26 and
Fig. 9.23.
  Figure 9.23 shows that an investor will make a profit as long as the stock price is in the range of INR
1,665 to INR 1,835. If the stock price moves out of this range, this strategy will result in a loss.

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Notes Table 9.26  Profit from a Written Straddle Position

Gain from the Gain from the Gain from the

Stock Price (INR)
Call (INR) Put (INR) Straddle (INR)

1,550 60 –175 –115

1,600 60 –125 –65

1,650 60 –75 –15

1,700 60 –25 35

1,750 60 25 85

1,800 10 25 35

1,850 –40 25 –15

1,900 –90 25 –65

1,950 –140 25 –115

100

Gain from Written Call

50
Gain from Written Straddle

0
1550 1600 1650 1700 1750 1800 1850 1900 1950
Stock Price
Gain

–50 at Maturity

Gain from Written Put

–100

–150

–200

Figure 9.23  Gains from a Written Straddle

A written straddle is appropriate if no significant movement is expected in the stock price, as it would
lead to profits.

9.4.2 Strips
Straddles are used when the probability of an increase in price is similar to the probability of a decrease
in the price. Strips are used when the probability of an increase in price is smaller than the probability of
a decrease in the price. Since an investor would be interested in buying a call if they expect the stock price
to increase and since they would be interested in buying a put if they expect the stock price to decrease, a
strip strategy implies that the probability of an increase in the stock price is not equal to that of a decrease
in the stock price. In fact, the probability of a decrease in the stock price is twice the probability of an
increase in the stock price.

Bought Strips.  A bought strip consists of a long position in one call and two puts with the same exer-
cise price and exercise date.

Written Strips.  A written strip involves writing one call and two puts.

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 Combinations of Options: Trading Strategies   231

Notes   E x a m ple 9 . 1 6
Assume that a Reliance share is currently selling for INR 2,750 and has a call as well as a put option on it,
with an exercise price of INR 2,800 and an expiry of 90 days. The price of the call is INR 50, and the price
of the put is INR 100. The gain from a bought strip is shown in Table 9.27 and in Fig. 9.24.
  The investor with a bought strip will make a loss as long as the stock price is in the range of INR 2,675
to INR 3,050, and they will make a profit if the stock price goes below INR 2,675 or above INR 3,050. On
comparing this with the profit position from a bought straddle, where the price range for the loss was
INR 2,650 to INR 2,950, it is seen that the investor with a bought strip will make a profit if the stock price
is in the range of INR 2,650 to INR 2,675, while the investor with a bought straddle will make a loss in

Table 9.27  Profit from a Bought Strip Position

Gain from the Gain from the Two Gain from the
Stock Price (INR)
Bought Call (INR) Bought Puts (INR) Strip (INR)

2,600 –50 200 150

2,650 –50 100 50

2,700 –50 0 –50

2,750 –50 –100 –150

2,800 –50 –200 –250

2,850 0 –200 –200

2,900 50 –200 –150

2,950 100 –200 –100

3,000 150 –200 –50

3,050 200 –200 0

3,100 250 –200 50

3,150 300 –200 100

3,200 350 –200 150

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Figure 9.24  Gains from Purchased Strips

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 232   Financial Risk Management

Notes that range. Moreover, the profit from a strip is larger when the price decreases below INR 2,650. Thus, a
bought strip is preferable when the probability of an increase in the downward movement of stock prices
is higher. The strip buyer will also benefit if the stock price increases beyond INR 3,050, whereas in a
straddle, the maximum price for the stock to provide profit is INR 2,950.

  E x a m ple 9 . 1 7
Assume that a Reliance share is currently selling for INR 2,750 and it has a call as well as a put option on
it, with an exercise price of INR 2,800 and an expiry of 90 days. The price of the call is INR 50, and the
price of the put is INR 100. The profit from a written strip is shown in Table 9.28 and Fig. 9.25.

Table 9.28  Profit from a Written Strip Position

Gain from the Gain from the Two Gain from the
Stock Price (INR)
Written Call (INR) Bought Puts (INR) Strip (INR)

2,600 50 –200 –150

2,700 50 0 50

2,800 50 200 250

2,900 –50 200 150

2,950 –100 200 100

3,000 –150 200 50

3,050 –200 200 0

3,100 –250 200 –50

3,150 –300 200 –100

3,200 –350 200 –150

  A written strip results in a profit when the stock price is in the range of INR 2,675 to INR 3,150.
Thus, a written strip strategy is preferable when the stock price is expected to be steady and not likely
to move in either direction and when the movement, if any, is expected to be upwards, rather than
downwards.



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Figure 9.25  Gains from a Written Strip Position

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 Combinations of Options: Trading Strategies   233

Notes 9.4.3 Straps
A strap strategy involves combining two calls and one put. The idea behind a bought strap is that the stock
is more likely to move in an upward direction than in a downward direction.

Bought Straps.  A bought strap involves buying two calls and one put with the same exercise date.

  E x a m ple 9 . 1 8
Assume that a Reliance share is currently selling for INR 2,750 and it has a call as well as a put option on it
with an exercise price of INR 2,800 and an expiry of 90 days. The price of the call is INR 50, and the price
of the put is INR 100. Table 9.29 and Fig. 9.26 show the profit from this bought strap strategy.

Table 9.29  Profit from the Bought Strap Position

Gain from the Two Gain from the Gain from the
Stock Price (INR)
Bought Calls (INR) Bought Put (INR) Strap (INR)

2,400 –100 300 200

2,500 –100 200 100

2,600 –100 100 0

2,700 –100 0 –100

2,800 –100 –100 –200

2,900 100 –100 0

3,000 300 –100 200

  In a bought strap strategy, the investor will make a profit as long as the stock price is above INR 2,900
or below INR 2,600, and they will make losses if the stock price is within the range of INR 2,600 to INR
2,900. When compared with the straddle, this shows that a bought straddle will result in a profit when the
stock price is in the range of INR 2,900 to INR 2,950 and the profits will be more when the price is above
INR 2,900. Thus, a bought strap is more beneficial if the prices are expected to have substantial upward
movement.





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Figure 9.26  Gains from a Bought Strap Position

Written Straps.  A written strap means that the investor writes two calls and one put. A written strap
results in immediate cash inflow upon writing options.

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 234   Financial Risk Management

Notes   E x a m ple 9 . 1 9
Assume that a Reliance share is currently selling for INR 2,750 and it has a call as well as a put option on it
with an exercise price of INR 2,800 and an expiry of 90 days. The price of the call is INR 50, and the price
of the put is INR 100. Table 9.30 and Fig. 9.27 show the profit from a written strap strategy.

Table 9.30  Profit from a Written Strap Position

Gain from the Two Gain from the Gain from the
Stock Price (INR)
Bought Calls (INR) Bought Put (INR) Strap (INR)

2,400 –100 300 200

2,500 –100 200 100

2,600 –100 100 0

2,700 –100 0 –100

2,800 –100 –100 –200

2,900 100 –100 0

3,000 300 –100 200

  This position will result in profits when the stock price is in the range of INR 2,600 and INR 2,900. If
the stock price increases beyond INR 2,900, this strategy will result in substantial losses.
  Thus, a written strap is advantageous when the stock price is likely to remain in the close range of the
exercise price and the chances of it going down slightly are more than the chances of it going up.

300
Gain from Written Strap
200
Gains from Writing Two Calls
100

0
Gain

2400 2450 2500 2550 2600 2650 2700 2750 2800 2850 2900 2950 3000
–100 Stock Price at
Maturity
–200 Gains from Written Put
–300

–400

Figure 9.27  Gains from a Written Strap Position

9.4.4 Strangles
A strangle involves the purchase of a put and a call with the same expiration date but with different exer-
cise prices. The call exercise price is generally higher than the put exercise price.
Assume there is a call on an IDBI Bank share with an exercise price of INR 160, selling for INR 15,
and a put option with an exercise price of INR 170, selling for INR 8. The current IDBI Bank share price
is INR 168. The profit for the strangle is shown in Table 9.31 and Fig. 9.28.
The profit diagram shows that the strangle will result in a maximum loss of INR 13 as long as the stock
price is in the range of the two exercise prices. The investor will make a profit only if the stock price is
below INR 147 or above INR 183.

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 Combinations of Options: Trading Strategies   235

Notes Table 9.31  Profit from the Strangle Position

Stock Price Gain from the Bought Gain from the Bought Gain from the
(INR) Call (SX = 160) (INR) Put (SX = 170) (INR) Strangle (INR)

130 –15 32 17

140 –15 22 7

150 –15 12 –3

160 –15 2 –13

170 –5 –8 –13

180 5 –8 –3

190 15 –8 7

200 25 –8 17

The profit pattern with a strangle depends on how close the exercise prices are. If they are further
apart, there is less downside risk, and the stock price will have to increase to a higher value for a profit to
be made.
A strangle is similar to a straddle in the sense that the investor is betting that the stock price will sig-
nificantly move but is unsure of the direction of movement. However, in a strangle, the stock price will
have to move further than in a straddle in order to result in a profit. However, the downside risk if the
stock price ends up at the central value is less with a strangle.








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Figure 9.28  The Gain from a Strangle

9.4.5  Other Pay-offs

This chapter has shown a few ways in which options can be used to produce various profit patterns. If
European options expiring at a particular time T with every possible exercise price are available, any
profit function at time T can be obtained by combining options. Table 9.32 shows the details of the vari-
ous strategies using options.

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 236   Financial Risk Management

Table 9.32 A Summary of Strategies Involving the Use of a Combination of Options

Market
Strategy Construction Implications
Outlook

Long call Bullish Buy call Gain if the stock price increases and loss is
minimized to the call price paid

Short call Bearish Write call loss if the stock price increases and gain is
minimized to the call price received

Long put Bearish Buy put Gain if the stock price decreases and loss is
minimized to the put price paid

Short put Bullish Write put Gain if the stock price decreases and loss is
minimized to the put price paid

Covered call Bearish Buy stock and write call If the stock price goes down, loss is reduced by
the amount of call price received. If the stock
price goes up, the profit is limited

Protective put Bearish Buy stock and buy put Loss in stock is offset by gain from put, insuring
minimum value of stock, and if the stock price
goes up, gain is preserved

Bullish money Bullish Long call with low exercise price and Constant profit if both calls are in-the-money and
spread short call with high exercise price constant loss if both calls are out-of-money in the
case of spread using calls

Calendar Neutral Short call with earlier expiry date and The time value of the long expiry call would be
spread long call with later expiry date the profit

Butterfly spread Neutral Long call with low exercise price, long Profit as long as the stock price is close to the
call with high exercise price, and two medium exercise price, and loss if it moves far
short calls with medium exercise price away from the medium exercise price

Bought straddle Bullish or Long call and long put with the same Gain as long as the stock price falls out of a
bearish exercise price and exercise date given range

Written Neutral Short call and short put with the same Gain as long as the stock price remains within a
straddle exercise price and exercise date range

Long strangle Bullish or Long call and long put with different Gain as long as the stock price falls out of a
bearish exercise prices and exercise date given range

Short strangle Neutral Short call and short put with different Gain as long as the stock price remains within a
exercise prices and exercise dates given range

9.5  Losses from Options Trading

The success of most of the trades in which options are used to make money depends on the direction
of movement of the price of the underlying security. As long as the price of the underlying security
moves according to expectations, the strategy would provide profits. However, if the underlying asset
price moves in the opposite direction, it can lead to losses. Since the profit potential for any of these
strategies is very small, it becomes necessary to engage in a large number of options contracts or engage
in a leverage in order to make large profits. Both of these would amplify the losses if the underlying
asset price moves in the opposite direction. Therefore, it is necessary to take corrective actions in case
the price moves in the opposite direction. How options trading can result in huge losses is explained in

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 Combinations of Options: Trading Strategies   237

Notes
BOX 9.4 The Collapse of Barings Bank

Barings Bank was founded in 1762 and was the oldest mer- of straddles. At one time, he was short in 37,925 calls and
chant bank in Great Britain. In 1803, it helped the USA 32,967 puts. He also had a long position in 1,000 Nik-
in arranging the finances for the Louisiana Purchase. On kei 225 index futures contracts. The Nikkei index was trad-
February 24, 1995, Peter Baring, the Chairman of the Bar- ing within the range of 17,000 to 20,000, and this written
ings Bank informed the Bank of England that Nick Leeson, straddle strategy was providing profits for Leeson.
a trader in its subsidiary in Singapore, had lost a huge sum However, on January 17, 1995, an earthquake struck
of money through speculation on Nikkei 225 index options Kobe and the Japanese stock market was affected. In a pe-
and futures. Later, it was found that the loss had exceeded riod of five days, the index fell by more than 1,000 points.
USD 1 billion, leading to the bankruptcy of the bank. But The written straddle started to provide losses as the index had
how did Leeson lose so much money? moved out of the range in which profits could be made. The
In 1992, Nick Leeson was posted to Singapore in Barings wise move for Leeson would have been to get out of straddles
Futures, which was established to enable Barings to execute and go long in puts. By going long in puts alone, he would
trades on the Singapore International Monetary Exchange have made profits when the market went down. However, Lee-
(SIMEX). In 1993, Leeson started trading on the firm’s own son believed that this drop in the market was temporary and
account. He started with arbitrage trading, which involved the market would soon recover and go back to the original
Nikkei 225 stock index futures and 10-year Japanese Gov- range. Thus, he kept his position in the straddles. In addition,
ernment bond (JGB) futures, which were traded in both the he went long in Nikkei 225 index futures, betting that the
SIMEX and the Osaka Stock Exchange. Since both the con- market index would soon increase. As the market fell further,
tracts were traded on two exchanges, the price of these con- he increased his long holding of the index futures, still believ-
tracts should be the same in both the contracts. Whenever ing that the market would go up and that he would make
the price diverged in the two exchanges, arbitrage profits more profits. By February 23, 1995, Leeson had positions
could be earned at a very low level of risk. Soon, Leeson in 61,000 index futures contracts, which was about 50 per
undertook more risky activities by betting on the direction of cent of the open interest in the March contract and 24 per
stock price movements on the Tokyo Stock Exchange. He be- cent in the April contract. As the market index fell further, the
gan selling a large number of straddles on the Nikkei 225 losses mounted. The total losses amounted to approximately
index. A written straddle would provide profits as long as 927 million British pounds, while the equity of Barings Bank
there is no significant movement in the market in either direc- was only 440 million British pounds. The Internationale
tion and as long as the index stays within a given range. In Nederlanden Group (ING) assumed the assets and liabilities
order to magnify the profits, he entered into a large number of Barings Bank.

Source: Anatoli Kuprianov, “Derivative Debacles: Case Studies of Large Losses in Derivatives Markets,” Federal
Reserve Bank of Richmond Economic Quarterly, Vol. 81, No. 4 (Fall 1995): pp 1–39.

Box 9.4 through the example of the collapse of Barings Bank. This case shows that trading in options
could lead to losses. Nick Leeson, the one responsible for the collapse of Barings Bank, also used index
futures, which compounded the problem. Therefore, it is important to use derivative securities, whether
options or futures, in a careful manner.

9.6 Strategies Using Options, a Risk-free Security

and Underlying Assets
We saw that call options, put options, and the underlying securities can be used to form portfolios. Some
of these strategies were termed as a covered call strategy, reverse hedge strategy, and portfolio insurance
strategy, and each of these portfolios had different pay-offs. In addition to the underlying security, calls,
and puts, one can combine a risk-free security to get the desired pattern of pay-offs. In this section, we
will discuss the various ways in which a risk-free security can be combined with options and the underly-
ing security.

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Notes 9.6.1  Combination of Call Options and Risk-free Securities

When an investor buys a call option and uses a risk-free investment, the cash flows associated with this
strategy will show that it is equivalent to obtaining portfolio insurance, with the minimum value of the
portfolio being the exercise price.

  E x a m ple 9 . 2 0
Assume that there exists a call option on SBI shares with an exercise price of INR 2,400 and exercise pe-
riod of 90 days. Currently, an SBI share is selling at INR 2,300. The risk-free interest rate is 8%.
  At the current time:
1. Buy a call option on SBI shares with an exercise price of INR 2,400 and exercise date of 90 days. The
investment in the call option is the current call premium C.
2. Invest the present value of the exercise price of the option in a risk-free security. The amount that will
be invested in the risk-free security is SX × exp(–rt) = 2,400 × exp(–0.08 × 90 / 365).
The current total investment = C + SX × exp(–rt)
On the expiry date:
  The value of the call will be Max [(ST – SX), 0] = Max [(ST – 2,400), 0]. This means that the value of the
call on the expiry date will be zero for all stock prices below INR 2,400 and the value will increase by INR
1 for each INR 1 increase in the stock price beyond INR 2,400.
The value of the risk-free investment will be SX × exp(–rt) × exp(rt) = SX , or the exercise price.
The cash flows associated with this strategy are shown in Table 9.33.
Table 9.33 shows that the risk-free security provides a minimum portfolio value of INR 2,400 or
provides an insurance against the unfavourable outcomes of the stock, while the call option provides all
the upside potential of the stock. The cost of forming the portfolio through the risk-free security is shown
below:
Cost of forming the portfolio = Cost of the call option + Amount of risk-free investment
= C + SX × e–rT

Table 9.33  Terminal Value Associated with a Call Option and a Risk-free Security

Stock Price on the Value of the Value of

Value of the
Expiration Date Risk-free the Portfolio
Call (INR)
(INR) Security (INR) (INR)

2,200 0 2,400 2,400

2,250 0 2,400 2,400

2,300 0 2,400 2,400

2,350 0 2,400 2,400

2,400 0 2,400 2,400

2,450 50 2,400 2,450

2,500 100 2,400 2,500

2,550 150 2,400 2,550

2,600 200 2,400 2,600

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 Combinations of Options: Trading Strategies   239

Notes 9.6.2  Combination of Long Stocks and Long Puts

Combining a long stock with a long put is also known as a protective put strategy. When a person buys
a stock, they face the risk of a decrease in the stock price. When the stock price decreases, the investor
will incur a loss of INR 1 for each INR 1 decrease in the share price. When the investor buys a put option
along with the stock, the put option will show a gain of INR 1 for each INR 1 decrease in the share price
when the put option is in-the-money. When the stock price is above the exercise price, the put option will
not be exercised and hence its value will be zero. Thus, any loss in the share investment will be compen-
sated by the gain from the put investment for all share prices below the exercise price, so that the value of
the combination of the bought stock and the bought put will have a constant value equal to the exercise
price as long as the share price is below the exercise price. On the other hand, if the share price is above
the exercise price, the value of the combination of the bought stock and the bought put will be equal to
the share price. Thus, the value of the combination of the bought stock and the bought put will be like an
insured portfolio, with the minimum value equal to the exercise price.

  E x a m ple 9 . 2 1
Assume that there exists a put option on SBI shares with an exercise price of INR 2,400 and exercise pe-
riod of 90 days. Currently, an SBI share is selling at INR 2,300. The risk-free interest rate is 8%.
  At the current time:
1. Buy a put option on SBI shares with an exercise price of INR 2,400 and exercise date of 90 days. The
investment in buying the put is the current put price P.
2. Buy a share of the stock at a price of INR 2,300. The investment is the current stock price St.
Therefore, the total investment at the current time is St + P. On the expiry date:
The value of the put will be Max [(SX – ST), 0] = Max [(2,400 – ST), 0]. This means that the value of a
put on the expiry date will be zero for all stock prices above INR 2,400 and the value will increase by INR
1 for each INR 1 decrease in the stock price below INR 2,400.
The value of the investment in shares will be ST.
The cash flows associated with this strategy are shown in Table 9.34.

Table 9.34  Terminal Value Associated with the Strategy of a Put Option and Stock

Stock Price on
Value of the Value of the Value of the
the Expiration
Put (INR) Stock (INR) Portfolio (INR)
Date (INR)

2,200 200 2,200 2,400

2,250 150 2,250 2,400

2,300 100 2,300 2,400

2,350 50 2,350 2,400

2,400 0 2,400 2,400

2,450 0 2,450 2,450

2,500 0 2,500 2,500

2,550 0 2,550 2,550

2,600 0 2,600 2,600

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 240   Financial Risk Management

Notes   Table 9.34 shows that the put option provides insurance against the unfavourable outcomes of stock,
while the stock provides all the upside potential of the stock, and the minimum value of this portfolio is
INR 2,400. The cost of forming this portfolio is shown below:
Cost of forming the portfolio = Cost of put option + Price of stock bought
= P + St
Drawing a comparison between Tables 9.33 and 9.34 shows that both the strategies, that is, (i) buying
a call option on the SBI share and investing in a risk-free security and (ii) buying the SBI share and buy-
ing a put option on the SBI share with the same exercise price and exercise date, provide exactly the same
portfolio value on the expiration date of the options. Since the expiry date of the call and put options is
the same and since these two strategies provide identical terminal values, investment in these two portfo-
lios should be the same. This principle leads to the put–call parity relationship.

9.7 The Put–Call Relationship

In the previous section, we saw that the strategy of a long call and a long risk-free security and the strategy
of a long stock and a long put have exactly the same terminal value and, therefore, these two strategies
should cost exactly the same amount. The cost of the strategy of a long call and a long risk-free security is
C + SX × e–rT, and the cost of a long stock and a long put is P + St. Thus, we must have,
C + SX × e–rT = St + P  Or
P = C – [St – (SX × e–rT)]
where,  C = Call price,
P = Put price,
St = Current stock price,
SX = Exercise price of the call and put options,
T = Time to maturity of the call and put options in years, and
r = Risk-free interest rate applicable to the maturity period of the options.
This relationship is known as the put–call parity relationship. The put–call parity relationship shows
that the price of a put and call are related to each other and depend on the current stock price, the exercise
price of the options, the remaining time to maturity of the options, and the appropriate risk-free interest
rate in the market.
Note that the put–call parity only provides the relationship between call and put prices and does not
provide the pricing relationship for either the call or the put.

  E x a m ple 9 . 2 2
Assume that an SBI share is currently trading at INR 2,300. There is also a call option and a put option on
the SBI with an exercise price of INR 2,400 and with a maturity of 90 days. The call option is priced at INR
165. The ninety-day risk-free rate is 8% per annum. Calculate the price of the put option.
  According to put–call parity,
P = C – [St – (SX × e–rT )]
P = 165 – [2,300 – (2,400 × e–[0.08×(90/365)])]
P = INR 165 – (INR 2,300 – INR 2,353.12) = INR 218.12
This shows that a put option on SBI shares with an exercise price of INR 2,400 and a maturity of 90 days
should sell for INR 218.12 if the price of a call option with the same exercise price and exercise date is
INR 165.

P r oble m 9 . 1
The S&P CNX Nifty index is at 4,623.25 on September 1. There exist call options and put options on the S&P CNX
Nifty index with expiry on September 24. The exercise price of both the call and the put is INR 5,000. The call is

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 Combinations of Options: Trading Strategies 241

priced at INR 32.9. According to put–call parity, what should be the put price on the basis of the
Notes
assumption that the call is fairly priced? The risk-free interest rate is 8%.
Solution to Problem 9.1
According to put–call parity,

P = C – [St – (SX × e–rT )]

P = 32.9 – [4,623.25 – (5,000 × e–[0.08×(24/365)])]
P = INR 32.9 – (INR 4,623.5 – INR 4,980.31) = INR 389.97

On the basis of the put–call parity, the put price should be INR 389.97.

PrOBLEm 9.2
The BEML option lot size is 375. Its share price as on September 1 is INR 1,111.35. A put option
with the exercise date of November 26 and an exercise price of INR 1,140 is priced at INR
116.15. If put–call parity holds, what will be the price of the call option with the exercise date of
November 26 and an exercise price of INR 1,140?
Solution to Problem 9.2
According to put–call parity,

P = C – [St – (SX × e–rT )]

116.15 = C – [1,111.35 – (1,140 × e–[0.08×(87/365)])]
116.15 = C – (1,111.35 – 1,118.47) = C + 7.12
C = INR 116.15 – INR 7.12 = INR 109.03

CHaPTEr SUmmary
 The underlying security can be combined with either call If the stock price is expected to decrease, the call with the
options or with put options to hedge the risk of investing in low exercise price will be written and the call with the
stocks. higher exercise price will be bought. Money spreads can
 Calls with different exercise prices or puts with different also be created using put options.
exercise prices can be combined to make money in the  A box spread involves buying a bullish money spread using
short run. calls and a bearish money spread using puts. The pay-off
 Calls and puts can also be combined to make money. The from a box spread is the difference between the two exercise
results of such strategies depend on the expected price prices, and it is constant, irrespective of the stock prices.
movement of the underlying security.  A calendar spread refers to the strategy of buying a call
 A covered call means that an investor who owns the option with a particular exercise date and writing a call
stock writes a call option on the same stock. Covered call option with a different exercise date. The gain would be the
writing is undertaken when the stock price is not expected time value of the option with the longer exercise date.
to increase beyond Exercise price + Option premium
 A butterfly spread involves three call options with different
received.
exercise prices. Calls with the lowest and highest exercise
 A protective put is used for portfolio insurance, wherein prices would be bought and the option with the medium
an investor who owns the stock also buys a put. In case exercise price would be written.
the stock price decreases, gains from the put would offset  A straddle strategy involves a put and a call on the same
the loss from the stock so that the minimum value of the security. When both the call and the put are bought, the
portfolio can be established. If the stock price increases, the bought straddle would provide losses if the underlying asset
portfolio value would also increase. price remains in a given range and would provide profit
 Calls with different exercise prices can be used to form if the underlying stock price goes out of that range. On
money spreads. If the stock prices are expected to be the other hand, a written straddle strategy, which involves
between the two exercise prices, a low-exercise-price call writing a call as well as a put, would provide profit as long as
will be bought and a high-exercise-price call will be written. the underlying asset price stays within a given range.

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 242 Financial Risk Management

 A bought strip involves buying one call and two puts, and a  A strangle involves buying a call and a put but with different
written strip involves writing one call and two puts. Strips exercise prices.
are used when the probability of a decrease in the stock  Each of the above strategies has different profit positions
price is more than the probability of an increase in the stock depending upon the movement of the stock price. Depend-
price. ing upon the expected stock price at the maturity of the
 A bought strap involves buying two calls and one put, and a options, an investor can choose an appropriate strategy of
written strap involves writing two calls and one put. Straps combining the options.
are used when the probability of an increase in the stock price
is higher than the probability of a decrease in the stock price.

mULTIPLE-CHOICE QUESTIONS
1. Which of the following creates a bull spread? B. A calendar spread can be created by buying a put and
A. Buy a low strike price call and sell a high strike price call selling a call when the strike prices are the same and the
B. Buy a high strike price call and sell a low strike price call times to maturity are different
C. Buy a low strike price call and sell a high strike price put C. A calendar spread can be created by buying a call and sell-
D. Buy a low strike price put and sell a high strike price call ing a call when the strike prices are different and the times
to maturity are different
2. Which of the following creates a bear spread?
D. A calendar spread can be created by buying a call and
A. Buy a low strike price call and sell a high strike price call
selling a call when the strike prices are the same and the
B. Buy a high strike price call and sell a low strike price call
times to maturity are different
C. Buy a low strike price call and sell a high strike price put
D. Buy a low strike price put and sell a high strike price call 8. What is a description of the trading strategy where an investor
sells a 3-month call option and buys a one-year call option,
3. Which of the following creates a bull spread?
where both options have a strike price of $100 and the under-
A. Buy a low strike price put and sell a high strike price put
lying stock price is $75?
B. Buy a high strike price put and sell a low strike price put
A. Neutral Calendar Spread
C. Buy a high strike price call and sell a low strike price put
B. Bullish Calendar Spread
D. Buy a high strike price put and sell a low strike price call
C. Bearish Calendar Spread
4. Which of the following creates a bear spread? D. None of the above
A. Buy a low strike price put and sell a high strike price put
9. Which of the following is correct?
B. Buy a high strike price put and sell a low strike price put
A. A diagonal spread can be created by buying a call and sell-
C. Buy a high strike price call and sell a low strike price put
ing a put when the strike prices are the same and the times
D. Buy a high strike price put and sell a low strike price call
to maturity are different
5. What is the number of different option series used in creating B. A diagonal spread can be created by buying a put and
a butterfly spread? selling a call when the strike prices are the same and the
A. 1 B. 2 C. 3 D. 4 times to maturity are different
C. A diagonal spread can be created by buying a call and sell-
6. A stock price is currently $23. A reverse (i.e short) butterfly ing a call when the strike prices are different and the times
spread is created from options with strike prices of $20, $25, to maturity are different
and $30. Which of the following is true? D. A diagonal spread can be created by buying a call and
A. The gain when the stock price is greater that $30 is less selling a call when the strike prices are the same and the
than the gain when the stock price is less than $20 times to maturity are different
B. The gain when the stock price is greater that $30 is greater
than the gain when the stock price is less than $20 10. Which of the following is true of a box spread?
C. The gain when the stock price is greater that $30 is the A. It is a package consisting of a bull spread and a bear spread
same as the gain when the stock price is less than $20 B. It involves two call options and two put options
D. It is incorrect to assume that there is always a gain when C. It has a known value at maturity
the stock price is greater than $30 or less than $20 D. All of the above

7. Which of the following is correct?

A. A calendar spread can be created by buying a call and sell-
ing a put when the strike prices are the same and the times
to maturity are different

Answer
1. A 2. B 3. A 4. B 5. C 6. C 7. D 8. B 9. C 10. D

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 Combinations of Options: Trading Strategies 243

rEVIEW QUESTIONS
1. What is the advantage of writing a covered call over writing a 6. When would you enter into a bought strip and a written strip
naked call? transaction?
2. How can one achieve portfolio insurance using put options? 7. When would you enter into a bought strap and a written strap
3. What is the concept behind calendar spread transactions? transaction?
4. When would you enter into a butterfly spread transaction? 8. When would you enter into a strangle transaction?
5. When would you enter into a bought straddle and a written
straddle transaction?

SELF-aSSESmENT TEST
1. Under what price expectations would an investor enter into the available, as shown in the following table.
following strategies? Assume that a stock is trading at INR 400 Exercise Call Price Put Price
and it has a call and a put option with an exercise price of INR Exercise date Price (INR) (INR) (INR)
420 and maturity of three months. The call premium is INR 20 November 27 1,300 80 110
and the put premium is INR 35. The contract size is 400. November 27 1,250 145 50
(i) Written naked call November 27 1,350 20 175
(ii) Written naked put December 26 1,300 110 140
(iii) Bought call December 26 1,250 180 85
(iv) Bought put December 26 1,350 45 210
(v) Covered call
(vi) Protective put The stock price on November 27 is INR 1,280 and that on
(vii) Reverse hedge December 26 is INR 1,340. A December 1,300 call option is
(viii) Short stock and short put priced at INR 60, a December 1,250 call is priced at INR 110,
and a December 1,350 call is priced at INR 15. A December
2. A stock is trading at INR 400, and it has a call and a put 1,300 put option is priced at INR 70, a December 1,250 put
option with an exercise price of INR 420 and maturity of three is priced at INR 40, and a December 1,350 call is priced at
months. The call premium is INR 20 and the put premium is INR 120.
INR 35. Another series of call and put options with an exercise (i) What would be the gain or loss if you enter into a bullish
price of INR 390 is available with the same maturity, and the money spread using call options with the exercise date
price of a call is INR 36 and the price of a put is INR 28. The of November 27 and exercise prices of INR 1,250 and
contract size is 400. INR 1,350?
(i) What would be the gains and losses if you enter into a (ii) What would be the gain or loss if you enter into a bearish
bullish money spread using calls? money spread using put options with the exercise date
(ii) What would be the gains and losses if you enter into a of December 26 and exercise prices of INR 1,250 and
bullish money spread using puts? INR 1,350?
(iii) What will be the gains and losses if you enter into a box (iii) What would be the gain from a calendar spread by using
spread? calls with an exercise price of INR 1,300?

3. A stock is trading at INR 400, and it has a call and a put option 5. A stock is trading at INR 1,240 on October 1. Call options and
with an exercise price of INR 420 and maturity of 3 months. put options with different exercise dates and exercise prices are
The call premium is INR 20 and the put premium is INR 35. available, as shown in the following table.
Another series of call and put options with an exercise price of Exercise Price Call Price Put Price
INR 390 is available with the same maturity, and the price of Exercise date (INR) (INR) (INR)
a call is INR 36 and the price of a put is INR 28. The contract November 27 1,300 80 110
size is 400. November 27 1,250 145 50
(i) What would be the gain and loss if you enter into a November 27 1,350 20 175
bearish money spread using calls? December 26 1,300 110 140
(ii) What would be the gain and loss if you enter into a December 26 1,250 180 85
bearish money spread using puts? December 26 1,350 45 210
4. A stock is trading at INR 1,240 on October 1. Call options and The stock price on November 27 is INR 1,280 and on that
put options with different exercise dates and exercise prices are December 26 is INR 1,340. A December 1,300 call option

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 244   Financial Risk Management

is priced at INR 60, a December 1,250 call is priced at INR (i) What would be the gain or loss if you enter into a long
110, and a December 1,350 call is priced at INR 15. A strip using options with the exercise date of November 27
December 1,300 put option is priced at INR 70, a December and an exercise price of INR 1,250?
1,250 put is priced at INR 40, and a December 1,350 call is (ii) What would be the gain or loss if you enter into a short
priced at INR 120. strip using options with the exercise date of December 26
(i) What would be the gain or loss if you enter into a and an exercise price of INR 1,300?
butterfly spread using call options with the exercise date
of November 27? 8. A stock is trading at INR 1,240 on October 1. Call options and
(ii) What would be the gain or loss if you enter into a put options with different exercise dates and exercise prices are
butterfly spread using put options with the exercise date available, as shown in the following table.
of December 26? Exercise Price Call Price Put Price
6. A stock is trading at INR 1,240 on October 1. Call options and Exercise date (INR) (INR) (INR)
put options with different exercise dates and exercise prices are November 27 1,300 80 110
available, as shown in the following table. November 27 1,250 145 50
Exercise Price Call Price November 27 1,350 20 175
Put Price (INR) December 26 1,300 110 140
Exercise date (INR) (INR)
110 December 26 1,250 180 85
November 27 1,300  80
 50 December 26 1,350 45 210
November 27 1,250 145
175
November 27 1,350  20 The stock price on November 27 is INR 1,280 and that on
140
December 26 1,300 110 December 26 is INR 1,340. A December 1,300 call option is
 85
December 26 1,250 180 priced at INR 60, a December 1,250 call is priced at INR 110,
210
December 26 1,350  45 and a December 1,350 call is priced at INR 15. A December
The stock price on November 27 is INR 1,280 and that on 1,300 put option is priced at INR 70, a December 1,250 put
December 26 is INR 1,340. A December 1,300 call option is priced at INR 40, and a December 1,350 call is priced at
is priced at INR 60, a December 1,250 call is priced at INR INR 120.
110, and a December 1,350 call is priced at INR 15. A (i) What would be the gain or loss if you enter into a long
December 1,300 put option is priced at INR 70, a December strap using options with the exercise date of November
1,250 put is priced at INR 40, and a December 1,350 call is 27 and an exercise price of INR 1,250?
priced at INR 120. (ii) What would be the gain or loss if you enter into a short
(i) What would be the gain or loss if you enter into a long strap using options with the exercise date of December
straddle using options with the exercise date of November 26 and an exercise price of INR 1,300?
27 and an exercise price of INR 1,250?
(ii) What would be the gain or loss if you enter into a short 9. A stock is trading at INR 1,240 on October 1. Call options and
straddle using options with the exercise date of December put options with different exercise dates and exercise prices are
26 and an exercise price of INR 1,350? available, as shown in the following table.

7. A stock is trading at INR 1,240 on October 1. Call options and Exercise Price Call Price Put Price
put options with different exercise dates and exercise prices are Exercise date (INR) (INR) (INR)
available, as shown in the following table. November 27 1,300  80 110
November 27 1,250 145  50
Exercise Price Call Price Put Price
November 27 1,350  20 175
Exercise date (INR) (INR) (INR)
December 26 1,300 110 140
November 27 1,300 80 110
December 26 1,250 180  85
November 27 1,250 145 50
December 26 1,350 45 210
November 27 1,350 20 175
December 26 1,300 110 140  The stock price on November 27 is INR 1,280 and that on
December 26 1,250 180 85 December 26 is INR 1,340. A December 1,300 call option
December 26 1,350 45 210 is priced at INR 60, a December 1,250 call is priced at INR
The stock price on November 27 is INR 1,280 and that on 110, and a December 1,350 call is priced at INR 15. A
December 26 is INR 1,340. A December 1,300 call option December 1,300 put option is priced at INR 70, a December
is priced at INR 60, a December 1,250 call is priced at INR 1,250 put is priced at INR 40, and a December 1,350 call is
110, and a December 1,350 call is priced at INR 15. A priced at INR 120.
December 1,300 put option is priced at INR 70, a December What would be the gain or loss if you enter into a strangle
1,250 put is priced at INR 40, and a December 1,350 call is  using options with the exercise date of November 27 with
priced at INR 120. exercise prices of INR 1,250 and INR 1,350.

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 Combinations of Options: Trading Strategies   245

10. 
A stock is trading at INR 1,240 on October 1. Call  The stock price on November 27 is INR 1,280 and that on
options and put options with different exercise dates and December 26 is INR 1,340. A December 1,300 call option is
exercise prices are available, as shown in the following priced at INR 60, a December 1,250 call is priced at INR 110,
table. a December 1,350 call is priced at INR 15, and a December
1,200 call is priced at INR 170. A December 1,300 put option
Exercise Price Call Price Put Price is priced at INR 70, a December 1,250 put is priced at INR 40,
Exercise date (INR) (INR) (INR) a December 1,350 put is priced at INR 120, and a December
November 27 1,300 80 110 1,200 put is priced at INR 5.
November 27 1,250 145 50 What would be the gain or loss if you enter into an iron
November 27 1,350 20 175  condor strategy using options with the exercise date of
November 27 1,200 210 5 November 27?
December 26 1,300 110 140
December 26 1,250 180 85
December 26 1,350 45 210
December 26 1,200 250 20

   C a se S tu d y

On November 1, 2008, Akhil, the manager of Bharat Funds, is con- Table 1

templating how he can provide positive returns to the shareholders
of the fund.
Return on
Bharat Fund was started on January 1, 2005, with a total capital Return on
Period Benchmark CNX
of INR 300 million. This capital was mainly invested in the equity Bharat Fund
of stocks traded on the Indian market. Since the Indian market Nifty Index
was doing very well from 2005 to 2008, this fund also did very 2005 34% 40%
well during this period. For example, the CNX Nifty index started
at 2,115 on January 3, 2005. The return on the fund and the 2006 40% 48%
benchmark Nifty Index are shown in Table 1.
Akhil was happy that he was able to beat the benchmark index 2007 55% 62%
by a big margin during this period. The net asset value increased
from INR 300 million on January 1, 2005, to INR 1,007 million Table 2
by December 2007. However, he started facing problems when
the Indian stock market dropped considerably, in line with all the
other markets during the financial crisis. He calculated the return on Return on Return on
the benchmark index and his fund for every quarter from January Period Benchmark CNX Bharat
2008 to September 2008 and for October 2008, as shown in Table 2. Nifty Index Fund
From January 1, 2008, to October 31, 2008, the benchmark
index dropped from 6,138 to 2,885, a drop of 53% over 10 months. Q1, 2008 –23.0% –18%
The net asset value had decreased to INR 568 million, a decrease of
44% from January 1, 2008, to October 31, 2008. Q2, 2008 –14.7% –10%
All the global markets had been going down considerably since
Q3, 2008 –2.9% –2%
January 1, 2008, and there was no consensus about how long the
effect of the financial crisis will last. All the governments in the October –26.4% –22%
world were using stimulus plans to spur the economic growth 2008
and many analysts believed that the economy as well as the stock
market will recover and start an increasing trend from January 1,
2009.
On November 10, Akhil wants to follow some strategies that will volatile over the last 10 months, he decides to concentrate on his
protect the shareholders of Bharat Fund from a further drop in portfolio on a month-to-month basis. He wants to use options to
the net asset value of the fund. Since the market has been highly protect the net asset value from dropping and to provide additional
gains.

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 246   Financial Risk Management

Table 3 Akhil has heard about covered call writing and portfolio insur-
ance using options but is not sure which of these strategies will be
better.
Exercise Price Call Price Put Price
(INR) (INR) (INR) Discussion Questions
2,600 403.85 124.70 1. If he wants to enter into covered call writing, which of
these options should he choose? If the value of the index on
2,650 301.05 141.55 November 27, 2008, is 2,752, what will be the value of the port-
folio on November 27, 2008?
2,700 338.40 151.00
2. If Akhil enters into a portfolio insurance strategy using puts,
2,750 299.60 167.00 which of these options should he choose? If the value of the
index on November 27, 2008, is 2,752, what will be the value
2,800 268.35 189.30 of the portfolio on November 27, 2008?
3. Since the market is expected to be bearish, Akhil wants to
2,850 242.55 208.35
enter into a bearish money spread. How can this be accom-
2,900 218.30 229.80 plished using call options and what would be the gain from
this money spread transaction if the index is at 2,752 on
2,950 181.90 306.40 November 27?
4. Since the market is expected to be bearish, Akhil wants to
3,000 169.05 279.35 enter into a bearish money spread. How can this be accom-
3,050 147.75 264.00 plished using put options and what would be the gain from
this money spread transaction if the index is at 2,752 on
3,100 127.35 337.10 November 27?
5. How can Akhil use a butterfly spread using calls and what
3,150 110.75 429.95 would be the gain if the index is at 2,752 on November 27?
6. How can Akhil use a straddle strategy and what would be the
3,200  88.95 425.85
gain if the index is at 2,752 on November 27?
3,250  72.50 498.80 7. How can Akhil use a strip strategy and what would be the gain
if the index is at 2,752 on November 27?
3,300  60.55 495.80 8. How can Akhil use a strap strategy and what would be the gain
if the index is at 2,752 on November 27?
He has collected some data about various options available on 9. Akhil wants to use a calendar spread using a call with an exer-
the CNX Nifty index as of November 1, 2008. cise price of INR 2,700 call with expiry on November 27 and
There were 49 call options and 49 put options available with December 28. The price of the 2,700 call with expiry on No-
exercise prices ranging from INR 2,300 to INR 4,750 and with an vember 27 is INR 338.40 and the price of the 2,700 call with
exercise date of November 27, 2008. He has also estimated that the expiry on December 28 is INR 402 on November 1, 2008. The
index is likely to be in the range of 2,600 to 3,300 on November 2,700 December call is priced at INR 185.50 on November 27,
27, 2008. Table 3 shows the call and put prices for various exercise when the index value is 2,752.
prices with the expiry date of November 27, 2008.

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 10
The Binomial Options Pricing
Model

LEARNING OBJECTIVES

After completing this chapter, you From 2004, the US accounting standards required that expensing
will be able to answer the following of employee stock option be moved from a footnote to account-
questions: ing statements to an income statement, since the valuing of these
 What is meant by the options became important. Till 2003, all companies were using
binomial model for options the Black–Scholes options pricing model to value these options.
pricing? However, most companies switched to the binomial options pric-
ing model, as this model can take into account variables such as
 What is meant by no-arbitrage the probability of exercise of an option as well as the probability
options pricing? of retirement of termination, in addition to usual factors such as
 How to calculate the price volatility in the model.
of a call option using single-
Source: “Binomial or Black–Scholes,” Executive Compensation Trends:
period, two-period, and multi-
Equilar, Inc. Newsletter, July 2005, 3–4.
period binomial models?
 How to calculate the price
of a put option using single-
period, two-period, and multi- BOX 10.1 Binomial Options Pricing Models Used to
period binomial models? Value Employee Stock Option Plans
 How to calculate the price
of a call and a put option
on stocks that pay dividends
using binomial models?
 How to calculate the price
of an American call and an
American put option using
binomial models?

In Chapter 8, we saw that the prices of call and put options are related to each other. However, the put–call
parity relationship is only applicable if we know the price of either the call option or the put option. If
we know the price of one of these options, we can immediately calculate the price of the other using the
put–call parity relationship. In this chapter, we will first derive the pricing relationship for a European
call option and then use this basic relationship to derive the pricing formula for a European put option

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 248   Financial Risk Management

Notes Table 10.1  Terminal Value of a Portfolio of One Long Stock and a Written Call

Stock Price at
Stock Value Call Value Portfolio Value
Maturity

SL SL 0 SL

SH SH –(SH – SX) SX

as well as for an American call option and an American put option. We will first deal with the simple ap-
proach called binomial options pricing and then discuss the Black–Scholes approach to options pricing
in Chapter 11.

10.1 The Binomial Options Pricing Model for Call Options

As Box 10.1 suggests, the binomial options pricing model can be considered superior to the usual Black–
Scholes model in the valuation of employee stock options. The binomial options pricing model is also
considered to be a better model for valuing interest rate options and currency options. The binomial
options pricing model was developed by Cox, Ingersoll, and Rubinstein in 1979. This model makes no
assumption on how the return on the underlying asset is generated and can account for any type of price
movement.
The binomial options pricing model provides the basics of options pricing. In this section, a brief idea
of binomial options pricing will be discussed. The binomial options pricing model is described in detail
in Section 10.2.
Assume that a call option is available with a maturity of T days from today and the risk-free rate is
constant over the life of the option and is equal to r. Further, assume that the stock price at the expiration
date can take only one of the two values, SH or SL. Let the exercise price of the call option be SX and that
SL < SX < SH.
Let the current price of the stock be S0 and the price of the call be C0. Consider forming a portfolio
of one stock and one written call. The terminal value of this portfolio can be calculated as shown in
Table 10.1.
This portfolio has a value of SL if the terminal stock price is SL and SX if the terminal stock price is SH.
Thus, this portfolio is risky, as the terminal value of this portfolio is not known with certainty at time zero.
However, consider a strategy of buying nC stocks for each call written, such that the portfolio is risk-
free. This means that the terminal value of the portfolio will be the same, irrespective of whether the
terminal stock price is SL or SH. This method of forming a portfolio is called a riskless hedge and the value
of nC is called hedge ratio 1.
The terminal value of this risk-less hedge is given in Table 10.2.
Since the portfolio is risk-less, these two values must be equal, or
nC SH – SH + SX = nC SL
or
SH − S X
nC =
SH − SL
If we choose to buy (SH – SX) / (SH – SL) stock for each call written, the portfolio will be risk-less.

Table 10.2  Terminal Value of a Portfolio of a Risk-less Hedge

Stock Price at Maturity Stock Value Call Value Portfolio Value

SL nC SL 0 nC SL

SH nC SH –(SH – SX) nC SH – SH + SX

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 The Binomial Options Pricing Model   249

Notes Table 10.3  Terminal Value of a Portfolio of a Stock and Risk-less Borrowing

ST Stock Value Value of Risk-free Borrowing Portfolio Value

SL nC SL –nC1 SX nC SL – nC1 SX
SH nC SH –nC1 SX nC SH – nC1 SX

Note that nC < 1, because SL < SX. Thus, a risk-less hedge requires buying less than one share of a stock
for each call written.
Since the portfolio is risk-less, we can calculate the price of the call option as follows:
The initial investment is nC S0 – C0, because buying nC stock requires a cash outflow of nC S0 and the
written call will result in a cash inflow of C0.
The terminal value is nC SL, which is risk-less. Thus, the current price of this risk-less portfolio should
be equal to the present value of the terminal value, or
nC S0 – C0 = (nC SL) (1 + r)–T
If we define k = SL / SX and nC1 = k nC, we have nC SL = nC1 SX. In other words:
S 
nC1 = nC  L 
 SX 
The pricing relationship for a call option is:
C0 = nC S0 – nC1 SX (1 + r)–T (10.1)
Equation (10.1) provides the price of a call option, where nC and nc1 are called hedge ratio 1 and hedge
ratio 2, respectively.
Hedge ratio 1 (nC) is the ratio of the number of shares to be purchased for each call to be written, and
hedge ratio 2 (nC1) is the fraction of the exercise price to be borrowed at the risk-free rate at this time in
order to replicate the call.
Hedge ratio 2 (nC1) can be understood in the following manner:
Consider buying nC shares of stock and borrowing the present value of nC1 SX at the current time at the
risk-free rate. The terminal value of this portfolio is shown in Table 10.3.
Since the portfolio value is equal to
nC SL – nC1 SX = nC SL – nC SL = 0  when ST = SL (since nC1 SX = nC SL),
 S − SX 
nC SH – nC1 SX = nC SH – nC SL = SH – SX when ST = SH  since nC = H
 SH − SL 
This shows that the terminal value of a portfolio of nC stock and risk-less borrowing of the hedged port-
folio with the present value of nC1 proportion of the exercise price is the same as the terminal value of a
call option with a price of C0. Thus, a bought call can be replicated by buying nC shares and borrowing a
fraction of the exercise price for the maturity of the option, with the fraction being nC1.

  E x a mple 1 0 . 1
Assume that Tata Motors stock is currently selling for INR 750. There is a call option on Tata Motors with
a maturity of 90 days and an exercise price of INR 800. The stock price on the expiration date could take
either of the following two values: INR 720 or INR 840. Form a risk-less hedge.
Here,
SH − S X 840 − 800 1
nC = = =
SH − SL 840 − 720 3

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 250   Financial Risk Management

Notes A risk-less hedge requires buying one-third of the stock for each call written or buying one stock and
writing three calls. The terminal value of the risk-less hedge portfolio is shown in Table 10.4.

Table 10.4  Terminal Value of a Portfolio of a Risk-less Hedge

Stock Price at Portfolio Value

Stock Value (INR) Call Value (INR)
Maturity (INR) (INR)
720 240 0 240
840 280 –40 240

This shows that the risk-less portfolio will have a value of INR 240.

  E x a mple 1 0 . 2
Assume that Tata Motors stock is currently selling for INR 750. There is a call option on Tata Motors with
a maturity of 90 days and an exercise price of INR 800. The stock price on the expiration date could take
either of the following two values: INR 720 or INR 840. The risk-free rate is 8%. What will be the price of
a call option that has a maturity of 90 days?
Hedge ratio 1
SH − S X 840 − 800 1
nC = , nC = =
SH − SL 840 − 720 3
Hedge ratio 2
S   1   720 
nC1 S X = nC SL or nC1 = nC  L  =  3   800  = 0.3
 SX
The price of the three-month call option will be (at a risk-free rate of 10% per annum):
C0 = nC S0 – nC1 SX (1 + r)–T
1
C0 = × 750 – 0.3 × 800 × (1.08)–(90/365) = INR 14.51
3
This shows that the call option will be priced at INR 14.51.
The call option can also be created by buying one-third of a Tata Motors share at INR 250 (750 / 3) and
borrowing [0.3 × 800 × (1.08)–(90/365)] = INR 235.49 at the risk-free rate.

P roblem 1 0 . 1
The contract size of Bank of India options is 950. Bank of India shares are selling at INR 338 on September 1. Call
options and put options are available with expiry on October 29 and with an exercise price of INR 350. It is expected
that the Bank of India share price will be either INR 360 or INR 320. The risk-free rate is 9%. Using the binomial
options pricing model, calculate the call option price on September 1.
Solution to Problem 10.1
According to binomial options pricing, the call price is calculated as:

C0 = nC S0 – nC1 SX (1 + r)–T

Given: S0 = INR 338; SX = INR 350; SH = INR 360; SL = INR 320; r = 9%; T = (Number of days from September 1 to
October 29) / 365 = 58 / 365. To calculate the call price, we need to calculate hedge ratio 1 (nC) and hedge ratio 2 (nC1)
Step 1: Calculate hedge ratio 1 (nC), which is given by:
SH − S X 360 − 350
nC = = = 0.25
SH − SL 360 − 320

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 The Binomial Options Pricing Model   251

This means that for each call written, four shares will have to be purchased.
Notes
Step 2: Calculate hedge ratio 2 (nC1), which is given by:
S  320
nC1 = nC  L  = 0.25 × = 0.228571
 SX  350
Step 3: Calculate the call price, which is given by:

C0 = nC S0 – nC1 SX (1 + r)–T = 0.25 × 338 – 0.228571 × 350 × (1.09)–(58/365) = INR 5.58

This requires an investment in stock of INR 84.50 (0.25 × 388) and a risk-less borrowing of INR 78.92 [0.228571
× 350 × (1.09)–(58/365)].

The call price is INR 5.58 per share or INR 5,301 for a lot of 950 shares.

P roblem 1 0 . 2
On July 1, ONGC shares are selling at INR 1,185. There are call options and put options available with the exercise
date of September 30 and an exercise price of INR 1,260 on ONGC shares with a contract size of 225. It is estimated
that the stock price could be either INR 1,300 or INR 1,100 on the expiry date of September 30. The risk-free rate is
8%. Calculate the price of a call option on July 1.
Solution to Problem 10.2
According to binomial options pricing, the call price is calculated as:

C0 = nC S0 – nC1 SX (1 + r)–T

Given: S0 = INR 1,185; SX = INR 1,260; SH = INR 1,300; SL = INR 1,100; r = 8%; T = (Number of days from July 1 to
September 30) / 365 = 92 / 365. To calculate the call price, we need to calculate hedge ratio 1 (nC) and hedge ratio 2
(nC1)

Step 1: Calculate hedge ratio 1 (nC), which is given by:

SH − S X 1, 300 − 1, 260
nC = = = 0. 2
SH − SL 1, 300 − 1,100

This means that for each call written, five shares will have to be purchased.

Step 2: Calculate hedge ratio 2 (nC1), which is given by:

S  1,100
nC1 = nC  L  = 0.2 × = 0.1746
 SX  1, 260

Step 3: Calculate the call price, which is given by:

C0 = nC S0 – nC1 SX (1 + r)–T = 0.2 × 1,185 – 0.1746 × 1,260 × (1.08)–(92/365) = INR 21.83

This requires an investment in stock of INR 237.60 (0.2 × 1,188) and risk-less borrowing of INR 215.77 [0.1746 ×
1,260 × (1.08)–(92/365)].

The call price is INR 21.83 per share or INR 4,911.85 for a lot of 225 shares.

When an investor is involved in covered call writing, that is, buying one share and writing one call, the
profit or loss from this strategy depends on how the price of the stock as well as the price of the option
change. If the stock price increases by INR 1 and the option price increases by less than INR 1, the inves-
tor will make a profit. This is because the investor can buy a call and sell the stock, thus liquidating his
original position, and this can be done at a profit. However, if the call price increases by more than INR 1,
the investor will lose. If the share price increases by INR 1 and the option price also increases by INR 1,
the investor will neither gain nor lose. However, the latter scenario, that is, the increase in the stock price
exactly matching the increase in the call price, will happen only when the call is deep in-the-money.
When the call is out-of-money, the change in the price of the call option will be different from the change
in the price of the stock.

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 252   Financial Risk Management

Notes When an investor buys a share of stock, they will gain from this position if the share price increases
and lose if the share price decreases. However, a written call position will result in a gain if the share price
decreases, while it will result in a loss if the share price increases. Thus, the pay-off from a portfolio of
shares and a written call depends on which of the gains dominates. If the gain from the option is more
than the loss from the stock when the stock price decreases or if the gain from the stock is more than the
loss from the option when the stock price increases, the hedge position will result in a profit. Otherwise,
it will result in a loss.
Thus, the gain or loss from a hedge depends on the relationship between the changes in the option
price and the stock price. If the change in the option price is exactly equal to the change in the stock price,
the hedge strategy should result in no profit and no loss. This is known as a perfect hedge or a risk-less
hedge. A risk-less hedge is obtained whenever the change in the price of the stock is exactly equal to the
change in the price of the option.
In the case of a binomial option with only two possible prices, SH and SL, the possible change in the
stock price is (SH – SL) and the possible change in the option price is (SH – SX). Thus, a perfect hedge is
obtained when the hedge ratio is nC. Thus, hedge ratio 1 can be defined as the ratio of the change in the
option price to a given change in the stock price.

10.2  The Binomial Options Pricing Model for Put Options

Put option pricing can also be carried out by forming a perfect risk-free hedge portfolio. Assume that a
put option is available with a maturity of T days from today and the risk-free rate is constant over the life
of the option and is equal to r. Further, assume that the stock price at the expiration date could take only
one of the two values, SH or SL. Let the exercise price of the call option be SX and that SL < SX < SH.
Let the current price of the stock be S0 and the price of put be P0. Consider forming a portfolio of
one stock and one bought put. The terminal value of this portfolio can be calculated as shown in
Table 10.5.
This portfolio has a value of SX if the terminal stock price is SL and SH if the terminal stock price is
SH. Thus, this portfolio is risky, as the terminal value of this portfolio is not known with certainty at time
zero.
However, consider a strategy of buying nP stock for each put bought, such that the portfolio is risk-
free. This means that the terminal value of the portfolio will be the same, irrespective of whether the ter-
minal stock price is SL or SH. This method of forming a portfolio is called a risk-less hedge, and the value
of nP is called hedge ratio 1 for the put.
The terminal value of this risk-less hedge is given in Table 10.6.
Thus, for a risk-free hedge:
nP SL + SX – SL = nP SH 
or
S X − SL
nP =
SH − SL
If we choose to buy (SH – SX) / (SH – SL) stock for each put bought, the portfolio will be risk-less.
Note that nP < 1, because SX < SL. Thus, a risk-less hedge requires buying less than one share of stock
for each put bought.

Table 10.5  Terminal Value of a Portfolio of One Long Stock and One Bought Put

Stock Price at Maturity Stock Value Put Value Portfolio Value

SL SL (SX – SL) SX

SH SH 0 SH

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 The Binomial Options Pricing Model   253

Notes Table 10.6  Terminal Value of a Hedge Portfolio of Puts and Stock

ST Stock Value Put Value Portfolio Value

SL np SL SX – SL np SL + SX – SL

SH np SH 0 np SH

The initial investment is nP S0 + P0. Since the initial investment should be equal to the present value of
the terminal value of the risk-less portfolio:
nP S0 + P0 = nP SH (1 + r)–T
Defining  kP = SH / SX and nP1 = nP kP = nP (SH / SX):
P0 = nP1 SX (1 + r)–T – nP S0
Here, nP1 is the percentage of the present value of the exercise price that should be borrowed at the risk-
free rate to purchase the stock and put option.
Thus, the calculation of the put price by using the binomial options formula also requires two
hedge ratios. Hedge ratio 1 (nP) is the number of shares to be bought for each put bought, which will be
equal to the ratio of the change in the price of the put to the change in the price of a share. Hedge ratio 2
(nP1) is the fraction of the exercise price that is to be borrowed at the risk-free rate in order to replicate
the put option.

  E x a mple 1 0 . 3
Assume that Tata Motors stock is currently selling for INR 750. There is a put option on Tata Motors with
a maturity of 90 days and an exercise price of INR 800. The stock price on the expiration date could take
either of the following two values: INR 720 or INR 840. Form a risk-less hedge since:
S X − SL 800 − 720 2
nP = nP = =
SH − SL 840 − 720 3
A risk-less hedge requires buying two-thirds of the stock for each put bought or buying two stocks and
three puts. The terminal value of the risk-less hedge portfolio is shown in Table 10.7.

Table 10.7  Terminal Value of the Portfolio of a Risk-less Hedge

Stock Price at Stock Value Put Value Portfolio

Maturity (INR) (INR) (INR) Value (INR)

720 480 80 560

840 560 0 560

  E x a mple 1 0 . 4
Assume that Tata Motors stock is currently selling for INR 750. There is a put option on Tata Motors with
a maturity of 90 days and an exercise price of INR 800. The stock price on the expiration date could take
either of the following two values: INR 720 or INR 840. The risk-free rate is 9%. Calculate the put option
price using binomial options pricing.
Given: S0 = INR 750; SX = INR 800; SH = INR 840; SL = INR 720; r = 9%; T = 90 / 365.
To calculate the put price, we need to calculate hedge ratio 1 (nP) and hedge ratio 2 (nP1).

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 254   Financial Risk Management

Notes Step 1: Calculate hedge ratio 1 (nP), which is given by:

S X − SL 800 − 720 2
nP = = =
SH − SL 840 − 720 3
This means that for every two puts bought, three shares will have to be purchased.
Step 2: Calculate hedge ratio 2 (nP1), which is given by:
S   2   840 
nP1 = nP  H  =  3   800  = 0.7
 SX
The put option price of the Tata Motors share will be:
P0 = nP1 SX (1 + r)–T – np S0
2
= 0.7 × 800 × (1.08)–(90/365) – × 750
3
= INR 49.47
The put option price will be INR 49.47.
We can use put–call parity to check the price of the put option, given the put price is INR 48.22.
  According to put–call parity,
C0 = S0 + P0 – SX (1 + r)–T
= 750 + 48.22 – 800 (1.08)–(90/365)
= INR 14.51

P roblem 1 0 . 3
The contract size of Bank of India options is 950. Bank of India shares are selling at INR 338 on September 1. Call
options and put options are available with expiry on October 29 and an exercise price of INR 350. It is expected
that the Bank of India share price will be either INR 360 or INR 320. The risk-free rate is 9%. By using the binomial
options pricing model, calculate the put option price on September 1.
Solution to Problem 10.3
According to binomial options pricing, the put price is calculated as:

P0 = nP1 SX (1 + r)–T – nP S0

Given: S0 = INR 338; SX = INR 350; SH = INR 360; SL = INR 320; r = 9%; T = (Number of days from September 1
to October 29) / 365 = 58 / 365. To calculate the put price, we need to calculate hedge ratio 1 (nP) and hedge
ratio 2 (nP1).

Step 1: Calculate hedge ratio 1 (nP), which is given by:

S X − SL 350 − 320
nP = = = 0.75.
SH − SL 360 − 320

This means that for every three puts bought, four shares will have to be purchased.

Step 2: Calculate hedge ratio 2 (nP1), which is given by:

S  360
nP1 = nP  H  = 0.75 × 350 = 0.771429
 SX
Step 3: Calculate the put price, which is given by:

P0 = nP1 SX (1 + r)–T – nP S0 = 0.771429 × 350 × (1.09)–(58/365) – 0.75 × 338 = INR 12.64

This requires an investment in stock of INR 253.50 (0.75 × 388) and risk-less borrowing of INR 266.14 [0.771429 ×
350 × (1.09)–(58/365)]. The put price is INR 12.64 per share or INR 12,008.91 for a lot of 950 shares.

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 The Binomial Options Pricing Model   255

Notes P roblem 1 0 . 4
On July 1, ONGC shares are selling at INR 1,185. There are call options and put options available with the exercise
date of September 30 and an exercise price of INR 1,260 on the ONGC shares with a contract size of 225. It is
estimated that the stock price could be either INR 1,300 or INR 1,100 on the expiry date of September 30. The risk-
free rate is 8%. Calculate the price of a put option on July 1.
Solution to Problem 10.4
According to binomial options pricing, the put price is calculated as:

P0 = nP1 SX (1 + r)–T – nP S0

Given: S0 = INR 1,185; SX = INR 1,260; SH = INR 1,300; SL = INR 1,100; r = 8%; T = (Number of days from July
1 to September 30) / 365 = 92 / 365. To calculate the put price, we need to calculate hedge ratio 1 (nP) and hedge
ratio 2 (nP1).

Step 1: Calculate hedge ratio 1 (nP), which is given by:

S X − SL 1, 260 − 1,100
nP = = = 0. 8.
SH − SL 1, 300 − 1,100
This means that for every put bought, four shares will have to be purchased.

Step 2: Calculate hedge ratio 2 (nP1), which is given by:

S  1, 300
nP1 = nP  H  = 0.8 × = 0.825397
 SX  1, 260

Step 3: Calculate the put price, which is given by:

P0 = nP1 SX (1 + r)–T – nP S0 = 0.825397 × 1,260 × (1.08)–(92/365) – 0.8 × 1,185 = INR 69.65

This requires an investment in stock of INR 1,017.65 (0.8 × 1,185) and risk-less borrowing of INR 948.00 [0.825397
× 1,260 × (1.09)–(92/365)]. The put price is INR 69.65 per share or INR 15,671.25 for a lot of 225 shares.

10.3 The Relation Between the Hedge Ratios for Call

and Put Options
Hedge ratio 1 for a call option is the number of shares of stock that is to be bought for each call written
so that the portfolio is risk-free, and hedge ratio 1 for a put option is the number of shares of stock that
is to be bought for each put option bought so that the portfolio is risk-free. It can be seen that these two
hedge ratios are related. Since:
SH − S X S − SL
nC =  and  nP = X ,
SH − SL SH − SL
(SH − S X ) + (S X − SL )
nC + nP = =1
SH − SL
np = 1 – nC
This shows that hedge ratio 1 for a put is equal to 1 – hedge ratio 1 for the call. For example, if a risk-
free portfolio for a call requires the purchase of one-third of a share for each call written, the hedge
portfolio of a put will require the purchase of two-thirds of a share for each put bought. Similarly, we can
also show that:
nP1 = 1 – nC1

10.4  The No-arbitrage Pricing Argument

The binomial options pricing model is based on the principle of no-arbitrage pricing, which is also
known as the “law of one price.” According to the law of one price, two portfolios that have similar risks
and similar terminal values should have the same price.

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 256   Financial Risk Management

Notes In binomial call option pricing, there are two portfolios: Portfolio 1 consists of one written call, and
portfolio 2 consists of a long position in nC stocks and risk-free borrowing of nC1 per cent of the present
value of the exercise price of the call option. The current investments in the two portfolios are:
Investment in portfolio 1 = C0
Investment in portfolio 2 = nC S0 – nC1 e–rT SX
Terminal value of portfolio 1 = Max [(ST – SX), 0]
Terminal value of portfolio 2 = nC ST – nC1 SX
Substituting:
SH − S X S 
nC =  and nC1 = nC  L 
SH − SL  SX 
SH − S X
Terminal value of the portfolio = ×(ST − SL )
SH − SL
At maturity, if ST = SH :
ST − S X
terminal value of portfolio 2 = ×(ST − SL ) = (ST − S X )
ST − SL
At maturity, if ST = SL:
SH − S X
Terminal value of portfolio 2 = ×(ST − ST ) = 0
SH − SL
This shows that:
Terminal value of portfolio 2 = Max [(ST – SX), 0]
The terminal value of investing in portfolio 2, which consists of a long position in nC stocks and risk-free
borrowing of nC1 per cent of the present value of the exercise price of the call option, is exactly equal to the
terminal value of writing one call option. Thus, we are replicating a call option through an investment in
stock and risk-less borrowing. Since the two portfolios have the same terminal value, the current invest-
ment in these two portfolios should be the same; if the two values are not the same, it would lead to arbi-
trage profits. Therefore, the binomial call option price is derived from the no-arbitrage argument. A similar
argument will show that the binomial put option price is also derived using the no-arbitrage argument.

10.5  The Derivation of the Binomial Options Pricing Model

The binomial options pricing model is derived based on a number of restrictive assumptions which are
listed below:
1. All investors would prefer more wealth, rather than less.
2. Markets are perfect and frictionless. This means that there are no transaction costs, no margin re-
quirements, no taxes, and all investors are price takers.
3. Investors would receive the proceeds of all short sales and can trade fractional securities
4. There is only one interest rate r at which investors can borrow and lend without any risk.
5. The pricing of the stock is described as follows:
At any given time, the price St is known. The price at the next discrete interval would either increase
to u St or decrease to d St, where the percentage increase is u – 1 and the percentage decrease is 1 – d.
If the current price is INR 100 and if u – 1 = 5% and 1 – d = 4%, the price on the next interval would
be either INR 105 or INR 96.

6. At the beginning, the price process for subsequent periods is known. This means that at time 0, we
will know the values of u, d, and r for all future periods. This does not mean that u, d, and r are con-
stant across all periods.
On the basis of these assumptions, a binomial options pricing model can be developed.

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 The Binomial Options Pricing Model   257

Notes 10.6 The Single-period Binomial Options Pricing Model

A single-period binomial options pricing model is useful in valuing non-dividend-paying European op-
tions, as this option can be exercised only on the exercise date and we are only interested in the possible
stock prices on the exercise date.
At time T – 1, the stock price is ST–1. At time T, the stock price could be either u ST–1 or d ST–1, where
u > 1 and d < 1. This means that the price at T will either increase to u ST–1 or decrease to d ST–1. This is
shown in Figure 10.1.
If there is a call option with an exercise price of SX and an expiry date of T, the value of the call at
time T can be calculated as shown in Figure 10.2.
Since a bought call can be replicated by buying a certain number of stocks and by borrowing a cer-
tain portion of the present value of the exercise price, let us assume that D number of stocks would be
bought and INR B will be borrowed. Then the value of this portfolio at time T would be as shown below.
At time T:
VT = D ST–1 u – B erT if uptick and VT = D ST–1 d – B erT  if downtick
The current investment (VT–1) is:
VT–1 = D ST–1 – B
Suppose we choose D and B such that the portfolio value is the same as the value of the call at time T. Let
CT,u be the value of the call at time T if the stock price is u ST and CT,d be the value of the call at time T if
the stock price is d ST. Then:
D u ST–1 – B erT = CT,u
D d ST–1 – B erT = CT,d
Solving for D and B, we get:
CTu − CTd
∆=
ST −1 (u − d )
CTu (1 + d ) − CTd (1 + u)
B=
(u − d ) e rT
Since the pay-off at time T is the same for the portfolio and the call, the current investment should be the
same for the portfolio and the call. Or,
CT–1 = D ST–1 – B
Substituting D and B into the current call price, we get:
CTu − CTd d CTu − u CTd
CT −1 = −
(u − d ) (u − d ) e rT
  (e rT − d )   (u − e rT )  
CT −1 = e − rT    CTu +   CTd 
  (u − d )   (u − d )  

67X X6
 7í

67í

6
 7G G67í

Figure 10.1  Determination of the Value of a Stock by

Using a Single-period Binomial Tree

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 258   Financial Risk Management

�
Notes &7X 0D[>X67í±6[@

&7í

&7G 0D[>G67í±6[@

Figure 10.2  Determination of the Value of Call by

Using a Single-period Binomial Tree

If we denote
e rT − d
p=
u−d
Then,

u − e rT
(1 – p) =
u−d
CT–1 = e–rT [p CTu + (1 – p) CTd]
This shows the price of a single-period binomial call option price. This equation can be understood as
explained. Binomial options pricing is based on creating a risk-free portfolio through the combination
of D stocks for each call written. Thus, the value of the option at time T – 1 is the expected future pay-off
from the call option discounted at the risk-free rate.
If the binomial options pricing is interpreted in this manner, p and 1 – p can be interpreted as being the
probability of the stock price increasing and decreasing, respectively, in a risk-neutral world.
In a risk-neutral world, the investors do not require any risk premium on any asset and their expected
returns on all assets would be equal to the risk-free rate. It can be shown that by using the binomial op-
tions pricing model, the expected returns will be equal to the risk-free rate.
Since p is the probability of the stock price increasing and 1 – p is the probability of the stock price
decreasing, the expected terminal stock price at time T – 1 can be written as
E(ST) = p u ST–1 + (1 – p) d ST–1
If we substitute the value for p and 1 – p in the above equation, we get:
E(ST) = ST–1 erT
Thus, one of the most important principles in options pricing is risk-neutrality, and the pricing is often
called risk-neutral valuation. This price is also correct in a risk-averse world, which is the usual descrip-
tion of the real world.
Note that p and (1 – p) calculated above are the risk-neutral probabilities and are not the actual prob-
abilities of the stock price increasing and decreasing. Whatever be the actual probability of the stock price
increasing and decreasing, the risk-neutral probability will be the same. We need to only assume that the
terminal price is u ST–1 and d ST–1, and we need not have to worry about the probability of reaching u ST–1
and d ST–1.

  E x a mple 1 0 . 5
Assume that a stock is currently priced at INR 1,200. There exists a call option with an exercise price of
INR 1,240 and an expiry of 90 days. At the end of 90 days, the stock price can either increase by 8% or
decrease by 3%. If the risk-free rate is 6%, calculate the price of the call by using the binomial options
pricing model.
Given: u = 1.08; d = 0.97; S0 = INR 1,200; SX = INR 1,240; r = 6%; T = 90 / 365

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 The Binomial Options Pricing Model   259

Notes First, calculate the risk-neutral probabilities p and (1 – p).

0.06 × (90 /365)
e rT − d e − 0.97
p= = = 0.4082
u−d 1.08 − 0.97
0.06×(90 /365)
u − e rT 1.08 − e
(1 – p) = = = 0.5918
u−d 1.08 − 0.97
CTu = Max [0, (STu – SX)] = Max [0, (1,200 × 1.08 – 1,240)] = Max [0, (1,296 – 1,240)] = INR 56
CTd = Max [0, (STd – SX)] = Max [0, (1,200 × 0.97 – 1,240)] = Max [0, (1,164 – 1,240)] = INR 0
Thus, the expected value of the call at time 1:
Expected value at time 1 = 0.4082 × 56 + 0.5918 × 0 = INR 22.86
Discounting this expected terminal value at 6% over 90 days gives:
CT–1 = CT e–rT = 22.86 × e–0.06×(90/365) = INR 22.52

P roblem 1 0 . 5
Infosys stock is selling at INR 1,130 on September 1. There exits a call option on Infosys with expiry on October 29
and an exercise price of INR 1,150. It is estimated that by October 29, the Infosys share price could either increase by
6% or decrease by 4%. The risk-free rate is 8%. Calculate the call price by using the single-period binomial options
pricing model.
Solution to Problem 10.5
Given: u = 1.06; d = 0.96; S0 = INR 1,130; SX = INR 1,150; r = 8%; T = 58 / 365

First, calculate the risk-neutral probabilities p and (1 – p).

0.08×(58 / 365
e rT − d e )
− 0.96
p= = = 0.528
u−d 1.06 − 0.96
0.08×(58 / 365)
u − e rT 1.06 − e
(1 – p) = = = 0.472
u−d 1.06 − 0.96
CTu = Max [0, (STu – SX)] = Max [0, (1,130 × 1.06 – 1,200)] = Max [0, (1,197.80 – 1,150)] = INR 47.80
CTd = Max [0, (STd – SX)] = Max [0, (1,130 × 0.96 – 1,200)] = Max [0, (1,084.80 – 1,150)] = INR 0
Thus, the expected value of the call at time 1:

Expected value at time 1 = 0.528 × 47.80 + 0.472 × 0 = INR 22.56

Discounting this terminal expected value at 8% over 58 days gives:

CT–1 = CT e–rT = 22.56 × e–0.08×(58/365) = INR 22.275

The call price at time (T – 1) will be INR 22.275.

10.7  The Two-period Binomial Options Pricing Model

We will now extend the single-period model to a two-period model. Assume that the call will expire at
time T and there are two periods before maturity, (T – 1) and (T – 2). We are trying to value the call at
time (T – 2). We will assume that the stock price will increase by (u – 1)% or decrease by (1 + d)%, with
u > 1 and d < 1 in every period, and that u, d, and r are constant in both the periods. This means that the
stock price at T – 1 will be u ST–2 or d ST–2 and the stock price at T will be u ST–1 or d ST–1 (a formula for
the conditions in which the values of u and d can change in the two periods can be derived). The value
of stock price and the value of the call on the three dates, T, (T – 1), and (T – 2) are shown in Figs. 10.3
and 10.4.
The calculation of the option price at time T is done by backward induction. We first calculate the call
price at time (T – 1) from the call value at time T by using the single-period binomial options pricing

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 260   Financial Risk Management

Notes 67XX X67í

67íX ��
X67í

67XG XG67í
67í

67íG G67í

67GG G67í

�
Figure 10.3  Pattern of Stock Prices Obtained
Using a Two-period Binomial Tree

model. However, there are two possible situations at time T, that is, uptick of stock price or downtick of
stock price at time (T – 1). Thus, we will calculate the call price when there is uptick and also the call price
when there is downtick. We would then apply the single-period binomial options pricing model once
again to calculate the call price at time (T – 2).
CTuu = Max [0, (STuu – SX)]
CTud = CTdu = Max [0, (STud – SX)]
CTdd = Max [0, (STdd – SX)]
The risk-neutral probabilities for time (T – 1) to time T can be calculated as:

e rT1 − d
p2 =
u−d
Then:
− rT
C(T–1)u = [p2 × CTuu + (1 – p2) × CTud] e 1
C(T–1)d = [p2 × CTud + (1 – p2) × CTdd] e − rT1
where T1 is calculated as [Number of days from (T – 1) to T] / 365. Once we have found the call price at
time T – 1 for uptick of the price and for downtick of the price at time T – 1, we would bring it back one
more time using the risk-neutral probabilities for period T – 2 to period T – 1.
e rT2 − d
p1 =
u −d
− rT2
CT–2 = [p1 × C(T–1)u + (1 – p1) × C(T–1)d] e

&7±X 0D[ &7XX 0D[>X67±±6[@

>X67±±6[@
&7± &7GX 0D[>XG67±±6[@
&7±G 0D[
>G67±±6[@
&7GG 0D[>G67±±6[@

Figure 10.4  Pattern of Call Prices Obtained

Using a Two-period Binomial Tree

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 The Binomial Options Pricing Model   261

Notes If u, d, and r are constant and the periods are of equal time interval of t years, this can be written as:
CT–2 = e–2r t[p2 CTuu + 2 p (1 – p) CTud + (1 – p)2 CTdd]
because the risk-neutral probabilities in each period will be the same.

  E x a mple 1 0 . 6
Assume that a stock is currently priced at INR 1,200. There exists a call option with an exercise price of
INR 1,240 and an expiry of 90 days. This 90-day period can be considered to be two periods of 45 days
each. In each of the 45-day period, the stock price can either increase by 4% or decrease by 1.5%. If the
risk-free rate is 6%, calculate the price of the call by using the binomial options pricing model.
Given: u = 1.04; d = 0.985; S0 = INR 1,200; SX = INR 1,240; r = 6%; T1= 45 / 365; T2 = 45 / 365
The risk-neutral probabilities for time T – 1 to time T can be calculated as:
(0.06×45/365)
e rT1 − d e − 0.985
p2 = = = 0.4077
u−d 1.06 − 0.985
 CTuu = Max [0, (STuu – SX)] = Max [0, (1,200 × 1.04 × 1.04 – 1,240)] = Max (0, 57.92) = INR 57.92
 CTud = CTdu = Max [0, (STud – SX)] = Max [0, (1,200 × 1.04 × 0.985 – 1,240)] = Max (0, –10.72) = 0
CTdd = Max [0, (STdd – SX)] = Max [0, (1,200 × 0.985 × 0.985 – 1,240)]= Max (0, –75.73) = 0
Then:
− rT1
C(T–1)u = [p2 × CTuu + (1 – p2) × CTud] e = (0.4077 × 57.92 + 0.58417 × 0) e–0.06×45/365 = INR 23.61
− rT1
C(T–1)d = [p2 × CTud + (1 – p2) × CTdd] e = (0.41583 × 0 + 0.58417 × 0) e–0.06×45/365 = 0
From the call prices at (T – 1), we can calculate the call price at (T – 2) as follows:

e rT2 − d e 0.06 × 45/365 − 0.985

p1= = = 0.4077
u−d 1.04 − 0.985
CT–2 = [p1 × C(T–1)u + (1 – p1) × C(T–1)d] e − rT2 = 0.4077 × 23.61 + 0.5923 × 0 = INR 9.62

In Examples 10.5 and 10.6, the call option price is calculated for a stock currently selling at INR 1,200
and having an exercise price of INR 1,240 and an exercise period of 90 days. In the single-period model,
the call price is calculated as INR 22.52, and in the two-period model, the call price is calculated as INR
9.62. Why would a two-period model provide a lower call price when compared to a single-period model?
In the single-period model, there are only two possible stock prices—one higher than the exercise
price and one below the exercise price, and the probability of the call being in-the-money is 0.4082. In the
two-period model, there are three possible stock prices on the exercise date—high price, medium price,
and low price. The probabilities of these prices are calculated as:
Probability of high price = Probability of price increase during period 1
× Probability of price increase during period 2
= p2 × p1
= 0.4077 × 0.4077
= 0.1662
Probability of medium price = Probability of price increase during period 1
× Probability of price decrease in period 2 [p1 × (1 – p2)]
+ Probability of price decrease during period 1
× Probability of price increase during period 2
= (1 – p1) × p2
= 0.4077 × (1 – 0.4077) + (1 – 0.4077) × 0.4077
= 0.4830

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Notes Probability of low price = Probability of price decrease during period 1

× Probability of price decrease during period 2
= (1 – p2) × (1 – p1)
= (1 – 0.4077) × (1 – 0.4077)
= 0.3508
Since the call option is in-the-money only at the high price, the call price is calculated with the probability
of 0.1662 in the two-period model, whereas it is calculated with the probability of 0.4082 in the single-
period model.
This is the major advantage of a binomial model, as the call price movement is based on what happens
to the stock price in the interim period before expiry. In a single-period model, we do not give impor-
tance to the stock price movement in the period before expiry, whereas in multi-period binomial models,
we can take into account the possible stock price movement during the period from the time the call is
bought till its expiry date. A binomial model can be used to obtain call prices for any distribution of stock
price movement.

P roblem 1 0 . 6
Infosys stock is selling at INR 1,130. There exits a call option on Infosys with expiry in 60 days at an exercise price of
INR 1,140. It is estimated that every 30 days, the Infosys price could increase by 6% or decrease by 4%. The risk-free
rate is 8%. Calculate the call price by using the two-period binomial options pricing model.
Solution to Problem 10.6
Given: u = 1.06; d = 0.96; S0 = INR 1,130; SX = INR 1,140; r = 8%; T1 = 30 / 365; T2 = 30 / 365
The risk-neutral probabilities for time 30 days to time 60 days can be calculated as:
(0.08 × 30 / 365)
e rT1 − d e − 0.96
p2 = = = 0.46597
u−d 1.06 − 0.96
CTuu = Max [0, (STuu – SX)] = Max [0, (1,130 × 1.06 × 1.06 – 1,140)] = Max (0,129.67) = INR 129.67
CTud = CTdu = Max [0, (STud – SX)] = Max [0, (1,130 × 1.046 × 0.96 – 1,150)] = Max (0, 9.89) = INR 9.89
CTdd = Max [0, (STdd – SX)] = Max [0, (1,130 × 0.96 × 0.96 – 1,150)] = Max (0, –98.59) = 0
Then:
− rT1
C(T–1)u = [p2 × CTuu + (1 – p2) × CTud)] e = (0.46597 × 129.67 + 0.53403 × 9.89) e–0.08×30/365 = INR 66.14
− rT1
   C(T–1)d = [p2 × CTud + (1 – p2) × CTdd)] e = (0.46597 × 9.89 + 0.53403 × 0) e–0.08×30/365 = INR 4.64

From the call prices at (T – 1), we can calculate the call price at (T – 2) as follows:
0.08 × 30 / 365
e rT2 − d e − 0.96
p1= = = 0.46597
u−d 1.06 − 0.96
− rT2
CT–2 = [ p1 × C(T–1)u + (1 – p1) × C(T–1)d] e = 0.46597 × 66.14 + 0.53403 × 4.64 = INR 33.30

10.8  The Multi-period Binomial Options Pricing Model

In a multi-period binomial options pricing model, we again assume that the price will either increase
by (u – 1)% or decrease by (1 + d)% with u > 0 and d < 0 during each time period. On the basis of this
assumption, we can calculate the stock price at every time period. The call value at the maturity of the op-
tion can also be calculated. Then, following the same process as that for a two-period model, a backward
calculation is made until the current call price is calculated.
In the two-period model, it was shown that the stock price at time T – 1 can be either S(T–1)u or S(T–1)
d and the stock price at time T can be either STuu, STud, STdu, or STdd. If we add one more period, the stock
price at T – 3 would be ST–3 and that at T – 2 would be either S(T–2)u or S(T–2)d. At time T – 1, the stock
price would be either S(T–1)uu, S(T–1)ud, S(T–1)du, or S(T–1)dd. At T, the stock price would be either STuuu, STuud,
STudu, STduu, STddu, or STddd. The stock price at maturity may arise as a result of three upticks—two upticks
and one downtick (which happens three times), one uptick and two downticks (which happens three
times), and three downticks. If we continue to add a fourth period, there are 16 possible terminal stock
prices, and they will result from either four upticks, three upticks and one downtick (which happens four

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 The Binomial Options Pricing Model   263

Notes times), two upticks and two downticks (which happens six times), one uptick and three downticks (which
happens four times), and four downticks.
If there are n periods, the number of possible stock prices would be 2n, and we need to estimate the
number of upticks in order to estimate the possible stock price at maturity. This can be done by using the
combination rule, which says that the number of k upticks in n periods is given by:
n!
n Ck =
k ! (n − k )!
where k! = k (k – 1) (k – 2) ……. 1.
If there are four periods and we want to know the number of times two upticks will occur, we get
4! 24
4 C2 = = =6
2! (4 − 2)! (2 × 2)
That is, two upticks will occur six times.
In the case of a two-period model, the call prices are given by:
CT–2 = e–2rt[p2 CTuu + 2 p (1 – p) CTud + (1 – p)2 CTdd]
In a two-period model, there is one uptick and one downtick during the first period and two upticks and
two downticks in the second period.
If we assume that u, d, and r are constant for all periods and k is the number of upticks in n periods,
the call price at T – n is given by:
n
C(T −n) = e − rn ∑ n Ck pk (1 − p)(n − k ) max 0,(1 + u)k (1 + d )(n − k ) S(T −n) − S X 
k =0

where n Ck = n! / [k! (n – k)!].

  E x a mple 1 0 . 7
Consider a stock currently selling at INR 20 and a call option with an exercise price of INR 21 with an
expiry of six months. It is estimated that in each month, the stock price would either increase by 3% or
decrease by 2%. The monthly risk-free rate is 0.5% (annual rate is 6%). Estimate the call price now.
0.06 × (1/12)
e rt − d e − 0.98 0.025
p= = = = 0.5
u−d 1.03 − 0.98 0.05
1 – p = 0.5
The values of the number of upticks (k), number of ways in which upticks can be generated ( n Ck ), stock
price at maturity for various upticks (ST), and corresponding terminal value of the call (CT) are shown in
table 10.8.

Table 10.8  Upticks, Stock Price at Maturity and Terminal Value of the Call

k nCk ST CT

6  1 20 × (1 + 0.03)6 = 23.88 23.88 – 21 = 2.88

5  6 20 × (1 + 0.03)5 × (1 – 0.02) = 22.72 22.72 – 21 = 1.72

4 15 20 × (1 + 0.03)4 × (1 – 0.02)2 = 21.62 21.62 – 21 = 0.62

3 20 20 × (1 + 0.03)3 × (1 – 0.02)3 = 20.57 0

2 15 20 × (1 + 0.03)2 × (1 – 0.02)4 = 19.57 0
1  6 20 × (1 + 0.03)1 × (1 – 0.02)5 = 18.62 0
0  1 20 × (1 – 0.02)6 = 17.72 0

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 264   Financial Risk Management

Notes The call price at time T – 6 would be given by:

6
 1 
CT–6 =  × [1 × (0.5)6 × (0.5)0 × 2.88 + 6 × (0.5)5 × (0.5)1 × 1.72 + 15 × (0.5)4 × (0.5)2 × 0.62]
 1.005 
= INR 0.35

10.9 The Determination of u and d

The most important parameters in the binomial model are u and d, and they have to be estimated. Cox,
Ingersoll, and Rubenstein showed that u and d can be calculated if the stock price is based on a lognormal
distribution (the lognormal distribution is explained in Chapter 11) as:
1
u = eσ ∆t
 and d =
u
where s is the price volatility of the stock and Dt is the length of one step of the binomial tree. If we use
the values of u and d as defined above, the risk-neutral probability p can be calculated as:
e r ∆t − d
p=
u−d

P roblem 1 0 . 7
Assume that a stock is currently priced at INR 1,200. There exists a call option with an exercise price of INR 1,240
and an expiry of 90 days. This 90-day period can be considered to be two periods of 45 days each. The standard
deviation of the stock is 25%. If the risk-free rate is 6%, calculate the price of the call by using the binomial options
pricing model.
Solution to Problem 10.7
Given: Dt = 45 / 365 = 0.123288; r = 6%; S0 = INR 1,200; SX = INR 1,240; s = 25%

Then,

u = eσ ∆t
= e0.25 × (0.123288) = 1.0917
1
d = = 0.916
u
0.06 × 45 / 365
e r ∆t − d e − 0.916
p= = = 0.52
u−d 1.0917 − 0.916
CTuu = M
 ax [(STuu – SX), 0]
= Max [(u2 ST–2 – SX), 0]
= Max [(1.09172 × 1,200 – 1,240), 0]
= Max [(1,430.17 – 1,200), 0]
= INR 230.17
 ax [(STud – SX), 0]
CTud = M
= Max [(u d ST–2 – SX), 0]
= Max [(1.0917 × 0.916 × 1,200 – 1,240), 0]
= Max [(1,200 – 1,200), 0]
= INR 0
 ax [(STuu – SX), 0]
CTuu = M
= Max [(d2 ST–2 – SX), 0]
= Max [(0.9162 × 1,200 – 1,240), 0]
= Max [(1,006.87 – 1,200), 0]
= INR 0

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 The Binomial Options Pricing Model   265

CT–2 = e–2r[p2 CTuu + 2 p (1 – p) CTud + (1 – p)2 CTdd]

Notes
= e–2×0.06×(45/365) (0.52 × 0.52 × 230.17)
= INR 61.32

10.10 The Valuation of a European Call Paying a Given

Dividend Amount
In order to value a European call that pays a given dollar amount, we will consider one of the periods in
which the stock goes ex-dividend and assume that the dividend amount is known. It will also be assumed
that the stock price will decrease by the exact amount of the dividends. Then, the call value can be found
by using the recursive relationship that was derived earlier.

  E x a mple 1 0 . 8
Consider a stock currently selling at INR 20. There is a call option with an exercise price of INR 21 and an
expiry of three months. It is estimated that in each month the stock price would either increase by 6% or
decrease by 4%. The monthly risk-free rate is 1%. The stock is expected to pay a dividend of INR 1 at the
end of two months. Estimate the current call price.
  The stock prices at various periods can be calculated as:
ST–3 = INR 20
ST–2,u = INR 20 × (1 + 0.06) = INR 21.2
ST–2,d = INR 20 × (1 – 0.04) = INR 19.2
ST–1,uu = INR 21.2 × (1 + 0.06) – 1.0 = INR 22.47 – INR 1.0 = INR 21.47
ST–1,ud = INR 21.2 × (1 – 0.04) – 1.0 = INR 20.35 – INR 1.0 = INR 19.35
ST–1,du = INR 21.2 × (1 – 0.04) – 1.0 = INR 20.35 – INR 1.0 = INR 19.35
ST–1,dd = INR 19.2 × (1 – 0.04) – 1.0 = INR 18.43 – INR 1.0 = INR 17.43
ST,uuu = INR 21.47 × (1 + 0.06) = INR 22.76
ST,uud = INR 21.47 × (1 – 0.04) = INR 20.61
ST,udu = INR 21.47 × (1 – 0.04) = INR 20.61
ST,duu = INR 21.47 × (1 – 0.04) = INR 20.61
ST,dud = INR 19.35 × (1 – 0.04) = INR 18.57
ST,ddu = INR 19.35 × (1 – 0.04) = INR 18.57
ST,udd = INR 19.35 × (1 – 0.04) = INR 18.57
ST,ddd = INR 17.43 × (1 – 0.04) = INR 16.73
The corresponding call values at T are given by:
CT,uuu = INR 22.76 – INR 21 = INR 1.76
CT,uud = INR 20.61 – INR 21 = 0  (since the option cannot have negative value)
CT,udu = INR 20.61 – INR 21 = 0  (since the option cannot have negative value)
CT,duu = INR 20.61 – INR 21 = 0  (since the option cannot have negative value)
CT,dud = INR 19.06 – INR 21 = 0  (since the option cannot have negative value)
CT,ddu = INR 19.06 – INR 21 = 0  (since the option cannot have negative value)
CT,udd = INR 19.06 – INR 21 = 0  (since the option cannot have negative value)
CT,ddd = INR 17.21 – INR 21 = 0  (since the option cannot have negative value)
e rt − d (e 0.1 − 0.96) + 0.04 5
p= = = = 0. 5
u−d 1.04 − 0.96 10
(1 – p) = 0.5

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Notes Then:
1.76 × 0.5 + 0 × 0.5
CT–1,uu = = INR 0.8713
1.01
CT–1,ud = 0
CT–1,du = 0
CT–1,dd = 0
0.8713 × 0.5 + 0 × 0.5
CT–2,u = = INR 0.4313
1.01
CT–2, d = 0
0.4313 × 0.5 + 0 × 0.5
CT–3 = = INR 0.2135
1.01
The call price would be INR 0.2135.

10.11 The Valuation of an American Call Paying a Given

Dividend Amount
The same approach can be used to value an American call. However, when dividends are paid, it may be
optimal to exercise the call early. Valuation of American calls using binomial options pricing will provide
the conditions under which early exercise is advisable.
On the ex-dividend date, the value of an American call would be:
 pC + (1 − p)Cd 
max  u , S − SX 
 (1 + r ) 
The first term provides the theoretical value of the call or the price at which the call will be selling, and the
second term is the gain if the call is exercised. In order for an investor to exercise the call early, the gain
from exercise should be greater than the call price that is based on binomial options pricing.

  E x a mple 1 0 . 9
Consider a stock currently selling at INR 20 and an American call option with an exercise price of INR 21
and an expiry of three months. It is estimated that in each month the stock price either increases by 6%
or decreases by 4%. The monthly risk-free rate is 1%. The stock is expected to pay a dividend of INR 1 at
the end of two periods. Estimate the current call price.
  This is the same as Example 10.8, and the stock prices and call values at the ex-dividend dates are given
as follows:
ST–3 = INR 20
ST–2,u = INR 20 × (1 + 0.06) = INR 21.2
ST–2,d = INR 20 × (1 – 0.04) = INR 19.2
ST–1,uu = INR 21.2 × (1 + 0.06) – INR 1.0 = INR 22.47 – INR 1.0 = INR 21.47
ST–1,ud = INR 21.2 × (1 – 0.04) – INR 1.0 = INR 20.35 – INR 1.0 = INR 19.35
ST–1,du = INR 21.2 × (1 – 0.04) – INR 1.0 = INR 20.35 – INR 1.0 = INR 19.35
ST–1,dd = INR 19.2 × (1 – 0.04) – INR 1.0 = INR 18.43 – INR 1.0 = INR 17.43
ST,uuu = INR 21.47 × (1 + 0.06) = INR 22.76
ST,uud = INR 21.47 × (1 – 0.04) = INR 20.61
ST,udu = INR 21.47 × (1 – 0.04) = INR 20.61
ST,duu = INR 21.47 × (1 – 0.04) = INR 20.61
ST,dud = INR 19.35 × (1 – 0.04) = INR 18.57

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 The Binomial Options Pricing Model   267

Notes ST,ddu = INR 19.35 × (1 – 0.04) = INR 18.57

ST,udd = INR 19.35 × (1 – 0.04) = INR 18.57
ST,ddd = INR 17.43 × (1 – 0.04) = INR 16.73
The corresponding call values at T are given by
CT,uuu = INR 22.76 – INR 21 = INR 1.76
CT,uud = INR 20.61 – INR 21 = 0  (since the option cannot have negative value)
CT,udu = INR 20.61 – INR 21 = 0  (since the option cannot have negative value)
CT,duu = INR 20.61 – INR 21 = 0  (since the option cannot have negative value)
CT,dud = INR 19.06 – INR 21 = 0  (since the option cannot have negative value)
CT,ddu = INR 19.06 – INR 21 = 0  (since the option cannot have negative value)
CT,udd = INR 19.06 – INR 21 = 0  (since the option cannot have negative value)
CT,ddd = INR 17.21 – INR 21 = 0  (since the option cannot have negative value)
e rt − d (e 0.1 − 0.96) + 0.04 5
p= = = = 0. 5
u−d 1.04 − 0.96 10
(1 – p) = 0.5
Then
1.76 × 0.5 + 0 × 0.5
CT–1,uu = = INR 0.8713
1.01
CT–1,ud = 0
CT–1,du = 0
CT–1,dd = 0
0.8713 × 0.5 + 0 × 0.5
CT–2,u = = INR 0.4313
1.01
CT–2,d = 0
It is seen that CT,uuu, CT–1,uu, and CT–2,u are all positive. Let us compare the intrinsic value of the call at
these times.
 At T, uuu, the intrinsic value of the call = ST,uuu – SX = INR 22.76 – INR 21 = INR 1.76, which is the
same as the value of the call at that time.
 At T – 1, uu, the intrinsic value of the call = ST–1,uu – SX = INR 21.47 – INR 21 = 0.47. However at this
time, the call price in the market according to the binomial model would be INR 0.4313. Since the intrin-
sic value of the call is higher than the call value according to the model, it is better to exercise early and
gain INR 0.47, rather than to sell the option at 0.4313 in the market.

10.12 The Binomial Put Options Pricing Model

The binomial put options pricing can also be derived in a similar manner.
At time T – 1, the stock price is ST–1. At time T, the stock price could either increase by u% or decrease
by d%. Thus, the stock price at time T could be either u ST–1 or d ST–1. This is shown in the following
diagram:
67X X6
 7í

67í

6
 7G G67í

M10 Financial Risk Management 01 XXXX.indd 267 6/27/2018 11:08:15 AM

 268   Financial Risk Management

Notes If there is a put option with an exercise price of SX and an expiry date of T, the value of the put at
time T can be calculated as
37X 0D[>6�
[±X67í@

37í

37G 0D[>6[±G67í@

A bought put can be replicated by short selling a certain number of stocks and investing a certain por-
tion of the present value of the exercise price at a risk-free rate. Let us assume D is the number of stocks that
would be shorted and INR B is the investment at the risk-free rate. Then, the value of this portfolio would be:
At time 1,
VT = –D ST–1 u + B erT  if uptick
and
VT = –D ST–1 d + B erT  if downtick
The current investment VT–1 is:
VT–1 = B – D ST–1
Suppose we choose D and B such that the portfolio value is the same as the value of the put at time T,
we have
–D ST–1 u + B erT = PT,u
–D ST–1 d + B erT = PT,d
Solving for D and B, we get
PTd − PTu
∆=
ST −1 (u − d )
PTd u − PTu d
B=
(u − d )e rT
Since the pay-off at time T is the same for the portfolio and the put, the current investment should also
be the same for the portfolio and the put. That is:
PT–1 = B – D ST–1
Substituting for D and B into the current put price, we get

  u − e rT   e rT − d  
PT −1 = e − rT    PTd +  u − d  PTu 
  u − d    

If we denote
rT
p = e −d
u−d
and
rT
1 – p = u−e
u−d
where p and (1 – p) are the risk-neutral probabilities for uptick and downtick, respectively, then:
PT–1 = [p PTu + (1 – p) PTd] e–rT

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 The Binomial Options Pricing Model   269

Notes This is the price of a single-period binomial put option.

It can be seen that the risk-neutral probabilities p and (1 – p) are the same while valuing calls as well as
puts. This is not a coincidence, as the risk-neutral probability p is the probability that the stock price will
increase and (1 – p) is the probability that the stock price will decrease. This shows that the stock price
movement is independent of the options written on the stock.

  E x a mple 1 0 . 1 0
Assume that a stock is currently priced at INR 1,200. There exists a put option with an exercise price of
INR 1,240 and an expiry of 90 days. At the end of 90 days, the stock price can either increase by 8% or
decrease by 3%. If the risk-free rate is 6%, calculate the price of the call by using the binomial options
pricing model.
Given: u = 1.08; d = 0.97; S0 = INR 1,200; SX = INR 1,240; r = 6%; T = 90 / 365
First, calculate the risk-neutral probabilities p and (1 – p).
0.06 × 90 /365
e rT − d e − 0.97
p= = = 0.4082
u−d 1.08 − 0.97
0.06 × 90 /365
u − e rT 1.08 − e
1–p= = = 0.5918
u−d 1.08 − 0.97
PTu = Max [0, (SX – STu)] = Max [0, (1,240 – 1,200 × 1.08)] = Max [0, (1,240 – 1,296)] = 0
PTd = Max [0, (SX – STd)] = Max [0, (1,240 – 1,200 × 0.97)] = Max [0, (1,240 – 1,164)] = INR 76
Thus,
Expected value of the put at time 1 = 0.4082 × 0 + 0.5918 × 76 = INR 44.98
Discounting this expected terminal value at 6% over 90 days gives
CT–1 = CT e–rT = 44.98 × e–0.06×90/365 = INR 44.32

P roblem 1 0 . 8
Infosys stock is selling at INR 1,130 on September 1. There exists a put option on Infosys with expiry on
October 29 and an exercise price of INR 1,150. It is estimated that by October 29, the Infosys price could either
increase by 6% or decrease by 4%. The risk-free rate is 8%. Calculate the call price using the single-period binomial
options pricing model.
Solution to Problem 10.8
Given: u = 1.06; d = 0.96; S0 = INR 1,130; SX = INR 1,150; r = 8%; T = 58 / 365

First, calculate the risk-neutral probabilities p and (1 – p).

0.08 × 58 / 365
e rT − d e − 0.96
p= = = 0.528
u−d 1.06 − 0.96
0.08 × 58 / 365
u − e rT 1.06 − e
1–p= = = 0.472
u−d 1.06 − 0.96

PTu = Max [0, (SX – STu)] = Max [0, (1,150 – 1,130 × 1.06)] = Max [0, (1,150 – 1,197.80)] = INR 0
PTd = Max [0, (SX – STd)] = Max [0, (1,150 – 1,130 × 0.96)] = Max [0, (1,150 – 1,084.80)] = INR 65.20
Thus:

Expected value of the put at time 1 = 0.528 × 0 + 0.472 × 65.20 = INR 30.77

Discounting this terminal expected value at 8% over 58 days gives

PT–1 = PT e–rT = 30.77 × e–0.08×58/365 = INR 30.38

The put price at time (T – 1) will be INR 30.38.

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 270 Financial Risk Management

Notes PROBLEM 10.9

Assume that a stock is currently priced at INR 20. There exists a put option with an exercise price of INR 21 and an
expiry of 90 days. At the end of 90 days, the stock price can either increase by 8% or decrease by 3%. If the risk-free
rate is 6%, calculate the price of the put by using the binomial put pricing model.
Solution to Problem 10.9
First, calculate the risk-neutral probabilities p and (1 – p)
0.06 × 90 / 365
e rt − d e − 0.97
p= = = 0.4082
u−d 1.08 − 0.97
1 – p = 1 – 0.818 = 0.5918
PTu = Max [0, (SX – STu)] = Max [0, (21 – 20 × 1.08)] = Max [0, (21 – 21.60)] = 0
PTd = Max [0, (SX – STd)] = Max [0, (21 – 20 × 0.97)] = Max [0, (21 – 19.40)] = INR 1.60
Thus,

Expected value of the put at time T – 1 = 0 × 0.4082 + 1.60 × 0.5918 = INR 0.9469

Discounting this expected terminal value at 6% over 90 days gives

CT–1 = 0.9469 × e–0.06×90/365 = INR 0.933

This shows that the put value is less than its intrinsic value. However, this possibility is permissible for European
put options, as these options cannot be exercised early. However, an American put option can never sell at a
value less than its intrinsic value. If it sells at its intrinsic value before expiration, it is optimal to exercise early.
The investor will receive the intrinsic value, and they can replicate a put portfolio at a cost less than the intrinsic
value. owing to the possible early exercise associated with put options, multi-period put option models become very
complicated.

CHaPTER SUMMaRy
 Binomial options pricing model is a general model, and it  If p and (1 – p) are defined as:
can be used for any distribution of price of an underlying
e rT − d u − e rT
asset p= and 1 − p = ,
u−d u−d
 In binomial options pricing, the underlying asset price is
assumed to have either of the two prices at every period the call price can be written as:

 Binomial options pricing is based on the no-arbitrage pricing CT–1 = e–rT [p CTu + (1 – p) CTd],
model where CTu and CTd are the terminal values of the call when the
 No-arbitrage call option pricing is based on creating a port- price of the underlying assets is u ST–1 and d ST–1, respectively
folio of the underlying asset and risk-free borrowing, so that  p and (1 – p) are called risk-neutral probabilities and not
the pay-off from the portfolio is exactly the same as that from the actual probabilities of the price of the underlying asset
a call option increasing or decreasing
 A call option can be replicated by borrowing nc1 number of  The single-period binomial model is suitable for European
the underlying securities and borrowing nc2 fraction of the options on stocks that do not pay dividends
present value of the exercise price of the call option  Multi-period models are used for pricing European options on
stocks that pay dividends and for pricing American options
 nc1 is known as hedge ratio 1, and nc2 is known as hedge
 Multi-period models use the principle of backward-recursive
ratio 2
single-period model
 General binomial pricing assumes that the underlying asset
 The put price for a single-period binomial model is calculated
price can be either u St–1 or d St–1, where u > 1 and d < 1 at time t
as:
and St–1 is the price of the underlying asset at the beginning
of the period PT–1 = e–rT [p PTu + (1 – p) PTd]

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 The Binomial Options Pricing Model 271

MULTIPLE-CHOICE QUESTIONS
1. How many nodes are there at the end of a Cox-Ross-Rubin- B. Draw a tree for an initial stock price of 22 and subtract the
stein five-step binomial tree? present value of future dividends at each node
A. 4 B. 5 C. Draw a tree with an initial stock price of 18 and add the
C. 6 D. 7 present value of future dividends at each node
D. Draw a tree with an initial stock price of 18 and add 2 at
2. Which of the following cannot be estimated from a single bi-
each node
nomial tree?
A. delta B. gamma 7. What is the recommended way of making interest rates a
C. theta D. vega function of time in a Cox, Ross, Rubinstein tree?
A. Make u a function of time
3. Which of the following is true for u in a Cox-Ross-Rubinstein
B. Make p a function of time
binomial tree?
C. Make u and p a function of time
A. It depends on the interest rate and the volatility
D. Make the lengths of the time steps unequal
B. It depends on the volatility but not the interest rate
C. It depends on the interest rate but not the volatility 8. What is the recommended way of making volatility a function
D. It depends on neither the interest rate nor the volatility of time in a Cox, Ross, Rubinstein tree?
A. Make u a function of time
4. How many different paths are there through a Cox-Ross-Ru-
B. Make p a function of time
binstein tree with four-steps?
C. Make u and p a function of time
A. 5 B. 9
D. Make the lengths of the time steps unequal
C. 12 D. 16
9. A binomial tree prices an American option at $3.12 and the
5. When we move from assuming no dividends to assuming a
corresponding European option at $3.04. The Black-Scholes
constant dividend yield, which of the following is true for a
price of the European option is $2.98. What is the control vari-
Cox, Ross, Rubinstein tree?
ate price of the American option?
A. The parameters u and p change
A. $3.06 B. $3.18
B. p changes but u does not
C. $2.90 D. $3.08
C. u changes but p does not
D. Neither p nor u changes 10. The chapter discusses an alternative to the Cox, Ross, Rubin-
stein tree. In this alternative, which of the following are true:
6. When the stock price is 20 and the present value of dividends
A. The relationship between u and d is: u = 1/d
is 2, which of the following is the recommended way of con-
B. The relationship between u and d is: u-1=1-d
structing a tree?
C. The probabilities on the tree are all 0.5
A. Draw a tree for an initial stock price of 20 and subtract the
D. None of the above
present value of future dividends at each node

Answer
1. B 2. C 3. A 4. C 5. D 6. A 7. C 8. C 9. D 10. D

REVIEW QUESTIONS
1. What is the major advantage of binomial options pricing mod- 6. Binomial options pricing model uses risk-neutral probabili-
els as compared to the Black–Scholes Model? ties in valuing options. What is meant by risk-neutral prob-
2. What are the assumptions about share price movement in abilities?
binomial options pricing? 7. Under what conditions would you use a single-period bino-
3. Explain the principle of no-arbitrage in binomial options mial option?
pricing. 8. Under what conditions would you use a two-period binomial
4. How can a call option be replicated by using the underlying option?
asset and a risk-free asset? 9. Under what conditions would you use a multiple-period bi-
5. There are two hedge ratios used in binomial options pricing. nomial option?
Explain these ratios. 10. Why is a two-period model superior to a single-period model
for valuing an option on a stock that pays dividends?

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 272 Financial Risk Management

SELF-aSSESMENT TEST
1. The contract size of Allahabad Bank options is 2,450. either increase by 7% or decrease by 5%. The risk-free rate is
Allahabad Bank shares are selling at INR 88 on March 1. Call 6%. Calculate the call price by using the two-period binomial
options and put options are available with expiry on April 29 options pricing model.
and an exercise price of INR 100. It is expected that the Bank
of India share price will be either INR 95 or INR 80. The risk- 8. Consider a stock currently selling at INR 180. There is a call
free rate is 8%. By using the binomial options pricing model, option with an exercise price of INR 200 and an expiry of
calculate the call option price on March 1. three months. It is estimated that in each month the stock
price would either increase by 8% or decrease by 5%. The
2. The contract size of Allahabad Bank options is 2,450. monthly risk-free rate is 0.6%. The stock is expected to pay
Allahabad Bank shares are selling at INR 88 on March 1. Call a dividend of INR 2 at the end of one month. Estimate the
options and put options are available with expiry on April 29 call price now.
and an exercise price of INR 100. It is expected that the Bank
of India share price will be either INR 95 or INR 80. The risk- 9. Consider a stock currently selling at INR 180. There is a put
free rate is 8%. By using the binomial options pricing model, option with an exercise price of INR 200 and an expiry of
calculate the put option price on March 1. three months. It is estimated that in each month the stock
price would either increase by 8% or decrease by 5%. The
3. Assume that Asian Paints stock is currently selling for INR monthly risk-free rate is 0.6%. The stock is expected to pay
1,750. There is a put option on Asian Paints with a maturity a dividend of INR 2 at the end of one month. Estimate the
of 90 days and an exercise price of INR 1,800. The stock price current put price.
on the expiration date could take either of the following two
values: INR 1,850 or INR 1,700. Form a risk-less hedge and 10. Assume that a stock is currently priced at INR 180. There
calculate the price of a call option and a put option on the exists a call option with an exercise price of INR 220 and an
stock. expiry of 90 days. This 90-day period can be considered to be
two periods of 45 days each. The standard deviation of the
4. Assume that a stock is currently priced at INR 800. There stock is 20%. If the risk-free rate is 8%, calculate the price of
exists a call option with an exercise price of INR 780 and an the call by using the binomial options pricing model.
expiry of 58 days. At the end of 58 days, the stock price can
either increase by 6% or decrease by 4%. If the risk-free rate 11. Assume that a stock is currently priced at INR 180. There
is 8%, calculate the price of the call by using the binomial exists a put option with an exercise price of INR 220 and
options pricing model. an expiry of 90 days. This 90-day period can be considered
to be two periods of 45 days each. The standard devia-
5. Assume that a stock is currently priced at INR 800. There tion of the stock is 20%. If the risk-free rate is 8%, calculate
exists a put option with an exercise price of INR 780 and an the price of the put by using the binomial options pricing
expiry of 58 days. At the end of 58 days, the stock price can model.
either increase by 6% or decrease by 4%. If the risk-free rate
is 8%, calculate the price of the call by using the binomial 12. Consider a stock currently selling at INR 180 and a call option
options pricing model. with an exercise price of INR 220 with an expiry of six months. It is
estimated that in each month the stock price would either increase
6. A stock is selling at INR 1,250. There exits a call option on by 5% or decrease by 3%. The monthly risk-free rate is 0.75% (the
this stock with expiry in 60 days and an exercise price of INR annual rate is 9%). Estimate the current call price.
1,300. It is estimated that every 30 days, the stock price could
either increase by 7% or decrease by 5%. The risk-free rate is 13. Consider a stock currently selling at INR 180 and a put
6%. Calculate the call price by using the two-period binomial option with an exercise price of INR 220 with an expiry of
options pricing model. six months. It is estimated that in each month the stock price
would either increase by 5% or decrease by 3%. The monthly
7. A stock is selling at INR 1,250. There exits a put option on risk-free rate is 0.75% (the annual rate is 9%). Estimate the
this stock with expiry in 60 days at an exercise price of INR current put price.
1,300. It is estimated that every 30 days, the stock price could

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 The Binomial Options Pricing Model   273

   C a se S tud y

Akhil, the manager of Bharat Funds, has used put–call arbitrage to Call and put options with an exercise price of INR 450 and with
provide additional gains to the shareholders of the fund. Now, he the expiry date of November 26 are priced at INR 57.40 and INR
is not sure whether options themselves are fairly priced. He would 66.65, respectively. The State Bank of India is expected to pay a
like to earn profits by identifying the underpriced and overpriced dividend of INR 10 per share with the ex-dividend price on
options, so that he can make additional gains. He has identified October 15.
the Nifty index, Tata Steel, and State Bank of India options for this Akhil would like to know whether the options are fairly priced.
purpose. He feels that a single-period model will be applicable for index
On September 1, the Nifty index is at 5,080. Since the Nifty options. For Tata Steel options, he believes that a two-period
index has been trading in the range of 4,900 to 5,200 over the past model will be necessary, because the stock pays dividends and
three years, he assumes that the value of the index can be either he considers two periods, starting on September 1 and October
5,200 or 4,900 by the expiry date of November 26. There will be no 15, when the stock goes ex-dividend. For the State Bank of India
dividends paid during the life of the option. The contract multiplier options, he wants to use a three-period model, as the volatility is
is 50. Call and put options with an exercise price of INR 5,100 are high. The three periods will start on September 1, October 1, and
priced at INR 136 and INR 552.30, respectively. November 1.
On September 1, the State Bank of India shares are selling at Akhil wants to know whether the call and put options are
INR 1,740. The standard deviation of the stock prices has been priced correctly according to the binomial models, and if there are
estimated as 20%. Call and put options with an exercise price of mispriced, he would like to make additional profits.
INR 1,800 and with the expiry date of November 26 are priced at
INR 162.60 and INR 188.65, respectively. The State Bank of India is
Discussion Question
not expected to pay any dividends before November 26.
On September 1, Tata Steel shares are selling at INR 420. The 1. You are required to advice Akhil on identifying the underpriced
standard deviation of the stock prices has been estimated as 14%. and overpriced options.

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M10 Financial Risk Management 01 XXXX.indd 274 6/27/2018 11:09:18 AM
 11
The Black–Scholes
Options Pricing Model

LEARNING OBJECTIVES

After completing this chapter, you The Royal Swedish Academy of Sciences awarded the Bank of
will be able to answer the following Sweden Prize in Economic Sciences in Memory of Alfred Nobel,
questions: 1997, to Professor Robert C. Merton, Harvard University, Cam-
 What are the assumptions bridge, USA, and Professor Myron S. Scholes, Stanford University,
made in the Black–Scholes Stanford, USA, for a new method to determine the value of deriva-
options pricing model? tives. Robert C. Merton and Myron S. Scholes, in collaboration
with the late Fischer Black, developed a pioneering formula for the
 What is meant by no-arbitrage
valuation of stock options. Their methodology paved the way for
options pricing?
economic valuations in many areas. It also generated new types of
 How to calculate the price of financial instruments and facilitated more efficient risk management
a call option using the Black– in society.
Scholes model?
Source: Nobel Prize Organization, Press Release, October 14, 1997.
 How to calculate the price of
a put option using the Black–
Scholes model?
BoX 11.1 Nobel Prize in Economics for Scholes and Merton
 What factors affect the price
of call and put options?
 What is implied volatility and
how can it be used?
 What is meant by the volatility
smile and how can it be used?

In Chapter 10, binomial options pricing model, in which there are only two possible prices at the ex-
piration date, were considered in order to develop the pricing relationship for calls and puts. This
is, however, a very unrealistic situation, as the stock price on the expiration date can have a large number
of possible values and hence we require a more general valuation relationship. Although a number of
models have been developed to provide a more general valuation relationship, the model developed by
Fisher Black and Myron Scholes is considered to be the most significant. This model is described in this
chapter.

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 276   Financial Risk Management

Notes 11.1 The History of Options Pricing Research

For a long time, researchers have been working with the aim of coming up with a method to value op-
tions. Even before options were traded on exchanges, options were available on securities issued by
corporations, such as warrants, convertible bonds, and convertible preferred stock, and these called con-
tingent claims, that is, the pay-off from these securities is contingent on certain events. For example, the
exercise of warrants will be contingent on the stock price exceeding the exercise price of the warrants. The
first effort to value contingent claims was undertaken by a French mathematician, Louis Bachelier, in his
PhD thesis dissertation in 1900. In this dissertation, he derived a closed-form valuation model for pricing
standard calls and puts. This formula of Bachelier ignored discounting and assumed that the underlying
asset prices can be negative. Because of these issues, it could not be applied to options on stocks, as the
stock price can never be negative. In 1961, Sprenkle improved the approach of Bachelier and assumed
lognormal returns, so that the stock price can never be negative. His formula required the estimation of
the degree of risk aversion and average growth of return on stocks. Because these parameters were dif-
ficult to estimate, this formula did not gain importance. The formula was improved by Boness in 1964
by accounting for the time value of money and by considering the expected return on the stock. In 1965,
Samuelson assumed that the risk level for an option can be different from that of the stock, and in 1969,
Samuelson and Merton assumed that the option price is a function of the stock price and proposed that
the discount rate used to value the option should be determined by a hedging strategy in which the inves-
tors hold an option and some amount of stocks. They came up with a formula that was based on a utility
function. All these formulas required the estimation of some variables that were not clearly observable
and hence had to be estimated on the basis of certain assumptions. In 1973, Black and Scholes showed
that the expected return of the option price should be the risk-free rate and that by holding a certain
amount of stock, the option position could be dynamically hedged. The only parameter that was difficult
to estimate in the Black–Scholes model was the volatility of the stock return. This was recognized as one
of the most important contributions to the field of Economics, and the Nobel Committee decided to
confer the Nobel price in Economics in 1997.
The Black–Scholes model makes specific assumptions about how the stock price evolves over time,
and this process is discussed in Section 11.2.

11.2  Stock Price Behaviour

Consider the case of a call option written on a stock with an exercise price of SX, expiring in T years. If
the stock is currently selling at S0, the call will have a positive value only if the stock price at expiry (ST)
is more than SX. If we can find out the probability of the various prices that a stock can have at time T,
we can then calculate the value of the call. This requires knowledge about how the stock price evolves.
Researchers have devoted considerable time in order to find a suitable probability distribution of stock
prices, and the lognormal distribution has been accepted as a suitable probability distribution for stock
prices.

11.2.1  Lognormal Distribution

If a variable follows a lognormal distribution, then the natural logarithm of the variable will have a nor-
mal distribution. Normal distribution for stock prices is not tenable, as a normal distribution assumes
both positive and negative values, whereas stock prices can never be negative. That is why a lognormal
distribution is chosen. If stock prices are lognormally distributed, then the natural logarithm of the stock
prices will follow a normal distribution. Thus, if ST is the terminal price of the stock, then ln(ST) will be
normally distributed. Any normal distribution is characterized by two parameters, namely, the mean and
the standard deviation. Since ln(ST) is normally distributed, we need to specify the mean and variance for
ln(ST) in order to describe the distribution. If the price at time t is S0, the expected return on the stock is
m, the volatility of the stock price is s, and the mean and standard deviation of ln(ST) are given by:
 σ2 
Mean = lnS0 +  µ − T
 2 

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 The Black–Scholes Options Pricing Model   277

Notes Standard deviation = σ T

The expected value of the mean of ST = S0 euT
2
Variance of ST = S 2 e 2µT (e σ T − 1)
0
Therefore:
 σ2  
ln(ST ) − ln(S0 ) ≅ f   m −  T , σ 2T 
  T  

11.2.2 The Valuation of Options

According to the Black-Scholes Model, the stock on which the call option is written does not pay divi-
dends during the life of the option and that the return on the stock over a short time interval of Dt is
normally distributed and the returns in two non-overlapping intervals are independent. Since the returns
are assumed to be normally distributed, the stock price will have a lognormal distribution. If m is the
expected return on the stock and s is the volatility or the standard deviation of the stock price, the mean
return over the interval Dt is m Dt and the standard deviation of the return is s Dt. The assumption made
in the Black–Scholes model is that
∆S
~ ft( µ ∆ , σ 2 ∆ t )
S
where D S is the change in stock price in time Dt and f(m, v) is a normal distribution with mean m and
variance v.

11.3 The Assumptions in the Black–Scholes Options Pricing

Model
Black and Scholes assume the following in their derivation of the options pricing relationship:
1. The stock price behaviour corresponds to the lognormal model.
2. There are no transaction costs or taxes, and all securities are infinitely divisible. Thus, an investor can
purchase or sell any fraction of the underlying security or options without paying any commission
or taxes on the gains.
3. There are no dividends on the stock during the life of the option. Thus, the Black–Scholes analysis ap-
plies only to non-dividend-paying stocks. This formula can be modified to take dividends into account.
4. There are no risk-less arbitrage opportunities. In binomial options pricing, it was shown that a port-
folio can be formed by taking a short position in one call and a long position in a certain number of
shares of the stock and that in the absence of arbitrage opportunities, this portfolio will provide risk-
free returns. The Black–Scholes model uses the same argument in developing the options pricing
formula. By using continuous compounding and a lognormal distribution for the stock price, Black
and Scholes derived differential equations, and the solution to these differential equations provides
the options pricing equation. The main difference between the earlier formulas for options pricing
and Black–Scholes options pricing is that Black and Scholes found out that both the stock price and
the option price are affected by the same source of uncertainty, which is stock price movement, and
took this into consideration while deriving the options pricing equation. Thus, in any short period of
time, the price of an option should be perfectly correlated with the stock price, that is, the call price
should be perfectly positively correlated and the put option price should be perfectly negatively cor-
related with the stock price. Because of this property, if the stock price increases in this short interval
of time, the call price will increase and the put price will decrease. Therefore, one can use options and
stock in such a way that any gains (losses) on the stock position can be exactly offset by losses (gains)
on the option position, so that the value of the portfolio at the maturity of the option is known with
certainty at the time of forming the portfolio, or the resulting portfolio is risk-less.
5. Security trading is continuous. This means that the underlying security as well as the options and the
risk-less security are traded every instant.
6. Investors can borrow as well as lend at the same risk-free rate of interest, and the short-term risk-free
rate of interest, r, is constant.

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Notes 11.4 The Black–Scholes Model for Pricing Call Options

Under the assumptions shown in Section 11.2, the Black–Scholes formula is written as:
rT
C0 = S0 N (d1 ) − e − e S X N (d2 )
where,

 S   σ2 
ln  0  +  + r T
 SX   2 
d1 =
σ T
and
d2 = d1 − σ T
N(d1) and N(d2) represent the cumulative probability function for a standardized normal variable.
A comparison of the Black–Scholes formula with the binomial options pricing formula derived in
Section 15.1 shows the following:
Black–Scholes formula: C0 = S0N(d1)–e–rT SxN(d2)
Binomial options pricing formula: C0 = nC S0 – nC1 SX (1 + r)–T
A comparison of these two formulas shows that:
nC in the binomial model is equivalent to N(d1) in the Black–Scholes model, and
nC1 in the binomial model is equivalent to N(d2) in the Black–Scholes model.
The binomial model uses discrete discounting at the risk-free rate, whereas the Black–Scholes model
uses discounting at continuous compounding at the risk-free rate.
Since nC is hedge ratio 1, which provides the number of shares to be bought for each call written in the
binomial model, N(d1), too, in the Black–Scholes formula provides the number of shares to be bought
for each call written.
Since nC1 provides the fraction of the exercise price that needs to be borrowed in order to replicate the
call option in the binomial model, N(d2), too, in the Black–Scholes formula provides the fraction of the
exercise price that needs to be borrowed in order to replicate the call option.
The hedge ratio nC or N(d1) is the ratio of the change in the call price to a small change in the price
of the underlying security, and it is given by the slope of the call option price curve at the stock price S.
If the stock price is INR 750 and the value of N(d1) = 0.2, it means that 0.2 of a stock must be purchased
for each call written or five shares must be purchased for every 10 calls written.
However, an important difference between the binomial model and the Black–Scholes model must be
noted. In the binomial model, we assumed that the terminal value of the stock can be either SH or SL and
calculated the hedge ratios using these prices as:
SH − S X
nC =
S H − SL
Thus, this hedge ratio will remain constant throughout the life of the option.
However, in the Black–Scholes model, the hedge ratio nC is an instantaneous hedge ratio. It holds as
long as the price of the stock is at the level S0. If the price moves from S0 to S0*, the slope of the call price
will change and hence the hedge ratio will also change. Thus, the hedge portfolio will have to be fre-
quently adjusted or rebalanced whenever the stock price changes, so that the portfolio remains risk-less.

P robl e m 1 1 . 1
Assume that on June 1, Tata Steel is selling at INR 488.95 and there is a call option on this stock expiring on June
29 with an exercise price of INR 500. The risk-free rate is 12%, and the volatility of the stock is estimated as 25%.
Calculate the price of the call according to the Black–Scholes formula.
Solution to Problem 11.1
Given: S0 = INR 488.95; SX = INR 500; r = 12%; s = 25%; T = 28 / 365

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 The Black–Scholes Options Pricing Model   279

Step 1: Calculate the values of d1 and d2.

Notes
 S   σ2 
ln  0  +  + r  T
S
 X  2 
d1 =
σ T
 488.95   0.25 × 0.25 
ln  + + 0.12 
 500   2 
d1 = 1/2
 28 
0.25 × 
 365 
d1 = –0.1552
  28  
1/ 2
d2 = d1 − σ T = − 0.1551 − 0.25 ×    = − 0.2244
  365  


Step 2: Find the values of N(d1) and N(d2). This can be done by using the Excel spreadsheet function that gives the
cumulative normal distribution values.

N(d1) = N(–0.1552) = 0.4383  and  N(d2) = N(–0.2244) = 0.4112

Step 3: Use the values of N(d1) and N(d2) in the Black–Scholes formula to calculate the call option price.
  28  
C0 = S0 N(d1) – SX N(d2) e–rT = (0.4383 × 488.95) – 0.4112 × 500 × exp  −0.12 ×   = INR 10.60
  365  
Thus, the price of the call option is INR 10.60.

P robl e m 1 1 . 2
Assume that Tata Motors stock is currently selling for INR 750. There is a call option on Tata Motors with a maturity
of 90 days and an exercise price of INR 800. The volatility in the stock price is estimated to be 22%. The risk-free rate
is 8%. What will be the price of a call option that has a maturity of 90 days?
Solution to Problem 11.2
Given: S0 = INR 750; SX = INR 800; r = 8%; s = 22%; T = 90 / 365
Step 1: Calculate the values of d1 and d2.

 S   σ2 
ln  0  +  + r  T
 SX   2 
d1 =
σ T
 750   0.22 × 0.22  90
ln  + + 0.08  ×
 800   2  365
d1 = 1/ 2
 90 
0.22 × 
 365 
d1 = –0.3556
  90  
1/ 2
d2 = d1 − σ T = − 0.3556 − 0.22 ×    = − 0.4648
  365  

Step 2: Find the values of N(d1) and N(d2). This can be done by using the Excel spreadsheet function that gives the
cumulative normal distribution values.

N(d1) = N(–0.3556) = 0.3611  and  N(d2) = N(–0.4648) = 0.3210

Step 3: Use the values of N(d1) and N(d2) in the Black–Scholes formula to calculate the call option price.
  90  
C0 = S0 N(d1) – SX N(d2) e–rT = (0.3611 × 750) – 0.3210 × 800 × exp  −0.08 ×   = INR 19.00
  365  

Thus, the price of the call option is INR 19.00.

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Notes 11.5  The Black–Scholes Model for Pricing Put Options

The Black–Scholes pricing relationship for a European put option is given by:
C0 = e − rT S X N (−d2 ) − S0 N (−d1 )
where,

S   σ2 
ln  0  +  2 + r  T
 SX
d1 =
σ T
and
d2 = d1 − σ T
N(–d1) and N(–d2) represent the cumulative probability function for a standardized normal variable.
It can be noted that d1 and d2 are the same as what was defined earlier for call option pricing.
It should be noted that that this formula is similar to the put pricing formula under the binomial
model. According to the binomial model:
P0 = n1p SX (1 + r)–T – np S0
Since: 
np = 1 – nc and n1p = 1 – n1c
Therefore:
P0 = (1– n1C) SX (1 + r)–T – (1 – nC) S0
However, nC = N(d1) and n1C = N(d2) from the Black–Scholes formula. Therefore:
np = 1 – nc = 1 – N(d1) and n1p = 1 – n1c = 1 – N(d2)
Since N(d1) is the probability P(x < d1), 1 – N(d1) is the probability P(x > d1). Since a normal distribution
is symmetric, we can write:
1 – N(d1) = P(x > d1) = P(x < –d1) = N(–d1)
Similarly,
1 – N(d2) = P(x > d2) = P(x < –d2) = N(–d2)

 E x ampl e 1 1 . 1
The price of a put for the Tata Steel stock with a stock price of INR 488.95, exercise price of INR 500,
time to maturity of 28 days, and a volatility of 25% at a risk-free rate of 12% can be calculated as
follows:
Given: S0 = INR 488.95; SX = INR 500; r = 12%; s = 25%; T = 28 / 365
Step 1: Calculate d1 and d2.
This is calculated for the call option pricing as:
 488.95   0.25 × 0.25  28
ln   + + 0.12  ×
 500   2  365
d1 = 1/2
= − 0.1552
 28 
0.25 × 
 365 
  28  
1/2
d2 = − 0.1551 − 0.25 ×   = − 0.2244
  365  


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 The Black–Scholes Options Pricing Model   281

Notes Step 2: Find the values of N(d1) and N(d2) as:

N(d1) = 0.4383  and  N(d2) = 0.4112
Thus:
N(–d1) = 1 – 0.4383 = 0.5617  and  N(–d2) = 1 – 0.4112 = 0.5888
Step 3: Use the values of N(–d1) and N (–d2) in the Black–Scholes formula to calculate the put option
price.
  28  
P0 = exp  − 0.12 ×  × 500 × 0.5888 − (0.5617 × 488.95) = INR 22.49
  365  
Thus, the price of the put is INR 22.49.

P robl e m 1 1 . 3
The contract size of Bank of India options is 950. Bank of India shares are selling at INR 338 on September 1. Call
options and put options are available with expiry on October 29 and with an exercise price of INR 350. It is estimated
that the standard deviation of the stock price is 30%. The risk-free rate is 9%. By using the Black–Scholes options
pricing model, calculate the put option price on September 1.
Solution to Problem 11.3
Given: S0 = INR 338; SX = INR 350; r = 9%; s = 30%; T = 58 / 365
Step 1: Calculate d1 and d2
This is calculated for call option pricing as:
 338   0.30 × 0.30  58
ln  + + 0.09  ×
 350   2  365
d1 = 1/2
= − 0.11235
 58 
0.09 × 
 365 

  28  
1/2
d2 = − 0.1551 − 0.25 ×    = − 0.23193
  365  

Step 2: Find the values of N(d1) and N(d2) as:

N(d1) = 0.4553  and  N(d2) = 0.4083

Thus:

N(–d1) = 1 – 0.4553 = 0.5447  and  N(–d2) = 1 – 0.4083 = 0.5917

Step 3: Use the values of N(–d1) and N(–d2) in the Black–Scholes formula to calculate the put option price.

  58  
P0 = exp  −0.09 ×  × 350 × 0.5917  − (0.5447 × 338) = INR 25.96
  365 
Thus, the price of the put is INR 25.96.

11.6 Determinants of Options Prices

From the Black–Scholes pricing relationship, it can be seen that the prices of both calls and puts are re-
lated to the following:
1. The current price of the underlying asset, St
2. The exercise price, SX
3. The time to expiration, T
4. Volatility of the underlying asset, s
5. The risk-free interest rate, r

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Notes The exact relationship between the changes in these variables and the prices of calls and puts is ex-
plained in this section.

11.6.1 The Current Price of the Underlying Asset

For a given exercise price of the option, the higher the current price of the stock, the higher is the value
of the call option and the lower is the value of the put option.
An option’s value is made up of two components: intrinsic value and time value. The time value will be
the greatest when the stock price is close to the exercise price, and for an option that is deep in-the-money
or deep out-of-money, the time value will be smaller. The price of the options that are deep in-the-money
will change by INR 1 for each INR 1 change in the price of the underlying stock, and the time value will
be small because the probability of a further increase in the price of the option is small. However, for op-
tions that are at-the-money, the probability that the option will move to in-the-money is high and hence
the time value will also be high.
Thus, in-the-money options will have a higher value than out-of-money options because of their
positive intrinsic value, and at-the-money options will have a higher value when compared to the cor-
responding out-of-money options because of their time value.
For a call option, the option will be in-the-money when the stock price is higher than the exercise
price, and if the stock price increases further, the value of the option will also increase. For at-the-money
options, the value of the call options will increase when the stock price increases, as the time value will
be higher for options when the stock price is closer to the exercise price. For out-of-money options, the
option value will increase when the stock price increases, because the probability of the option moving
to in-the-money is higher.
In case the stock price decreases, the in-the-money option value will decrease by the same rupee
amount as the stock price decrease. The value of at-the-money options will also decrease, as the stock
price will have to increase by the amount of the decrease in the stock price for it to move to in-the-money.
For out-of-money options, the option price will decrease, as the probability of the new decreased stock
price to increase to the exercise price by the exercise date will become smaller. Therefore, call option
prices are directly related to the prices of the underlying stock, i.e.,
∂C
>0
∂St
For a put option, the option will be in-the-money when the stock price is lower than the exercise price,
and if the stock price decreases further, the value of the option will increase. For at-the-money options,
the value of the put options will increase when the stock price decreases, as the time value will be higher
for options when the stock price is closer to the exercise price. For out-of-money options, the option
value will increase when the stock price decreases, because the probability of the option moving to in-
the-money is higher.
In case the stock price increases, the in-the-money option value will decrease by the same rupee
amount as the stock price increase. The value of at-the-money options will decrease as the stock price
will have to decrease by the amount of the increase in the stock price for it to move to in-the-money. For
out-of-money options, the option price will decrease, as the probability of the new increased stock price
to increase to the exercise price by the exercise date will become smaller. Therefore, put option prices are
inversely related to the prices of the underlying stock, i.e.,
∂P
<0
∂St
For example, the price of a call option on Tata Steel stock with an exercise price of INR 500 will be higher
when the Tata Steel share price is INR 488 at the time of writing the option than when the price was INR
475 at that time. Similarly, the price of a put option will be higher when the share price is INR 475 at the
time of writing the option than when the price was INR 488 at that time.
Figure 11.1 shows the relationship between the call price and the price of the underlying stock, and
Fig. 11.2 shows the relationship between the put price and the price of the underlying stock.

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 The Black–Scholes Options Pricing Model   283

Notes

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Figure 11.1  The Effect of Changes in the Stock Price on the Call Price

11.6.2  The Exercise Price

Consider two call options on the same stock with the same exercise date but with different exercise prices
SX1 and SX2, with SX1 > SX2. For a given stock price ST, if both the options are in-the-money, the call with
the lower exercise price will have a higher value, as the in-the-money value will be greater for a call with
the lower exercise price. For an at-the-money option having a higher exercise price, the call with the
lower exercise price will be in-the-money and hence the call with the lower exercise price will have a
higher value. For deep out-of-money options, the probability of the stock price increasing beyond the
lower exercise price will be higher than the probability of the stock price increasing beyond the higher
exercise price and hence the call option with the lower exercise price will have a higher value. Thus, the
call value and the exercise price are inversely proportional, i.e., calls with the lower exercise price will
have a higher value.
Consider two put options on the same stock with the same exercise date but with different exercise
prices SX1 and SX2, with SX1 > SX2. For a given stock price ST, if both the options are in-the-money, the
put with the higher exercise price will have a higher value, as the in-the-money value will be greater for
the put with the higher exercise price. For an at-the-money option having a lower exercise price, the put
with the higher exercise price will be in-the-money and hence the put with the higher exercise price will
have a higher value. For deep out-of-money options, the probability of the stock price decreasing below
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Figure 11.2  The Effect of Changes in the Call Price on the Put Price

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 284   Financial Risk Management

Notes

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Figure 11.3  The Effect of Changes in the Exercise Price on the Call Price

the higher exercise price will be higher than the probability of the stock price decreasing below the lower
exercise price and hence the put option with the higher exercise price will have a higher value. Thus, the
put value and the exercise price are directly proportional, i.e., puts with the higher exercise price will have
a higher value.
This can be written as:
∂C ∂P
<0 and >0
∂S X ∂S X
Figure 11.3 shows the relationship between the call price and the exercise price, and Fig. 11.4 shows the
relationship between the put price and the exercise price.

11.6.3  The Time to Expiration

The time to expiration of an option also impacts on the option price. For in-the-money options, a longer
time period for expiration implies a higher time value, as the probability of a further increase in the price
is higher for call options and the probability of a further decrease in the price is higher for put options.
For out-of-money options, the time value will also be higher if the options have a longer maturity, as
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Figure 11.4  The Effect of Changes in the Exercise Price on the Put Price

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 The Black–Scholes Options Pricing Model   285

Notes

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Figure 11.5  The Effect of Changes in the Time to Expiration on the Call Price

they can move to in-the-money over that period of time. Thus, both call option and put option prices are
directly proportional to the time to maturity.
∂C ∂P
> 0 and >0
∂T ∂T
Figure 11.5 shows the relationship between the call price and the time to expiration of the option, and
Fig. 11.6 shows the relationship between the put price and the time to expiration of the option.

11.6.4  Volatility of the Underlying Asset

Stock volatility refers to uncertainty in future stock prices. If the volatility is high, the chance that a stock
will do very well or very poorly will increase. For option buyers, volatility of the stock price is a matter of
concern. Since a call option is worth more if the stock does well, the call option value will be higher when
the stock is expected to do very well or when the volatility is higher. Similarly, a put option will be worth
more when the stock does poorly, which is more probable when the volatility is high. If the volatility is
high, the call price as well as the put price will be high.
Thus, the prices of both calls and puts are directly proportional to the volatility of the stock price, or
∂C ∂P
> 0 and >0
∂σ ∂σ
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Figure 11.6  The Effect of Changes in the Time to Expiration on the Put Price

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 286   Financial Risk Management

Notes

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Figure 11.7  The Effect of Changes in Volatility on the Call Price

The effect of the changes in the volatility of stock prices on the call price and put price is shown in
Fig. 11.7 and Fig. 11.8, respectively.

11.6.5  The Risk-free Rate

The impact of changes in the risk-free rate on the call price and put price is not as clear cut as the impact
of changes in the stock price, exercise price, time to expiration, or volatility. To understand the impact of
changes in the risk-free rate on call and put prices, we will consider how synthetic calls and puts can be
created.
A synthetic call position can be created by buying nC number of shares and borrowing n1C fraction of
the present value of the exercise price. This strategy will provide the same pay-off as a call option and will
lead to the following call pricing relationship:
Ct = nC St – n1c SX e–r(T–t)
The present value of the exercise price that needs to be borrowed at the risk-free rate will depend on the
risk-free interest rate. If the risk-free rate is high, the present value will be smaller and if the risk-free
rate is low, the present value will be higher. Since the call value is the difference between the investment
in stock and risk-free borrowing, the call value will be high when one needs to borrow less or when the
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Figure 11.8 The Effect of Changes in Volatility on the Put Price

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 The Black–Scholes Options Pricing Model   287

Notes

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Figure 11.9  The Effect of Changes in the Risk-free Rate on the Call Price

interest rates are high. Similarly, the call value will be low when the interest rates are low. Thus, the risk-
free rate and the call price are directly proportional, i.e.,
∂C
>0
∂rt
This relation is shown in Fig. 11.9.
A synthetic put position is created by investing n1p fraction of the present value of the exercise price
and short selling np number of shares of the underlying security, i.e.,
Pt = n1p SX e–r(T–t) – np St
When the interest rates are high, the amount that can be invested will be low and hence the put value will
be low. When the risk-free rate is low, the amount that can be invested will be high and hence the put will
also have a higher value. Thus, the put price and risk-free rate are inversely proportional, i.e.,

∂P
<0
∂r
This relationship is shown in Fig. 11.10.
In summary, the determinants of call and put price are shown in Table 11.1.
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Figure 11.10  The Effect of Changes in the Risk-free Rate on the Call Price

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 288   Financial Risk Management

Notes Table 11.1 Effect of Changes in Variables on Call and Put Value

Call Value Put Value

As the stock price increases Increases Decreases

As the stock price decreases Decreases Increases

As the exercise price increases Decreases Increases

As the exercise price decreases Increases Decreases

As the time to expiration increases Increases Increases

As the time to expiration decreases Increases Increases

As the volatility of stock price increases Increases Increases

As the volatility of stock price decreases Increases Increases

As the risk-free rate increases Increases Decreases

As the risk-free rate decreases Decreases Increases

11.7 The Options Pricing Model for Securities that

Pay Known Dividends
When a stock pays dividends, the options are not payout-protected. This means that when a stock goes
ex-dividend, the stock price will decrease by the amount of dividends that are declared. The decrease in
the stock price due to dividend payment will decrease the price of a call option and increase the price of
a put option. Thus, the option price should take into account the possibility of dividend payment during
the life of the option.
Since the stock price is the present value of future dividends, the difference between the current stock
price and the stock price at expiration is the present value of dividends to be received at the maturity of
the option. Thus, a European call option on a dividend-paying stock is actually a call option on the stock
price adjusted for the present value of all dividends during the life of the option. Therefore, an adjustment
needs to be made in the Black–Scholes formula, where the current stock price is replaced with the current
stock price less the present value of dividends during the life of the option. Thus, the price of a European
call on a dividend-paying stock is given by:
rT
C0 = (S0 − De rt1 ) N (d1 ) − e − e S X N (d2 )
where,

 S − De rt1   σ 2 
ln  0  +  + r T
 SX   2 
d1 =
σ T
and
d2 = d1 − σ T

P robl e m 1 1 . 4
Assume that the Tata Motors stock is currently selling for INR 750. There is a call option on Tata Motors with a
maturity of 90 days and an exercise price of INR 800. The volatility in the stock price is estimated to be 22%. The
risk-free rate is 8%. Tata Motors is expected to pay dividends of INR 15 after 30 days. What will be the price of a call
option that has a maturity of 90 days?

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 The Black–Scholes Options Pricing Model   289

Notes Solution to Problem 11.4

Since a dividend of INR 15 will be paid after 30 days, the present value of dividends is given by:

D e − rT1 = 15 × e–0.08×30/365 = INR 14.90

Then, the current stock price adjusted for the dividends = INR 750 – INR 14.90 = INR 735.10.

Therefore, S0 = INR 735.10; SX = INR 800; r = 8%; s = 22%; and T = 90 / 365.

Step 1: Calculate the values of d1 and d2.

 S   σ2 
ln  0  +  + r T
S
 X  2 
d1 =
σ T
 735.10   0.22 × 0.22  90
ln  + + 0.06  ×
 800   2  365
= 1/2
= − 0.5392
 90 
0.22 × 
 365 

  90  
1/2
d2 = d1 − σ T = − 0.5392 − 0.22 ×    = − 0.6485
  365  

Step 2: Find the values of N(d1) and N(d2). This can be done by using the Excel spreadsheet function that gives the
cumulative normal distribution values.

N (d1) = N (–0.5392) = 0.2948  and  N(d2) = N(–0.6485) = 0.2583

Step 3: Use the values of N(d1) and N(d2) in the Black–Scholes formula to calculate the call option price.
  90  
C0 = S0 N(d1) – SX N(d2) e–rT = (0.2948 × 735.10) – 0.2583 × 800 × exp  −0.08 ×   = INR 14.12
  365 
Thus, the price of the call option is INR 14.12.

P robl e m 1 1 . 5
Assume that on March 1, Tata Steel stock is selling at INR 480 and there is a call option on this stock expiring after
90 days with an exercise price of INR 500. The risk-free rate is 12%, and the volatility of stock is estimated as 25%.
The stock will pay a dividend of INR 15 after 60 days. Calculate the price of the call according to the Black–Scholes
formula.
Solution to Problem 11.5
In this case, if there is no dividend paid, the price can be calculated as:

 480   0.25 × 0.25  90

ln  + + 0.12  ×
 500   2  365
d1 = 1/ 2
= − 0.4219
 90 
0.25 × 
 365 

  28  
1/2
d2 = − 0.1551 − 0.25 ×    = − 0.4912
  365  

N(d1) = 0.3365  and  N(d2) = 0.3116
  90  
C0 = (0.43365 × 480) – 0.3116 × 500 × exp  −0.12 ×   = INR 7.14
  365 
If the dividend is paid,
Present value of the dividend = 15 × e 0.12×60/365 = INR 14.70

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 290   Financial Risk Management

Thus, the current stock price will be adjusted to INR 480 – INR 14.70 = INR 465.30. Using this price as the current
Notes
price, the option price would be INR 3.30. This example shows that the price of the option would change from INR
7.14 for a non-dividend-paying stock to INR 3.30 for a dividend-paying stock.

11.8 Volatility
Of the five variables that impact option prices, exercise price, current stock price, time to maturity of the
option, and risk-free interest rates are known at the time the option is bought. However, the volatility of
stock returns is unknown and needs to be estimated. If volatility is not estimated correctly, the option
price that is calculated from the model will also be subject to error. The volatility can be estimated in a
number of ways, and the various methods are explained in this section.
In estimating historical volatility, the historical price of the stock is used. A five-step procedure is used
to estimate historical volatility:
1. Decide on the length of the interval for which historical prices should be used. It could be daily
prices, weekly prices, or monthly prices. In doing so, the ex-dividend days during the estimation
period should also be considered.
2. Decide on the number of observations that are to be made. Making too many observations implicates
that very old data is being used, and this may not represent the current situation. If too little data is
used, the estimate may be biased. It is very difficult to decide on the number of observations that are
to be made.
3. Compute the continuously compounded rate of return for each interval from the price data. This can
be calculated as:
S 
rt 2 = ln  t 2 
 St1 

 St2 denotes the stock price at the end of the interval, St1 denotes the stock price at the beginning of the
interval, and rt2 is the return from the stock during the period t1 to t2.
  If there were ex-dividend dates during the interval, rt2 is calculated as:
 (S + D) 
rt 2 = ln  t 2 
 St1 

4. Calculate the average return from the stock as:

1 n
r =   ∑ rt
 n  t =1

 where n is the number of returns that have been calculated.

5. Estimate the variance of stock returns as:

 1  n 2
Var (r ) =   ∑
 n − 1  t =1
(rt − r )

This variance estimate provides the volatility of the stock return for the interval that was chosen. In
order to convert the variance of periodic return to variance of annual return, this variance estimate will
have to be multiplied by the appropriate value. For example, if weekly return is used to calculate the vari-
ance, it must be multiplied by 52 to get the variance of annual return.
Historical volatility has to be used very carefully. What we are looking for is the volatility that might
be present during the life of the option. By using historical volatility, we assume that the volatility will not
change in the future. However, the volatility might change if there are any changes in firm-specific infor-
mation such as capital structure and liquidity. Historical volatility can give some idea about the volatility
that might be present, but it needs to be used with caution.

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 The Black–Scholes Options Pricing Model   291

Notes  E x ampl e 1 1 . 2
Table 11.2 provides the details of the stock price on 25 days as well as the daily return. From this, the
historical volatility can be calculated as shown below:

1 n
Mean return = r =   ∑ rt = 0.000717
 n  t =1

 1  n 2
Var(r ) =  ∑ (r
 n − 1  t =1 t
− r ) = 0.0022

Table 11.2  Daily Stock Prices and Returns

Day Closing Price (INR) Price Change St / St –1 Daily Return ln (St / St –1)

0 242.0

1 243.5 1.006198 0.006179

2 242.4 0.995483 –0.00453

3 242.4 1.000000 0.00000

4 243.5 1.004538 0.004528

5 244.0 1.002053 0.002051

6 245.0 1.004098 0.00409

7 244.5 0.997959 –0.00204

8 244.0 0.997955 –0.00205

9 244.4 1.001639 0.001638

10 244.6 1.000818 0.000818

11 245.1 1.002044 0.002042

12 244.8 0.998776 –0.00122

13 244.8 1.000000 0.00000

14 244.6 0.999183 –0.00082

15 244.4 0.999182 –0.00082

16 244.8 1.001637 0.001635

17 245.2 1.001634 0.001633

18 245.6 1.001631 0.00163

19 245.5 0.999593 –0.00041

20 245.7 1.000815 0.000814

21 245.8 1.000407 0.000407

22 246.0 1.000814 0.000813

23 246.2 1.000813 0.000813

24 246.0 0.999188 –0.00081

25 246.2 1.000813 0.000813

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 292   Financial Risk Management

Notes 11.9 Implied Volatility

In developing the options pricing formula, we use the volatility measure. However, it is also possible to
calculate the volatility measure from the option price. Since C = f (St, SX, T, s, rf), if we know the value of
any five of these values, we can always estimate the value of the sixth one. Thus, if we know C, St, SX, T,
and rf, we can calculate the volatility measure s. When the volatility is calculated from the current option
price, the calculated volatility is called the implied volatility of the option.
Implied volatility is considered a better measure of volatility, because it shows the volatility estimate
that is used in calculating the option price. This measure can be calculated from the option price by using
a trial-and-error method.
In using implied volatility to calculate the future option price, an obvious question is which option
price needs to be used to calculate the implied volatility? At any given time, there are a number of options
with different exercise prices for the same exercise date, and the implied volatility calculated for different
options may not be the same. In this case, which of the implied volatilities must be used in calculating
the option price?
Implied volatility can indicate the options that are relatively underpriced or overpriced. In relation
to the other options in the same class, the option that has the lowest implied volatility is considered to
be relatively underpriced. However, there may be some valid reasons for the difference in the implied
volatility. For example, if we calculate the implied volatility of two options with the same exercise price
but different maturity, it is likely that the volatility is expected to change over time such that the implied
volatility of the long maturity option is different from the implied volatility of short maturity option. For
options with the same expiry date but different exercise prices, the implied volatility may be different be-
cause of a possible increase in prices or because of possible dividend payment. Therefore, it is necessary
to examine why the implied volatility could be different for options.
Once it is ascertained that there are no factors that can cause the implied volatilities to be different,
the differences in implied volatilities can be used to trade in the market. For example, if the calculated
implied volatility is 25% but you believe that the volatility should be 40%, then the option is underpriced.
In this case, buying the option will give a higher return. Since a call option can be replicated by short sell-
ing the underlying stock and the risk-free investment (using hedge ratio 1 and hedge ratio 2), an arbitrage
profit can be made if the implied volatility of the call option is considered to be different from the true
volatility. The arbitrage profit would be the difference in the option prices with volatility estimates of 25%
and 40%. Since the option with the higher volatility should have a higher value, the option price should
be based on a volatility of 40%. However, the implied volatility is only 25% and, therefore, the option price
would be lower. When the pricing in the market is correctly determined using 40% volatility, the option
price would increase and the arbitrager can make profits.
It has been empirically estimated that implied volatility has a mean-reverting property. This means
that over time, the implied volatility tends to be equal to its long-term average value. Thus, if the implied
volatility is lower than the average value, the implied volatility would increase, whereas if the implied
volatility is higher than the average value, the implied volatility would decrease. This property of implied
volatility can be used to make profits in the market.
For example, let us consider that you believe the stock price to increase. If the implied volatility of
a call option is below the long-term average value, you will buy the call. By doing so, you are not only
buying the underlying asset, but you are also buying volatility. Even if the stock price does not increase,
the price of the call option would increase, as the options would be priced on the basis of the increase in
the implied volatility during the later part of their life because of the mean-reverting feature of implied
volatility. This will result in profit for you from the increase in the call price. However, trading on volatil-
ity is a risky business and can lead to substantial losses as in the case of Long-Term Capital Management
(LTCM). This is explained in Box 11.2.

11.10  Volatility Smile

According to the Black–Scholes model of options pricing, the implied volatility of an option is independ-
ent of its exercise price and exercise date. This means that the implied volatility should be the same for
all outstanding options, whether call or put, at all times. If we plot the implied volatility against either the
exercise price or exercise date, we should get a straight line for implied volatility, and if it is plotted on a

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 The Black–Scholes Options Pricing Model   293

Notes
BOX 11.2 LTCM and Trading on Volatility

LTCM lost USD 1.3 billion through trading on volatility using priced, and these options would be purchased. When the mar-
options during 1998.LTCM used mathematical models to es- ket was turbulent, LTCM believed that there were opportunities
timate the implied volatility of options trading in the market to make money. When the Russian crisis happened, the inves-
and then compared the implied volatility to its own estimate of tors fled to safety and started to shift their investments from
what the volatility should be. If the implied volatility is higher, risky portfolios to least-risky portfolios. This caused the stock
it implies that the option is overpriced and that the price would indexes and the prices of stocks to decrease. The mathemati-
come down. In this case, the options will be written. In case the cal models did not work in such a turbulent market, and LTCM
implied volatility is lower, the option is considered as under- started making losses from both buying and selling options.

Source: Nicholas Dunbar, Inventing Money: The Story of Long-Term Capital Management and the Legends Behind it, Australia:
John Wiley and Sons Ltd, 2000.

three-dimensional diagram, the surface should be flat. Prior to the stock market crash of 1987, the volatil-
ity surface was indeed flat. However, after that, the volatility surface has no longer been flat. It has been
observed that the options with longer maturities typically tend to have a higher volatility than those with
lower maturities. In addition, out-of money options tend to have a higher implied volatility than options
that are near-the-money. If we plot the implied volatility against the exercise price and exercise date, the
surface shows a figure that looks like a person smiling. This is known as the volatility smile.
This smile phenomenon has spread to interest rate options, stock options, and currency options. As
the Black–Scholes model cannot explain this smile, researchers are now trying to develop other models
that can explain this behaviour.
Figure 11.11 shows the volatility smile for index options for different exercise prices but with the same
exercise date.
The volatility smile and the need to develop a pricing model that will take into account the volatility
smile becomes important for a number of reasons as shown below:
1. Since the hedge ratio is the ratio of the change in the price of the option to the change in the price of
the stock, it becomes necessary to know the correct model of pricing in order to arrive at the hedge
ratio. The hedge ratio calculated using the Black–Scholes model may not be correct.
2. Exotic options and structured products have been developed to hedge different risks, such as knock-
out options and lookback options. Since an exotic option is a combination of plain vanilla options,






,PSOLHG9RODWLOLW\














 
([HUFLVH3ULFH

Figure 11.11  Volatility Smile

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 294 Financial Risk Management

should we use the same implied volatility as that used in the Black–Scholes model? If so, which
implied volatility should be used if the implied volatility is different for the different options?
A number of models that take the volatility smile into account have been developed, such as:
1. Local volatility models, where the stock price process is expressed as a function of the stock-price-
dependent volatility. This will lead to binomial trees of local forward volatilities. The hedge ratio
obtained from these models would be smaller than the hedge ratios obtained from the Black–Scholes
Model.
2. Stochastic volatility models, in which the volatility is considered stochastic, but reverting towards a
long-term mean. This can be considered as a binomial model with a different volatility for each node
of the tree. In this model, there will be a mixture of high and low volatilities, and this will produce
fat tails in the distribution. This model’s option price can be considered as the average of the Black–
Scholes prices for high and low volatilities.
3. Models have also been developed using jump diffusion models, which account for jumps in the stock
prices that occur in the real world.
Each of the models has its own drawbacks, and researchers are still working on developing a model
that can account for the volatility smile.

CHAPTeR SUMMARy
 Black and Scholes developed a formula on the basis of portional to the put price); (ii) the exercise price (inversely
the assumption that the movement in the stock price is a proportional to the call price and directly proportional to
continuous stochastic process. According to them, the call the put price); (iii) the exercise date (directly propor-
price for a non-dividend-paying stock is given by: tional to the call price and directly proportional to the
rT put price); (iv) the volatility of the stock price (directly
C0 = S0 N (d1 ) − e − e S X N (d2 )
proportional to the call price and directly proportional to
where, the put price); and (v) the risk-free interest rate (directly
proportional to the call price and inversely proportional to
 S   σ2  the put price).
ln  0  +  + r T
S
 X  2   The Black–Scholes model can be modified for American
d1 =
σ T options and European options on stocks that pay divi-
dends.
and
 The most difficult-to-estimate parameter in options pricing is
d2 = d1 − σ T volatility. Volatility can be estimated either by using historical
data or by calculating the implied volatility from the actual
N(d1) and N(d2) represent the cumulative probability function
option price.
for a standardized normal variable.
 The Black–Scholes model assumes constant implied volatility
 The Black–Scholes model for a put option on a stock that pays for all options, irrespective of their exercise dates and exercise
no dividend is given by: prices; however, practical data shows that the implied volatility
rT
P0 = e − e S X N (d2 ) − S0 N (d1 ) is not the same for all options and, typically, out-of-money
options exhibit a higher implied volatility when compared to
where d1 and d2 are as defined in the preceding point. near-the-money options. This is knows as the volatility smile.
 Options prices are affected by: (i) the current stock price  Researchers are developing models to take into account the
(directly proportional to the call price and inversely pro- volatility smile.

MULTIPLe-CHOICe QUeSTIONS
1. Which of the following is acquired (in addition to a cash pay- 2. Which of the following is acquired (in addition to a cash pay-
off ) when the holder of a put futures exercises? off ) when the holder of a call futures exercises?
A. A long position in a futures contract A. A long position in a futures contract
B. A short position in a futures contract B. A short position in a futures contract
C. A long position in the underlying asset C. A long position in the underlying asset
D. A short position in the underlying asset D. A short position in the underlying asset

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 The Black–Scholes Options Pricing Model 295

3. The risk-free rate is 5% and the dividend yield on the S&P 500 C. A futures on an option payoff
index is 2%. Which of the following is correct when a futures D. None of the above
option on the index is being valued?
A. The futures price of the S&P 500 is treated like a stock 7. A futures price is currently 40 cents. It is expected to move up
paying a dividend yield of 5%. to 44 cents or down to 34 cents in the next six months. The
B. The futures price of the S&P 500 is treated like a stock risk-free interest rate is 6%. What is the probability of an up
paying a dividend yield of 2%. movement in a risk-neutral world?
C. The futures price of the S&P 500 is treated like a stock A. 0.4 B. 0.5
paying a dividend yield of 3%. C. 0.72 D. 0.6
D. The futures price of the S&P 500 is treated like a non-
dividend-paying stock. 8. A futures price is currently 40 cents. It is expected to move up
to 44 cents or down to 34 cents in the next six months. The
4. Which of the following is NOT true?
risk-free interest rate is 6%. What is the value of a six-month
A. Black’s model can be used to value an American-style
put option with a strike price of 37 cents?
option on futures
B. Black’s model can be used to value a European-style A. 3.00 cents B. 2.91 cents
option on futures C. 1.16 cents D. 1.20 cents
C. Black’s model can be used to value a European-style
9. A futures price is currently 40 cents. It is expected to move up
option on spot
to 44 cents or down to 34 cents in the next six months. The
D. Black’s model is widely used by practitioners
risk-free interest rate is 6%. What is the value of a six month
5. Which of the following is true when the futures price exceeds call option with a strike price of 39 cents?
the spot price? A. 5.00 cents B. 2.91 cents
A. Calls on futures should never be exercised early C. 3.00 cents D. 4.21 cents
B. Put on futures should never be exercised early
C. A call on futures is always worth at least as much as the 10. Which of the following are true?
corresponding call on spot A. Futures options are usually European
D. A call on spot is always worth at least as much as the cor- B. Futures options are usually American
responding call on futures C. Both American and European futures options trade
6. Which of the following describes a futures-style option? actively are exchanges
A. An option on a futures D. Both American and European futures options trade
B. An option on spot with daily settlement actively in the OTC market

Answer
1. B 2. A 3. A 4. A 5. C 6. C 7. D 8. C 9. B 10. B

ReVIeW QUeSTIONS
1. In options pricing, two hedge ratios are used. Explain what 4. What is meant by implied volatility? How can implied volatil-
these two hedge ratios are and what they imply. ity be used?
2. What are the factors that determine the call price? How do 5. What is meant by the volatility smile? Why is understanding
changes in these factors affect the call price? the volatility smile important?
3. What are the factors that determine the put price? How do
changes in these factors affect the put price?

SeLF-ASSeSMeNT TeST
1. The contract size of Allahabad Bank options is 2,450. Allahabad exercise price of INR 100. The volatility of the stock price is
Bank shares are selling at INR 88 on March 1. Call options 12%, and the risk-free rate is 8%. Using the binomial options
and put options are available with expiry on April 29 and an pricing model, calculate the put option price on March 1.
exercise price of INR 100. The volatility of the stock price is
12%, and the risk-free rate is 8%. Using the binomial options 3. Assume that Asian Paints stock is currently selling for INR
pricing model, calculate the call option price on March 1. 1,750. There is a put option on Asian Paints with a maturity
of 90 days and an exercise price of INR 1,800. The volatility
2. The contract size of Allahabad Bank options is 2,450. Allahabad of the stock price is 15%, and the risk-free rate is 9%. Form a
Bank shares are selling at INR 88 on March 1. Call options risk-less hedge and calculate the price of a call option and a put
and put options are available with expiry on April 29 and an option on the stock.

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 296   Financial Risk Management

4. Assume that a stock is currently priced at INR 800. There   9. Consider a stock currently selling at INR 180. There is a put
exists a call option with an exercise price of INR 780 and an option with an exercise price of INR 200 and an expiry of
expiry of 58 days. The volatility of the stock price is 18%. If the three months. The volatility of the stock price is 18%, and the
risk-free rate is 8%, calculate the price of the call by using the risk-free rate is 8%. The stock is expected to pay a dividend
binomial options pricing model. of INR 2 at the end of one month. Estimate the current put
price.
5. Assume that a stock is currently priced at INR 800. There
exists a put option with an exercise price of INR 780 and an 10. Assume that a stock is currently priced at INR 180. There
expiry of 58 days. The volatility of the stock price is 18%. If the exists a call option with an exercise price of INR 220 and an
risk-free rate is 8%, calculate the price of the call by using the expiry of 90 days. The standard deviation of the stock is 20%.
binomial options pricing model. If the risk-free rate is 8%, calculate the price of the call.
6. A stock is selling at INR 1,250. There exists a call option on 11. Assume that a stock is currently priced at INR 180. There
this stock with expiry in 60 days and an exercise price of INR exists a put option with an exercise price of INR 220 and an
1,300. The stock price volatility is 22%. The risk-free rate is 6%. expiry of 90 days. The standard deviation of the stock is 20%.
Calculate the call price. If the risk-free rate is 8%, calculate the price of the put.
  7. A stock is selling at INR 1,250. There exits a put option on 12. Consider a stock currently selling at INR 180 and a call
this stock with expiry in 60 days and an exercise price of INR option with an exercise price of INR 220 with an expiry of
1,300. The stock price volatility is 22%, and the risk-free rate six months. The stock price volatility is 16%, and the risk-free
is 6%. Calculate the call price. rate is 9%. Estimate the current call price.
  8. Consider a stock currently selling at INR 180. There is a call 13. Consider a stock currently selling at INR 180 and a put
option with an exercise price of INR 200 and an expiry of option with an exercise price of INR 220 with an expiry of
three months. The volatility of the stock price is 18%, and the six months. The stock price volatility is 16%, and the risk-free
risk-free rate is 8%. The stock is expected to pay a dividend of rate is 9%. Estimate the current put price.
INR 2 at the end of one month. Estimate the current call price.

   C as e S tud y
Akhil, the manager of Bharat Funds, has used the put–call arbitrage respectively. The State Bank of India is expected to pay a dividend
to provide additional gains to the shareholders of the fund. Now, of INR 10 per share with the ex-dividend price on October 15.
he is not sure whether the options themselves are fairly priced. He Akhil would like to know whether the options are fairly priced.
would like to earn profits by identifying the underpriced and over- He feels that a single-period model will be applicable for index
priced options so that he can make additional gains. He has identi- options. For Tata Steel options, he believes that a two-period
fied the Nifty index, Tata Steel, and State Bank of India options for model will be necessary, because the stock pays dividends and he
this purpose. considers the two periods starting on September 1 and October
On September 1, the Nifty index is at 5,080. Since the Nifty 15, when the stock goes ex-dividend. For the State Bank of India
index has been trading in the range of 4,900 to 5,200 over the past options, he wants to use thee-period options, as the volatility is
three years, he assumes that the value of the index can be either high. The three periods will start on September 1, October 1, and
5,200 or 4,900 by the expiry date of November 26. There will November 1.
be no dividends paid during the life of the option. The contract Akhil wants to know whether the call and put options are
multiplier is 50. The standard deviation of the index is 22%. Call correctly priced, based on the binomial models, and if they are
and put options with an exercise price of 5,100 are priced at INR mispriced, he would like to make additional profits. The risk-free
136 and INR 552.30, respectively. rate is estimated as 8% per annum.
  On September 1, State Bank of India shares are selling at INR Akhil would like to calculate the call and put option prices
1,740. The standard deviation of the stock prices has been esti- by using the Black–Scholes options pricing model as well as the
mated as 20%. Call and put options with an exercise price of INR binomial options pricing model.
1,800 and expiry on November 26 are priced at INR 162.60 and
INR 188.65, respectively. The State Bank of India is not expected to
Discussion Questions
pay any dividends before November 26.
On September 1, Tata Steel shares are selling at INR 420. 1. Advise Akhil to identify the underpriced and overpriced op-
The standard deviation of the stock prices has been estimated as tions
14%. Call and put options with an exercise price of INR 450 and 2. Explain whether binomial model or Black–Scholes model
expiry on November 26 are priced at INR 57.40 and INR 66.65, should be used to value these options.

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 12
Greeks in Options

LEARNING OBJECTIVES

After completing this chapter, you It is important to know how option prices move in order to make
will be able to answer the following money consistently. Since the value of options changes when the
questions: underlying asset price changes, one needs to know the relation-
 Why is it necessary for ship between the movements in stock price and option price.
financial institutions to hedge Options values are like algebraic equations, and they are based
their option positions? on the price of the underlying asset, exercise price, time to maturity,
volatility, interest rates, and dividends if it is a stock. In order to
 Why is it difficult to hedge
solve these equations, Greeks have been developed, and these
option positions?
Greeks are extensively used by traders. Greeks will let the traders
 What is meant by the delta, to structure winning trades and determine the profitable entry and
gamma, theta, vega, and rho exit points.
of options?
Source: Chris Macmahon,
 What is meant by delta “It’s All Greek to Me,” Futures, May 17, 2007.
hedging?
 How can one make an option
gamma-neutral? BOX 12.1 Why Greeks?
 How are the delta, gamma,
theta, vega, and rho of an
option calculated?

In Chapters 7 to 11, the role of options in managing risks and how options can be traded were explained.
In this section, we will discuss the risks associated with options trading and how these risks can be man-
aged.

12.1 risks in Options Trading

Options are either traded on exchanges, where the market makers provide bid–ask quotations and pro-
vide liquidity to the options market, or they are created on the over-the-counter markets, usually be-
tween a financial institution and a corporate borrower who is looking to hedge price risk. Sometimes,
the market maker in the exchange may have to take a position in an option by becoming counterparty to
the hedger. When the market maker has an open position in options, they need to hedge this position so

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 298   Financial Risk Management

Notes that they can reduce the risk. For exchange-traded options, hedging the risk of an open position is easy,
as the only thing that the market maker has to do is take an offsetting position in the exchange. However,
it is difficult for a financial institution to hedge its risk in over-the-counter transactions, which are usu-
ally tailor-made to the needs of the customers. Therefore, financial institutions need to understand the
risks they face by entering into options contracts with their customers and devise ways in which the risks
can be hedged. The risks associated with options are expressed through various Greek letters, which are
called Greeks.
As shown in Box 12.1, Greeks associated with options will allow the traders to hedge the risks that
arise while using options. In this chapter, we will discuss the various risks that are faced by financial in-
stitutions and the ways in which they can hedge these risks.

12.2 Characteristics of Options Hedging

It is very tricky to hedge an option, as the sensitivity of the option price to changes in the stock price is not
constant. This happens because the option price would change when the stock price changes, but the ex-
tent of exchanges in the options price depends on whether the option is in-the-money or out-of-money.
In deep-in-the-money options, a change of INR 1 in the stock price will be accompanied by a change of
INR 1 in the option price. However, for other options, there is no such clear relationship. Further, the
sensitivity of the option price to changes in the stock price also depends on the time to maturity of the
options. As an option nears its maturity, the relationship between stock price changes and option price
changes also varies. Because of these factors, it is important to ensure that when hedging an option, the
changes in the position of the hedger in the underlying asset are taken into account. The volatility of the
underlying asset returns can also affect the option price. If the volatility increases, the option price will
increase even if the underlying stock price does not change. Because of these reasons, it is difficult to
hedge option positions.

Example 12.1
Assume that a financial institution has sold an INR 250,000 call option on 100,000 shares of a non-
dividend-paying stock. The current stock price is INR 60, exercise price of the option is INR 63, stock
price volatility is 25%, time to maturity is 90 days, and risk-free interest rate is 5% per annum.
Given the above data, the call option price can be calculated using the Black–Scholes formula as:

 60    0.25 × 0.25   90  
ln   + 0.05 +   ×  365  
 63    2 
d1 = = 0.2316
90
0. 25 ×
365
90
d2 = d1 – s = –0.3558
365
From these we get:
N(d1) = 0.4084  and  N(d2) = 0.3610
Thus:
C = (60 × 0.4084) – (63 × 0.3610 × e–0.05×90/365) = INR 2.04
The total value of the call price on 100,000 shares = INR 203,400. Since the financial institution has sold
calls for INR 250,000, it has sold the option for INR 46.600. However, the financial institution has to
hedge this position.

Financial institutions use a number of strategies such as naked position, covered position and hedging
through the gap to hedge their option positions.

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 Greeks in Options   299

Notes 12.2.1 The Naked Position

This means that the financial institution does nothing to hedge this position. If the call is exercised, the
financial institution will have to buy the underlying shares at the prevailing market price and deliver the
stock. For example, in 90-days’ time, if the stock price is INR 70, the incurred loss would be 100,000 ×
(70 – 63) – 250,000 = INR 450,000. On the other hand, if the stock price is INR 62 after 90 days, the call
will not be exercised and the financial institution makes a profit of INR 250,000.

12.2.2 The Covered Position

In using a covered position, the financial institution can buy 100,000 shares immediately upon entering
into the call contract. It would require an immediate outflow of INR 6,000,000 (100,000 shares at INR
60 each). If the call is exercised, the stock that was bought can be given to the call buyer and there is no
loss to the financial institution. However, the financial institution can make huge losses if the call is not
exercised. The call will not be exercised only when the stock price is below the exercise price. If the stock
price at the maturity date of the option is INR 56, the stock will be worth only INR 5,600,000 and the
financial institution would have lost INR 150,000 after taking into account the option premium received
(INR 6,000,000 – INR 5,600,000 – 250,000).
Thus, both the naked position and the covered position do not offer proper hedges. If the Black–
Scholes options pricing formula holds, the maximum loss to the financial institution upon exercise
should not exceed the call value, which, in this example, is INR 203,400. Thus, a perfect hedge means that
whatever be the stock price in the market, the cost of the hedge should not exceed INR 203,400.

12.2.3 Hedging Through the Cap

It was seen earlier that the naked position is good whenever the call is out-of-money and will not be
exercised; on the other hand, the covered position is good when the call is in-the-money and will be exer-
cised. With this in mind, we can form a strategy of buying the underlying stock whenever the stock price
increases beyond the exercise price, or when the call moves to in-the-money and a strategy of selling the
stock to have a naked position whenever the call moves to out-of-money.
Although this strategy looks attractive, there are a number of problems associated with it. The use of
this strategy is appropriate as long as there is a very small price movement. However, if there are large
movements in the stock price such that it frequently increases beyond the exercise price and decreases
below the exercise price, the transaction costs of buying and selling the underlying security would be
very high.
The discussion so far explains the problems associated with hedging option positions. In order to
hedge the option position efficiently, one needs to understand how the option price changes in relation
to changes in the underlying variables that can affect the option price. In Chapter 11, we saw that the
current stock price, exercise price, volatility of the stock price movement, time to maturity of the option,
and risk-free interest rate are the variables that affect option prices. The relationship between the change
in the option price and the changes in each of these variables is denoted by a Greek letter, and these are
explained in the following sections.

12.3 Greeks in Options Hedging

A number of Greek letters have been developed with respect to options hedging. They are delta,
gamma, vega, theta, and rho. Greeks indicate the sensitivity of options price changes to changes in the five
parameters of options price, namely, stock price, exercise price, time to expiration, volatility, and risk-
free rate.
The delta of an option is defined as the rate of change in option price with respect to the price of the
underlying asset, i.e.,
δC
∆=
δS

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 300   Financial Risk Management

Notes
BOX 12.2 Options Trading rises 45% in F & O Market

From January 2008 to March 2009, volumes in options tion of delta hedgers. While traders are involved in delta
trading in the derivatives have increased by 45% even hedging, the risk of adverse price movement is reduced and
though stock markets have fallen consistently. The experts if the trades are executed effectively, delta hedging can pro-
believe that this rise in volume is due to the active participa- vide a return of about 15%.

Source: Palak Shah, “Options Trading Rises 45% in F&O Market,” Business Standard, March 11, 2009.

Gamma is the rate of change in the value of the option portfolio with respect to the delta, i.e.,
δC
Γ=
δ∆
Vega is the rate of change in the value of the option portfolio with respect to the volatility of the underly-
ing asset, i.e.,
δC
Λ=
δσ
Theta refers to the rate of change in the value of the option portfolio with respect to the time to
maturity, i.e.,
δC
Θ=
δT
Rho refers to the rate of change in the value of the option portfolio with respect to the risk-free interest
rate, i.e.,
δC
ρ=
δr

12.4 Delta
The delta of an option is defined as the rate of change in option price with respect to the price of the
underlying asset, i.e.,
δC
∆=
δS
It is measured from the slope of the curve drawn between the option price and stock price. If the delta of
an option is 0.3, it means that if the stock price changes by a small amount, say INR 5, the option price
would change by INR 1.50. Box 12.2 explains the principle of delta hedging.

Example 12.2
Consider the case of an investor selling a call option on a stock that is selling for INR 50 with the option
price equal to INR 5. The delta of the call is estimated as 0.4. This means that if the stock price increases
from INR 50 to INR 51, the option price would increase by INR 0.40, to INR 5.40. When writing a cov-
ered call, the portfolio consists of a written call and a bought position in the underlying stock. If the stock
price increases, the portfolio value increases by the increase in the stock price, but the increase in the call
price would decrease the value of the portfolio. Similarly, if the stock price decreases, the stock portion
of the portfolio would provide a loss, while a decrease in the call price would provide a profit from the
written call portion of the portfolio. Thus, price changes in the underlying stock and in the call option
move in opposite directions. When we want a perfect hedge, we need to ensure that the gain made from
the stock position exactly offsets the loss made from the option position, and vice versa. If we can achieve

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 Greeks in Options   301

Notes this, the portfolio of a long stock and a written call will not be affected by changes in the stock price. How
do we achieve this?
  We know that delta is a measure of the rate of change in call option price to change in the stock price.
If we buy delta number of stocks for each call written, the price change in the call option value will be
exactly offset by the change in the stock value. If the delta is 0.3, we would buy 0.3 stocks for each call writ-
ten, i.e., we would buy 3 stocks for every 10 calls written. If the stock price increases by INR 1, the stock
portion of the portfolio would increase by INR 3. However, the call price would increase by INR 0.30,
and 10 written calls would provide a loss of INR 3. Thus, the gain from the stock position would exactly
offset the loss from the option position as long as the hedge ratio, i.e., the number of stocks that need to
bought for each call written, equals delta. This is known as delta hedging, and the portfolio created using
delta hedging is said to be delta-neutral.

Note that the portfolio created in this manner will remain delta-neutral only for a very short time. This
happens because the relationship between the stock price and the option price is not linear, but convex.
When the stock price increases from the current level, the option price also increases. The delta at the new
stock price and option price would be different. Thus, delta hedging is effective as long as the stock price
changes only once. However, in reality, the stock price can change a number of times before the maturity
of the option. If a portfolio is to be delta-neutral at all times, the portfolio has to be adjusted to be delta-
neutral whenever the stock price changes. If the delta increases, more stock needs to be purchased, and
if the delta decreases, some of the stock has to be sold. This process is known as dynamic delta hedging.
However, complete dynamic delta hedging, that is, delta hedging whenever there is a stock price change,
is impractical, because it would increase the transaction costs.
Note that the delta is equivalent to hedge ratio 1 in the options pricing formula. In the Black–Scholes
formula, N(d1) is the delta of the call option. For a put option, the delta is given by N(d1) – 1. If the delta of
the call is positive, then the delta of the put is negative. This means that for each call written, delta number
of underlying assets should be bought, and for each put option bought, delta number of shares should
be bought. If the share price decreases, the put price would increase, providing a hedge for the portfolio.
The deltas that have been explained so far are for calls and puts on non-dividend-paying European
options. We can also calculate the deltas for other options as shown below:
For European calls on a stock that pays a dividend yield of d%:
D = e–dt N(d1)
For European puts on a stock that pays a dividend yield of d%:
D = e–dt [N(d1) – 1]
For European currency call options:
D = e–r*t N(d1)
where r* is the risk-free interest rate in the foreign currency and d1 is defined for currency options in
Section 17.1.
For European currency put options:
D = e–r*t [N(d1) – 1]
where r* is the risk-free interest rate in the foreign currency and d1 is defined for currency options in
Section 17.1.
For European futures call options:
D = e–rt N(d1)
where d1 is defined for futures options in Section 17.6.2.
For European futures put options:
D = e–rt [N(d1) – 1]
where d1 is defined for futures options in Section 17.6.2.

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 302   Financial Risk Management

Notes

'HOWD
6WRFN3ULFH

Figure 12.1  The Variation in the Delta with Stock Price for a Call Option

The variation in the delta of a call option with stock price is shown in Fig. 12.1, and the variation in the
delta of a put option with stock price is shown in Fig. 12.2.

P r ob l e m 1 2 . 1
The share price of ACC is INR 807 on September 1. Call options on ACC with the exercise date of October 29 and an
exercise price of INR 840 are selling for INR 42.80. The volatility of ACC shares is estimated as 20%, and the risk-free
rate is 8%. What is the delta of these call options?
Solution to Problem 12.1
The delta of a call option is given by the hedge ratio N(d1) and is calculated as:

 870    0.20 × 0.20   58  

ln   + 0.08 +   ×  365  
 840    2 
d1 = = −0.3034
58
0.20 ×
365
N(d1) = N(–0.3034) = 0.3808
This means that for each call written, 0.3808 shares need to be purchased, and for each 1% increase (decrease) in the
share price, the call option would increase (decrease) by 0.3808%.

P r ob l e m 1 2 . 2
ICICI Bank has written a 90-day European option to sell USD 1,000,000 at an exchange rate of USD 1 = INR 47. The
current exchange rate is USD 1 = INR 47.40. The risk-free rate in India is 8%, the risk-free rate in the USA is 4%, and
'HOWD

6WRFN3ULFH

Figure 12.2  The Variation in the Delta with Stock Price for a Put Option

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 Greeks in Options   303

the volatility of USD–INR exchange rate is 30%. What is the delta of the put option and what position should be taken
Notes
in the underlying currency for delta hedging?

Solution to Problem 12.2

This is a written put option for the bank. The delta of the put option can be calculated as:

Delta of the put option = [N(d1) – 1] e–r*T

 47.40    0.3 × 0.3   90  

ln  + 0.08 −  0.04 + ×
 47   

2   365  
d1 = = 0.19759
90
0.30 ×
365
N(d1) = 0.5783
Delta of the currency put option = [N(d1) – 1] e–r*T = (0.5783 – 1) e–0.04×90/365 = –0.4175
Since this provides the delta of the bought put option, the delta of the written put option will be 0.4175.
  This means that for each 1% increase (decrease) in the spot rate, the value of the written put option would increase
(decrease) by 0.41754%.
  Since the put option is written on USD 1,000,000, the bank needs to take a short position in the U.S. dollar for the
amount of USD 417,540.
This would hedge the portfolio against exchange rate change just once. If the exchange rate changes often, the
delta must be changed.

12.4.1 The Use of Futures in Delta Hedging

Delta hedging requires a position in the underlying asset in order to hedge the position in options. How-
ever, taking a position in the underlying assets is costly, as it may involve immediate investment (in case
the delta hedging requires a long position in the underlying asset) as well as transaction costs. This prob-
lem of additional investment can be avoided by using futures contracts on the underlying asset for delta
hedging the option position. Since the movement in futures prices tends to be in line with the underlying
asset prices and since the investment needed in a futures contract is very small (because it involves only
the payment of the margin amount), using futures would be a more attractive alternative for delta hedg-
ing. It is not necessary that the maturity of the futures contracts should be the same as the maturity of the
options contract.
Let  TF = maturity of the futures contract,
HA = the value of the asset that is needed for delta hedging, and
HF = the value of the futures contract on the asset needed for delta hedging.
If the asset is a stock that pays no dividends, the futures price is given by:
F = S0 exp(r TF)
If the stock price changes by D S, the futures price would change by exp(r TF). Thus, the delta of a futures
contract is given by:
Delta of a futures contract = exp(r TF)
Thus, the value of a futures contract, HF, needed to hedge HA of the asset position is:
HF = HA exp(–r TF)
If the underlying asset is a dividend-paying stock with a dividend yield of d%:
HF = HA exp[–(r – d) TF]
If the underlying asset is a currency:
HF = HA exp[–(r – r*) TF]

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Notes P r ob l e m 1 2 . 3
ICICI Bank has written a 90-day European option to sell USD 1,000,000 at an exchange rate of USD 1 = INR 47. The
current exchange rate is USD 1 = INR 47.40. The risk-free rate in India is 8%, the risk-free rate in the USA 4%, and
the volatility of the USD–INR exchange rate is 30%. The bank plans to hedge the option position by taking a position
in the USD–INR futures contract maturing in 90 days. What position should be taken in the futures and for what
amount?

Solution to Problem 12.3

Since the bank will sell U.S. dollars in the future, it will enter into a put option contract. The delta of the put option
is given by:

Delta of the put option = [N(d1) – 1] e–r*T

 47.40    0.3 × 0.3   90  

ln  + 0.08 −  0.04 +
 47   

2   365  
d1 = = 0.19759
90
0.30 ×
365
N(d1) = 0.5783
Delta of the currency put option = [N(d1) – 1] e–r*T = (0.5783 – 1) e–0.04×90/365 = –0.4175
Since this provides the delta of the bought put option, the delta of the written put option will be 0.4175.
  This means that for each 1% increase (decrease) in the spot rate, the value of the written put option would increase
(decrease) by 0.41754%.
  Since the put option is written on USD 1,000,000, the bank needs to take a short position in the U.S. dollar for the
amount of USD 417,540.

The delta of the futures, HF is:

  90  
HF = HA exp[–(r – r*) TF ] = 417,540 × exp  −(0.08 − 0.04) × 
  365  

Or

NF = USD 413,422
The amount of short futures needed to hedge the position would be USD 413,422.

12.4.2 The Delta of a Portfolio

When a financial institution holds a portfolio of options, it can either hedge each and every option in the
portfolio separately, or it can hedge the entire portfolio. When a trader holds a position in various options
on the same underlying asset, it would be cheaper to hedge the portfolio as a whole, rather than hedging
each option position separately. Hedging an option position requires taking a position in the underlying
asset, and the transaction cost can turn out to be very high if each option position is hedged separately.
In such a case, portfolio hedging using portfolio delta would provide the hedge at a low cost. In order to
do this, the delta of the portfolio needs to be calculated. The delta of a portfolio is a weighted average of
the deltas of individual options in the portfolio, the weights being the value of each option. If wi is the
value of option i, Di is the delta of the option i, and N is the number of options in the portfolio, then the
portfolio delta is calculated as:
N
∆ P = ∑ wi ∆ i
i =1

When delta hedging a portfolio of options, the value of the asset or the futures on that asset that are to be
bought or sold can be calculated using the delta of the portfolio.

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Notes P r ob l e m 1 2 . 4
ICICI Bank has the following options on the U.S. dollar:
Written put options for INR 1,000,000 at INR 47.50 and with an expiry of 90 days
Bought call options for INR 500,000 at INR 47.00 and with an expiry of 30 days
Written call option for INR 1,500,000 at INR 48.20 and with an expiry of 180 days
The current exchange rate is INR 47.40; the exchange rate volatility is 30%, and the risk-free rate in India and in the
USA is 8% and 4%, respectively. Calculate the delta of the portfolio.
Solution to Problem 12.4
Delta of option 1 is calculated as:

Delta of the written put option = –[N(d1) – 1] er*T

 47.40    0.3 × 0.3   90  
ln  + 0.08 −  0.04 +  ×  365  
 47.50    2 
d1 = = 0.1265
90
0.30 ×
365
N(d1) = 0.5503

Delta of the written currency put option = –[N(d1) – 1] e–r*T = (0.5503 – 1) × e–0.04×90/365 = 0.41756

Delta of option 2 is calculated as:

Delta of the bought call option = N(d1) e–r*T

 47.40    0.3 × 0.3   30  
ln  + 0.08 −  0.04 +  ×  365  
 47.40    2 
d1 = = 0.0812
90
0.30 ×
365
N(d1) = 0.5324
Delta of the bought currency call option = N(d1) e–r*T = (0.5324) × e–0.04×30/365 = 0.5306
Delta of option 3 is calculated as:

Delta of the written call option = –N(d1) e–r*T

 47.40    0.3 × 0.3   180  

ln  + 0.08 −  0.04 +  ×  365  
 48.20    2 
d1 = = 0.1195
180
0.30 ×
365
N(d1) = 0.5476
Delta of the bought currency call option = –N(d1) e–r*T = (0.5476) × e–0.04×180/365 = –0.5369
The corresponding deltas for these options can be calculated as:
Option 1: 0.41756
Option 2: 0.5306
Option 3: –0.5369

The delta of the portfolio is calculated as:

DP = (0.41756 × 1,000,000) + (0.5306 × 500,000) – (0.5369 × 1,500,000) = –0.1225

Since the delta of the portfolio is negative, the bank will make the portfolio delta-neutral by taking a long position in
the U.S. dollar for an amount of USD122,500.
If six-month U.S. dollar futures are used to hedge, the value of the futures would be:
  180  
Value of the futures = 122,500 × exp  − (0.08 − 0.04)  = USD 120,107.20
  365  
The bank will take a long position in six-month futures for a value of USD 120,107.20.

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Notes 12.5 Gamma

The gamma (G) of an option is the rate of change in the delta of the option with respect to small changes
in the price of the underlying asset. Mathematically, G can be written as:
δC
Γ=
δ∆
If the gamma is small, the change in delta is slow and it is easier to keep the portfolio delta-neutral
at all times, as the portfolio need not be rebalanced frequently. However, if the gamma is large, changes
in delta are large and the portfolio needs to be frequently rebalanced, which can involve considerable
costs.
When the gamma is positive, the portfolio will decrease in value if there is no change in the value of
the underlying asset, whereas it would increase in value if the price of the underlying asset changes by a
large amount, either positively or negatively. When the gamma is negative, the portfolio will increase in
value when there are no changes in the value of the underlying asset, but there would be a large decrease
in the value of the portfolio if there are large changes in the value of the underlying security, either posi-
tive or negative. As the absolute value of gamma increases, the sensitivity of the value of the option port-
folio with respect to the changes in the underlying asset price increases.
Variation in the gamma of a call option with stock price is shown in Fig. 12.3.
Very often, financial institutions want to make the portfolio gamma-neutral so that large price changes
in the underlying asset would not affect the value of the option portfolio.

12.5.1 Making a Portfolio Gamma-neutral

The gamma for the underlying asset or for the futures on the underlying asset is zero. This is because, for
the underlying security as well as for the futures, the pricing relationship is a linear relationship and hence
the delta is constant. However, for options, the gamma can be positive or negative, as the pricing relation-
ship between the underlying security and the options is convex and the delta of the option is not constant.
Earlier, we saw that a portfolio of options can be made delta-neutral by delta hedging. However, when
the underlying asset price changes, the delta would also change causing the portfolio to be no longer
delta-hedged. In order to keep the delta-hedged portfolio to be in a hedged position even when the pric-
es of the underlying security change, the portfolio can be made gamma-neutral. When the portfolio is
gamma-neutral, its gamma is zero and hence any change in the underlying stock price would not change
the delta of the portfolio and delta hedging would provide the appropriate hedge even if the underlying
stock price changes.
*DPPD

6WRFN3ULFH

Figure 12.3  The Variation in the Gamma with Stock Price for a European Call

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 Greeks in Options   307

Notes Suppose the original portfolio has a gamma of GP. We can add more options to this portfolio. Let us
assume that each option that is added to the original portfolio has a gamma of GT. Then, the gamma of
the new portfolio would be:
Gamma of new portfolio = wT GT + GP
To make this portfolio gamma-neutral, the weight wT must satisfy:
−G P
wT =
GT
If we add additional traded options to the original portfolio of options held, the portfolio would be
gamma-neutral, and the number of new options to be added is given by the ratio of the gamma of the
original portfolio and the gamma of the options added.
However, an important point has to be noted in making the portfolio gamma-neutral. When we add
additional options to the original portfolio of options, the delta of the original portfolio would change
and hence an additional position in the underlying security or in the futures contract on the underlying
security must be taken to make the original portfolio delta-neutral. Thus, to make the portfolio gamma-
neutral, additional positions in both the options and the underlying assets need to be taken. This requires
rebalancing of the portfolio so that the portfolio remains gamma-hedged.
Another point with gamma-neutrality is that the portfolio would be gamma-neutral only for a short
time. As time passes, the gamma would change and the positions in the options and the underlying asset
will have to be changed. This requires rebalancing of the portfolio so that the portfolio remains gamma-
hedged.
Making the portfolio delta-neutral provides protection in case of small price changes during portfolio
rebalancing. On the other hand, making the portfolio gamma-neutral provides protection in large price
changes during the rebalancing of the gamma hedge.

Example 12.3
Suppose you hold a portfolio of options that is delta-neutral and has a gamma of 1,800. The delta
and gamma of the option are 0.58 and 1.75, respectively. The delta-hedged portfolio can be made
gamma-neutral by including a short position of 1,800 / 1.75 = 1,028.57 = 1,029 call options. How-
ever, adding 1,029 written call options would change the delta of the portfolio from zero to 1,029 ×
0.58 = 597. This means that 597 additional underlying assets must be added in order to maintain the
delta-neutrality.

12.5.2 Calculating Gamma

For a European call option that pays no dividends, the gamma is given by:
N ′ (d1 )
Γ=
Sσ T
where,

 S   σ2 
ln 
 SX  +  r + 2  T
d1 =
σ T
For a European call or put option on a stock index that pays a continuous dividend at rate d, the gamma
is given by:

N ′ (d1 ) e − dT
Γ=
Sσ T

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Notes where,
 S   σ2 
ln  + r − d + T
 SX   2 
d1 =
σ T
For a currency option, the gamma is given by:

N ′ (d1 ) e − r *T
Γ=
Sσ T
where,

 S   σ2 
ln  + r − r * + T
 SX   2 
d1 =
σ T
The gamma for a futures option is given by:

N ′ (d1 ) e − rT
Γ=
Sσ T
where,

 F   σ2 
ln 
 SX  +  r + 2  T
d1 =
σ T
P r ob l e m 1 2 . 5
A trader holds a portfolio of options that is delta-neutral, but has a gamma of –1,500. The traded call option has a
delta of 0.4456 and a gamma of 1.3456. How can this portfolio be made gamma-neutral?
Solution to Problem 12.5
In order to make the portfolio gamma-neutral, the trader has to buy additional call options, as the gamma of the
portfolio is negative; the number of additional options to be bought is calculated as:

Gamma of the portfolio 1500

Number of options to buy = = = 1,114.75 = 1,115
Gamma of the option 1.3456
However, this will not make the portfolio delta-neutral. The additional options will make the delta of the portfolio
to be 1,115 × 0.4456 = 496.84. Thus, 497 of the underlying securities are to be sold in order to make the portfolio
delta-neutral.

12.6 Theta
The theta (Q) of a portfolio of options is a measure of the rate of change in the value of the portfolio with
time to maturity, or with a decrease in T, with all the other factors that affect the stock price remaining
constant. It is also referred to as the time decay of the option portfolio.
For a European call on a non-dividend-paying stock, the theta is given by:
SN ′(d1 )σ
Θ=− − rS X e − rT N (d2 )
2 T
where,

 S   σ2 
ln 
 SX  +  r + 2  T
d1 =
σ T

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 Greeks in Options   309

Notes d2 = d1 – s T
 1   −x2 
N9(x) =   exp  
 2∏  2 

For a European put option on a stock that pays no dividend:

SN ′(d1 )σ
Θ=− + rS X e − rT N (−d2 )
2 T
For a European call option that pays dividends at rate d:

SN ′(d1 )σe − dT
Θ=− + dSN (d1 )e − dT − rS X e − rT N (d2 )
2 T
where,

 S   σ2 
ln  + r − d + T
 SX   2 
d1 =
σ T
The theta is always negative for an option. This is because, as the time to maturity decreases, the option
value decreases. When the stock price is very low, the theta is close to zero for a call option. For at-the-
money options, the theta is relatively large and negative. Variation in theta with stock price for an option
is shown in Fig. 12.4.

12.7 The Relationship Between Delta, Gamma and Theta

If V is the value of any derivative security, where the underlying security is a stock that pays a continuous
dividend at rate d, it can be shown that:
1
Θ + (r − d ) S∆ + σ 2 S 2 = rV
2
If D is zero, or for a delta-neutral portfolio:
1
Θ + σ 2 S 2 Γ = rV
2
When Q is large and positive, G will tend to be large and negative, and vice versa.
7KHWD

6WRFN3ULFH

Figure 12.4  The Variation in the Theta with Stock Price for a European Call

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 310   Financial Risk Management

Notes 12.8 Vega

In the Black–Scholes options pricing model, it is assumed that the volatility of the underlying asset re-
mains constant during the life of the option. In reality, the volatility of the underlying asset is not con-
stant. Therefore, the option price is likely to change not only with the passage of time and with changes in
the stock price but also with changes in volatility.
The vega of the portfolio of options is a measure of the rate of change in the value of the portfolio of
the option with respect to changes in the volatility of the underlying asset. If the vega is very small, the
sensitivity of the value of the option portfolio to changes in the volatility of the underlying asset is low. If
the vega is large, the sensitivity of the value of the option portfolio to small changes in the volatility of the
underlying asset could be high.
The vega of a position in the underlying asset or in the futures on the underlying asset is zero. A port-
folio can be made vega-neutral by using a technique similar to the one used to create a gamma-neutral
portfolio. To make a portfolio vega-neutral, more options are included in the portfolio such that the vega
of the new portfolio is zero. The number of new options to be included is given by:
Λ
Number of new options to make the portfolio vega-neutral = –
ΛT
where, L is the vega of the portfolio already owned and LT is the vega of the new options.
However, a portfolio that is gamma-neutral will not be vega-neutral, and vice versa. If a portfolio
needs to be both gamma-neutral and vega-neutral, at least two different options must be used, one to
make the portfolio gamma-neutral and the other to make it vega-neutral.

Example 12.4
A delta-neutral portfolio has a gamma of –3,000 and a vega of –5,000. There exists an option with a delta
of 0.4, gamma of 0.3, and vega of 2.5. How do you make this portfolio vega-neutral?
  Since the vega of the portfolio is –5,000 and the vega of the option is 2.5, the portfolio can be made
vega-neutral by taking a long position in 2,000 options.
  However, the delta would increase by 2,000 × 0.4 = 800. This means that 800 units of assets must be sold
in order to maintain delta-neutrality.
  The gamma would also change from the current value of 3,000 to –3,000 + (2000 × 0.3) = –2,400
  To make the portfolio both gamma- and vega-neutral, assume there is another option with a gamma
of 0.5, delta of 0.6, and vega of 3.
 If w1 and w2 are the number of options (first and second, respectively) that should be included, we get
two equations for gamma-neutrality and vega-neutrality:
–5000 + 2.5 w1 + 3 w2 = 0  (vega-neutrality)
–3000 + 0.3 w1 + 0.5 w2 = 0  (gamma-neutrality)
Solving these two equations, we get:
w1 = –18,572  and  w2 = 18,143
Thus, the portfolio can be made vega- and gamma-neutral by selling 18,572 of the first option and buying
18,143 of the second option.
  This would change the delta of the option by (–18,572 × 0.4) + (18,143 × 0.6) = 2,857. Thus, 2,857 of
the underlying assets must be sold in order to make the portfolio delta-neutral.

  For a European call or put option on a non-dividend-paying stock, the vega is given by:
Λ = S T N 9(d1 )
where,
 S   σ2 
ln   +  r + T
 SX   2 
d1 =
σ T

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 Greeks in Options   311

Notes For a European call or put option with a continuous dividend yield of d, the vega is given by:
Λ = S T N ′(d1 )e − dT
where,
 S   σ2 
ln   +  r − d + T
 SX   2 
d1 =
σ T
For a currency option, the vega is given by:
Λ = S T N ′(d1 )e − r *T
where,
 S   σ2 
ln   +  r − d + T
 SX   2 
d1 =
σ T
For a futures option, the vega is given by:
Λ = F T N ′(d1 )e − rT
where,
 S   σ2 
ln   +  r + T
 SX   2 
d1 =
σ T
The vega is always positive, and the variation in the vega with stock price is shown in Fig. 12.5.

12.9 Rho
The rho of a portfolio is a measure of the rate of change in the value of the option portfolio to changes in
the interest rate.
For a European call option on a non-dividend-paying stock, the rho is given by:
ρρ = XTN (d2 )e − rT
where,
 S   σ2 
ln   +  r + T
 SX   2 
d1 =
σ T
9HJD

6WRFN3ULFH

Figure 12.5  The Variation in the Vega of an Option with Stock Price.

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 312   Financial Risk Management

Notes and
d2 = d1 – s T
For an European put option:
ρρ = − XTN (−d2 )e − rT
In currency options, there are two rhos corresponding to the two interest rates. The rho corresponding to
the domestic interest rate is given by:
ρD = XTN (d2 )e − r *T
where,
 S   σ2 
ln  + r − r * + T
 SX   2 
d1 =
σ T
and
d 2 = d1 – s T
The rho corresponding to the foreign interest rate for a call is given by:
ρ F = −Te r *T SN (d1 )
where,
 S   σ2 
ln  +
  r − r * + T
 SX 2 
d1 =
σ T
The rho corresponding to the foreign interest rate for a put is given by:
ρF = Te r *T SN (−d1 )
where,
 S   σ2 
ln  +
  r − r * + T
 SX 2 
d1 =
σ T
Example 12.5
Consider a stock that is currently selling for INR 150. There is a call option with an exercise price of INR
180 and maturity of 90 days. The current risk-free rate is 6% per annum, and the volatility of the stock is
25% per annum. Calculate the rho for this call option.
 150   0.252   90 
ln  +  0.06 + 2   365 
 170    = –0.8267
d1 =
90
0.25 ×
365
 90 
d2 = –0.8267 –  0.25 × = –0.9511
 365 
N(d1) = 0.2041   N(d2) = 0.1807
90 
ρ = XTN (d2 ) e − rT = 180 ×  

× 0.1807 × exp  −0.06 ×
90 
= 7.053
 365   365 
This means that if the interest rate changes by 1% from the current rate of 6%, the option price would
change by 7.053%.

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 Greeks in Options   313

Notes 12.10 Creating Portfolio Insurance Using Synthetic Puts

In Chapter 9, it was seen that portfolio insurance can be obtained by using a protective put strategy. In a
protective put strategy, it was seen that portfolio insurance can be provided by combining a put option
with a stock, as any decrease in the stock price will be exactly offset by an increase in the value of the put
such that a minimum value of the portfolio will be maintained if the stock price is below the exercise price
and the value of the portfolio will increase by INR 1 for each INR 1 increase in the stock price. This is how
portfolio insurance is provided. What happens if there is no put option available or if there is no trading
in the put option even if a put is available? It is possible to create a put option synthetically by delta hedg-
ing. We will discuss this aspect in this section.
Creation of an option synthetically requires that the trader maintains a position in the underlying
asset such that the delta of the position in the underlying asset equals the delta of the required option
position. While hedging a position in the underlying asset using options, it is necessary to buy the stocks
such that the number of stocks bought equals the delta of the put option. If the delta of the put is 0.4, it
means that for each put option bought, 0.4 stocks will be bought. This means that if 0.4 stocks are sold and
the proceeds are invested in risk-free assets, then it is equivalent to writing an option. This is explained
in Example 12.6.

  Example 12.6
Assume that Mega Fund has invested in stocks, and the portfolio is worth INR 500,000,000 on July 1. The
portfolio manager is concerned about a possible decrease in the value of the portfolio by September 30
and would like to enter into a portfolio insurance plan. The portfolio is highly correlated with the S&P
CNX Nifty index. There are put options available on the Nifty index with the expiry date of September
30 with an exercise price of INR 5,000. Since the contract multiplier is 50 for the index options, the value
of each put is 5,000 × 50 = INR 250,000. Thus, 2,000 options will be bought at the exercise price of INR
5,000. If the index decreases to 4,900, the value of the portfolio with the option included will be equiva-
lent to:
Value of the stock position = 2,000 × 4,900 × 50 = INR 490,000,000
Value of the put position = (5,000 – 4,900) × 50 × 2,000 = INR 10,000,000
Total value of the position = INR 500,000,000
If the index increases to 5,100, the value of the portfolio with the option included is:
Value of the stock position = 2,000 × 5,100 × 50 = INR 510,000,000
Value of the put position = 0 × 50 × 2,000 = INR 0
Total value of the position = INR 510,000,000
This shows that portfolio insurance is obtained by buying 2,000 put options.
Assume that the put option has the following parameters:
SX = INR 5,000; the dividend yield is 2% per annum; the risk-free rate is 8% per annum; volatility of the
index = 20%; maturity is 92 days. From this data, we can calculate the delta of the options as follows:

 S    σ2  
ln   +    + (r − d )T 
 S X    2  
d1 =
σ T
 5000    (0.2)2   92  
ln  +  + (0.08 − 0.02)  

 5000    2    365  
d1 = = 0.20082
 92 
0.2 
 365 

N(d1) = N(0.20082) = 0.57958

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Notes Then, the delta of this option is given by:

Delta = e–qT [N(d1) – 1] = e–0.02×(92/365) × (0.57958 – 1) = –0.41831
This means that 41.831% of the existing portfolio should be sold and the proceeds invested in risk-free
assets.
Value of the portfolio to be sold = 41.831% × 500,000,000 = INR 209,155,000
Value of the remaining portfolio = INR 500,000,000 – INR 209,155,000 = INR 290,845,000
Amount invested at risk-free rate = Amount of portfolio sold = INR 209,155,000
On September 30, assume that the index value is 4,900
 290,845,000 
Value of the portfolio =  × 4,900 = INR 285,028,100
 5,000 
Amount from the risk-free investment = 209,155,000 × e(0.08×92/365) = INR 213,415.290
Amount of dividend at 2% dividend yield = 290,845,000 × e(0.02×92/365) = INR 1,469,879
Total Amount = INR 499,913,270 ≈ INR 500,000,000
If the index value on September 30 is 5,100,
 290,845,000 
Value of the portfolio =  × 5,100 = INR 296,661,900
 5,000 
Amount from the risk-free investment = 209,155,000 × e(0.08×92/365) = INR 213,415.290
Amount of dividend at 2% dividend yield = 290,845,000 × e(0.02×92/365) = INR 1,469,879
Total Amount = INR 511,547,070 ≈ INR 500,000,000
This example shows that by setting the portfolio equal to the delta of the put option, the put option can
be made to have portfolio insurance.
  Note that since the delta changes, there should be an additional sale or purchase of the portfolio, de-
pending on the changes in the delta. When the value of the index decreases, the delta of the put option
would become more negative, as a result of which, additional portfolios are to be sold and the amount
invested in risk-free assets. When the value of the index increases, the delta of the put option will become
less negative and it would require the purchase of additional portfolios using the risk-free investment.
  If the index value decreases to 4,850 after two days, we can calculate the delta of the put as:
 S   σ2 
ln   +  + (r − d )T 
 SX   2 
d1 =
σ T

 4850    (0.2)2   90  
ln   +   + (0.08 − 0.02)  
 5000    2   365  
d1 = = −0.108075
90
0. 2
365
N(d1) = N(–0.108075) = 0.45697
Then, the delta of this option is given by:
Delta = e–qT[N(d1) – 1] = e–0.02×(90/365) × (0.45697 – 1) = –0.54036
This means that we need to sell 54.036% of the portfolio. However, 41.831% has already been sold. Thus,
additional 12.21% of the portfolio or INR 61,025,000 should be sold and invested in risk-free assets.
  If the index value increases to 5,100 on August 1, the delta of the put can be calculated as:
 S   σ2 
ln 
 SX  +  2 + (r − d )T 
d1 =  
σ T

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 Greeks in Options   315

Notes  5100    (0.2)2   61  

ln   +   + (0.08 − 0.02)  
 5000    2   365  
d1 = = 0.405723
90
0. 2
365
N(d1) = N(0.405723) = 0.6575
Then, the delta of this option is given by:
Delta = e–qT[N(d1) – 1] = e–0.02×(90/365) × (0.6575 – 1) = –0.3408
This means that 54.036% – 34.08% of the original portfolio needs to be bought, i.e., a portfolio for INR
99,780,000 should be bought on August 1.

Portfolio insurance through the creation of a synthetic put requires selling the underlying asset
and investing the proceeds in risk-free assets or buying the underlying asset from risk-free borrow-
ing on a continuous basis, based on the price movement of the underlying asset. This means that
the portfolio manager will sell the stock after the market has declined and buy the stocks after the
market has gone up. This is the cost of insurance. Further, the transaction costs can be very high
in this strategy. The transaction costs can be considerably reduced if futures are used instead of the
asset itself.
If futures are available, we can calculate the delta of the futures contract as follows:
If T is the maturity of the futures contract, HA is the value of the asset that needs to be hedged, and HF
is the value of futures required for delta hedging, then:
HF = e–rT HA
This is because F = S erT, and if S changes by INR 1, F will change by erT, and the delta of the futures be-
comes equal to erT.
If the asset pays dividends at the rate of q, the delta of the futures is given by:
∆ F = e(r–q)T and HF = e(r–q)T HA
When using futures to create a synthetic put, the maturity of the futures (T) is usually higher than the
date on which the portfolio insurance is required (T1). If the portfolio manager requires insurance on
September 30, a futures contract with maturity on October 31 may be used. In that case, the dollar amount
of the futures to be sold as a proportion of the portfolio value is given by:
e − qT1 e–(r–q)T [1 – N(d1)]
If the value of the portfolio to be insured is INR X and the contract size of the futures is F, then the
number of contracts needed is e − qT1 e–(r–q)T [1 – N(d1)] (X / A).

Example 12.7
Assume that the contract multiplier for the futures selling for INR 5,102 is 50. Since the portfolio value to
be hedged is INR 500,000,000, the number of contracts to be sold via futures is calculated as:
Given: T = 92 days, T1 = 123 days, d1 = 0.20082, X = INR 500,000,000, F = INR 5,102; r = 8%, and q = 2%.
X
Percentage of portfolio value to be sold in futures = e − qT1 e–(r–q)T [1 – N(d1)]  
A
 500,000,000 
  = e–0.02×(92/365) × e–(0.08–0.02)×(123/365) × [1 – N(0.20082)] ×  
 50 × 5,102 
  = 803.47
   = 804 contracts

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 316 Financial Risk Management

Notes Suppose the index is at 4,900 on September 30 and the futures are selling at INR 4,925, then the value of
the portfolio will be:
 4, 900 
Value of assets = 500, 000, 000 ×  = INR 490,000,000
 5, 000 
Gain from futures = 804 × 50 × (5,102 – 4,925) = INR 7,115,400
Dividends = 500,000,000 × e(0.02×92/365) = INR 2,526,912
Total value of the portfolio = INR 499,642,312 ≈ INR 500,000,000
Suppose the index is at 5,100 on September 30 and the futures are selling at INR 5,126, the value of the
portfolio will be:
5,100 
Value of assets = 500, 000, 000 ×  = INR 510,000,000
 5, 000 
Gain from futures = 804 × 50 × (5,102 – 5,126) = –INR 964,800
Dividends = 500,000,000 × e(0.02×92/365) = INR 2,526,912
Total value of the portfolio = INR 511,562,112 ≈ INR 510,000,000
This shows that when the index value decreases, the portfolio value is close to INR 500,000,000, and when
the index value increases, the portfolio value increases; thus, the portfolio is insured.

12.11 Hedging Options positions in practice

The abovementioned techniques of delta-neutrality, gamma-neutrality, and vega-neutrality are used to
make the portfolio of options immune to a small change in stock price for just once. However, as the
stock price is subject to frequent changes, these techniques would require continuous rebalancing of the
portfolio, requiring the addition of more options and/or underlying assets to the original portfolio of op-
tions or the selling of the options and/or underlying assets. This continuous rebalancing is expensive and
hence option hedgers would not be following this strategy of making the portfolio delta-, gamma-, and
vega-neutral at all times. The trader would first assess the risks involved, decide how much of the risk is
acceptable, and then formulate the appropriate hedging policies.
Delta, gamma, and vega provide an idea of the magnitude of the risks that the hedger is undertak-
ing. Hedgers will also form their own opinion regarding how the underlying asset price is likely to move
before the expiration of the options. They would also have an idea about the volatility in the underlying
stock price. On the basis of their opinions about the price movement and volatility, the hedgers would
decide how much of the risk is acceptable. If all of the risk is acceptable, then no hedging will be under-
taken. If not, an appropriate position would be taken in the underlying asset and/or option in order to
hedge the risk.

CHapTEr SUmmary
 Financial institutions that enter into over-the-counter options  Delta refers to the change in the option price with respect to a
contracts face risk, as the risk from the hedger is transferred change in the underlying asset price.
to the financial institutions.  By making the portfolio delta-neutral, the portfolio is
 Financial institutions, therefore, need to assess the risks of immunized against changes in the underlying asset price.
their option positions and make arrangements to hedge these However, delta hedging has to be dynamic in nature, because
risks. the option delta changes when the underlying asset price
 Risks are very difficult to hedge, as the option value can changes.
change because of changes in the underlying asset price, time  Gamma is a measure of the sensitivity of delta to changes in
to maturity, and volatility of the underlying asset price. the underlying asset price.
 Financial institutions would make their option portfolio  By making the portfolio gamma-neutral, delta hedging can
delta-neutral. be maintained. However, gamma hedging would require

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 Greeks in Options 317

adjustments in the portfolio such that the portfolio remains  Rho is a measure of the sensitivity of the option price to
delta-neutral. changes in the risk-free rate.
 Vega is a measure of the sensitivity of the option price to
changes in the volatility of the underlying asset price. The
portfolios can also be made vega-neutral.

mUlTIplE-CHOICE QUESTIONS

1. A call option on a stock has a delta of 0.3. A trader has sold 7. A portfolio of derivatives on a stock has a delta of 2400 and a
1,000 options. What position should the trader take to hedge gamma of –10. An option on the stock with a delta of 0.5 and
the position? a gamma of 0.04 can be traded. What position in the option is
A. Sell 300 shares B. Buy 300 shares necessary to make the portfolio gamma neutral?
C. Sell 700 shares D. Buy 700 shares A. Long position in 250 options
B. Short position in 250 options
2. What does theta measure? C. Long position in 20 options
A. The rate of change of delta with the asset price D. Short position in 20 options
B. The rate of change of the portfolio value with the passage
of time 8. A trader uses a stop-loss strategy to hedge a short position in
C. The sensitivity of a portfolio value to interest rate changes a three-month call option with a strike price of 0.7000 on an
D. None of the above exchange rate. The current exchange rate is 0.6950 and value
of the option is 0.1. The trader covers the option when the
3. What does gamma measure? exchange rate reaches 0.7005 and uncovers (i.e., assumes a na-
A. The rate of change of delta with the asset price ked position) if the exchange rate falls to 0.6995. Which of the
B. The rate of change of the portfolio value with the passage following is NOT true?
of time A. The exchange rate trading might cost nothing so that the
C. The sensitivity of a portfolio value to interest rate changes trader gains 0.1 for each option sold
D. None of the above B. The exchange rate trading might cost considerably more
than 0.1 for each option sold so that the trader loses
4. What does vega measure?
money
A. The rate of change of delta with the asset price
C. The present value of the gain or loss from the exchange
B. The rate of change of the portfolio value with the passage
rate trading should be about 0.1 on average for each
of time
option sold
C. The sensitivity of a portfolio value to interest rate changes D. The hedge works reasonably well
D. None of the above
9. Maintaining a delta-neutral portfolio is an example of which
5. What does rho measure? of the following
A. The rate of change of delta with the asset price A. Stop-loss strategy
B. The rate of change of the portfolio value with the passage B. Dynamic hedging
of time C. Hedge and forget strategy
C. The sensitivity of a portfolio value to interest rate changes D. Static hedging
D. None of the above
10. Which of the following could NOT be a delta-neutral
6. Which of the following is true? portfolio?
A. The delta of a European put equals minus the delta of a A. A long position in call options plus a short position in the
European call underlying stock
B. The delta of a European put equals the delta of a European B. A short position in call options plus a short position in
call the underlying stock
C. The gamma of a European put equals minus the gamma C. A long position in put options and a long position in the
of a European call underlying stock
D. The gamma of a European put equals the gamma of a D. A long position in a put option and a long position in a
European call call option

Answer
1. B 2. B 3. A 4. D 5. C 6. D 7. A 8. D 9. B 10. B

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 318 Financial Risk Management

rEVIEW QUESTIONS
1. Why is it necessary for financial institutions to hedge their op- (ii) Gamma hedging
tion positions? (iii) Vega hedging
2. Why is option hedging a complicated affair? 4. What is meant by the delta, gamma, theta, vega, and rho of
3. What is meant by: options?
(i) Delta hedging 5. How would you make a portfolio gamma-neutral?

SElF-aSSESmENT TEST
1. The share price of a stock is INR 850 on September 1. 7. A stock is currently selling for INR 400, and there exists a call
Call options on this stock with the exercise date of October option on the stock with a maturity of 90 days and an exercise
29 and an exercise price of INR 900 are selling for INR price of INR 420. The volatility of the stock is 30%, and the
37.80. The volatility of these shares is estimated as 18%, risk-free rate is 8%. The stock does not pay dividends, and
and the risk-free rate is 9%. What is the delta of these call the option is a European option. Calculate the delta, theta,
options? gamma, vega, and rho of this option.

2. The State Bank of India has written a 60-day European option 8. Assume that Alpha Fund has invested in stocks and the
to sell AUD 500,000 at an exchange rate of AUD 1 = INR 35. portfolio is worth INR 7,000,000 on August 1. The portfolio
The current exchange rate is AUD 1 = INR 36.20. The risk-free manager is concerned about a possible decrease in the
rate in India is 9%, the risk-free rate in Australia is 7%, and the value of the portfolio by October 31 and would like to enter
volatility of the AUD–INR exchange rate is 24%. What is the into a portfolio insurance plan. The portfolio is highly
delta of the put option and what position should SBI take in correlated with the S&P CNX Nifty index. There are put
the underlying currency for delta hedging? options available on the Nifty index with the expiry date of
October 31 and an exercise price of INR 5,400. The dividend
3. Assume that a financial institution has sold an INR 500,000 yield on the Nifty index is 2% per annum, risk-free asset is
call option on 100,000 shares of a non-dividend-paying stock. 8% per annum, and volatility of the index is 20%. Show how
The current stock price is INR 500, exercise price of the option a put option can be created synthetically in order to obtain
is INR 530, stock price volatility is 30%, time to maturity of the portfolio insurance.
option is 60 days, and risk-free rate is 8%. Calculate the delta 9. Assume that Alpha Fund has invested in stocks and the
of the option. portfolio is worth INR 7,000,000 on August 1. The portfolio
manager is concerned about a possible decrease in the value
4. A financial institution has written 60-day European call of the portfolio by October 31 and would like to enter into a
options to buy SGD 1 million at an exchange rate of SGD 1 portfolio insurance plan. The portfolio is highly correlated
= INR 28. The current exchange rate is SGD 1 = INR 27.65. The with the S&P CNX Nifty index. There are put options
risk-free rate in India is 9%, and the risk-free rate in Singapore available on the Nifty index with the expiry date of October
is 6%. The volatility of the SGD–INR exchange rate is 20%. 31 and an exercise price of INR 5,400. The dividend yield on
What position should be taken in the underlying currency for the Nifty index is 2% per annum, risk-free asset is 8% per
delta hedging? annum, and volatility of the index is 20%. There are futures
contracts available with maturity on October 31 at INR 5,420
5. Suppose you hold a portfolio of options that is delta-neutral and with maturity on November 30 at INR 5,520. Show how a
and has a gamma of 2,500. The delta and gamma of an option put option can be created synthetically using futures in order
are 0.4 and 1.6, respectively. How can you make the delta- to obtain portfolio insurance.
hedged portfolio to be gamma-neutral?
10. Suppose you hold a portfolio of options that is delta-neutral
6. A delta-neutral portfolio has a gamma of 1,800 and a vega of and has a gamma of 1,500 and a vega of –2600. There are two
–3,000. There exists an option with a delta of 0.3, gamma of options with a delta of 0.5 and 0.3, gamma of 1.8 and 1.2,
1.2, and vega of 2.8. How would you make this portfolio vega- and vega of 3.0 and 2.8. How would you make this portfolio
neutral? gamma-neutral as well as vega-neutral?

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 Greeks in Options   319

   C a se S tud y

Akhil, the manager of Bharat Hedge Funds, uses derivative securi- There is also an October index futures with a futures price of INR
ties extensively to reduce the risks. When he started studying op- 4,637 expiring on October 29.
tions, he learnt that hedging using options is not simple. There are The volatility of the Nifty index is estimated as 24%, and the
a number of Greek letters used, and these cannot be understood risk-free rate is 8%.
easily. Furthermore, he has learnt that it is necessary to go for a dy- Bharat Fund also received money from foreign investors for
namic hedging strategy in order to preserve the gains. He is won- USD 1 million, and these investors are paid a dividend of 10%
dering how he can hedge his portfolio of stocks and options. every three months, with the next payment due on December 31.
His portfolio is currently worth INR 3 billion. Of this, INR 200 Since the amount is to be paid in U.S. dollars, Akhil would like to
million is invested in stocks. The stock portfolio is highly correlated hedge the exchange rate risk by buying U.S. dollar options. The
with the Nifty index, with a correlation of 0.88. On September 1, exercise price of December options is INR 46.85, and the options
the Nifty index is at 4,800 and index call options and put options are selling for INR 1.28. The volatility of the USD–INR exchange
are available with an exercise price in the range of INR 4,700 to rate is 18%.
INR 5,000 with expiry on October 29. The prices of these options Akhil is worried about a possible downside risk and wants to
are as shown in Table 1. hedge the value of the portfolio.

Table 1
Discussion Questions
Exercise Price Call Price Put Price 1. Explain the risks associated with the use of options for hedg-
(INR) (INR) (INR) ing.
2.  Explain how Akhil can delta-hedge the portfolio.
4,600 267 247 3.  How can Akhil make the portfolio gamma-neutral?
4.  How can Akhil make the portfolio vega-neutral?
4,700 217 286 5. How can Akhil make the portfolio gamma-neutral as well as
vega-neutral?
4,800 173 358
6. How can Akhil create a put option synthetically in order to
4,900 135 400 hedge the portfolio?
7. How can Akhil make the U.S. dollar option gamma-neutral
5,000 105 474 and vega-neutral?

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M12 Financial Risk Management 01 XXXX.indd 320 6/27/2018 11:13:04 AM
 Glossary

A C
Accrued interest: The prorated portion of a bond’s coupon since Calendar spread: A combination of the same type of option with
the previous coupon payment. the same exercise price but different exercise dates.
American options: Options that can be exercised anytime during Callable bonds: Bonds that can be redeemed before maturity by
the life of the option. an issuer on payment of an amount known as the call price.
Arbitrage: Making profits with zero net investment and taking Call option: An option to buy the underlying asset at a fixed price,
no risk when there is a mispricing of related securities in the known as the exercise price, on or before a specified date,
market. known as the exercise date or strike date.
Arbitrager: A trader who enters into arbitrage trades. Call price: The price at which the issuer will redeem the bond us-
Asian options: Options in which pay-off is based on the average ing the call provision.
price of the underlying asset over an agreed period of time and Call risk: The risk that the issuer will redeem the callable bonds
the exercise price. before maturity and is faced by buyers of callable bonds.
At-the-money option: An option where the underlying asset Cash settlement: A procedure in which settlement of a deriva-
price is close to its strike price. tive contract is in terms of cash exchange instead of delivery
of the asset.
B Cheaper-to-deliver bond: The bond that can be delivered under
Backwardation: Occurs when the futures prices are falling with the interest rate futures contract that provides the maximum
time to expiration. benefit to the trader who delivers the bond.
Badla: A system of forward trading in Indian stock exchanges. It Chooser option: An option in which the buyer can decide whether
has been banned since 2001 by the Securities and Exchange the option should be a call option or a put option after a pre-
Board of India. determined time.
Barrier options: Options that can be either activated or terminated Clearing: Refers to the process of clearly recording the transac-
when the underlying asset price reaches a predetermined bar- tions concluded in the exchanges.
rier or boundary price. Clearing member: A member of the clearing corporation who is
Basis (at any time): The difference between the spot price and the authorized to clear all the trades undertaken by traders in the
futures price (at that time). exchange.
Basis risk: The risk that the basis at maturity of the futures con- Clearing corporation or Clearinghouse: The clearing and set-
tract is different from zero. tlement agency for all transactions executed in the exchanges.
Basket option: An option that is written on a portfolio of assets. Cliquet or Ratchet option: A series of at-the-money options with
Bermudan option: An option that provides a number of prede- periodic settlement and the exercise price is reset at the price
termined discrete exercise dates on which an option can be level at the time of reset.
exercised. Closing out the position: Refers to the trader taking an opposite
Binary or digital option: An option that provides a pay-off which position to the position taken initially so that the net position
would be a fixed amount is the option is in-the-money and in the derivative contract is zero.
zero otherwise. Commodity swap: A swap in which the floating market price of
Binomial options pricing model: Used to value the options the commodity is exchanged for a fixed price over a certain
based on the assumption that the stock price at any time can period.
be either of two values at the future time. Compound option: An option on an option and can be a call on
Binomial tree: The representation of possible asset price move- a call or a call on a put.
ments over time in which the asset price can either move up or Contango: Refers to the situation when the futures prices keep
down by a given amount every period. increasing with decreasing time to expiration.
Black–Scholes options pricing model: Used to value the options Contract size: The quantity of the underlying asset specified in a
based on the assumption that the stock return evolves as log- derivatives contract.
normal distribution. Conversion factor: Used in interest rate futures where any gov-
Bond futures: A futures contract whose underlying asset is usu- ernment bond can be delivered instead of the underlying secu-
ally a government bond. rity and conversion factor is used to calculate the price of the
Bond option: An option written on bonds as the underlying asset. bond that is delivered.
Box spread: A combination of a bullish money spread and bearish Conversion ratio: The number of shares a convertible bondholder
money spread with the same exercise prices and exercise dates. is entitled to if they decide to convert the bond into shares.
Butterfly spread: Involves positions in options with three differ- Convertible bonds: Bonds that can be converted into a fixed
ent exercise prices and with the same exercise date. number of shares on or before a certain time period.

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 322   Financial Risk Management

Counterparty risk: The risk that one of the parties to a derivatives on the basis of the relative sensitivity of the value of options to
contract may not fulfill the obligations under the contract. changes in the price of the underlying security.
Coupe option: An option in which the exercise price is reset to Derivative security: A security whose value is derived from
the minimum of the spot price of the asset at the time of reset the value of the asset on which the derivative is written
and the initial exercise price. on.
Covered call position: Indicates that the trader owns the under- Directional trading: Refers to speculative trading where the
lying asset and at the same has written call options. speculator trades based on the direction in which he expects
Covered position: Indicates that exposure to the risk of changing the asset price to move.
prices of the asset is hedged using a derivative security. Duration of a bond: A measure of how long, on average, the
Covered interest rate parity: Indicates that the forward premium holder of the bond has to wait before receiving the total cash
in exchange rate is equal to the differential between the interest payments from the bond.
rates in the two countries. Dynamic hedging: The hedger continuously monitors the price
Credit default swap: A bilateral contract in which one party pays movements of the underlying asset and modifies the hedge ra-
a periodic fee on a notional principal in return for a contin- tio so as to remain hedged at all times.
gent payment by the other party following the occurrence of a
credit event with respect to a reference entity. E
Credit derivatives: Derivative products that are used to hedge the Edokko option: A barrier option with signals as to when the op-
credit risk faced. tion is likely to be knocked in or knocked out.
Credit event: A contingency, the risk of which is being trans- Employee stock option: An option issued by a company to its
ferred to a credit derivative transaction. employees as a part of their compensation, providing the em-
Credit-linked note: A bond that has payments determined by ployees with the right to buy a fixed number of shares at a price
credit events of a different company. specified.
Credit option: An option to buy or sell a specified floating-rate Equity swap: A swap in which cash flows based on the perform-
reference asset at a pre-specified exercise price. ance of the underlying equity is swapped with cash flows based
Credit risk: Arises whenever one party’s capacity to pay its com- on a floating-interest rate.
mitments changes adversely. European option: An option that can be exercised only on the
Cross hedging: Refers to the use of one type of instrument to exercise date.
hedge the risk in a different type of instrument. Event risk: The risk that arises when an unforeseen event takes
Currency futures contract: A futures contract in which one party place that affects both the revenue and cash flows.
agrees to buy or sell a specified amount of a currency at a fu- Exchange option: An option allows the buyer to exchange one
ture specified time at an exchange rate specified at the current asset for another.
time. Exchange rate risk: The risk that arises due to unforeseen changes
Currency option: An option written on currency exchange in the currency exchange rates.
rates. Exchange-traded derivative: A derivatives contract that is listed
Currency swap: A swap in which one party agrees to exchange and traded according to the rules and regulations of the ex-
payments based on one currency with another party for pay- change.
ments based on another currency. Exercise date: The date by which the option matures.
Exercise price: The price at which the option buyer can either buy
D or sell the underlying asset.
Day order: An order that will be executed within a given day and Exercising option: Refers to the act of using the option to either
if not executed, it will be cancelled. buy or sell the underlying asset at the exercise price.
Daily price limit: The maximum amount by which the price of Extendible option: An option whose expiration date can be ex-
futures or options can change and if the limit is reached, the tended either by the buyer of the option or the writer of the
exchange has the right to suspend trading in that security. option.
Daily settlement price: The price determined by the derivatives Exotic option: An option in which the pay-off structure can be
exchange for settlement of margin in daily marking-to-market. determined on the basis of occurrence of various events dur-
Default risk: The risk that the issuer of a bond may fail to pay ing the life of the option.
either the interest or the principal amount at specified times. Extreme spread option: An option whose pay-off is based on the
Delivery location: The location specified in the derivative con- minimum price near the maturity of the option and the high-
tract in which the assets will be delivered. est price during the start of the option.
Delivery month: The month in which delivery of the asset under
the derivative contract will take place. F
Delivery option: The option given to the sellers of futures to Fixed interest rate: The interest rate on a loan is fixed for the ma-
choose the grade of the asset and the location in which the turity of the loan period.
asset will be delivered. Floating interest rate: The interest rate on a loan is reset at pe-
Delta (of an option): The rate of change in option price with re- riodic intervals during the period of the loan based on some
spect to the change in price of the underlying asset. reference rate.
Delta hedging: Hedging in which the number of shares of the un- Forward contract: An agreement between two parties in which
derlying security used to hedge an option position is decided one party agrees to either buy or sell a specified quantity of

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 Glossary  323

an asset at a future time at a price that is determined at the Initial margin: The amount of cash that needs to be provided by
current time. all traders at the time of entering into futures contracts and by
Forward interest rate: The interest rate at which one can either writers of option contracts.
borrow or lend at a future time where this interest rate is fixed Instalment option: An option in which the option premium is
at the current time. paid over the life of the option instead of at the time of buying
Forward exchange rate: The currency exchange rate at which one the option.
currency can be exchanged for another at a future time where Interbank rate: The interest rate at which one bank can borrow
this exchange rate is fixed at the current time. from other banks, known as interbank offer rate, or, lend to
Forward premium: The percentage appreciation of the currency other banks, known as interbank bid rate.
forward rate relative to the current spot exchange rate. Interest rate cap: An option in which the maximum rate is set by
Forward rate agreement (FRA): An agreement between two par- the borrower.
ties in which the future borrowing or lending rate is set at a Interest rate collar: Involves buying an interest arte cap and writ-
mutually agreed rate. ing an interest rate floor.
Forward start option: An agreement to enter into an options Interest rate floor: An option in which the minimum rate is set
contract at a future time. by investors.
Forward swap: A swap agreement under which the swap will Interest rate risk: The risk that investors face due to uncertain
commence at a later date. future interest rates.
Futures contract: An agreement between two parties in which Interest rate futures: Futures in which the underlying asset’s price
one party agrees to either buy or sell a specified quantity of an is dependent only on the level of interest rates.
asset at a future time at a price that is determined at the current Interest rate option: An option written on the level of interest
time and is traded on futures exchange. rates as the underlying asset.
Futures option: An option written on futures contracts. Interest rate swap: A swap in which one party agrees to exchange
interest payments based on a fixed rate with another party for
G interest payments based on a floating rate.
Gamma (of an option): The rate of change in the delta of the op- In-the-money value (of an option): Refers to minimum of zero
tion with respect to small changes in the price of the underly- and the difference between the underlying asset price and ex-
ing asset. ercise price in the case of a call option and the minimum of
Gamma-neutral portfolio: A portfolio in which that the gamma zero and the difference between the exercise price and the un-
of the portfolio is zero. derlying asset price in case of a put option.
Good-till-cancelled order: An order in which the order to buy Intrinsic value (of an option): Refers to the in-the-money value
or sell derivatives securities in an exchange will remain open of an option.
unless the original trader cancels the order. Iron candor spread: Involves buying and selling call options and
Good-till-date order: An order in which the order to buy or sell put options with different exercise prices and the same exercise
derivatives securities in an exchange will remain open until a date.
given date. Israeli option: An option in which the option writer can cancel
the option early by paying a fixed amount of money to the op-
H tion buyer.
Hawaiian option: An option whose pay-off is based on the aver-
age price of the underlying asset over an agreed period of time L
and the exercise price and can be exercised early. LIBOR (London interbank offer rate): The rate at which one
Hedger: A person who undertakes hedging activity. bank can borrow from another bank in London Bank market.
Hedge ratio: The ratio of the size of exposure to any asset Limit order: An order that sets a price known as the limit
being hedged to the size of the position taken in futures con- price and orders can only be executed at the limit price or
tract. better.
Hedging: An activity undertaken to reduce the risks of chang- Long hedge: A hedge in which the hedger agrees to buy the asset
ing commodity price, interest rate, currency exchange rate or in the future and uses to hedge a short position in the asset.
credit standing. Long position (in any asset): Indicates that the hedger owns the
asset and wants to hedge against possible price decreases.
I Long position (in futures): Indicates that the hedger agrees to
Implied forward rate: The forward interest rate that is calcu- buy the asset at a future time
lated using the spot rates in the term structure of interest Long position (in option): Indicates that the trader has bought
rates. the options.
Implied volatility: The volatility of the stock that is implied in the Lookback option: A path-dependant option in which the pay-off
market price of the option. is based on the minimum or maximum price of the asset over
Index arbitrage: An action taken while the index futures are the life of the option.
priced in the market different from the theoretical value calcu-
lated using the value of the index. M
Index futures: A futures contract in which the underlying asset Market order: An order that should be executed at the best pos-
is a stock index. sible prices at the earliest opportunity.

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Margin: The amount of money each clearing member is required Plain vanilla option: An option that provides a known pay-off on
to post to the clearinghouse of the exchange for all trades exercise of the option.
cleared through that clearing member. Portfolio insurance: A technique that uses either options or
Margin account: The account maintained by the broker in the futures to fix a minimum value for the portfolio.
name of the trader which is updated daily based on the daily Position limit: Refers to the maximum number of derivative con-
settlement price. tracts that can be held by a trader at any given time.
Margin call: The call provided by the broker to the trader when- Premium margin: The amount of premium received by the writer
ever the margin account balance falls below the variation of options to be posted as margin.
margin. Price risk: The risk of changes in the price of inputs and outputs
Marking-to-market: A process whereby the margin account of a that will have an impact on the cash flow of businesses.
trader is updated every day suing the daily settlement price. Program trading: Refers to automatic trigger of trades whenever
Money spread: Refers to a portfolio that contains the same type there exists an index arbitrage opportunity.
of option with the same expiration date but different exercise Protective put: The strategy of buying underlying security as well
prices. as buying puts on the underlying security.
Mountain range option: A combination of basket options. Protection buyer: An entity that seeks protection against the risk
MIBOR (Mumbai interbank offer rate): The interest rate at which of default of the reference obligation.
one bank can borrow from another bank in the Mumbai Bank Protection seller: An entity that takes the risk of default of the
market. reference obligation of the protection buyer in exchange for pe-
riodic payments.
N Put–call arbitrage: An arbitrage opportunity arises when the ac-
Naked call position: Indicates that the trader has a position in a tual market price of the put is different from the price calcu-
call option without any position in the underlying asset. lated using the put–call parity.
Non-deliverable forward contract: A forward contract in which Put–call parity: Provides the relationship between the price of a
the underlying asset is not delivered and the contract is settled put and a call with the same exercise price and exercise date.
by exchange of cash. Put bond: A bond in which the bondholder has the right to sell the
Notional principal: A monetary figure that is used in swaps as a bond to the issuer at its face value.
part of the calculation of payment amounts and this amount is Put option: An option contract in which the buyer of the put op-
not exchanged. tion has the right to sell the underlying shares at a specified
price on or before a specified date.
O
Open interest: Refers to the number of contracts available for de- Q
livery at that time and is the sum of all long positions or all Quanto option: An option on an asset denominated in a foreign
short positions. currency with an associated predetermined exchange rate.
Operating exposure: A form of currency exposure that a company
faces when its future cash flows are affected by changes in cur- R
rency exchange rates. Rainbow option: An option in which the underlying asset in-
Operating risk: The risk faced by businesses due to variability of cludes a portfolio of two or more assets.
cash flows caused by business cycles and economic cycles. Reinvestment rate risk: The risk that the future interest rates at
Option class: All options of same type, either calls or puts, belong which interim payments received from loans or bonds can be
to a option class. reinvested is not known.
Option contract: Provides the buyer of the options the right, Repo rate: The interest rate at which repurchase agreements are
which the option buyer may exercise or not, to buy or sell the priced at.
underlying asset at a fixed price, known as the exercise price, on Repurchase agreement: An agreement between two parties in
or before a specified date, known as the strike date or exercise which one party agrees to sell government securities and pur-
date. chase them back at an agreed upon price at a specified future
Option premium or option price: The market price determined date.
in the options exchange that will be paid by the buyer of option Rho (of an option): The rate of change in the value of an option to
to writer of option. changes in interest rate.
Option series: Consists of all options in a given option class with Rights: These are issued by corporations to the existing sharehold-
the same exercise date. ers that give the right to buy a specified number of shares at a
Over-the-counter derivative contracts: Contracts between pri- certain price on or before a certain time period.
vate parties in which the terms are decided between the parties Risk-free interest rate: The return on an investment whose future
involved. value is known with certainty at the time of making the invest-
ment.
P Risk management: The practice of undertaking hedging activities
Parisian option: An option where the options are knocked-in or using derivative securities.
knocked-out only if the asset price stays above or below the Risk margin: The amount of margin that must be posted by the
barrier price for a certain period of time. writers of the option and is calculated on the basis of variability
Passport option: An option on the balance of a trading account. of option prices.

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 Glossary  325

Russian option: An option in which the buyer of the option is paid Swap contract: A contract wherein two parties agree to exchange
a certain amount if the option is in-the-money before maturity future cash flows according to a mutually agreed formula.
but goes out-of-money on expiration date. Swap dealer: A party that actually enters into swap agreements
with others as part of their operations.
S Swap facilitator: A specialist in swap market who helps clients
Settlement: The process by which the exchange arranges for result- find ways to alter or avoid unwanted risks through swap trans-
ant cash and delivery arrangements whenever a trader closes actions.
the position in derivatives. Swap rate: The rate of interest paid by one party to another in a
Settlement price: The price at which the contract is settled. swap contract and can be either fixed or floating.
Shout option: An option where the holder of the option can shout Swaption: An option to enter into a swap.
at one or more points in time during the life of the option and Synthetic security: Security in which pay-offs can be replicated by
adjust the specifics of the exercise price or maturity date. using other available securities.
Short hedge: The hedger agrees to sell the assets in the futures and
uses to hedge a long position in the asset. T
Short position (in an asset): Indicates that the hedger does not Tenor: The length of time for which the swap payments will be
own the asset now. exchanged. It is also known as the maturity or expiration date
Short position (in futures): Indicates that the trader has agreed to of the swap.
sell the underlying asset under the terms of the futures contract. Term structure (of interest rates): Indicates the relationship be-
Short position (in options): Indicates that the trader has written tween maturity of bonds and their yields and can be used to
an option. predict future interest rates.
Speculation: An activity whereby a trader hopes to earn money Terminal value (of an option): Refers to the value of option on
based on his or her expectations about future price movements the exercise date.
of assets. Theta (of an option): The rate of change in the value of option with
Speculator: A trader who engages in speculative activity. time to maturity of the option.
Spot interest rate: The interest rate on any borrowing or lending to Time value (of an option): The value that is derived from the prob-
be done at the current time. ability that the option will turn into money by the exercise date.
Spot exchange rate: The rate at which a currency can be exchanged Trading member: A member of the clearing corporation who is
for another at the current time. authorized to trade in the exchanges.
Spread option: An option based on a portfolio of assets and the Translation exposure: The exposure of the assets and liabilities in
payoff is based on the spread between the prices of the assets. the balance sheet of a multinational corporation to exchange
Spread order: An order in which the trader will place two orders rate changes.
on the same underlying asset with different maturities in case Transaction exposure: The exposure a company faces for transac-
of futures, and either with different maturities or exercise prices tions entered into due to changes in interest rates or exchange
in case of options. rates or commodity prices.
Spread trading: Refers to taking a long position in one contract Total return swap: A bilateral contract that is designed to transfer
and a short position in another contract with different maturi- credit risk from one party to another based on the total eco-
ties in case of futures and with different maturities or exercise nomic performance of a reference asset.
prices in case of futures.
Stack rolling hedge: A hedge in which the total exposure for a U
long period will be hedged using the near-month contract and Underlying asset: The asset on which the derivatives contract is
hedge will be rolled over with monthly contracts every month. written.
Stop-loss order: An order in which the trades will place a stop Upside risk: The risk that the changes in the prices of assets and
price and if the actual market price reaches the stop price, the commodities will benefit the company.
order will become a market order.
Straddle: A combination of a call and a put option with the same V
exercise price and exercise date, either bought or sold. Variation margin: The minimum amount that must remain in the
Strangle: A combination of a call and a put with the same expira- margin account of a trader and if the actual margin a mount
tion date and different exercise prices. falls below variation margin, the trader will receive a margin
Strap: A combination of two call options and one put options call.
with the same exercise price and exercise date, either bought Vega (of an option): The rate of change in the value of an option
or sold. with respect to changes in the volatility of the underlying asset.
Strip: A combination of one call option and two put options with Volatility smile: Indicates the shape of implied volatility when it is
the same exercise price and exercise date, either bought or sold. drawn against either the exercise price or exercise date.
Strip hedging: Means that the total exposure for a long period is
stripped into periodic amounts and hedging is done for each W
stripped amount. Warrant: Issued by corporations, a warrant provides the buyer the
Swap broker: A broker that brings swap counterparties together so right to purchase a given number of shares at a specified price
that a swap can be arranged between them. on or before a specified time.

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