Editorial Board

Prof. (Dr.) Anil Kothari

Former Director and Chairman, Faculty of Management Studies, Former Coordinator,
Finishing School and Placement Cell, Mohanlal Sukhadia University, Rajasthan
Dr. Ashima Arora
Assistant Professor, Finance, Arun Jaitley National Institute of Financial Management,
Ministry of Finance, Government of India

Content Writers
Jayakar Sodagiri, Ms. Abha Gupta, Aditi Methi, Rachit Jaiswal,
Ankit Suri, Yogesh Sharma, Sunakshi Chadha, CS Upasana Gutt,
Dr. Narander Kumar Nigam, Shalini Girdhar, Dr. Sachin Gupta
Academic Coordinator
Mr. Deekshant Awasthi

© Department of Distance and Continuing Education

ISBN: 978-81-19417-84-1
1st Edition: 2023
E-mail: [email protected]
[email protected]

Published by:
Department of Distance and Continuing Education
Campus of Open Learning/School of Open Learning,
University of Delhi, Delhi-110007

Printed by:
School of Open Learning, University of Delhi
 DISCLAIMER

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© Department of Distance & Continuing Education, Campus of Open Learning,

School of Open Learning, University of Delhi
 Contents

PAGE

Lesson 1 : Introduction to Financial Markets

hi
1.1 Learning Objectives 2

el
1.2 Introduction 2
1.3 What do Markets do?
D 4

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1.4 Types of Financial Markets 6

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1.5 Distinction between Primary Market and Secondary Market 9
1.6

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The Difference between the Capital Market and the Money Market 10
1.7 Key Participants in Financial Markets
e r 10

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1.8
1.9 Derivatives 14
1.10 Types of Derivatives
, U 15
1.11
1.12
O L
Underlying Assets of Derivatives
Characteristics of Derivatives
16
18
1.13
/ S
Players in Derivative Market 19
1.14
O L
Advantages and Risks Associated with Derivatives 20
1.15
/ C
Forwards and Futures 26
1.16

C E
Similarities Between Forwards and Futures Contracts 29

D
1.17 Mechanics of Forward Contracts 31

©D
1.18 Mechanics of Future Contracts 32
1.19 Role of Futures Exchanges and Clearing Houses 34
1.20 Options Contracts 37
1.21 Bonds 46
1.22 Swaps 50
1.23 Other Derivative Instruments 52
1.24 Summary 53

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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

PAGE

1.25 Answers to In-Text Questions 67

1.26 Self-Assessment Questions 69
1.27 References 70
1.28 Suggested Readings 70

Lesson 2 : Determination of Forward and Futures Prices

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2.1 Learning Objectives 73
2.2
2.3
Introduction
Future Contracts
D el 73
74

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2.4 Forward Contract 76

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2.5 Difference Between Forward and Future Contracts 79
2.6 Determining Forward Price for an Investment Asset
s i 81

er
2.7 Determining Future Prices 81

iv
2.8 Stock Index Futures 82

Un
2.9 Currency Futures 83

,
2.10 Commodity Future 83
2.11 Cost of Carry

O L 84

S
2.12 Basis Risk 85
2.13 Arbitrage
L / 87

CO
2.14 Summary 88
2.15

E /
Answers to In-Text Questions 88

C
2.16 Self-Assessment Questions 89

D
2.17 Suggested Readings 89

© D
Lesson 3 : Hedging Strategies Using Futures
3.1 Learning Objectives 90
3.2 Introduction 91
3.3 Concepts of Hedging 92
3.4 The Multi-Purpose Concept of Hedging 93
3.5 The Basic Long and Short Hedges 98

ii PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 CONTENTS

PAGE
3.6 Cross Hedging 101
3.7 Hedge Ratio 106
3.8 Summary 107
3.9 Answers to In-Text Questions 107
3.10 Self-Assessment Questions 108
3.11 References 109
3.12 Suggested Readings
l hi 109

Lesson 4 : Introductions to Options

D e
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4.1 Learning Objectives 111

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4.2 Introduction 112
4.3 Pay-off for the Parties Under Option Contract

s i 115
4.4 Types of Options

e r 123

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4.5 Put-Call Parity 124
4.6 Greeks 128
4.7
, U
Exercising American Calls Early 132
4.8
4.9 Summary
O L
Exercising American Puts Early 132
133
4.10
/ S
Answers to In-Text Questions 133
4.11
O L
Self-Assessment Questions 134
4.12
/ C
References 135
4.13

C E
Suggested Readings 136

D
©D
Lesson 5 : Basic Option Pricing: The Binomial Option Pricing Model
5.1 Learning Objectives 137
5.2 Introduction to Option Pricing 138
5.3 Conceptualizing Binomial Option-Pricing Model (BOPM) 144
5.4 Calculating Option Prices Using BOPM 152
5.5 Summary 156
5.6 Answers to In-Text Questions 156
5.7 Self-Assessment Questions 157

PAGE iii
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

PAGE
5.8 References 158
5.9 Suggested Readings 158

Lesson 6 : Asset Price Random Walks

6.1 Learning Objectives 159
6.2 Introduction 160
6.3 Assumption of the Random Walk Theory

h i 161
6.4 Implication of the Theory
e l 162

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6.5 Criticism 163

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6.6 (I¿FLHQW 0DUNHW +\SRWKHVLV 
6.7 E.F. FAMA Model 169

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6.8 Criticism of EMH 171
6.9
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6.10 Summary
e r 173
6.11 Answers to In-Text Questions
i v 174
6.12 Self-Assessment Questions
U n 174

,
6.13 References 175
6.14 Suggested Readings

O L 176

/ S
Lesson 7 : Valuation of Derivatives in Continuous Time
7.1 Learning Objectives
O L 177

C
7.2 Introduction 178
7.3
E /
Black-Scholes Pricing Model 178
7.4
7.5
D C
Extension of Black-Scholes Formula
Valuation of Option on Stock Indices
181
184

©D
7.6 Valuation of Currency 185
7.7 Valuation of Futures 186
7.8 Sensitivity Analysis (The Greeks) 188
7.9 Hedging of Options 192
7.10 Summary 195
7.11 Answers to In-Text Questions 197
7.12 Self-Assessment Questions 198
7.13 References and Suggested Readings 198

iv PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 CONTENTS

PAGE
Lesson 8 : Financial Engineering
8.1 Learning Objectives 199
8.2 Introduction 200
8.3 Construction of Option Strategies 202
8.4 Betting of Price Changes 214
8.5 Exotic Options 216
8.6 Summary
l hi 220
8.7 Answers to In-Text Questions
Self-Assessment Questions
D e 221
222

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8.8
8.9 References 224

ity
8.10 Suggested Readings 224

Lesson 9 : Swaps Transactions

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v e
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9.1 Learning Objectives 225
9.2
9.3
Introduction
Swap
U n 226
227
9.4 Interest Rate Swaps
L , 228
9.5
S O
Types of Interest Rate Swap 229
9.6 Currency Swaps
L / 232

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9.7 Types of Currency Swaps 232
9.8
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9.9

C E
Pricing and Valuation of Interest Rate Swaps 240

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9.10 Pricing and Valuation of Currency Swaps 242

©D
9.11 Credit Default Swaps 243
9.12 Valuation of Credit Default Swaps 244
9.13 Summary 247
9.14 Answers to In-Text Questions 248
9.15 References 248
9.16 Suggested Readings 249

PAGE v
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

PAGE
Lesson 10 : Value at Risk
10.1 Learning Objectives 251
10.2 Introduction 252
10.3 Normal Linear VaR 253
10.4 Historical Simulation 255
10.5 Value at Risk for Option Portfolios 257
10.6 Quadratic Model

h i 260
10.7 Monte Carlo Simulation
e l 264

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10.8 Stress Testing and Back Testing 265

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10.9 Summary 266
10.10 Answers to In-Text Questions 267

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10.11 Self-Assessment Questions 267
10.12 References
s i 268
10.13 Suggested Readings
e r 269

i v
n
Lesson 11 : Credit Risk
11.1 Learning Objectives

, U 271

L
11.2 Introduction 273

O
11.3 Understanding Credit Risk 274

/ S
11.4 Bond Prices and the Probability of Default 276

O L
11.5 Historical Default Experience
11.6 Reducing Exposure to Credit Risk
278
280

/ C
11.7 Collateralized Debt Obligation (CDO) 283

C E
11.8 Regulation and Risk Management 286

D
11.9 Case Studies and Real-World Examples 289

©D
11.10 Credit Risk in Emerging Markets 291
11.11 Credit Risk in the Post-COVID-19 Era 293
11.12 Summary 298
11.13 Answers to In-Text Questions 300
11.14 Self-Assessment Questions 301
11.15 References 301
11.16 Suggested Readings 305
Glossary 307

vi PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
L E S S O N

1
Introduction to
Financial Markets
Jayakar Sodagiri
Email-Id: [email protected]

STRUCTURE
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1.1 Learning Objectives

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1.2 Introduction
1.3 What Do Markets Do?
1.4 Types of Financial Markets
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1.5 Distinction Between Primary Market and Secondary s
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Market

1.7 Key Participants in Financial Markets i v

1.6 The Difference Between the Capital Market and e
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1.9 Derivatives
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1.10 Types of Derivatives

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1.11 8QGHUO\LQJ $VVHWV RI 'HULYDWLYHV

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1.12 Characteristics of Derivatives
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1.13 Players in Derivative
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1.17©Mechanics of Forward Contracts
1.16 Similarities Between Forwards and Futures Contracts

1.18 Mechanics of Future Contracts

1.19 5ROH RI )XWXUHV ([FKDQJHV DQG &OHDULQJ +RXVHV
1.20 Options Contracts
1.21 Bonds
1.22 Swaps

PAGE 1
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 1.23 Other Derivative Instruments

1.24 Summary
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1.1 Learning Objectives
‹
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Understand the concept of financial markets and Identify different

of
types of financial markets, such as stock markets, bond markets,
foreign exchange markets, and money markets.
‹

i ty
Evaluate the role of financial markets in facilitating the buying and
selling of financial assets.
r s
‹

v e
Analyse and illustrate the types of derivatives, including forwards,

i
futures, options, bonds and swaps.
n
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‹ Acquaint with structured derivate products and their components.

1.2 Introduction L ,
S O
/
The word “market” frequently strikes up images of colourful bazaars in
L
O
India, where multitudes of people bustle through confined spaces while

C
surrounded by a kaleidoscope of hues and fragrances. But a market is

E /
more than just these vivacious images. Financial markets in India stretch

C
well beyond actual exchanges like the New York Stock Exchange or

D
the futures pits in Chicago, which are only a small part of the overall

©D
financial ecosystem. Indian financial markets have a long history that
predates organised trade or exchanges. Long before the development of
official trading systems, these markets have been supporting economic
activities and offering a platform for trade and investment.
In India, financial markets have existed for a very long period, ever since
communities first came there to participate in commerce and agriculture.
Farmers had to contend with unreliable crops in those early days. They
would need seeds for the following planting season and food to feed their

2 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 INTRODUCTION TO FINANCIAL MARKETS

family after having a poor crop production. They had to ask for loans Notes
from other farmers who had extra seeds or food in order to satisfy their
demands. Similar to the choice faced by current commodities dealers
in the 20th century, farmers had the decision of whether to sell their
surplus immediately or put it away for later use following a successful
harvest. The exchange rates between various commodities were unstable
and fluctuated dependent on elements like the day’s.

i
A primitive financial market was created by the free choices made by all
of those farmers, and it served many of the same functions as financial
l h
e
markets do today.
In order to meet their requirements for working capital and fixed capital,
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of
business organisations occasionally need money for both short-term and
long-term capital demands. In addition to having easily available money,

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it is crucial to have a reliable system in place that enables communication

r s
between fund suppliers (investors/lenders) and fund borrowers/users

e
(business units), assuring prompt cash transfers. The financial markets

v
n i
provide a platform or system that effectively handles the movement of
capital from investors or lenders to business units in order to meet this
difficulty.
, U
1.2.1 Financial Markets
O L
/ S
O L
Markets that enable the buying and selling of different assets, such as
bonds, equities, foreign exchange, and derivatives, are referred to as

/ C
financial markets. Although these marketplaces go by many names, such

C E
“Dalal Street” and “capital market,” they all have the same function.
Financial markets essentially provide businesses the chance to raise money

D
for expansion while also giving investors the chance to make money on

©D
their investments.
Consider the case of someone who has a savings account with a bank
to better demonstrate this. The bank may use the money that has been
deposited, together with monies from other account holders, to provide
loans to people and organisations in need, with an interest charge applied
to the borrowed funds.
Since they receive interest on their deposits and see their money increase
over time, the depositors themselves profit from this system. In order

PAGE 3
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes to help depositors and borrowers achieve their financial objectives, the
bank functions as a financial market.

1.3 What Do Markets Do?

Financial markets come in a variety of shapes and use a number of
different methods to function. They can range from formal settings like
street-side money changers seen in many Indian towns to highly structured
and organised institutions like the Bombay Stock Exchange. All of these
h i
e
financial markets have similar core purposes despite their variances.
l
D
Whether official or informal, financial markets offer an environment for

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a variety of activities. They make it easier for investors to exchange and
transfer ownership of financial assets like stocks, bonds, currencies, and

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derivatives by facilitating the buying and selling of these products. Since

s i
the value of financial instruments is determined by supply and demand

e r
dynamics, these markets are also essential for price discovery.

i v
Financial markets also serve as an interface for capital allocation. By

U n
issuing stocks or bonds, businesses can obtain money that they can use
to grow their operations, support new initiatives, or settle debts. On the

L ,
other hand, investors looking for chances to increase their wealth might

O
deploy their funds among the many marketable assets.

/ S
Financial markets also support risk management and liquidity. Investors’

O L
ease of entry and exit promotes liquidity and promotes effective trading.
Additionally, they provide financial risk management and mitigation tools

/ C
like futures and options that may aid with price variations, currency

C Eexchange rate fluctuations, and interest rate changes.

D
Financial markets in India serve as key venues for trading, capital allocation,

©D
price discovery, liquidity provision, and risk management, contributing
to the operation and expansion of the Indian economy whether they run
through legal exchanges or unofficial networks:
‹ Price Setting: An ounce of gold or a piece of stock are only worth
what someone is willing to pay to buy them. Price discovery is a
technique that markets provide for determining the relative worth
of various items based on the prices at which buyers and sellers
are prepared to deal.

4 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
INTRODUCTION TO FINANCIAL MARKETS

‹ Asset Valuation: Market pricing is the most reliable method for Notes
determining the value of a business, its possessions, or its real
estate. This is important for both buyers and sellers of companies
as well as for regulators. For example, an insurer may appear strong
if it values its assets at the prices it purchased for them years ago,
but the relevant question for assessing its solvency is what prices
those securities may sell for if it needed money to pay claims right

i
then.
‹ Arbitrage: In countries with weak financial markets, commodities
l h
and currencies may trade at wildly divergent prices in different
regions. As traders attempt to profit from these differences, prices
D e
of
tend to converge, improving overall economic efficiency.

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‹ Raising Capital: Companies may require capital to expand their

i
operations through the acquisition of additional machinery, the
s
r
construction of new structures, or in other ways. Shares, bonds, and

e
v
other financial instruments make this feasible. People who wish to

n i
buy credit cards, homes, cars, and other things utilise the financial

U
markets as a source of capital.
‹

L ,
Commercial Transactions: In addition to long-term capital, the

O
financial markets provide the fluid necessary for various corporate

S
operations. This includes arranging up payment for the export of

L /
a product and providing working capital so a company can pay its

O
employees if customer payments are delayed.
‹
/ C
Investing: The opportunity to build up assets that will create income

C E
in the future as well as to raise the value of money that isn’t needed
right away is provided by the stock, bond, and money markets.
D
©D
‹ Risk Management: The possibility that a foreign currency will lose
value in comparison to the local currency before an export payment
is received is one risk that may be mitigated through contracts for
futures, options, and other derivatives. They also enable markets to
value risk, letting organisations and individuals to exchange risks
up until they only hold those they decide to hold.

PAGE 5
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 1.4 Types of Financial Markets

The two primary segments of a financial market are money markets and
capital markets. While the money market handles short-term loans, the
capital market handles medium and long-term financing.

Financial Market

h i
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Capital Market Money Market

D e
of
Primary Market Call Money

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Treasury Bills (T-Bills)

i
Secondary Market

r s Commercial Bills

v e
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Commercial Paper

, U Certificate of
Deposits (C.D)

O L
(A) Money Market

/ S
In the money market, financial instruments with maturities of up to one

O L
year are exchanged as short-term investments. The money market only
trades in credit instruments, not in cash or actual money, such as bills

/ Cof exchange, promissory notes, commercial paper, treasury bills, etc.

C E These financial items resemble money very much. The government, other

D
groups, and business divisions can borrow money more easily to meet

©D
their urgent requirements thanks to these methods.
The phrase “money market” does not relate to one specific market. It
rather refers to the complete networks of financial institutions that deal in
short-term financing and act as a market for lenders as well as a source
of supply for borrowers. Online, via fax, or over the phone, is how most
money market transactions take place. The Indian money market comprises
the Reserve Bank of India, commercial banks, cooperative banks, and
other specialised financial institutions. The Reserve Bank of India has
a monopoly on the Indian money market. A few Non-Banking Financial

6 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 INTRODUCTION TO FINANCIAL MARKETS

Companies (NBFCs) and financial institutions, such as LIC, GIC, UTI, Notes
etc., also use the Indian money market.
Money Market Instruments
Following are some of the important money market instruments or securities:
(i) Call Money: Call money is largely used by banks to meet their
short-term liquidity demands. Every day, they often lend and borrow
money from one another. It has a one- to two-week maturity period
and is instantly repayable. The interest rate levied on call money

h i
loans is referred to as the “call rate.”

e l
D
(ii) Treasury Bill: The RBI issues treasury bills as a promissory note

of
to meet the short-term financial requirements. Treasury notes are
highly transferable financial instruments, thus their owners may

ty
always sell them or ask the RBI for a reduction. Typically, these

i
banknotes are issued on discount to their face value and repaid for
s
r
that amount. The difference between the issue price and the face

e
v
value of the Treasury bill, then, stands in for the interest that was

i
generated on the investment. These bills are secured securities that
n
U
have a maximum 364-day maturity. In the market for Treasury bills,

,
banks, financial institutions, and businesses often play a significant
role.

O L
S
(iii) Commercial Paper: Commercial Paper (CP) is a common tool for

/
funding businesses’ need for operating capital. The CP is a promissory
L
O
note-based unsecured financial instrument. This tool was made

C
available to business borrowers in 1990 so they could raise short-

E /
term capital. It may be given for a time frame of between 15 days

C
and one year. Commercial papers are transferable by delivery and

D
endorsement. The leading players in the commercial paper sector

©D
are well-known firms, or “Blue Chip companies.”
(iv) Certificate of Deposit: A Certificate of Deposit (CD) is a financial
product offered by banks and credit unions that represents a time
deposit. It is a fixed-term investment where an individual or entity
deposits a specific sum of money with the financial institution for
a predetermined period, known as the maturity period or term. In
return for locking in their funds for this fixed period, the depositor
receives a higher interest rate than what is typically offered by
regular savings accounts.

PAGE 7
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes (v) Trade Bill: Typically, dealers use credit to purchase products from
manufacturers or wholesalers. After the credit term has expired, the
sellers get payment. However, if a seller doesn’t want to wait or
needs money right soon, they can create a bill of exchange in the
buyer’s favour. If the buyer accepts the bill, it becomes a negotiable
instrument and is referred to as a bill of exchange or trade bill. This
trade bill can now be discounted with a bank before it matures.
When the commodities reach maturity, the drawee, or the buyer
of the goods, pays the bank. When commercial banks accept trade

h i
e l
bills, the term “commercial bill” is used. Consequently, a trade bill
is a tool that enables the holder to temporarily access funds to meet
their working capital needs.
D
(B) Capital Market
of
ty
A capital market is a marketplace for medium- and long-term investments.

s i
It is an institutional arrangement that provides chances for borrowing

r
medium- and long-term money as well as selling and trading assets.
e
v
This means that it covers all long-term loans from banks and financial

n i
institutions, loans from other countries, and capital raising through the

U
issuing of a range of instruments, including shares, debentures, bonds,

,
and other securities.

O L
The exchange of securities takes place on the securities market. The
primary market and the secondary market are the two segments. The

/ S
secondary market, also known as the stock market or stock exchange,
L
provides a forum for the buying and selling of existing assets, whereas
O
C
the primary market, also known as the new issue market, deals with the

E /
new or fresh issuing of securities.

C
1. Primary Market

D The Primary Market is made up of agreements that make it easier for

©D
businesses to raise long-term capital by issuing new shares and debentures.
You are aware that firms issue new shares and/or debentures when they
first incorporate and, if necessary, later on for commercial development.
The typical method is private placement with friends, family, and financial
institutions or going public with the issue.
In any event, the firms must adhere to a strict legal process and work
with a variety of middlemen that are essential to the main market, such
as underwriters, brokers, etc. You might be aware of the various Initial
Public Offers (IPOs) that several public sector organisations, like SAIL,

8 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 INTRODUCTION TO FINANCIAL MARKETS

BHEL, CIL, and PGCIL, as well as private sector companies, like Maruti, Notes
Infosys Ltd., Jindal Ltd., and others have made.
2. Secondary Market
The secondary market, sometimes referred to as the stock market or
stock exchange, plays an equally essential role in mobilising long-term
finances by providing the necessary liquidity to holdings in shares and
debentures. It provides a site where these securities may be promptly

i
and conveniently cashed out. Shares and debentures are regularly traded
on an organised market with a high degree of security and transparency.
l h
In reality, a thriving secondary market contributes to the success of the
D e
of
primary market by providing investors with the confidence that there will
always be a market for the liquidity of their holdings.

ty
The main market is dominated by merchant bankers, mutual funds,

s i
financial institutions, and individual investors. All of these parties are

r
present in the secondary market, along with stockbrokers who participate
e
v
in the stock exchange and facilitate transactions.

n i
Market
, U
1.5 Distinction Between Primary Market and Secondary

O L
S
The primary market and the secondary market differ primarily in the
ways listed below:
L /
O
1. Function: The primary market is where new securities (stocks,

C
/
bonds, etc.) are issued and sold for the first time by companies or

C E
governments to raise capital, while the secondary market is where
existing securities are bought and sold among investors.

D
©D
2. Participants: In the primary market, the majority of participants are
financial institutions, mutual funds, underwriters, DIIs and individual
investors; in the secondary market, the majority of participants
in the secondary market include individual investors, institutional
investors, market makers, high-frequency traders, brokers, regulators,
and listed companies, facilitating the trading of existing securities.
3. Listing Requirement: The primary market has no such limitations,
in contrast to the secondary market, where only securities that have
been approved for the purpose (listed) may be exchanged.

PAGE 9
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 4. Determination of Prices: When it comes to the primary market,

the management sets the pricing while properly adhering to SEBI
requirements for newly issued securities. However, in the secondary
market, the price of the assets is decided by market factors such
as supply and demand, and it is always changing.

1.6 The Difference between the Capital Market and the

i
Money Market

l h
e
The capital market is very different from the money market:

D
1. The money market is associated with short-term cash, whereas the

of
capital market is linked to long-term finances.

ty
2. The money market deals with securities such as treasury bills,

i
commercial paper, trade bills, deposit certificates, and so on,

r s
whereas the capital market deals with shares, debentures, bonds,
and government securities.

v e
n i
3. Participants in the money market include the Reserve Bank of India,

U
commercial banks, non-banking financial institutions, etc. Participants

,
in the capital market include stockbrokers, underwriters, mutual

L
funds, financial institutions, and private investors.

O
S
4. The Reserve Bank of India (RBI) is in charge of the money market,

L /
while the Securities Exchange Board of India (SEBI) governs the

O
capital market.

/ C
E
1.7 Key Participants in Financial Markets

D C Numerous important players who are essential to the operation of the

©D
financial markets are present. The major players in the Indian financial
markets are listed below:
‹ Retail Investors: Retail investors are those who use their own money
to invest in the financial markets. Through brokerage accounts or
investing platforms, they may make investments in stocks, bonds,
mutual funds, and other financial instruments.
‹ Institutional Investors: Institutions like banks, insurance firms,
mutual funds, pension funds, and other sizable financial institutions

10 PAGE
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School of Open Learning, University of Delhi
INTRODUCTION TO FINANCIAL MARKETS

are examples of institutional investors. They manage substantial Notes

sums of cash in the financial markets and invest on behalf of their
customers or policyholders.
‹ Stock Exchanges: Two renowned stock exchanges in India are the
National Stock Exchange (NSE) and the Bombay Stock Exchange
(BSE). These exchanges provide trading platforms for stocks, other
securities, and derivatives. They support price determination and

i
ensure fair and open commerce.
‹ Regulators: Organisations like the Securities and Exchange Board
l h
of India (SEBI) and the Reserve Bank of India (RBI) oversee and
regulate the Indian financial markets. They establish structures and
D e
of
rules to ensure investor safety, market integrity, and stability.

ty
‹ Brokers and Depository Participants: Brokers facilitate the buying

i
and selling of securities by acting as a middleman between investors

s
r
and exchanges. To enable electronic ownership and settlement,

e
depository participants manage the dematerialization and transfer
v
of securities.
n i
U
‹ Clearing Corporations: Clearing firms, including the Indian Clearing

L ,
Corporation Ltd. (ICCL) and the National Securities Clearing
Corporation Ltd. (NSCCL), provides clearing and settlement services.

S O
They manage risk, preserve the integrity of financial dealings, and

/
guarantee the quick and simple settlement of trades.
L
O
‹ Credit Rating Agencies: The creditworthiness of issuers and their

/ C
debt instruments is evaluated by credit rating organisations like

E
CRISIL, ICRA, and CARE. They rate securities according to the

D C
issuer’s capacity to pay debts, giving investors information about
the level of risk involved in a given security’s investment.

©D
‹ Market Intermediaries: Merchant banks, investment banks,
stockbrokers, and financial consultants are examples of market
intermediaries. They help issuers, investors, and market players in
a variety of financial operations by providing a range of services
such as underwriting, consulting, and research.
‹ Non-Banking Financial Companies (NBFCs): In contrast to
conventional banking practices like accepting deposits, NBFCs

PAGE 11
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes offer banking services and financial products. They are important
in extending loans, particularly to groups who are not well-served
by conventional banks.
‹ Issuers: Companies, governments, and other organisations that provide
securities on the financial markets are referred to as issuers. To
finance their operations or initiatives, they raise cash by issuing
stocks, bonds, and other debt instruments.

i
These crucial players support the development, efficiency, and liquidity of

l h
the Indian financial markets, assuring the efficient operation of investment
and capital allocation operations.

D e
1.8 Factors that Influence the Supply andf Demand of
o
ty
Financial Assets

s i
r
The supply and demand of financial assets in the markets are influenced

e
by a variety of factors. These factors can be broadly categorized into two
v
i
groups: macroeconomic factors and market-specific factors:

n
U
A. Macroeconomic Factors:

L ,
(a) Economic Growth: The supply and demand of financial assets are
significantly influenced by India’s overall economic growth. Increased

S O
investment possibilities and a higher demand for financial assets

L /
are frequently effects of higher economic growth.

O
(b) Inflation: The purchasing power of investors and individuals is

C
E/
impacted by the inflation rate. When there is significant inflation,
investors start to look for bigger returns, which might raise the

D C demand for financial assets.

D
(c) Monetary Policy: The Reserve Bank of India’s (RBI) guidelines for

©
interest rates, liquidity, and credit availability directly affect the
dynamics of supply and demand for financial assets. Interest rate
changes affect borrowing costs and the allure of various financial
products.
(d) Fiscal Policy: The general status of the economy and investor
sentiment are impacted by government tax, spending, and budget
deficit policies, which in turn affect investor sentiment and the
demand for financial assets.

12 PAGE
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School of Open Learning, University of Delhi
 INTRODUCTION TO FINANCIAL MARKETS

(e) Exchange Rates: Exchange rate fluctuations have an effect on how Notes
appealing financial assets with different currency values are. Changes
in exchange rates may have an impact on foreign investors’ decisions
to buy Indian financial assets.
B. Market-Specific Factors:
(a) Investor Sentiment: The perception of past, present, and future market
circumstances by market players, as well as their risk tolerance, can

i
have a big influence on the demand for financial assets. Demand
frequently rises when people are feeling well, but demand might
l h
fall when people are feeling bad.

D e
of
(b) Corporate Performance: The demand for their stocks and other
financial assets is strongly impacted by the financial success of

ty
firms listed on the stock market. Increased earnings and dividends
are examples of strong company performance that can draw in

s i
r
investors and boost demand.

v e
(c) Regulatory Environment: The supply and demand of financial

n i
assets may be impacted by regulations put in place by regulatory

U
agencies like the Securities and Exchange Board of India (SEBI).

L ,
Regulation changes, such as the easing or tightening of investment
requirements, can affect investor behaviour.

S O
(d) Market Liquidity: Supply and demand for financial assets are

L /
influenced by how simple it is to purchase and sell them on the

O
market. More investors are attracted to markets with higher liquidity,

/ C
which increases demand.

C E
(e) Global Factors: The demand for financial assets in India may be
impacted by foreign market movements, geopolitical developments,

D
and global economic conditions. The amount of money flowing

©D
into Indian financial assets may be influenced by variables such as
international interest rates, commodity prices, and investor perception
of emerging economies.
Financial asset supply and demand are fluid and subject to the combined
effects of various factors. The interaction of these variables affects investor
behaviour and general market conditions in the Indian financial markets.

PAGE 13
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 1.9 Derivatives

Derivatives are financial agreements whose value is derived from underlying
assets like stocks, bonds, commodities, currencies, or market indices. These
contracts’ value is derived by changes in price, interest rates, or other
factors related to the underlying asset. Derivatives are essentially financial
tools that let traders and investors speculate on or protect themselves
against future price changes or hazards in the underlying asset without
actually owning the asset.

h i
Typically, there are four primary categories of derivatives:
e l
D
‹ Futures Contracts: Futures contracts are standardised contracts to buy

of
or sell a product at a specified price (the futures price) on a given
future date. In order to profit from anticipated price fluctuations,

ty
they are widely employed for speculation or hedging.
‹

s i
Options Contracts: Options contracts provide the holder the opportunity,

r
but not the duty, to buy (call option) or sell (put option) the underlying
e
v
asset at a certain price (the strike price) within a predefined time

n i
frame. Options provide flexibility and may be used for many different

U
strategies, including hedging, speculating, and making money.
‹

L ,
Swaps: Swaps are contracts that two parties enter into to exchange
cash flows or other financial instruments under predefined conditions.

S O
The most common type of interest rate swaps involves parties

L /
exchanging fixed and variable interest rate payments in order to
lower interest rate risk.

C O
Forward Contracts: Forward contracts are tailored agreements
/
‹

E
between two parties to buy or sell a certain item at a specific price

C
at a later time. In contrast to futures contracts, forward contracts

D
are frequently arranged in secret and are not traded on exchanges.

©D
In the financial market, derivatives are used for risk management,
speculation, hedging, and arbitrage. They provide market players the
ability to control their exposure to price swings, access possibilities for
leveraged investments, and customize financial instruments to meet their
unique needs.
Derivatives can be useful instruments, but they also come with hazards,
such as market volatility, counterparty risk, and the possibility of
significant losses. When working with derivatives, proper comprehension,
risk management, and regulatory monitoring are crucial.

14 PAGE
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 INTRODUCTION TO FINANCIAL MARKETS

1.10 Types of Derivatives Notes

We now know that the underlying asset, index, rate, or benchmark

determines the value of financial products referred to as derivatives.
They are contracts between two or more parties that let them trade on
different financial markets, control risks, and make predictions about price
movements without actually owning the underlying assets. With the use
of derivatives, traders and investors may tailor their investment strategies
to meet their unique requirements and market expectations.
h i
There are four main types of derivatives:
e l
1. Forwards: Forwards are customised contracts that require two parties
D
of
to buy or sell an item at a specific price at a future date. Let’s take
a hypothetical situation between a farmer and a food processing
business in India into consideration:
i ty
r s
Illustration: A forward contract for the sale of 1,000 kilograms of

e
wheat at Rs. 2,000 per kilogramme after six months is signed by a

v
n i
farmer cultivating wheat in India and a food processing firm. The
ability to lock in the price and quantity of wheat through a forward

, U
contract benefits both parties by giving the farmer pricing certainty

L
and the food processing industry supply assurance.

O
2. Futures: Futures contracts are standardised arrangements to buy or
S
L /
sell a product at a specified price at a later time. They are often
traded on exchanges, and the contract terms are standard. Let’s have

C O
a look at an illustration employing stock index futures:

E /
Illustration: An Indian investor predicts a surge in the stock market

C
during the next three months. He makes the decision to purchase

D
one Nifty 50 futures contract, which is equal to 50 units of the

©D
Nifty 50 index. The investor signs the contract, which has a three-
month expiration date and costs Rs. 15,000 per index point. The
investor would benefit by Rs. 200 (200 points × Rs. 1 per point)
each contract if the Nifty 50 index rose by 200 points at the time
of expiration.
3. Options: Options contracts provide the holder the opportunity, but not
the obligation, to buy (call option) or sell (put option) an underlying
asset at a certain price within a specified timeframe. Let’s have a
look at a stock option example:

PAGE 15
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Illustration: An investor in India who holds stock in a corporation

seeks protection against any downside risk. He buys put options with
a strike price of Rs. 1,000 per share and a month-long expiration
period on the company’s shares. If the share price falls below
Rs. 1,000 during the month, the investor can exercise the put option,
selling the shares at the higher strike price and minimising his losses.
4. Swaps: Agreements between two parties to exchange cash flows or

i
other financial instruments in line with predefined terms are known

l h
as swaps. Let’s take an interest rate swap in the context of India.

D e
Illustration: An Indian firm that has borrowed money at a variable
interest rate would rather have a fixed rate to reduce interest rate risk.

of
With a financial institution, the corporation enters into an interest rate
swap. In this swap, the firm agrees to pay the financial institution a

i ty
fixed interest rate of 7% while the financial institution promises to

r s
pay the company a variable interest rate that is determined by the

e
current market rate. The swap effectively changes the company’s

v
i
floating-rate obligation into a fixed-rate liability.

U n
These varied derivatives provide a range of methods and instruments to

,
control risks, predict price changes, increase investment returns, and meet

L
certain financial goals.

O
/ S
1.11 Underlying Assets of Derivatives

O L
Derivatives may be based on a variety of underlying assets. Some underlying

/ C
assets commonly used in derivatives trading are discussed below:

CE
1. Commodities: Due to India’s robust agricultural and industrial

D
industries, commodity derivatives are common. Gold, silver, crude

© D oil, natural gas, agricultural products (wheat, rice, cotton), and base
metals (copper, aluminium, and zinc are examples of commodities
that can be used as the foundation for derivatives. Market participants
have the chance of hedging against price volatility and speculating
on price swings thanks to commodity derivatives.
Illustration: Due to the unpredictability of the world economy, an
investor in India anticipates a rise in gold prices in the upcoming

16 PAGE
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School of Open Learning, University of Delhi
INTRODUCTION TO FINANCIAL MARKETS

months. They buy a gold futures contract that has actual gold as its Notes
underlying asset. Without holding any real gold, the investor can
benefit from a gain in the price of gold if it rises as predicted.
2. Stocks and Indices: A lot of derivatives are exchanged that are
dependent on certain equities or stock indexes. The National Stock
Exchange (NSE) and the Bombay Stock Exchange (BSE) both
provide derivatives contracts on both individual stocks and indices

i
like the Nifty 50 and the Sensex.
Illustration: A trader anticipates the price of a specific stock to
l h
rise because he feels it is undervalued. He has the choice to buy
call options on the stock, which allow them the right to buy the
D e
of
underlying shares within a specified time frame and at a specified
price. If the stock price rises over the strike price, the trader can

i ty
exercise the call option and benefit from the price difference.

r s
3. Bonds and Interest Rates: Bond and interest rate derivatives are

e
crucial for controlling interest rate risks and speculating on interest
v
i
rate changes. Corporate and government bonds are used as the
n
U
underlying assets for derivative transactions. In the Indian debt

,
market, securities called Interest Rate Futures (IRFs) are often
traded.

O L
S
Illustration: An institutional investor with a portfolio of fixed-rate

/
bonds wants to hedge against the possibility that bond values would
L
O
fall as a result of projected interest rate increases. By exchanging

C
their fixed-rate bond cash flows for floating-rate cash flows based

E /
on an agreed-upon reference interest rate, he can participate in an

C
interest rate swap to lessen their exposure to interest rate risk.

D
4. Currencies: Market players can trade and speculate on the exchange

©D
rates between various currencies thanks to currency derivatives.
Derivatives contracts based on popular currency pairings including
USD/INR, EUR/INR, and GBP/INR are available on the currency
market in India.
Illustration: There are imminent payments in US dollars due from an
Indian corporation. In order to hedge against fluctuations in currency
exchange rates, the firm enters into a currency futures contract to sell
a specific number of USD/INR at a specified exchange rate. They

PAGE 17
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes can do this to lock in a good exchange rate and shield themselves
from possible losses brought on by unfavourable currency swings.

1.12 Characteristics of Derivatives

Derivative contracts have a number of essential qualities and elements
that determine their nature and usefulness. Let’s examine and assess a
few of these qualities:
1. Underlying Asset: The underlying asset for derivative contracts
h i
e l
might be a currency, stock, bond, commodity, index, or interest rate.

D
The underlying asset’s price changes or fluctuations determine the

of
derivative contract’s value and performance.
2. Leverage: With the use of derivatives, market participants may take

i ty
a greater stake in the market while making a comparatively smaller

r s
initial investment. Leverage raises the risks involved while also

e
boosting possible benefits. In derivatives, leverage may lead to

i v
significant losses. It is important to keep in mind that if the market

n
moves against the participant’s position.

U
,
3. Contract Specifications: Specific terms and conditions govern

O L
derivative contracts, defining their composition and responsibilities.
The kind of derivative (such as futures, options, or swaps), contract

/ S
size, expiry date, strike price (for options), and settlement mechanism

O L
are some examples of these criteria. The contract specifications
support trade on exchanges and guarantee standardisation.

/ C
E
4. Flexibility: In terms of risk management and investing techniques,

C
derivatives provide flexibility. Derivatives are a tool that market

D
players can utilise for a variety of purposes, including speculation,

©D
hedging, arbitrage, portfolio diversification, and creating customised
financial instruments. Numerous trading and risk management
methods may be used because of the variety of derivative instruments
available.
5. Risk and Volatility: Risks and market volatility are inextricably
linked to derivative contracts. The value of derivatives may vary
significantly as a result of changes in the price of the underlying
asset, interest rates, or other market factors. Participants face both

18 PAGE
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 INTRODUCTION TO FINANCIAL MARKETS

possibilities and hazards as a result of this volatility, which highlights Notes

the significance of developing risk management methods and being
aware of these risks before engaging in derivative trading.
6. Transferability & Liquidity: Participants can enter or exit positions
very readily due to the fact that derivative contracts are frequently
quite liquid and tradeable on exchanges. Market liquidity supports
effective price determination, smaller bid-ask spreads, and lower

i
transaction costs. Participants may efficiently manage their holdings

h
and put trading methods into practice thanks to liquidity.
7. Counterparty Risk: When employing derivatives, there is a danger that
e l
the counterparty, or other party to the transaction, won’t satisfy their
D
of
obligations. The dependence on the counterparty’s creditworthiness
and financial stability creates this risk. Participants should carefully

i ty
assess the counterparty’s creditworthiness and take risk-reduction

s
measures into consideration, such as employing central counterparties
r
e
or clearinghouses.

i v
8. Regulatory Oversight: In order to maintain stability, fairness, and

n
transparency, derivative markets are regulated. Regulatory authorities
U
,
impose rules and regulations to safeguard market integrity, protect

L
investors, and promote efficient functioning of derivative markets.

O
Compliance with regulatory requirements is crucial to maintain

/ S
market confidence and mitigate systemic risks.

O L
The nature and attributes of derivative contracts must be understood
well by market players. While engaging in derivative transactions, it is

/ C
crucial to properly manage risks, have a thorough understanding of the

E
underlying assets, and comply with regulatory requirements in order to
C
D
optimize potential rewards and limit hazards.

©D
1.13 Players in Derivative Market
The derivative market is a complex financial ecosystem with various
participants, each playing a distinct role in the buying, selling, and trading
of derivative instruments.
Here are descriptions of some of the key players in the derivative market:
1. Hedgers: These are people or organizations (such businesses, farmers,
or investors) who utilize derivatives to control or limit their exposure

PAGE 19
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes to changes in the price of an underlying asset. Derivatives are used

by hedgers to reduce risk and steady their financial positions. To
hedge against price volatility, a farmer, for instance, can utilize
futures contracts to fix a price for their crop.
2. Speculators: Traders that enter the derivatives market with the
primary objective of benefitting from price changes in the underlying
assets are known as speculators. They lack a natural interest in

i
the underlying asset, but they are prepared to take on risk in order
to profit from price swings. Leverage is a common tool used by
l h
e
speculators to boost possible profits (or losses) from their trading
tactics.
D
of
3. Arbitrageurs: The traders known as arbitrageurs look to make
money off of pricing differences or inefficiencies in related markets

i ty
or derivative contracts. To take advantage of price differences and

r s
generate risk-free returns, they simultaneously buy and sell comparable

e
assets or contracts. Arbitrageurs aid in regulating pricing on various

v
marketplaces.

n i
1.14 Advantages and U
,
Risks Associated with Derivatives

O L
There are certain advantages to using derivatives in risk management and

/ S
investing strategies along with certain hazards. Let’s investigate both facets.

O L
Advantages of using derivatives in investment and risk management
strategies:

/ C
E
1. Hedging: By establishing counterbalanced positions in the futures

C
market, derivatives enable investors to insure against prospective

D
losses. Futures contracts can be used by a business, for instance, to

© D protect itself from unfavourable changes in the price of a commodity

it depends on. The danger of price volatility may be reduced and
their profit margins can be guaranteed by doing this.
Illustration: ABC Ltd., manufactures electrical goods. Considering
how heavily the firm depends on imported components, any large
increase in the cost of such components might have a negative effect
on their profit margins. ABC Ltd. decides to employ derivatives
for hedging in order to reduce this risk.

20 PAGE
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INTRODUCTION TO FINANCIAL MARKETS

Step 1: Identify the Risk: The cost of the imported components is Notes
significantly impacted by variations in the international exchange
rate between the Indian Rupee (INR) and the US Dollar (USD),
according to ABC Ltd. The cost of importing the components will
rise as the INR appreciates versus the USD, thereby reducing their
profit margins.
Step 2: Implement the Hedge: ABC Ltd. makes the decision to

i
sign a futures contract in order to protect itself from the currency

l h
risk. They make a deal with a bank to sell USD at a certain rate

e
in the future. By doing this, they stabilise the currency rate and
shield themselves against any negative changes.
D
of
Step 3: Outcome Scenarios:

ty
(a) If the INR Gains Value in Relation to the USD: In this scenario,

i
the price of importing components will drop. The fact that

s
r
ABC Ltd. is required to sell USD at a lower exchange rate

e
means that they will lose money on the futures contract. Their
v
i
profit margins will be protected since the decreased component
n
U
costs will cover the loss on the futures transaction.

L ,
(b) If the INR Losses Value in Relation to the USD: In this
scenario, the cost of importing components will go up. But

S O
due to their ability to sell USD at a higher exchange rate,

/
ABC Ltd. will make money on the futures contract. They will
L
O
effectively hedge their risk and maintain their profit margins

C
since the gain from the futures contract will balance the higher

E /
component prices.

D C
ABC Ltd. significantly reduces the risk of currency fluctuations
by employing derivatives for hedging. Stability in their company

©D
operations is guaranteed since they are shielded from potential
losses in their profit margins if the INR appreciates against
the USD.
Note: While hedging might offer defence against some dangers, it
also comes with expenses like transaction fees and the possibility
of losses if the hedging plan does not exactly coincide with market
movements. Therefore, before employing such techniques, businesses
need to thoroughly evaluate the risks and expenses related to hedging.

PAGE 21
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 2. Speculation: Without actually holding the underlying asset, derivatives

provide investors the chance to speculate on price changes. Because
of this, they may benefit from both rising and declining markets.
An investor may, for instance, buy call options on equities if they
think the market will increase or put options if they think it will
fall.
Illustration: Raj, a private investor, predicts that the Indian stock

i
market would climb significantly during the next several months.

l h
He chooses to make a prediction on the price movement of a certain

e
stock, XYZ Ltd., based on his analysis and market research.

D
Step 1: Speculation Strategy: Raj chooses to purchase call options

of
on XYZ Ltd. stock. He is granted the option, but not the obligation,
to buy the shares by the expiration date at the stipulated strike
price.
i ty
r s
Step 2: Execution: Raj gets in touch with his broker and buys call

e
options on XYZ Ltd. with a 500 INR strike price and a one-month
v
i
expiration date. Each contract for a call option corresponds to 100
n
U
shares.

,
Step 3: Outcome Scenarios:

L
O
(a) In the event that XYZ Ltd.’s stock price rises: Let’s say

S
that within a month, XYZ Ltd.’s stock price increases from

L /
INR 480 to INR 550. Raj may now acquire the shares at

O
the specified strike price of INR 500 by exercising his call

/ C options. Afterwards, he may resell the shares on the open

E
market for INR 550, creating a profit of INR 50 per share

D C (550 - 500). 100 shares are represented by each call option,

hence his overall profit would be INR 5,000 (100 shares *

©D
INR 50).
(b) If the Stock Price of XYZ Ltd. Remains Below the Strike
Price: If the stock price does not rise over the strike price of
INR 500 throughout the month, Raj has the choice of choosing
not to activate the call options. In this instance, his potential
loss is capped by the call option premium. Simply letting the
options expire worthless would restrict his loss to the price
paid.

22 PAGE
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INTRODUCTION TO FINANCIAL MARKETS

Raj has the chance to maybe make money by betting on the Notes
price movement of XYZ Ltd. via call options if his market
analysis is accurate. The premium for the options he purchased
represents a limited loss if the stock price does not increase
as expected.
Note: Compared to other investing techniques, speculating has a
higher level of risk. Speculators are aware that losses might result

i
from their forecasts coming true. The market must be thoroughly
understood, extensive study must be done, and probable losses must
l h
e
be anticipated by those who engage in speculative activity.
3. Enhanced Portfolio Performance: The usage of derivatives can
D
of
increase portfolio returns and diversify risk. Investors can increase
their exposure to other asset classes and market areas by adding

i ty
derivatives into their investment plans. This may enhance their
portfolio’s risk-return profile.
r s
e
Illustration: Priya is an investor with a well-diversified portfolio of
v
i
stocks, bonds, and cash. She thinks that increasing her portfolio’s
n
U
exposure to the Indian equities market will improve its performance.

,
However, Priya chooses to employ index derivatives as opposed to

L
directly purchasing individual equities.

O
S
Step 1: Objective: Gaining exposure to the total performance of the

/
Indian equities market, as reflected by a reference index like the
L
O
Nifty 50, is Priya’s goal.

/ C
Step 2: Implementing the Strategy: Priya makes the decision to

E
purchase index futures contracts. Due to the fact that they draw

D C
their value from the performance of the underlying benchmark
index, these futures contracts provide investors with broad market

©D
exposure.
Step 3: Outcome Scenarios:
(a) The Indian Equity Market Rises: Let’s say the Nifty 50
index sees a big rise in price. Priya’s portfolio will profit
from the index’s upward trend because she bought in index
futures. The gains from the futures contracts will raise her
portfolio’s overall performance.

PAGE 23
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes (b) The Indian Equity Market Declines: Priya’s investment

portfolio would suffer if the Nifty 50 index declines. However,
compared to holding individual companies, the impact will
be considerably lessened as the losses on the index futures
would somewhat offset the losses in her portfolio.
Priya increases her exposure to the performance of the larger
equity market without directly owning specific stocks by

i
introducing index futures into her portfolio. Her use of this

l h
tactic enables her to profit from market trends as a whole

e
while potentially spreading her risk across multiple industries
and businesses.
D
of
Note: Derivatives come with hazards even if they might improve
portfolio performance. Losses may result from unpredictable occurrences,

i ty
market volatility, and faulty projections. Therefore, before introducing

r s
derivatives into their investing strategy, investors should carefully

e
analyse their risk tolerance, do extensive research, and consider

v
i
expert guidance.

U n
4. Efficient Capital Allocation: Compared to direct ownership, derivatives

,
provide investors access to a certain market or asset class with a

O L
lower initial outlay. This allows for effective capital allocation and
offers leverage to boost prospective profits. Leverage raises the

/ S
possibility of losses, but it’s crucial to remember this as well.

O L
Illustration: Rahul, an investor, desires exposure to a certain industry

C
on the Indian stock market, such as the banking industry. He doesn’t

/
CE
have enough money to buy certain banking stocks though.
Step 1: Objective: Rahul wants to obtain exposure to the performance

D D of the banking industry without purchasing specific banking companies.

©
Step 2: Implementing the Strategy: Rahul decides to invest in
contracts for index options. He specifically buys call options on
the Nifty Bank index, which gauges the health of India’s banking
industry.
Step 3: Outcome Scenarios:
(a) The Banking Industry Succeeds Well: Assume that the
Nifty Bank index increases and the banking industry expands

24 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 INTRODUCTION TO FINANCIAL MARKETS

significantly. Rahul has the opportunity to execute his call Notes

options in this situation and benefit from the rise in the index’s
value. He may benefit from the performance of the banking
industry by using the gains from his options contracts without
having to make a sizable investment in certain equities.
(b) The Banking Industry Performs Poorly: Rahul’s call options
can become worthless if the banking industry declines. In this

i
situation, the most he may lose is the premium he paid for
the options contracts. However, compared to directly investing
l h
e
in individual banking stocks, his overall loss would be less
as his capital allocation was more effective utilising options.
D
of
Rahul effectively directs his limited cash to the banking sector’s
performance by employing index options. As opposed to direct

i ty
ownership of individual equities, he can profit from prospective
market changes with a lower initial outlay.
r s
e
Note: Utilising derivatives effectively requires a grasp of the risks
v
i
involved and the careful selection of suitable contracts. When
n
U
employing such techniques, investors need also take into account

,
elements like liquidity, transaction costs, and market circumstances.

O L
Effective and effective capital allocation depends on expert guidance
and a deep grasp of derivative products.

/ S
Risks associated with using derivatives in investment and risk management
strategies:
O L
/ C
1. Counterparty Risk: Contracts for derivatives are frequently made

E
with counterparties, and there is a chance that the counterparty will

D C
break its promises. This risk is especially severe in over-the-counter
(OTC) derivatives markets when contracts are not exchange-traded.

©D
It is crucial to properly assess counterparties’ creditworthiness and
financial health.
2. Market Volatility: Derivatives are susceptible to market changes
and are prone to large price swings. Rapid market fluctuations may
result in unforeseen losses or gains, particularly if the fundamental
assumptions upon which the derivatives are built turn out to be
incorrect.

PAGE 25
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 3. Liquidity Risk: It can be difficult to acquire or sell certain derivatives

fast without generating significant price changes, especially if they
are complicated. This is because some contracts may have restricted
liquidity. Due to this, it may become difficult to alter or exit holdings
at desired prices, which might result in losses.
4. Regulatory and Legal Risks: The trading and pricing of derivatives
can be affected by changes in laws or regulations since the markets
for derivatives are governed by them. To avoid penalties and maintain
fair market practises, regulations must be followed.
h i
e
Since the National Stock Exchange (NSE) was founded and a variety of l
D
derivative products, including stock futures, options, and index derivatives,

of
were introduced, derivatives have grown in popularity. These tools have
made risk management easier and given people the chance to speculate

ty
and engage in arbitrage. To prevent excessive exposure or possible losses,

s i
it is crucial for investors and market participants to fully comprehend the

e r
risks associated with using derivatives and to utilise them responsibly.

i v
n
1.15 Forwards and Futures
U
L ,
Forwards: A “forward” is a type of derivative contract that obligates the
parties to buy or sell an asset at a defined price and on a specific future

S O
date. Let’s examine the idea of forwards using examples:

L /
Illustration 1: Agricultural Commodity Forward Contract

O
Let’s say there are two parties: a farmer and a business that processes

C
E /
food. While the food processing business needs a specific amount of wheat
to satisfy its production requirements, the farmer anticipates harvesting a

D C sizable amount of wheat in three months. They sign a forward agreement.

D
Contract Terms: The farmer consents to provide the food processing

©
firm with 1,000 bushels of wheat for a price of INR 1,000 per bushel
over a three-month period.
Execution: Both parties formally agree to complete their responsibilities
under the forward contract on the date stated, which is three months after
the contract’s start date.
Outcome: Let’s say that three months later, the market price of a bushel
of wheat has increased to INR 1,200. In this instance, the forward contract
helps the food processing industry since it allows it to purchase wheat

26 PAGE
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School of Open Learning, University of Delhi
 INTRODUCTION TO FINANCIAL MARKETS

for INR 1,000 per bushel, saving INR 200 per bushel above the going Notes
market rate.
Illustration 2: Currency Forward Contract
Consider a situation where Indian business ABC Ltd. wants to import
machinery from the US and has to change Indian Rupees (INR) into
US Dollars (USD) to complete the payment. ABC Ltd. signs a currency
forward contract with a bank to lessen the risk of currency swings.
Contract Terms: ABC Ltd. promises to convert INR 10,00,000 into USD
h i
at a rate of 1 USD = INR 70 over the course of three months.
e l
D
Execution: The currency forward contract is signed, and both parties

of
agree to meet their responsibilities three months after the contract’s start
date, which is indicated in the contract.

ty
Outcome: Let’s say that after three months, the exchange rate is now

s i
1 USD = 75 INR. As a result of the forward contract, ABC Ltd. in this

e r
instance is able to purchase USD for INR 70, saving INR 5 per USD
compared to the current exchange rate.
i v
U n
In both examples, the parties to the forward contracts are responsible
for carrying out their commitments, regardless of the state of the market

L ,
at the time of the contract’s expiration. In contrast to exchange-traded

O
derivatives, which are standardised, forwards are frequently tailored

/ S
contracts that are negotiated over-the-counter (OTC).

O L
As the contract depends on the financial security and creditworthiness
of the associated counterparties, they provide flexibility but also expose

/ C
the parties to counterparty risk.

C E
Futures: Futures are standardised derivative contracts that require the

D
buyers and sellers of an asset to transact at a pre-set price and date in

©D
the future. Let’s examine the idea of futures using examples:
Illustration 1: Equity Index Futures
Ravi, an investor, wants to be exposed to the performance of the Nifty
50 index, which represents the Indian stock market. Utilising equities
index futures contracts is his choice.
Contract Terms: One Nifty 50 futures contract, which is equivalent to
a specific amount of the Nifty 50 index, is bought by Ravi.

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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Execution: A reputable exchange, like the National Stock Exchange

(NSE), is where the futures contract is exchanged. Ravi undertakes to
complete his commitments on the contract’s expiration date and purchases
the futures contract at the going market rate.
Outcome: Consider a scenario in which the Nifty 50 index has grown
by 500 points by the expiration date. Ravi’s futures contract would have
increased in value in this scenario, and he might sell the contract for
a profit. The profit would be determined by the rise or decrease in the
index value multiplied by the volume of the contract.
h i
Illustration 2: Commodity Futures
e l
D
Priya Jewels, a jewellery maker, requires a particular amount of gold to

of
satisfy its production demands. Priya Jewels chooses to employ commodities
futures contracts as a hedge against the possibility of rising gold prices.

ty
Contract Terms: A gold futures contract is bought by Priya Jewels for

s i
a specific amount of gold at a predetermined price.

e r
Execution: Trading for the futures contract takes place on a commodities

i v
market, such as the Multi Commodity market (MCX). Priya Jewels

U n
purchases the futures contract, specifying the price at which the gold
will be purchased, and avers that she will carry out her responsibilities

,
when the contract expires.
L
O
Outcome: Let’s say gold is now worth more on the market at the date

/ S
of expiration. In this situation, Priya Jewels may sell the futures contract

L
in the market for the previously agreed-upon amount to offset the rise in

O
the price of gold. Due to this, Priya Jewels may buy gold for less money

/ C
than the going rate on the market.

C EBoth examples use futures contracts, which are available to market

participants since they are standardised and traded on established

D exchanges. They offer an easy approach for investors to diversify their

©D
exposure to other asset classes and give them the opportunity to bet on
market movements, hedge against price volatility, or improve portfolio
performance. When compared to over-the-counter (OTC) derivatives,
futures contracts also provide liquidity, transparency, and centralised
clearing, lowering counterparty risk.
Note: Leverage is a component of futures trading that may compound gains
and losses. Trading futures contracts requires rigorous risk management
consideration as well as a full grasp of the underlying asset and market
dynamics.

28 PAGE
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 INTRODUCTION TO FINANCIAL MARKETS

1.16 Similarities between Forwards and Futures Contracts Notes

Futures and forwards contracts are both derivative financial transactions,

with several similarities:
1. Purpose: Forward and futures contracts are employed to manage risk,
hedge holdings, and forecast the value changes of the underlying
assets.

i
2. Contract Structure: In these agreements, two parties agree to acquire
or sell a product at a certain price on a given future date.
l h
3. Underlying Assets: Forwards and futures contracts can be based on a
wide range of underlying assets, including commodities, currencies,
D e
of
equities, interest rates, and more.

ty
4. Price Determination: The pricing of both contracts is influenced by

i
the underlying asset’s current price, interest rates, the time before
s
expiration, and market expectations.

e r
v
5. Volatility: Both forward and futures contracts offer a way to lock

n i
in pricing or positions in advance, which may be utilised to control
and reduce volatility risk.

, U
L
6. Margin Requirements: To assure performance and reduce counterparty

O
risk, both contracts often call for an initial margin or collateral from
both parties.
/ S
O L
7. Contract Expiration: Forward and futures contracts both have certain
expiration dates by which the contract’s obligations must be met.

/ C
8. Settlement Methods: According to the terms of the agreements and

C E
the desires of the parties, any contract may be paid by physical

D
delivery or monetary settlement.

©D
9. Risk Management: With the use of forward and futures contracts,
market participants may manage a number of risks, such as price
risk, interest rate risk, currency risk, and more.
10. Market Access: Both forward and futures contracts give market
players access to a variety of assets and marketplaces, enabling
them to take part in different industries and geographical areas.

PAGE 29
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Although forwards and futures contracts have certain similarities, it’s
crucial to remember that they also differ significantly from one another,
as was covered in the preceding answer. Standardisation, exchange trading,
counterparty risk, liquidity, and flexibility are the main areas of variation.

1.16.1 Differentiation between Forwards and Futures

Contracts

h i
l
S. No. Forward Contracts Future Contracts
1.
e
Forwards are flexible contracts that Futures contracts are standardized,

D
may be adapted to the particular which refers to the fact that they

of
requirements of the parties. contain established contract details
including contract size, delivery

ty
date, and location.
2.
i
Without the use of an exchange, Futures contracts are traded on

s
r
forwards are traded over-the-counter regulated exchanges where standard
(OTC) between two parties.

v e contracts are purchased and sold,

i
such as commodities exchanges or

n
stock exchanges.
3.

, U
The contracts in forwards are made
directly between the two parties,
The exchange serves as the mid-
dleman in futures transactions,

O L
the counterparties’ creditworthiness
becomes more important.
acting as the counterparty for
both buyers and sellers. As the

/ S exchange ensures that the contracts

O L will be performed, this lowers

counterparty risk.

/
4.
C Forwards contracts are OTC con- Futures contracts are traded on

C E tracts and not traded on a cen-

tralized platform, they may have
regulated exchanges with central-
ized markets that make it simple

D less liquidity. to purchase and sell them, they are

©D
more liquid than forward contracts.
5. Since each forward is separately Due to their exchange-based trading,
negotiated and is the result of futures contracts offer clear and
discussions between the parties, accessible pricing information. As
forward price discovery may be a result, figuring out the current
less transparent. market price is much simpler.

30 PAGE
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 INTRODUCTION TO FINANCIAL MARKETS

S. No. Forward Contracts Future Contracts Notes

6. Forwards provide more flexibility Futures contracts have less flex-
since they may be customized to ibility because the terms of the
meet particular demands, letting the contract are established due to
parties choose their own delivery their standardization.
dates and contract amounts.
7. There are no daily mark-to-market Futures contracts are subject to
settlements for forward contracts, daily mark-to-market settlement,
and gains and losses are only in which profits or losses are

h i
l
realized upon contract expiration. recognized each day in accor-
dance with the movement of the
contract’s price. Participants can
D e
of
simply enter or exit positions as
a result, helping to control risk.

ty
Upfront margin is required in futures whereas no initial margin is paid
forward.
s i
e r
1.17 Mechanics of Forward Contracts
i v
U n
Forward contracts are agreements between two parties for the purchase

L ,
or sale of an underlying asset at a specified price (the forward price) on
a given future date. The steps involved in a forward contract’s mechanics
are as follows:
S O
L /
1. Agreement: The underlying asset, forward price, contract size,

O
delivery date, and any other pertinent parameters are all agreed upon

C
/
by the two parties (seller and buyer) before the forward contract

C E
is executed. To suit the parties’ unique requirements, the contract
is often modified.

D
©D
2. Pricing: Negotiations between the buyer and seller decide the future
price. It considers elements including the underlying asset’s current
spot price, the remaining time before expiration, interest rates,
storage costs, and other important market elements.
3. Settlement: Unlike futures contracts, forward contracts do not require
daily mark-to-market settlements. Instead, settlement takes place
on the day when the contract expires. The seller then delivers the
underlying asset when the buyer has paid the agreed-upon advance
price to the seller.

PAGE 31
© Department of Distance & Continuing Education, Campus of Open Learning,
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 4. Delivery: There are two possible delivery outcomes in forward

contracts:
(a) Physical Delivery: The seller physically delivers the underlying
item to the buyer. For instance, in a commodities forward
contract, the seller may deliver the commodity to the buyer’s
selected location in the amount indicated. The underlying
shares in an equity forward contract may be moved from the

i
seller’s demat account to the buyer’s account.

l h
(b) Cash Settlement: Cash settlement is a different option, in which

D e
the buyer and seller exchange the price difference between
the forward price and the current spot price at the moment of

of
settlement. Financial forward contracts like currency forwards
or stock index forwards frequently employ cash settlement.

i ty
Illustration: Company A seeks to insure against the price of crude oil.

r s
With Company B, a producer of crude oil, it enters into a forward contract:
‹

v e
Agreement: A crude oil forward contract between Companies A and

i
B is reached for the delivery of 1,000 barrels of crude oil over the
n
U
course of three months. The forward price for a barrel is set at

,
INR 5,000.
‹

O L
Pricing: According to market conditions, supply and demand dynamics,
anticipated future crude oil prices, and other pertinent criteria, the

/ S
forward price is negotiated.
‹

O L
Settlement: When the contract expires three months later, Company

C
A pays Company B INR 5,000 per barrel, and Company B then

E / provides Company A with the 1,000 barrels of crude oil.

D C ‹ Delivery: In this instance, there is a physical delivery and Company

B moves the crude oil to the specified location for Company A.

©D
Company A has effectively reduced its exposure to fluctuations in the
price of crude oil by participating into the forward contract. By fixing
the purchasing price, it has reduced the chance of price swings.

1.18 Mechanics of Future Contracts

Futures contracts are standardised agreements to purchase or sell an
underlying asset at a defined price (the futures price) on a predetermined
date in the future.

32 PAGE
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 INTRODUCTION TO FINANCIAL MARKETS

The following steps are involved in how futures contracts work: Notes
1. Standardization: The contract size, delivery date, place, and other
parameters like quantity per lot are all standardized in futures
contracts, along with other terms. The exchange where the futures
contract is traded sets these requirements.
2. Pricing: The open market transaction between buyers and sellers
establishes the futures price. With factors like supply and demand,

i
interest rates, storage costs, and market sentiment taken into
consideration, it represents what the market feels the underlying
l h
asset will be worth in the future.

D e
of
3. Trading: Futures contracts are traded on renowned exchanges like
the National Stock Exchange (NSE) and the Multi Commodity

ty
Exchange (MCX), where buyers and sellers may create positions by

i
purchasing or selling contracts. The exchange serves as a middleman,

s
r
making trade easier.

v e
4. Margin Requirements: Participants are required to deposit an initial

n i
margin with their broker in order to trade futures contracts. Initial

U
margin serves as collateral to protect against any losses. To ensure

L ,
the sufficiency of their margin account, participants might also need
to maintain a maintenance margin level.

S O
5. Mark-to-Market Settlement: Mark-to-market is applied to futures

L /
contract settlement every day. At the end of each trading day, the

O
price change of the underlying asset is used to calculate the profits

/ C
or losses on the contract. The winning party receives the difference

E
from the loser party, and any gains or losses are resolved in cash.

D C
6. Delivery: The majority of futures contracts are paid by cash settlement,
meaning that the underlying product is not physically delivered. As

©D
an alternative, the contract is terminated prior to the delivery date,
and the price difference is paid in cash. Physical delivery, though it
is somewhat uncommon in practise, may be conceivable for some
contracts, such as commodities futures.
Illustration: Raj, an investor, wants to make predictions about the Nifty
50’s price movement, which serves as the industry standard for the Indian
stock market.

PAGE 33
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes ‹ Standardization: Raj buys a single Nifty 50 futures contract from

the NSE. Each contract is worth a certain amount of the Nifty 50
index.
‹ Pricing: Based on supply and demand, the market determines the
futures price of the Nifty 50 contract. It represents the estimated
future value of the Nifty 50 index.
‹ Trading: Raj purchases the Nifty 50 futures contract at the current

i
market price to open a long position. A second trader who anticipates

l h
a drop in the Nifty 50 index starts a short position by selling the
futures contract.

D e
of
‹ Mark-to-Market Settlement: The value of the futures contract is
marked-to-market at the conclusion of each trading day based on

ty
the Nifty 50 index’s closing price. Raj’s margin account will be

i
rewarded with a profit if the contract has appreciated in value. On

s
r
the other hand, Raj must use funds from his margin account to

e
cover losses if the contract has suffered a loss.
v
‹

n i
Delivery: Since Nifty 50 futures contracts are primarily cash-settled,

U
the underlying index is not really delivered. Raj might close out

L ,
his investment and take advantage of any gains or losses by selling
the futures contract before it expires.

S O
Raj may gain from the price changes of the Nifty 50 index without

L /
holding the underlying equities by trading Nifty 50 futures. Due to their

O
standardised structure and exchange-based trading, futures contracts

/ C
provide liquidity, convenience of trade, and transparent price discovery.

C E1.19 Role of Futures Exchanges and Clearing Houses

D
©D
By offering a centralised market, assuring counterparty risk reduction,
and preserving market integrity, futures exchanges and clearing houses
play critical roles in enabling futures trading.
Role of Futures Exchanges
The organized trading of standardized futures contracts takes place on
futures markets. Their roles include:
‹ Price Discovery: Exchanges offer a clear and effective setting for
buyers and sellers to deal with each other, leading to a clear and

34 PAGE
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 INTRODUCTION TO FINANCIAL MARKETS

open price discovery process. The interplay between supply and Notes
demand has an impact on futures pricing.
‹ Standardization: Exchanges offer a clear and effective setting for
buyers and sellers to deal with each other, leading to a clear and
open price discovery process. The relationship between supply and
demand affects the pricing of futures.
‹ Market Access: Access to a broad variety of fundamental assets,

i
such as commodities, shares, interest rates, and currencies, is made
possible via exchanges. This enables market players to broaden their
l h
exposure to different industries and diversify their holdings.

D e
of
‹ Regulatory Oversight: The regulatory oversight of exchanges is the
responsibility of pertinent organisations, such as the Securities and

ty
Exchange Board of India (SEBI) in the case of Indian exchanges.

i
Market integrity, ethical trading practices, and investor protection

s
r
are all supported by regulatory monitoring.
Illustration - Role of NSE:
v e
n i
One of India’s top exchanges, the National Stock Exchange (NSE),

, U
provides a wide variety of futures products, including stock futures and
equity index futures. Participants can trade these contracts on the NSE’s

O L
centralized market, where they can take advantage of quick execution

S
and transparent price discovery.
Role of Clearing houses
L /
O
In the futures market, clearing houses operate as a middleman between
C
/
buyers and sellers. Their roles include:

E
C
‹ Risk Management: By serving as the primary counterparty to all

D
transactions, clearinghouses reduce counterparty risk. They make certain

©D
that both the buyer and the seller carry out their responsibilities.
Clearinghouses ensure the efficient operation of the market by
lowering the risk of default and providing performance guarantees.
‹ Margining: Participants must deposit both initial margin and
maintenance margin into clearinghouses. Initial margin serves as
collateral, protecting against future losses, while maintenance margin
makes sure the margin account is enough. Margining assists in risk
management and shields market players from unfavourable price
changes.

PAGE 35
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes ‹ Settlement: By establishing the daily settlement price and assuring the
financial payment of profits or losses, clearinghouses streamline the
settlement process. They determine each participant’s net liabilities
and transfer money in accordance with those results.
Illustration - Role of Clearing Corporation of India Limited (CCIL)
India’s Clearing Corporation of India Limited (CCIL) functions as the
central counterparty for the clearing and settlement of futures contracts in

i
a number of asset classes, including stock derivatives, currency derivatives,

l
and interest rate derivatives. Through the management of counterparty
h
smooth operation of the derivatives market.
D e
risk and the facilitation of effective settlement, CCIL contributes to the

of
Futures exchanges and clearinghouses work together to establish a well-

ty
organized and effective futures trading market. They provide liquidity,

i
offer transparency, standardisation, and risk management, allowing market

s
r
players to control risk, speculate, and improve portfolio performance.

v e
Factors Influencing the Pricing of Futures Contracts

n i
The price of futures contracts is influenced by a number of variables that

the market as a whole:

, U
reflect the expectations and market dynamics for the underlying asset and

O L
1. Spot Price of the Underlying Asset: A key factor in determining the

/ S
futures price is the spot price, or the asset’s current market value.

O L
Due to market participants’ use of arbitrage to cover any material
price differences between the two, the futures price typically has

/ C
a close relationship to the spot price.

CE
2. Cost of Carry: The costs related to keeping the underlying asset

D
until the futures contract expiration are reflected in the cost of

D
carry. It takes into account elements like interest rates, dividends

© (for stocks), storage expenses, insurance costs, and financing costs.

The price of futures is influenced by the carry cost; greater carrying
costs translate into higher futures prices.
3. Supply and Demand Dynamics: Pricing for futures is heavily
influenced by supply and demand variables for the underlying asset.
Futures prices may rise if it is anticipated that demand for the asset
will rise or supply will decline, and vice versa.

36 PAGE
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 INTRODUCTION TO FINANCIAL MARKETS

4. Market Sentiment and Expectations: Futures price is influenced Notes

by investor expectations, market mood, and attitude towards the
underlying asset. The futures price may change in accordance with
whether market participants believe that the price of the asset will
be in a positive or negative trend.
5. Time to Expiration: The price of a futures contract depends on
how much time is left until it expires. The futures price often tends

i
to converge towards the spot price as the expiry date draws near,

l h
reflecting a declining time value and lowering the possibility of

e
significant price fluctuations.
6. Interest Rates: Particularly for financial futures contracts, interest
D
of
rates have an impact on futures prices. Higher carry costs translate
into higher futures prices when interest rates are higher, but lower
interest rates have the reverse impact.
i ty
r s
7. Volatility: The underlying asset’s price volatility has an impact

e
on futures pricing. More volatility produces larger predicted price
v
i
variations and, as a result, higher futures prices in order to balance
n
U
the increased risk.

L ,
8. Market Liquidity: Pricing may be impacted by the futures market’s
own liquidity. High trade volume liquid markets typically have

S O
tighter bid-ask spreads and more accurate pricing.

L /
It’s essential to remember that these variables interact, and their effects

O
on futures pricing might differ based on the particular market and asset

/ C
class. Market anticipation and unanticipated circumstances can also

E
increase volatility and affect pricing dynamics.

D C
1.20 Options Contracts

©D
Options contracts offer a flexible tool for risk management, speculating,
and generating revenue.
With the launch of index options on the National Stock Exchange (NSE),
options trading in India got underway in June 2001. Individual stock
options were later established; initially, only index options were offered.
To provide market players additional flexibility, SEBI (Securities and
Exchange Board of India) established standardized option contracts with

PAGE 37
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes weekly expirations in 2012. The number of options accessible to investors

increased in 2014 when SEBI permitted options trading on specific
equities. Option trading has been more common in India over time, and
institutional and ordinary traders have both expanded their engagement.
As a sort of financial derivative, options provide the holder the choice—
but not the obligation—to buy or sell the underlying asset at a specified
price (the striking price) on or before a specific future date (the expiration

i
date). In the financial markets, flexibility, risk management, and speculative
possibilities are crucial.
l h
D e
Options have a time limit after which they cease to be effective. Options
might be short-term (weekly or monthly) or long-term (quarterly or annual).

of
Some of the factors that impact option pricing include the cost of the
underlying asset, volatility, the amount of time left before expiration,

i ty
interest rates, and dividends. The two main exchanges in India where

r s
options are traded are the NSE and BSE (Bombay Stock Exchange).

e
In the Indian market, options can be utilized for risk management and
v
speculation.
n i
U
Illustration: A stockholder with an Indian stock portfolio wishes to hedge

L ,
against probable downside risks. Put options on an index, such the Nifty
50, can be bought by them.

S O
Risk Management: The investor might set a floor price for their portfolio

L /
by purchasing put options. Put options will gain in value if the market

O
falls, offsetting the portfolio losses.

/ C
Speculation: Alternatively A trader could guess that a certain stock will

C Emake a huge move. They have the option to purchase call options on
that stock, which would provide them the chance to profit if the stock
D price rose over the strike price before the option expired.

©D Need of Option Contracts

‹ Hedging: Options give traders and investors a way to protect their
holdings against unfavorable price changes. They can guard against
potential downside risks by buying put options. Call options, on
the other hand, serve as a hedge against potential upside risks.
‹ Risk Management: Options act as instruments for risk management
by reducing possible losses. By purchasing options, investors may

38 PAGE
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School of Open Learning, University of Delhi
 INTRODUCTION TO FINANCIAL MARKETS

limit their exposure to the underlying asset and cap their potential Notes
losses.
‹ Speculation: With the use of options, market players may engage in
speculative trading and profit from expected price changes without
actually owning the underlying asset. Correctly forecasting the
direction of price fluctuations may be profitable for traders.
‹ Income Generation: Options may be utilised in a number of different

i
ways to make money, including writing (selling) covered calls or
cash-secured puts. These tactics entail earning premiums through
l h
the sale of options while profiting from volatility or time decay.

D e
of
‹ Portfolio Diversification: By giving exposure to several asset classes
and strategies, options may increase diversity in a portfolio. Options

ty
can provide advantages for risk management and extra sources of
profits.

s i
Components of Option Contracts
e r
i v
The owner of an options contract has the option, but not the responsibility,

on or before the expiration date.

U n
to purchase or sell the underlying asset at a fixed price (the striking price)

L ,
Let us discuss the components of an options contract:

O
1. Underlying Asset: The financial instrument on which the options

S
L /
contract is based is known as the underlying asset. Stocks, indexes,
commodities, or currencies might all be included. Indices like the

O
Nifty 50 and the Sensex are common underlying assets for options
C
E /
trading in the Indian markets, as well as specific equities like
Reliance Industries and TATA Motors.

D C
2. Call and Put Options: Options contracts can be categorized into

©D
two types: call options and put options:
A. Call Option: The right to purchase the underlying asset at
the strike price on or before the expiration date is granted to
the holder of a call option. The holder of a call option may
exercise the option and purchase the underlying asset at a
discount if the price of the asset climbs above the strike price.
B. Put Option: The right to sell the underlying asset at the strike
price on or before the expiration date is granted to the holder

PAGE 39
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes of a put option. The put option holder may execute the option
and sell the underlying asset at a greater price if the price of
the underlying asset drops below the strike price.
3. Strike Price: The specified price at which an option buyer can
purchase or sell the underlying asset is known as the striking price,
also known as the exercise price. If the option is advantageous for
the holder, this is the price at which it will be exercised. Strike

i
prices in Indian markets are often predetermined at certain intervals
based on the value of the underlying asset.
l h
D e
4. Expiration Date: The option contract’s expiration date is the day
before or on which it does so. The option loses all value and the

of
holder’s ability to exercise it beyond the expiration date. In India,
options contracts typically have monthly expiry cycles; stock options

i ty
expire on the last Thursday of the month, whereas index options

r s
expire on the last Thursday of the week.
Illustration:
v e
n i
You’re interested in trading Nifty 50 index options. Currently trading at

U
19500 points, you anticipate the Nifty 50 to increase soon.

,
You make the following selections for your call option purchase:
L
O
‹ Underlying Asset: Nifty 50 index
‹
/ S
Strike Price: 19,700 points
‹

O L
Expiration Date: July 24, 2023

/ C
In this instance, you have the legal right to purchase the Nifty 50 index

E
at that price since you bought a call option with a strike price of 19500

D C points. By exercising your call option and purchasing the Nifty 50 index
at a cheaper price before it expires (June 24, 2023), you might possibly

©D
make money if the index rose over 15,200 points by that date.
Difference between Call Options and Put Options Contracts
The two major forms of options contracts, call options and put options,
each grant their holders certain rights.

40 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 INTRODUCTION TO FINANCIAL MARKETS

S. No. Component Call Option Put Option Notes

1. Definition The right to purchase the The right to sell the under-
underlying asset at a pre- lying asset at a fixed price
set price (the strike price) (the strike price) on or be-
on or before the expiration fore the expiration date is
date is provided by a call granted to the holder of a
option to the holder. When put option. When the value
the value of the underlying of the underlying asset drops,

i
asset increases, the call op- the put option holder gains.

h
tion holder gains.
2. Illustration You have a bullish outlook You have a gloomy outlook
e l
D
for the INR 400 Tata Motors for the Nifty 50 index, which

of
stock. You anticipate that the is trading around 15,000
stock price will rise soon. points right now. You an-
You make the following se- ticipate that the index will

ty
lections for your Tata Motors soon decrease. You choose to
call option purchase:
s i
purchase a put option with
‹ Underlying Asset: Tata

e r
the following information

v
on the Nifty 50 index:

i
Motors stock

n
‹ Underlying Asset: Nifty
‹ Strike Price: INR 420

U
50 index
‹ Expiration Date: July
15, 2023
L , ‹ Strike Price: 14,800
points

O
You can execute your call

S
‹ Expiration Date:

/
option and purchase Tata
July 15, 2023

L
Motors shares at the lower

O
strike price of INR 420 if You can exercise your put

C
the company’s stock price option and sell the Nifty 50

E /
increases over INR 420 by index at the higher strike
the expiration date—let’s price of 14,800 if it drops

D C assume it hits INR 450. This below 14,800 points by the

gives you the chance to profit expiration date, let’s say it

©D
on the price discrepancy and lowers to 14,500 points. This
maybe turn a profit. gives you the chance to profit
on the price discrepancy and
maybe turn a profit.
3. Rights The holder of a call option The holder of a put option
has the opportunity to pur- has the opportunity to sell
chase the underlying asset. the underlying asset.
4. Profit Poten- Rising prices are advanta- Put options profit from
tial geous for call options. declining underlying asset
values.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes S. No. Component Call Option Put Option

5. Price Call options are appropriate Put options are appropriate
Expectation for anticipation of a bullish for anticipation of a negative
market. market.
6. Risk and Call options offer a little Additionally, put options
Reward risk (the premium paid) and have a fixed risk (the pre-
a large potential gain. mium paid) and an infinite
potential gain.
Option Contracts Pricing

h i
e l
The intrinsic value and time value of an option are two important factors

D
in determining its value.

of
Intrinsic Value:
An option’s inherent value is the value that would endure even if it were

i ty
immediately exercised. It stands for the difference between the underlying

r s
asset’s current price and the option’s strike price. The intrinsic value may

e
be determined using the following formula for both call and put options:

v
‹

n i
Call Option: Intrinsic Value = Current Price of Underlying Asset -

U
Strike Price
‹
Underlying Asset
L ,
Put Option: Intrinsic Value = Strike Price - Current Price of

S O
If the calculated intrinsic value is positive, it means the option has intrinsic

L /
value. If it is zero or negative, the option has no intrinsic value.

O
Illustration:

C
E /
Let’s have a look at a call option on the shares of Reliance Industries

C
using the following information:

D ‹ Current Price of Reliance Industries stock: INR 2,000

©D
‹ Strike Price: INR 1,800
In this instance, the call option’s intrinsic value would be as follows:
Intrinsic Value = INR 2,000 - INR 1,800 = INR 200
As a result, the option holder would profit INR 200 per share if the call
option.
Illustration:
A put option with the following information on the Nifty 50 index:

42 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 INTRODUCTION TO FINANCIAL MARKETS

Current Value of Nifty 50 index: 15,500 points Notes

Strike Price: 16,000 points
In this case, the intrinsic value of the put option would be:
Intrinsic Value = INR 16,000 - INR 15,500 = INR 500
Therefore, the option holder would profit INR 500 per contract if the put
option were to be promptly executed.

i
Time Value:
The term “time value” describes the fraction of an option’s premium
l h
(the cost of the option) that is related to how much time is left before
it expires. It shows the potential for the option’s value to increase over
D e
of
time in response to market and underlying stock volatility, among other
things. As the option approaches its expiration date, time value decreases,

i
which has a substantial impact on an option’s overall value and cost.
ty
r s
The volatility of the underlying asset, the amount of time till expiry, interest

v e
rates, and market circumstances are just a few examples of the variables

i
that have an impact on an option’s temporal value. It is determined as
n
U
the discrepancy between the option’s intrinsic value and total premium.
Illustration:

L ,
O
Consider a call option on TATA Motors stock with the following details:
Total Premium: INR 300
/ S
Intrinsic Value: INR 50

O L
C
In this case, the time value of the call option would be:

E /
Time Value = Total Premium - Intrinsic Value

C
Time Value = INR 300 - INR 50 = INR 250
D
©D
Therefore, the option’s time value is INR 250, which represents the
market’s expectation of future price movements and potential gains before
expiration.
The time value of the option tends to decline as the expiry date draws
near, and its value increasingly depends on its intrinsic worth.
In order for traders to evaluate the value of an option and make wise
trading decisions, it is critical to understand the concepts of intrinsic
value and time value.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Option Trading Strategies

Let’s examine and demonstrate several options trading techniques, such as
purchasing calls, purchasing puts, writing covered calls, and using spreads:
1. Buying Calls: Optimistic options trading technique known as “buying
calls” involves buying call options with the hope that the price of
the underlying asset would increase. With this tactic, the buyer
might benefit from a future price gain while keeping the risk to

i
the amount of the option premium.
Illustration:
l h
D e
Let’s say you have a bullish outlook for the 1,500 INR Infosys

of
stock. You invest in a call option with a 1,600 INR strike price
and one-month expiration. You can execute the call option and take

ty
advantage of the price increase if the stock price increases over
INR 1,600 before the expiration date.
s i
e r
2. Buying Puts: A bearish option trading technique known as “buying

i v
puts” is where a trader buys put options in the hope that the price

U n
of the underlying asset would fall. With this tactic, the buyer might
benefit from a potential price fall while keeping the risk to the

,
amount of the option premium.
L
O
Illustration:

/ S
Let’s say you have a negative outlook on Maruti Suzuki stock, which

O L
is now selling at INR 8,000. You invest in a put option with a
strike price of INR 7,800 and a month from now till expiration.

/ C
You can exercise the put option and profit from the price decline if

C E the stock price drops below INR 7,800 before the expiration date.

D
3. Writing Covered Calls: An investor who already owns shares of

©D
the underlying asset sells call options against those shares in a
method known as “writing covered calls,” which is neutral to slightly
optimistic. Through the premium gained from selling the calls, this
approach makes money. It may be appropriate if the investor thinks
the stock price will either grow little or remain fairly constant.
Illustration:
Let’s say you hold 100 Reliance Industries shares, which are now
selling for INR 2,500. You “write” (sell) covered call options with

44 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
INTRODUCTION TO FINANCIAL MARKETS

a 2,600 INR strike price and a one-month expiration period. The Notes
call options will expire worthless if the stock price stays below
INR 2,600 till expiration, and you keep the premium you were paid
for selling the calls.
4. Spreads: Spreads are options trading strategies in which a number of
options contracts with various strike prices and/or expiration dates
are concurrently bought and sold. Spreads can be used to control

i
risk, lower the cost of purchasing options, or make money off of
particular market situations.
l h
There are various types of spreads, including:

D e
of
‹ Bull Call Spread: This tactic entails purchasing a call option
with a lower strike price and selling a call option with a higher

ty
strike price and the same expiration date. When a gradual

i
increase in the price of the underlying asset is anticipated, it

s
r
is employed.

v e
Bear Put Spread: This tactic entails purchasing a put option
i
‹

n
with a higher strike price and selling a put option with a

U
lower strike price and the same expiration date. When a little

employed.
L ,
fall in the value of the underlying asset is anticipated, it is

S O
Vertical Spreads: Buying and selling options with the same
/
‹

L
expiration date but different strike prices is known as a vertical

O
spread. Depending on the strike prices selected, they might

/ C
be bullish (call spread) or bearish (put spread).
‹

C E
Calendar Spreads: Options with the same expiration date but
different strike prices are bought and sold in vertical spreads.
D
Based on the selected strike prices, they can either be bullish

©D
(call spread) or bearish (put spread).
Illustration:
Assume you anticipate a slight increase in the price of HDFC Bank’s
shares, which is now trading at INR 1,200. By purchasing a call
option with a strike price of INR 1,200 and selling a call option
with a higher strike price of INR 1,250, both expiring in three
months, you might do a bull call spread. By employing this tactic,

PAGE 45
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes you can still benefit from the prospective gains while keeping your
initial costs to a minimum.

1.21 Bonds
Bonds are fixed-income instruments that are issued by businesses,
governments, local governments, and other entities to raise money.
These are financial instruments in which the issuer guarantees that the

h
bondholder will receive both the face value of the bond at maturity and
i
e
periodic interest payments (coupon payments) up to that point.
l
Function of bonds as Fixed Income Securities:
D
of
1. Income Generation: Bonds are essential for providing investors with
predictable income. Bondholders get recurring interest payments,

i ty
which are normally made yearly or semi-annually and offer a steady

r s
source of income. Bonds are therefore appealing to investors looking

e
for consistent income.

i v
2. Capital Preservation: Comparatively speaking to stocks, bonds are

U n
seen to be a safer investment. There is a decreased chance of losing

,
the primary sum when investing in bonds issued by trustworthy

O L
companies. By ensuring the face value will be repaid at maturity,
provided the issuer doesn’t default, bonds help preserve capital.

/ S
3. Diversification: In a portfolio of investments, bonds benefit from
L
diversity. Since bonds frequently rise when stock prices fall and fall
O
C
when bond prices rise, they typically have a negative correlation

E / with stocks. This negative correlation lessens volatility by balancing

C
the portfolio’s overall risk and return profile.

D 4. Risk Management: Bonds are instruments for risk management. To

©D
suit their level of risk tolerance and investment goals, investors can
select bonds with a range of credit ratings, maturities, and interest
rates. Government bonds, for instance, are sometimes regarded as
less hazardous than corporate bonds, although they could provide
lower yields.
5. Duration and Interest Rate Sensitivity: Bonds have durations, which
quantify how sensitive they are to interest rate changes. Shorter-
duration bonds are less vulnerable to fluctuations in interest rates

46 PAGE
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School of Open Learning, University of Delhi
 INTRODUCTION TO FINANCIAL MARKETS

than longer-duration bonds. For investors looking to minimise interest Notes

rate risk and make smart investment choices based on interest rate
assumptions, this connection is crucial.
6. Financing for Governments and Corporations: Governments and
businesses can finance their operations with the help of bonds.
Governments issue bonds to finance infrastructure improvement
projects, financial needs, or public projects. In a similar vein,

i
businesses issue bonds to raise funds for debt refinancing, corporate
expansion, and R&D. Entities can access market capital and diversify
l h
e
their funding sources by issuing bonds.
Bond investments should be assessed based on a number of criteria,
D
of
including credit quality, interest rate environment, maturity, and issuer
financial health. Before making a bond investment, investors should think
about their risk appetite, financial goals, and expert guidance.
i ty
Key Features of Bonds
r s
v e
Let’s examine the main characteristics of bonds, such as the coupon

n i
rate, maturity date, and par value, along with examples to clarify their

U
definitions:

,
1. Coupon Rate: The set yearly interest rate that the bond issuer
L
O
promises to pay to the bondholder is represented by the coupon rate,

S
also known as the coupon yield or nominal yield. Its proportion of

L /
the bond’s face value is how it is represented. The monthly interest

O
payments that the bondholder will receive throughout the course of

/ C
the bond’s life are determined by the coupon rate.

C E
Illustration: Assume you possess a corporate bond with a face value
of 10,000 Indian rupees and a 5% coupon rate. In this scenario,
D
you would get an annual interest payment of INR 500, or 5% of

©D
INR 10,000, every year.
2. Maturity Date: When the bond reaches its full term, or maturity date,
the issuer is required to pay the bondholder the face value, often
referred to as the par value or principal, of the bond. It denotes the
conclusion of the bond’s term and the moment when the principal
of the bondholder is repaid.
Illustration: A government bond with a face value of 100,000 INR
and a maturity date of December 31, 2030 comes to mind. The

PAGE 47
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes issuer is obligated to give the bondholder his entire face amount
of INR 100,000 by that date.
3. Par Value: The amount that the bond issuer promises to reimburse
the bondholder at maturity is referred to as the par value, also
known as the face value or principal. It acts as a benchmark for
computing interest payments and symbolises the bondholder’s initial
investment.

i
Illustration: Consider buying a municipal bond having a 1,000 INR

l h
par value. This indicates that the issuer is bound to pay you the
entire par value of INR 1,000 when the bond matures.

D e
of
It’s vital to remember that a bond’s market price might change over
the course of its life and may not correspond to its par value. The

ty
market price of the bond is more than its par value if it is selling

i
at a premium. The market price is more than the par value if the

s
r
bond is trading below par value. The market price of a bond might

e
fluctuate depending on the current interest rate environment, the
v
i
issuer’s creditworthiness, and the level of demand for bonds.
n
U
Bond investors may estimate the income potential, risk, and length of

L ,
their investments by understanding the coupon rate, maturity date,
and par value of bonds. When making investment selections, it’s

S O
important to take into account these characteristics together with

/
other elements including credit quality, market circumstances, and
L
O
the issuer’s financial stability.

/ C
Bond Prices and Yields

C EBond yields and prices are inversely correlated, which means that as bond
prices rise, yields fall and vice versa. The bond price-yield relationship,
D sometimes referred to as the bond price-yield curve, describes this

©D
connection:
1. Bond Price-Yield Relationship: The idea of present value may be
used to explain the link between bond price and yield. A bond’s
price is defined by the bond’s future cash flows, which include
coupon payments and principal repayment at maturity. The yield is
a measure of the rate of return on an investor’s bond investment.
The present value estimate is impacted by changes in market interest
rates (or yields), which affects bond prices. Rising interest rates

48 PAGE
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School of Open Learning, University of Delhi
 INTRODUCTION TO FINANCIAL MARKETS

decrease demand for existing bonds with lower coupon rates by Notes
making newly issued bonds with higher coupon rates more appealing.
The prices of existing bonds drop as a result. On the other hand, if
interest rates fall, the value of existing bonds with higher coupon
rates rises, driving up their values.
2. Bond Price-Yield Curve: A bond price-yield curve is a common
visual representation of the bond price-yield relationship. For a

i
variety of bonds with various maturities, the link between bond
prices and yields is plotted on this curve.
l h
Types of Bond

D e
of
Let’s examine and discuss the various kinds of bonds, such as corporate,
municipal, and government bonds:

ty
1. Government Bonds: National governments issue government bonds,

s i
commonly referred to as sovereign bonds or treasury bonds, to cover

r
budget shortfalls or finance public projects. Due to the complete
e
v
confidence and credit of the issuing government, these bonds are

n i
regarded as low-risk investments. Government bonds usually have

U
specified maturity dates and fixed coupon payments.

,
Examples: United States Treasury Bonds, German Bonds, Japanese
L
O
Government Bonds (JGBs), Indian Government Securities (G-Secs).

/ S
2. Corporate Bonds: Corporations and private businesses issue corporate

O L
bonds to obtain money for a variety of needs, including business
development, acquisitions, or debt refinancing. In order to make up

/ C
for the increased risk associated with the issuer’s creditworthiness,

C E
corporate bonds give higher yields than do government bonds.
Based on their credit ratings, which represent the issuer’s capacity
D
to fulfil its financial commitments, corporate bonds can be divided

©D
into several categories.
Examples: Reliance Industries Limited, State Bank of India (SBI),
HDFC Bank, NTPC Limited, etc.
3. Municipal Bonds: State and local governments, municipalities, and
other public organisations issue municipal bonds, commonly referred
to as munis, to fund infrastructure projects, schools, hospitals, and
other public works. Tax benefits are provided by municipal bonds
since their interest revenue is frequently free from federal income

PAGE 49
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes tax and, in certain situations, state and local taxes. They can either
be revenue bonds, which are backed by specific revenue sources,
or general obligation bonds, which are guaranteed by the issuer’s
full faith and credit.
Examples: Bengaluru Municipal Corporation (BMC) Bonds, Pune
Municipal Corporation (PMC) Bonds, Hyderabad Municipal Corporation
Bonds, etc.

i
4. International Bonds: Foreign governments, businesses, or supranational

l h
organisations may issue international bonds in a different currency

D e
than their home currency. These bonds give issuers access to global
capital markets and prospects for investors looking to participate

of
in foreign markets. Bonds issued by foreign governments may be
subject to currency risk since changes in exchange rates might affect

i ty
the bond’s coupon payments and principal payback values.

r s
Examples: Eurobonds, Samurai Bonds, Kangaroo Bonds.

v e
5. Convertible Bonds: Bondholders of convertible securities have the

i
opportunity to exchange their bonds for a specific number of the
n
U
issuer’s common shares. Because bondholders may profit from

,
rising share prices, these bonds provide potential upside through

O L
equity participation. To make up for the inbuilt conversion option,
convertible bonds often have lower coupon rates than non-convertible
bonds.
/ S
O L
Examples: Mahindra & Mahindra convertible bonds, Wipro convertible

C
bonds, Tata Motors convertible bonds, Infosys convertible bonds,

E / etc.

D C These are only a few illustrations of the various kinds of bonds that are
offered on the market. Each bond type has a unique risk profile, yield

©D
potential, and characteristics that are tailored to the interests and financial
goals of various investors.

1.22 Swaps
Swaps are derivative contracts that entail the trading of financial obligations
or cash flows between two parties over a predetermined time frame. In
order to manage risks, hedge exposures, and access particular financial
terms, they are commonly employed in the financial markets.

50 PAGE
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 INTRODUCTION TO FINANCIAL MARKETS

Types of Swaps Notes

Let’s discuss certain types of swaps and their function with reference to
Indian financial markets.
Interest Rate Swaps (IRS): Interest rate swaps involve two parties
exchanging payments with fixed and variable interest rates. A fixed interest
rate is agreed upon by one side in this swap, and a floating interest rate,
based on a reference rate, such as the MIBOR (Mumbai Interbank Offered

i
Rate), is agreed upon by the other party. Interest rate swaps are used to
control interest rate risk and produce the desired features of cash flow.
l h
Illustration: A business in India has a loan with a floating interest rate
D e
of
that it wishes to fix in order to protect itself against prospective interest
rate hikes. A party willing to pay the fixed rate and get the flexible rate

ty
may agree to an interest rate swap with the corporation. By doing this,

i
the business may essentially change its loan from one with a fluctuating

s
r
rate to one with a fixed one, stabilizing its interest payments.

v e
Currency Swaps: Principal and interest payments denominated in several

n i
currencies are exchanged during currency swaps. For companies with

U
exposure to foreign currencies that wish to control exchange rate risk or

L ,
obtain finance in a different currency, these swaps can be helpful. Parties
can benefit from comparative advantages in interest rates between various

S O
nations by engaging in currency exchanges.

L /
Illustration: An Indian business wants to grow its operations in the US

O
and needs finance in USD. However, Indian Rupees (INR) make up the

/ C
majority of its earnings. The business can engage in a currency swap

E
with a counterparty that wants INR and is ready to offer USD finance

D C
in order to reduce exchange rate risk. The corporation may now accept
finance in USD and periodically pay interest and principal in INR thanks

©D
to this exchange.
Credit Default Swaps (CDS): Contracts such as credit default swaps
allow one party to shift credit risk to another. In a CDS, one party pays
counterparty a monthly fee in return for insurance against the failure of
a certain underlying financial instrument, such a bond or loan. CDSs
are used to manage credit risk or make predictions about an issuer’s
creditworthiness.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Illustration: A corporate bond holder in India is worried about the

issuer’s creditworthiness. The investor can buy a credit default swap
from a counterparty to insure against the risk of default. The counterparty
commits to repay the investor if the issuer of the underlying bond defaults
in return for recurring premium payments.
Participants in the market have flexibility and risk management options
thanks to swaps. They enable organizations to alter how exposed they

i
are to credit risks, currencies, and interest rates. However, it’s crucial

l h
to keep in mind that swaps contain counterparty risk, and the parties

e
involved should thoroughly assess their counterparties’ creditworthiness
prior to engaging into swap arrangements.
D
1.23 Other Derivative Instruments of
i ty
s
There are various additional derivative products utilised in the financial

e r
markets in addition to forwards, futures, options, bonds, and swaps:
‹

i v
Caps and Floors: Caps and floors are derivative products that are

U n
used to speculate or hedge against changes in interest rates. While
a floor establishes a minimum interest rate, a cap restricts the

L ,
maximum interest rate that may be charged on a floating-rate loan

O
or investment. These tools make it easier for investors or borrowers

/ S
to hedge against interest rate volatility.
‹

O L
Credit Derivatives: The management of credit risk in connection
with loans, bonds, and other debt instruments is done via credit

/ Cderivatives. Credit Default Swaps (CDS) and Collateralized Debt

C E Obligations (CDOs) are two examples of credit derivatives. These

D
derivatives provide investors access to the credit markets and give

©D
them the chance to speculate or protect themselves against financial
catastrophes.
‹ Commodity Derivatives: Financial instruments known as commodity
derivatives are those that are connected to commodities like metals,
oil, gold, and natural gas. Commodity futures, options, and swaps
are examples of these derivatives, which give market players the
ability to control the price risk related to the underlying assets.
‹ Structured Products: Complex derivatives known as “structured
products” combine several financial instruments, such as options,

52 PAGE
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 INTRODUCTION TO FINANCIAL MARKETS

bonds, and swaps, to produce unique investment products. They Notes

are frequently customised to fit certain risk profiles or investment
objectives. Equity-linked notes, reverse convertible instruments, and
hybrid securities are a few examples of structured products.
‹ Mortgage-Backed Securities (MBS): Derivatives such as “mortgage-
backed securities” indicate ownership in a collection of mortgage
loans. They make it possible for financial firms to exchange and

i
securitize mortgage debt. Residential Mortgage-Backed Securities
(RMBS) and Commercial Mortgage-Backed Securities (CMBS) are
l h
e
two more kinds of MBS derivatives depending on the underlying
mortgages.
D
of
‹ Exchange-Traded Products (ETPs): Products that are exchange-
traded are derivatives that trade on stock exchanges. Exchange-
Traded Commodities (ETCs), Exchange-Traded Notes (ETNs),
i ty
r
and Exchange-Traded Funds (ETFs) are some examples. ETPs
s
e
give investors quick and transparent access to a variety of assets,

v
i
including equities, bonds, commodities, or indexes.

n
U
These are only a handful of other derivative products that are applied in

,
the financial markets. Each derivative has particular features, risk profiles,

O L
and uses of its own. Before engaging in trading or investing activities, it
is crucial for investors and market players to have a clear understanding

/ S
of the unique characteristics and dangers attached to each instrument.

O L
C
1.24 Summary

E /
Indian financial markets have a long history that goes back before there

D C
were official exchanges. They have fostered economic activity and given

©D
commerce and investment a platform. The term “financial markets” goes
beyond only exchanges like the NYSE or Chicago’s futures pits. They
comprise several markets for various types of assets, such as bonds,
stocks, forex, and derivatives. These markets make it easier to purchase
and sell financial assets, determine prices, allocate money, manage risk,
and provide liquidity. The money market, which deals with short-term
loans and instruments, and the capital market, which deals with medium-
and long-term financing through securities, are the two primary categories
of financial markets in India. Retail and institutional investors, banks,

PAGE 53
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes non-banking financial institutions, and regulatory organizations like SEBI

and the Reserve Bank of India also participate in these markets.
Financial contracts known as derivatives derive their value from underlying
assets such as stocks, bonds, commodities, currencies, and market indices.
They provide traders and investors the chance to make bets on or hedge
against potential price fluctuations or hazards in the underlying asset
without actually owning it. Futures contracts, options contracts, swaps,

i
and forward contracts are the four main types of derivatives. In the

l h
financial market, derivatives can be used for risk management, speculation,

e
hedging, and arbitrage. They offer flexibility, leverage, and liquidity but

D
can include hazards such counterparty risk and market volatility. Dealing

of
with these financial products requires understanding derivatives, managing
risks, and following rules.

i ty
Both forward and futures contracts are derivative financial products

r s
that are used to manage risk, hedge holdings, and forecast the value of

e
underlying assets. Contract structure, purpose, underlying assets, price

v
n i
variables, volatility control, margin requirements, contract expiry, settlement
procedures, risk management, and market access are only a few of the

U
commonalities amongst them. They do, however, differ greatly from one
,
L
another. While futures contracts are standardised and sold on regulated

O
exchanges, forwards are flexible, customised contracts exchanged over-

/ S
the-counter (OTC) between two parties. Forward contracts are subject

O L
to the counterparties’ creditworthiness and may have less liquidity, but
futures contracts provide liquidity, transparency, and central clearing, which

/ C
lowers counterparty risk. While futures contracts offer standardised terms

C Eand daily mark-to-market settlement, forward contracts give considerable

flexibility.

D
©D
Options are a useful instrument for risk management, speculation, and
money generation in the financial markets. Options trading in India
started off with index options in 2001 before being expanded to include
individual stock options. In 2012, standardised option contracts with weekly
expirations were implemented, and in 2014, options trading on particular
stocks were introduced. Options may be used to diversify portfolios,
manage risk exposure, speculate on price changes, earn money by writing
covered calls or cash-secured puts, and hedge against negative risks.
The underlying asset, call and put options, strike price, and expiration

54 PAGE
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 INTRODUCTION TO FINANCIAL MARKETS

date are important elements of an options contract. The intrinsic values Notes
of an option as well as its time value are determining considerations.
Purchasing calls, purchasing puts, writing covered calls, and employing
spreads including bull call spreads, bear put spreads, vertical spreads, and
calendar spreads are a few examples of different options trading methods.
Bonds are fixed-income securities that are issued by different organisations
to raise money. Through recurrent interest payments and the eventual

i
return of the bond’s face value, they give investors a steady stream of
income. Bonds provide governments and businesses with alternatives for
l h
e
financing as well as income creation, capital preservation, diversification,
risk management, duration and interest rate sensitivity. Bonds’ coupon
D
of
rate (annual interest rate), maturity date (when the face value is repaid),
and par value (amount paid at maturity) are important characteristics. The

ty
bond price-yield curve demonstrates the inverse relationship between bond

s i
prices and yields. Government bonds, corporate bonds, municipal bonds,

e r
international bonds, and convertible bonds are some of the numerous
types of bonds, each having a unique risk profile.
i v
U n
Swaps are derivative contracts that two parties can utilise in the financial
markets to exchange financial obligations or cash flows. To control risks,

L ,
hedge exposures, and access certain financial terms, they are used.

O
In order to control interest rate risk, Interest Rate Swaps (IRS) exchange

S
L /
payments with fixed and variable interest rates. For businesses with
exposure to international currencies, this exchanges principle and interest

O
payments in various currencies. By offering insurance against the collapse
C
E /
of an underlying financial instrument, one party can shift credit risk to
another party. Swaps offer flexibility and alternatives for risk management,

D C
but counterparty risk needs to be carefully considered. Before signing

©D
swap agreements, parties participating in the transaction must evaluate
the creditworthiness of their counterparties.
There are several additional derivative instruments utilised in financial
markets in addition to forwards, futures, options, bonds, and swaps.
Derivatives called “caps and floors” are used to speculate or hedge
against fluctuations in interest rates. Derivatives for controlling credit
risk include collateralized debt obligations and credit default swaps.
Commodity derivatives: Financial instruments used to control price risk

PAGE 55
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes that is linked to commodities like metals, oil, and natural gas. Complex
derivatives known as “structured products” combine many instruments
to produce one-of-a-kind investment products. Derivatives that reflect
ownership in a pool of mortgage loans are known as Mortgage-Backed
Securities (MBS). Exchange-Traded Products (ETPs): Derivatives, such
as commodities, notes, and funds, which are traded on stock exchanges.
Before engaging in trading or investment activities, it is important to
have a comprehensive grasp of each derivative’s unique features, risks,
and purposes.
h i
IN-TEXT QUESTIONS
e l
D
1. What is the Primary Function of Financial Markets?

of
(a) Providing a platform for trade and investment

ty
(b) Facilitating the exchange of goods and services

s i
(c) Supporting economic activities in agriculture

e r
(d) Offering a location for farmers to store surplus crops

i v
2. Why Did Farmers in Early Indian Communities Engage in

n
Financial Transactions?
U
,
(a) To establish official trading systems

L
(b) To exchange surplus crops with other farmers

O
S
(c) To speculate on fluctuating exchange rates

L /
(d) To participate in the New York Stock Exchange

O
3. What is the Primary Function of Financial Markets?

C
E / (a) Providing a platform for businesses to raise money for
expansion

D C (b) Facilitating the exchange of goods and services

©D
(c) Allowing individuals to deposit money in savings accounts
(d) Speculating on foreign exchange rates
4. How Do Depositors Benefit from the Financial Market System
Described in the Text?
(a) By earning interest on their deposits and seeing their money
grow over time
(b) By exchanging goods and services with other account
holders

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INTRODUCTION TO FINANCIAL MARKETS

(c) By speculating on the stock market and making profits on Notes

investments
(d) By borrowing money from banks at a lower interest rate
5. What is the Purpose of Price Discovery in Financial Markets?
(a) To estimate the relative worth of various goods
(b) To facilitate capital allocation
(c) To increase liquidity in the market

h i
(d) To mitigate financial risks
e l
6. How is Asset Valuation Typically Determined in Financial
D
of
Markets?
(a) Based on the prices paid for assets years ago
(b) Through market pricing
i ty
(c) By estimating future earnings of the company
r s
v e
i
(d) By comparing it to the value of similar assets

Markets?
U n
7. What is the Role of Arbitrage in Underdeveloped Financial

L ,
(a) To increase liquidity in the entire economy

O
(b) To promote efficient pricing of commodities and currencies
S
L /
(c) To raise capital for companies

O
(d) To facilitate commercial transactions

C
/
8. How Do Financial Markets Support Raising Capital for Companies?

E
C
(a) By providing protection against various risks

D
(b) By facilitating commercial transactions

©D
(c) Through the issuance of shares, bonds, and other financial
instruments
(d) By offering opportunities for investing and increasing asset
value
9. What Role Do Financial Markets Play in Commercial Transactions?
(a) Setting up payment for product sales abroad
(b) Generating income in the future

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes (c) Increasing liquidity in the market

(d) Protecting against financial risks
10. How Do Contracts for Futures, Options, and Derivatives Contribute
to Risk Management?
(a) By estimating the relative worth of various goods
(b) By providing liquidity in the market
(c) By offering protection against various risks

h i
l
(d) By promoting efficient pricing of commodities and currencies
e
D
11. What is the Primary Characteristic of the Money Market?

of
(a) Dealing with medium- and long-term loans

ty
(b) Trading cash or money itself
(c) Handling short-term investments
s i
e r
(d) Facilitating the issuance of new shares

i v
12. Which of the Following is an Example of a Money Market
Instrument?

U n
,
(a) Stocks

L
(b) Treasury bills

O
S
(c) Debentures

L /
(d) Mutual funds

O
13. What is the Primary Purpose of Commercial Paper?
C
/ (a) Raising long-term capital

CE
(b) Financing operating capital needs

D D (c) Trading existing assets

©
(d) Exchanging credit instruments
14. Certificates of Deposit (CDs) are Typically Issued by:
(a) Reserve Bank of India
(b) Commercial banks and special financial institutions
(c) Cooperative banks
(d) Non-Banking Financial Companies (NBFCs)

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15. What is the Purpose of a Trade Bill in the Money Market? Notes

(a) To facilitate short-term loans between banks

(b) To transfer money from one party to another
(c) To raise capital for businesses
(d) To enable the drawer to obtain cash for working capital
needs
16. What is the Main Characteristic of the Capital Market?

h i
(a) Dealing with short-term loans
e l
(b) Facilitating the buying and selling of securities
D
of
(c) Trading money itself

ty
(d) Issuing new shares and debentures
17. The Primary Market is Primarily Involved in:
s i
(a) Trading existing securities
e r
(b) Issuing new shares and debentures
i v
(c) Providing liquidity to holdings
U n
,
(d) Mobilizing long-term finances

L
18. What Role Does the Secondary Market Play in Relation to the
O
S
Primary Market?

L /
(a) Issuing new securities

O
(b) Trading short-term loans
C
/
(c) Providing liquidity to holdings
E
C
(d) Mobilizing medium-term finances

D
19. Who are the Primary Participants in the Primary Market?

©D
(a) Stockbrokers and individual investors
(b) Mutual funds and financial institutions
(c) Underwriters and brokers
(d) Reserve Bank of India and cooperative banks
20. Which Market Offers a High Level of Security and Transparency
in Trading Securities?
(a) Money market

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes (b) Primary market

(c) Secondary market
(d) Capital market
21. What is the Primary Purpose of the Primary Market?
(a) To offer a continuous market for already existing assets
(b) To raise long-term money through the issuance of new
securities

h i
(c) To regulate the capital market
e l
(d) To determine the prices of securities
D
of
22. Who are the Participants in the Secondary Market?

ty
(a) Financial institutions, mutual funds, and individual investors

i
(b) Underwriters, stockbrokers, and individual investors
s
e r
(c) Stockbrokers, underwriters, and financial institutions
(d) All of the above
i v
n
23. What is a Key Difference Between the Primary Market and the
U
,
Secondary Market Regarding Listing Requirements?

O L
(a) The primary market has listing requirements, while the
secondary market does not

/ S
L
(b) The secondary market has listing requirements, while the

O
primary market does not

/ C (c) Both the primary and secondary markets have listing

C E requirements

D
(d) Neither the primary nor the secondary market has listing

©D
requirements
24. Who Determines the Prices of Assets in the Primary Market?
(a) The management of the company
(b) Stockbrokers
(c) Financial institutions
(d) Market factors such as supply and demand

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INTRODUCTION TO FINANCIAL MARKETS

25. What is the Main Difference Between the Capital Market and Notes
the Money Market?
(a) The capital market deals with short-term funds, while the
money market deals with long-term finances
(b) The capital market deals with shares, debentures, and
government securities, while the money market deals with
securities like treasury bills and commercial paper
(c) The capital market is regulated by the Reserve Bank
h i
of India, while the money market is regulated by the
e l
D
Securities and Exchange Board of India

of
(d) The capital market involves retail investors, while the
money market involves institutional investors
26. Who are the Participants in the Money Market?
i ty
r s
(a) Stockbrokers, underwriters, and individual investors

v e
(b) Financial institutions, mutual funds, and individual investors

n i
(c) Retail investors and institutional investors

, U
(d) The Reserve Bank of India, commercial banks, and non-

L
banking financial institutions

O
27. Which Organization Regulates the Capital Market?
S
L /
(a) The Reserve Bank of India (RBI)

O
(b) The Securities and Exchange Board of India (SEBI)

C
/
(c) Credit Rating Agencies

E
C
(d) The National Stock Exchange (NSE)

D
28. What Do Credit Rating Agencies Evaluate?

©D
(a) The demand for financial assets
(b) The corporate performance
(c) The creditworthiness of issuers and their debt instruments
(d) The market liquidity
29. What Role do Brokers Play in the Financial Markets?
(a) They facilitate the buying and selling of securities
(b) They evaluate the creditworthiness of issuers

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes (c) They offer clearing and settlement services

(d) They regulate the market environment
30. What Can Impact the Demand for Financial Assets in the Market-
Specific Factors Category?
(a) Economic growth
(b) Investor sentiment
(c) Monetary policy

h i
(d) Global factors
e l
D
31. Derivatives Derive their Value from Which of the Following?

of
(a) Underlying assets

ty
(b) Counterparties
(c) Regulatory oversight
s i
(d) Leverage
e r
i v
32. Which Category of Derivatives is Often Used for Speculating

Price Changes?
U n
or Hedging with the Goal of Making Money off of Expected

L ,
(a) Futures contracts

O
(b) Options contracts
S
L /
(c) Swaps

C O (d) Forward contracts

/33. Options Contracts Provide the Holder the Choice to Do What?

CE
(a) Buy or sell an underlying asset

D D (b) Exchange cash flows with another party

©
(c) Purchase or sell a futures contract
(d) Trade fixed and variable interest rate payments
34. Which Type of Derivatives are Individualized Arrangements
Between Two Parties and are not Traded on Exchanges?
(a) Futures contracts
(b) Options contracts

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INTRODUCTION TO FINANCIAL MARKETS

(c) Swaps Notes

(d) Forward contracts

35. What is the Primary Purpose of Using Derivatives in the Financial
Market?
(a) Risk management
(b) Leveraged investments
(c) Customizing financial instruments

h i
(d) Speculating on price changes
e l
36. Derivatives Based on Commodities Allow Market Participants
D
of
to Do What?
(a) Hedge against price volatility
(b) Trade and speculate on exchange rates
i ty
(c) Insure against potential losses
r s
v e
i
(d) Control interest rate risks
37. What is Leverage in Derivatives?

U n
,
(a) The ability to transfer derivative contracts

L
(b) The risk associated with counterparty default

O
S
(c) The use of borrowed funds to increase investment exposure

L /
(d) The standardization of contract terms and conditions

O
38. Why is Liquidity Important in Derivative Markets?
C
/
(a) It reduces counterparty risk
E
C
(b) It allows for leverage in derivative trading

D
(c) It ensures regulatory oversight

©D
(d) It facilitates efficient trading and price determination
39. What is Counterparty Risk in Derivative Contracts?
(a) The risk of market volatility
(b) The risk of regulatory oversight
(c) The risk that the other party may not fulfil their obligations
(d) The risk associated with leverage

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 40. Why is Regulatory Oversight Important in Derivative Markets?

(a) To ensure transparency and fairness
(b) To increase leverage in derivative trading
(c) To eliminate counterparty risk
(d) To customize financial instruments
41. What is the Main Difference between Forwards and Futures

i
Contracts?

l
(a) Forwards are standardized, while futures contracts are
h
flexible
D e
of
(b) Forwards are traded on regulated exchanges, while futures
contracts are transacted over-the-counter

ty
(c) Forwards require daily mark-to-market settlements, while

s i
futures contracts settle only at expiration

e r
(d) Forwards provide liquidity and transparency, while futures

i v
contracts have reduced liquidity

n
42. Which Contract Type Offers More Flexibility and Customization?
U
,
(a) Forwards contracts

L
(b) Futures contracts
O
S
(c) Both offer the same level of flexibility

L /
(d) Neither offers flexibility or customization

O
43. What is the Main Advantage of Futures Contracts Over Forwards
C
/ Contracts?

CE
(a) Futures contracts offer more flexibility

D D (b) Futures contracts have reduced counterparty risk

©
(c) Futures contracts provide liquidity and transparency
(d) Futures contracts can be customized to specific requirements
44. How are Gains and Losses Settled in Forward Contracts?
(a) Daily mark-to-market settlements
(b) Physical delivery of the underlying asset

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INTRODUCTION TO FINANCIAL MARKETS

(c) Cash settlement based on the difference between the forward Notes
price and the current spot price
(d) Settlement occurs only at the contract’s expiration
45. Which Contract Type Requires an Initial Margin or Collateral?
(a) Forwards contracts
(b) Futures contracts
(c) Both require an initial margin or collateral

h i
(d) Neither requires an initial margin or collateral
e l
46. Options Contracts Provide Which of the Following Benefits?
D
of
(a) Protection against downside risks

ty
(b) Limiting potential losses
(c) Profiting from expected price changes
s i
(d) All of the above
e r
i v
47. Which Exchange(s) in India are Options Traded on?

n
(a) NSE (National Stock Exchange) only
U
,
(b) BSE (Bombay Stock Exchange) only
(c) Both NSE and BSE
O L
(d) None of the above
/ S
L
48. What is the Intrinsic Value of an Option?

O
C
(a) The value that would endure if the option were exercised

/
immediately
E
C
(b) The value related to how much time is left before the

D option expires

©D
(c) The difference between the current price of the underlying
asset and the option’s strike price
(d) The discrepancy between the option’s intrinsic value and
total premium
49. Which Options Trading Technique Involves Selling Call Options
Against Shares of the Underlying Asset?
(a) Buying calls

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes (b) Buying puts

(c) Writing covered calls
(d) Spreads
50. What is a Bull Call Spread?
(a) Buying a call option with a lower strike price and selling
a call option with a higher strike price

i
(b) Buying a put option with a higher strike price and selling

h
a put option with a lower strike price

e l
D
(c) Buying and selling options with the same expiration date

of
but different strike prices
(d) Buying and selling options with the same expiration date

ty
but different strike prices, expecting a gradual increase

s i
in the price of the underlying asset

e r
51. Options Contracts Provide Which of the Following Benefits?

i v
(a) Protection against downside risks

U n
(b) Limiting potential losses

,
(c) Profiting from expected price changes
L
O
(d) All of the above

/ S
52. Which Exchange(s) in India are Options Traded On?

L
(a) NSE (National Stock Exchange) only

CO
(b) BSE (Bombay Stock Exchange) only

E/ (c) Both NSE and BSE

DC
(d) None of the above

©D
53. What is the Intrinsic Value of an Option?
(a) The value that would endure if the option were exercised
immediately
(b) The value related to how much time is left before the
option expires
(c) The difference between the current price of the underlying
asset and the option’s strike price

66 PAGE
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INTRODUCTION TO FINANCIAL MARKETS

(d) The discrepancy between the option’s intrinsic value and Notes
total premium
54. Which Options Trading Technique Involves Selling Call Options
Against Shares of the Underlying Asset?
(a) Buying calls
(b) Buying puts

i
(c) Writing covered calls
(d) Spreads
l h
55. What is a Bull Call Spread?
D e
of
(a) Buying a call option with a lower strike price and selling
a call option with a higher strike price

i ty
(b) Buying a put option with a higher strike price and selling
a put option with a lower strike price
r s
e
(c) Buying and selling options with the same expiration date
v
but different strike prices

n i
U
(d) Buying and selling options with the same expiration date

,
but different strike prices, expecting a gradual increase

L
in the price of the underlying asset

O
/ S
L
1.25 Answers to In-Text Questions

C O
1. (a) Providing a platform for trade and investment

E /
2. (b) To exchange surplus crops with other farmers

C
3. (a) Providing a platform for businesses to raise money for expansion

D
©D
4. (a) By earning interest on their deposits and seeing their money
grow over time
5. (a) To estimate the relative worth of various goods
6. (b) Through market pricing
7. (b) To promote efficient pricing of commodities and currencies
8. (c) Through the issuance of shares, bonds, and other financial
instruments

PAGE 67
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 9. (a) Setting up payment for product sales abroad

10. (c) By offering protection against various risks
11. (c) Handling short-term investments
12. (b) Treasury bills
13. (b) Financing operating capital needs
14. (b) Commercial banks and special financial institutions
15. (d) To enable the drawer to obtain cash for working capital needs

h i
16. (b) Facilitating the buying and selling of securities
e l
D
17. (b) Issuing new shares and debentures

of
18. (c) Providing liquidity to holdings

ty
19. (c) Underwriters and brokers
20. (c) Secondary market

s i
r
21. (b) To raise long-term money through the issuance of new securities
e
22. (d) All of the above
i v
market does not
U n
23. (b) The secondary market has listing requirements, while the primary

L ,
24. (a) The management of the company

O
25. (b) The capital market deals with shares, debentures, and government
S
L /
securities, while the money market deals with securities like
treasury bills and commercial paper

C O
26. (d) The Reserve Bank of India, commercial banks, and non-banking

E / financial institutions

D C 27. (b) The Securities and Exchange Board of India (SEBI)

©D
28. (c) The creditworthiness of issuers and their debt instruments
29. (a) They facilitate the buying and selling of securities
30. (b) Investor sentiment
31. (a) Underlying assets
32. (a) Futures contracts
33. (a) Buy or sell an underlying asset
34. (d) Forward contracts

68 PAGE
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INTRODUCTION TO FINANCIAL MARKETS

35. (a) Risk management Notes

36. (a) Hedge against price volatility
37. (c) The use of borrowed funds to increase investment exposure
38. (d) It facilitates efficient trading and price determination
39. (c) The risk that the other party may not fulfil their obligations
40. (a) To ensure transparency and fairness
41. (b) Forwards are traded on regulated exchanges, while futures
h i
contracts are transacted over-the-counter
e l
D
42. (a) Forwards contracts

of
43. (c) Futures contracts provide liquidity and transparency

ty
44. (d) Settlement occurs only at the contract’s expiration
45. (b) Futures contracts
s i
46. (d) All of the above
e r
47. (c) Both NSE and BSE
i v
n
48. (c) The difference between the current price of the underlying asset
U
,
and the option’s strike price
49. (c) Writing covered calls

O L
S
50. (a) Buying a call option with a lower strike price and selling a

L /
call option with a higher strike price

O
51. (d) All of the above

C
/
52. (c) Both NSE and BSE

E
C
53. (c) The difference between the current price of the underlying asset

D
and the option’s strike price

©D
54. (c) Writing covered calls
55. (a) Buying a call option with a lower strike price and selling a
call option with a higher strike price

1.26 Self-Assessment Questions

1. Discuss the types of Financial Markets.

PAGE 69
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 2. What are the difference between Capital Market and the Money
Market?
3. Discuss the Derivatives and its type.
4. What are the advantages and risks associated with derivatives?

1.27 References

i
‹ Apte, Prakash, G., International Financial Management, 3rd edition,
Tata McGraw Hill Publishing Company Ltd., New Delhi, 2005.
l h
‹

D e
Bhalla, V.K., Financial Derivatives-Risk Management, Sultan Chand

of
and Company Ltd., New Delhi, 2001.
‹ Chance, Don M: DERIVATIVES and Risk Management Basics,

ty
Cengage Learning, Delhi.
‹

s i
Dubofsky, Junior, Miller W. Thomas, Derivatives valuation and risk

e r
management, Oxford University Press, New York, 2003.
‹
i v
Fabozzi et al., Foundations of Financial Markets and Institutions,

n
Pearson Education inc. Delhi, 2002.

U
,
‹ Gupta S.L., FINANCIAL DERIVATIVES THEORY, CONCEPTS AND

O L
PROBLEMS PHI, Delhi, Kumar S.S.S. FINANCIAL DERIVATIVES,
PHI, New Delhi, 2007.

/ S
Stulz M. Rene, RISK MANAGEMENT & DERIVATIVES, Cengage
L
‹

O
Learning, New Delhi.

/ C
E
1.28 Suggested Readings

D C ‹ Apte, P.G., International Financial Management, Tata McGraw-Hill

©D
Publishing.
‹ Avadhani, V.A.: Securities Analysis and Portfolio Management.
‹ Avadhani, V.A.: Capital Market Management.
‹ Avadhani, V.A.: Investments and Securities Markets in India.
‹ Bhole, L.M.: Financial Institutions and Markets.
‹ Chance, Don M: An Introduction to Derivatives, Dryden Press,
International Edition.

70 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
INTRODUCTION TO FINANCIAL MARKETS

‹ Chew, Lilian: Managing Derivative Risk, John Wiley, New Jersey. Notes
‹ Company Limited, New Delhi, 1997.
‹ Das, Satyajit: Swap & Derivative Financing, Probus.
‹ “Derivatives Market” NCFM Module, NSE India Publications.
‹ FRB, “Overview of Derivative Disclosures by Major US Banks,”
Federal Reserve.

h i
e l
D
of
i ty
r s
v e
n i
, U
O L
/ S
O L
/ C
C E
D
©D

PAGE 71
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
L E S S O N

2
Determination of Forward
and Futures Prices
Ms. Abha Gupta
Assistant Professor

i
Rukmini Devi Institute of Advanced Studies, GGSIPU

l h
Email-Id: [email protected]

STRUCTURE
D e
2.1 Learning Objectives
of
2.2 Introduction
i ty
2.3 Future Contracts
r s
2.4 Forward Contract
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2.5 Difference Between Forward and Future Contracts

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2.6 'HWHUPLQLQJ )RUZDUG 3ULFH IRU DQ ,QYHVWPHQW
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2.7 Determining Future Prices
2.8 6WRFN ,QGH[ )XWXUHV
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2.10 Commodity Future L
2.9 Currency Futures

2.11 Cost of Carry O

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2.14 Summary

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72 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 DETERMINATION OF FORWARD AND FUTURES PRICES

2.1 Learning Objectives Notes

‹ Student will understand the concept of Forward and Future Contracts.

‹ Student will understand the major difference between Forward and
Future Contracts.
‹ Student will understand the pricing of future and forward contracts.
‹ Student will understand the concept of hedging.

h i
2.2 Introduction
e l
The important feature of the financial markets is its extreme volatility.
D
of
The prices of equity shares, securities, foreign currencies, crude oil, metals

ty
along with all other commodities vary all the time, therefore poses a

i
substantial risk for all businesses who relate to these fluctuating prices.

r s
Moreover, with regular fluctuations in the foreign exchange rate, interest

e
rate it has become crucial to safeguard the corporations or entitles with

v
n i
a suitable mechanism for minimising their risk. Therefore, to lessen the
magnitude of associated risk, a new strategy of investment is used which
is called hedging.
, U
O L
Derivatives are commonly used for hedging. Whether you as a trader loves
derivative market or hate it, you cannot ignore the derivative market as

/ S
it is bigger than stock market if measured in terms of underlying assets.

O L
Even the value of assets underlying the outstanding derivative contracts
including all categories (Futures, options, forwards, swaps) it is even

/ C
higher than the world’s gross domestic value, which itself is astonishing.
E
Derivatives are a good medium of transferring the risk from one party
C
D
to another.

©D
A derivative is defined as a financial instrument whose value depends on
some underlying asset. These are the contracts undertaken between two
parties to minimize the risk associated with investment. Derivatives helps
in transferring the risk form the risk averse people to risk lovers. These
contracts are vital instruments for price discovery, hedging or building
effective portfolios. The derivatives are gaining trader’s acceptance even
in the Indian market as the volume of derivative contracts has shown
a tremendous growth. Derivative contracts can be standardised such as
future contracts and are called exchange traded derivatives while derivative

PAGE 73
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes contracts can also be customised as per the requirements of the customer
and are called as over the counter derivatives.
The National Stock Exchange (NSE) has emerged as the world’s largest
derivative exchange in the year 2022 by the number of contracts traded
based on the record maintained by derivative body “Futures Industry
Association”. Hence, it is important to understand the nitty gritty of
derivatives. In the following sub sections, we understand the two major

i
types of derivatives i.e. future contracts and forward contracts.

l h
2.3 Future Contracts
D e
of
A standardised contract, to buy or sell a specified commodity of a
standardised quality at a pre-determined price, at a pre-determined date

ty
is known as Future Contracts. Here, the date of delivery i.e. future date

s i
t = T (maturity), price to be paid, quantity to be delivered, location of

e r
delivery, delivery procedures, payment terms etc are agreed on the date

i v
of negotiation i.e. t = 0. This contract gives the holder the obligation to

n
take or make the requisite delivery.

U
A future contract is a contract between two parties wherein.
,
O L
A Short Position denotes the party who agreed to deliver the commodity.
A Long Position denotes the party who agreed to receive the commodity.

/ S
L
Let us consider one example to understand the concept.

O
There are two persons Mr. Ram (a farmer who produces wheat) and Mr.

C
/
Mohan (a bread producer). Mr. Ram is trying to secure the selling price

C Efor his next season’s wheat harvest whereas Mr. Mohan wants to secure
the buying price of his raw material i.e. wheat in order to predict his

D profit position from production of breads using wheat. Thus, both enter

©D
into a contract stating delivery of 300 kg of wheat in the month of July
at a price of 30 per kg. By entering into this contract, both Mr. Ram and
Mr. Mohan secures themselves with the price volatility.
In this example, Mr. Ram is the holder of short position (the party who
agreed to deliver/sell) while Mr. Mohan is the holder of long position
(the party who agreed to receive the commodity/buy).
The profit and losses from a future contract are computed on a daily
basis according to the terms of the contract for each party. For example;

74 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 DETERMINATION OF FORWARD AND FUTURES PRICES

suppose the future contract of wheat increases to INR 40 per kg, the Notes
very next day of contract between Mr. Ram and Mr. Mohan. Mr. Ram
as the holder of a short position suffers a loss of INR 10 per kg as the
market price of wheat is increased in the market whereas Mr. Mohan
as the holder of a long position has made a profit of INR 10 per kg as
the price which he is obliged to pay to Mr. Ram is less than the actual
market price.

i
At this moment, Mr. Ram’s account is debited with INR 30,000 (INR
10 per unit × 300 units) whereas Mr. Mohan’s account is credited with
l h
e
INR 30,000 (INR 10 per unit × 300 units). This adjustment continues on
a day-to-day basis till the expiry of the contract.
D
of
As the accounts of both the parties in futures contracts are adjusted
every day, most of the transactions in the futures market are settled in

i ty
cash, and the actual physical commodity is bought or sold in the cash

r s
market. Prices in the cash and futures market tend to move parallel to

e
one another, and when a futures contract expires, the prices merge into

v
n i
one price. So, on the date either party decides to close out their futures
position, the contract is settled as far as that party or those parties are

U
concerned. If the parties in our example settle the wheat futures contract
,
L
at Rs. 40 per unit, the bread manufacturer makes a profit of Rs. 50 per

O
unit and the farmer makes a loss of Rs. 50 per unit in the futures market.

/ S
Essential features of a future contract:

O L
1. Legally binding in nature for both the parties.

/ C
2. A future contract expires on a pre-determined date, called expiry

E
date.

cash.
D C
3. On expiry, contract needs to be settled either through delivery or in

©D
4. Organized in terms of price, quality of commodity, quantity of
commodity, delivery date and time.
5. Are traded on recognised stock exchanges.
6. Are liquid in nature.
Categories of Future Contracts
There are broadly two categories of future contracts

PAGE 75
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes
Future Contracts

Financial Futures Commodity Futures

(a) Interest rate future
(b) Currency future
(c) Stock index Future
h i
e l
D
of
2.4 Forward Contract

ty
The customised contract between two parties wherein settlement takes

i
place at a pre-determined date and time and price. It is a one-to-one
s
r
mutual contract, which is decided to be performed at some future date

e
v
on the pre- defined terms. Here, one of the two parties involved in the

n i
contract assumes a long position as the party agrees to buy the underlying

U
asset on a certain specified future date for a certain specified period.

,
Whereas, the other party of the contract, assumes a short position as the

O L
party agrees to sell the underlying asset on the pre-determined date at the
pre-decided price. Future contracts are flexible in nature and are tailor

/ S
made as per the requirements of the buyer and seller. One can enter into

L
a forward contract for any good, commodity or assets with your own
O
C
choice of delivery date , quantity etc. They are over the counter i.e. not

E /
traded on a recognised stock exchange. The major underlying assets in

C
these contracts are:

D (a) traditional agricultural commodities

©D
(b) currencies
(c) interest rates
Let us understand the concept with the following example:
Suppose, you have been admitted into a post graduate programme in one
of the most prestigious management institutes. To cope with your academic
curriculum, you need one laptop. You approach one of the laptop dealers
in your locality. The laptop as per your specifications and requirements
is not available at the shop but the shopkeeper assures you to deliver

76 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 DETERMINATION OF FORWARD AND FUTURES PRICES

the laptop as per your specifications after one week i.e. (August 8) for Notes
INR 50,000. He also mentioned, that in case you are not accepting the
offer today (i.e. August 1), then you will pay the actual market price
or the spot price of the laptop as on August 8, which can be more than
INR 50,000. To this, you accept the shopkeeper’s offer to buy the laptop
for INR 50,000 on August 8.
Since, you have entered into an agreement to buy the laptop, you have

i
purchased a forward contract wherein you will purchase the underlying
asset i.e. laptop on the due date. The following table will illustrate this
l h
e
contract
August 1 August 8
D
of
Buyer of Forward Contract: Buyer of Forward Contract:

ty
 *LYHQFRQVHQWWRSD\,15  3D\V ,15 

i
 $JUHHG WR SXUFKDVH WKH ODSWRS DW 2. Takes delivery of the laptop
D SUHGHWHUPLQHG SULFH DQG SUH
r s
GHWHUPLQHG GDWH LH $XJXVW 
v e
Seller of Forward Contract
i
Seller of the Forward Contract
n
U
 *LYHQFRQVHQWWRUHFHLYH,15  5HFHLYHV ,15 

,
for the underlying asset i.e. laptop

O L
 $JUHHG WR GHOLYHU WKH ODSWRS DW
D SUHGHWHUPLQHG SULFH DQG RQ D
2. Delivers the desired laptop

/ S
SUHGHWHUPLQHGGDWHLH$XJXVW

O L
Now, lets assume, on August 8 the spot price of the laptop is INR 52,000.

C
Here, you have made a gain of INR 2000 as you will pay the pre-agreed

E /
price of INR 50,000 for the laptop which is less than the actual price of

C
the laptop on the date of delivery. Therefore, forward contracts are use

D
for hedging the risk.

©D
Forward contracts are exposed to default risk also. Suppose, in the above
example, when the actual price of the laptop is more than the agreed
price of INR 50,000, the shopkeeper would prefer to sell the laptop in the
market rather than selling the laptop to you as market would fetch him
better price. Similarly, when the actual price is less than the agreed price
of INR 50,000, you as the buyer of the laptop would prefer to purchase
from the market instead of purchasing from the shopkeeper as you will

PAGE 77
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes find it attractive to purchase the laptop from the market. In this manner,
both you and the shopkeeper are exposed to each other’s risk of default.
Since the contracts are customised, they face poor liquidity.
Features of Forward Contract:
1. Bilateral in nature, hence exposed to counter party risk. There is a
risk of non performance of obligation by either of the two parties.
2. Customised in nature, therefore unique in terms of delivery date,
asset type, quality, quantity etc.
h i
e
3. One of the party takes a long position by agreeing to buy thel
D
commodity at a pre-determined price whereas other party takes a

of
short position by agreeing to sell the commodity at the same price.
4. The contract has to be settled on the delivery date with the delivery
of the asset.
i ty
r s
5. Forward contracts are more popular in foreign exchange and interest
rate markets.
v e
n i
Benefits and Limitations of a Forward Contract
BENEFITS

, U LIMITATIONS

L
Customized contracts 1RW WUDGHG RQ VWRFN H[FKDQJH

O
Used for hedging Poor liquidity

/ S
Does not involve any upfront premium ([SRVHG WR FRXQWHU SDUW\ ULVN

O
contracts L
or initial cost as required in future

/ C
Calculation of Payoff from a Forward Contract

C EAn Indian Company has to import a machine from USA. The price of the

D
machine is $2,00,000 payable after three months. The current exchange rate

©D
is INR82.2/$. As per the current rate, the Indian company would require
2,00,000 × 82.2 = 1,64,40,000. But, if the Indian company anticipates
depreciation of Indian currency in the upcoming three months, the cost
to the Indian company increases. In this situation, Indian company can
protect itself from the risk of currency depreciation by entering into
forward contract for exchange rate. Suppose the company buys three months
forward at a rate of 82.9. Now the company will be paying 1,65,80,000.

78 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 DETERMINATION OF FORWARD AND FUTURES PRICES

A forward contract includes the following four components: Notes

1. The underlier
2. The notional amount, n
3. The delivery price, k
4. Date of settlement
The market value of forward is equal to
n(s-k),

h i
where s is the spot price of the underlier on the day of settlement. This
e l
D
formula is derived from the fact that, on settlement date, the long party

of
is paying a delivery price k for an underlier then trading at price s. The
difference between those two prices, multiplied by the notional amount,

ty
is the market value of the forward.
IN-TEXT QUESTIONS
s i
1. A forward contract is:
e r
(a) customised contracts
i v
(b) flexible in nature
U n
(c) carries default risk
L ,
O
(d) All of these

/
2. Future contracts is ___.
S
(a) standardised
L (b) carries market risk

/ CO
(c) free from default risk (d) All of these

E
3. Forward contracts are not ___________ products.

C
D
4. Forward contracts are bilateral negotiated contract between two

D
parties and hence exposed to ___________.

©
2.5 Difference between Forward and Future Contracts
The following pointers indicate the fundamental differences between a
forward and future contract:
1. The Futures contracts are standardized in nature with respect to price,
delivery date, quantity, delivery mechanism etc. One can deal with
only those specific contracts which are supported by the exchange.

PAGE 79
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes On the other side, forwards contracts are entirely flexible in nature.
Moreover, they are negotiated between the parties, privately.
2. Forward contracts face both market and credit risk as the counterparty
may default whereas future contracts have only market risk. There
is no credit risk in case of future contracts as exchanges follow
daily price adjustments of profits and losses for both parties to the
contract. This ensures, future price market value to be reset to zero,

i
hence ensures no credit risk.

l h
3. Future contracts are mostly used by speculators who always bet on

D e
the direction in which there is a price moment of the asset, thus
in most cases, are closed before the actual settlement date. On the

of
other side, forward contracts are used by hedgers for hedging the
risk occurring due to volatility in the prices of underlying assets.

i ty
They are always settled on the day of settlement either via cash

r s
settlement or delivery takes place. Exiting a forward contract before

e
expiry is usually considered to be unattractive.

v
i
4. Forward contracts are settled with the delivery of the underlying
n
U
asset whereas in future contracts delivery is satisfied by entering

,
into another off-setting contract or by trading the contract on the
stock exchange.

O L
S
5. Forward contracts are entered with business intentions or for

/
commercial purposes whereas future contracts are done to transfer
L
O
the risk without transferring the asset.

/ C
Based on above reasons, one can say when forward contracts become

E
standardised and are traded on a stock exchange, they become future

D C contracts. Thus, every futures contract is a standardized forward contract.

Both contracts, whether forward or future do the same but difference

©D
lies in the fact that future contract do it in a better and efficient manner,
provides more transparency, ensures healthy risk management as compared
to forward contracts.
Basis Future Forward
Nature Standardised Customised
Traded 2Q 6WRFN ([FKDQJH Over the counter
Risk 0DUNHW 5LVN 0DUNHW5LVNDQG&RXQWHU3DUW\5LVN

80 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 DETERMINATION OF FORWARD AND FUTURES PRICES

Basis Future Forward Notes

Delivery Very few are settled Most of the contracts are settled
via actual delivery with actual delivery
Liquidity +LJK /LTXLGLW\ Low liquidity
Size of the contract Standardised Decided between the parties
Mark to Market Not performed Done on daily basis

i
2.6 Determining Forward Price for an Investment Asset

l h
e
The non dividend paying stocks and the zero coupon bonds are the most
common example of investment asset. These are the assets which provide
D
of
no income to the holder and also holds no storage costs.
FO = So ert
where; FO = forward price
i ty
SO = Spot Price
r s
v e
i
T = Time to Maturity

U n
Suppose, a trader purchase a four month forward contract to purchase
Zero Coupon bond having maturity one year from now. The current price

L ,
of the Zero coupon bond is INR 120. Assuming the risk free interest rate

O
compounded continuously at 6% per annum, compute the forward price
of the contract.
/ S
L
using the above equation; FO = So ert

O
C
(0.06 × 4/12)
Fo = 120 e
Fo = 122.42
E /
122.42.
D C
Hence, the forward price for an investment asset comes out to be INR

©D
2.7 Determining Future Prices
The price of the commodity or asset which is available for delivery today
is known as spot price. The future price and the spot price are not equal.
The difference between the spot price and the future price depends on
several factors which majorly includes the financial cost or dividend or
interest associated with a financial asset.

PAGE 81
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Let’s assume Mr. A owns a share which he can sell immediately for cash
or sell the share on a later date. If Mr A sells the share immediately, he
can invest the amount received and can earn return on the same while
at the same time, he has to forgone his dividend earning with immediate
selling the share which he may receive in future by holding the share
for long.
Now, let us discuss one another example where Mr. B wants to buy a

i
share. He can immediately buy a share at spot price or may enter into a

l h
future contract and take delivery of the share at a future date. If he enter

e
into a future contract, there will not be any cash outflow at the moment

D
and person can earn interest on the purchase price while at the same time

of
he is forgoing his dividend income as the person is not holding share at
the current moment.

i ty
Thus, the relationship between the spot and future price is as follows :

r s
Future Price = Spot Price (1+rf )t – dividend forgone
Where;
v e
rf = risk free interest rate
n i
t = period of investing
, U
O L
2.8 Stock Index Futures

/ S
O L
Stock index futures are the future contracts on the stock market indices.
It is a specified contract to buy or sell the face value of the underlying

/ C
stock index. The profit or loss from a futures contract that is settled at

C Edelivery is computed as a difference between the value of the index at

the time of delivery and the value of the index when originally purchased

D or sold. It is important to note that here, delivery at settlement cannot

©D
be in underlying stock but obviously in cash.
Suppose the stock index is currently at 3000. The risk free interest rate
is 7 per cent per annum. The average annual dividend yield is 2%. How
much would be the one year price stock index future price?
Using the same formula as mentioned above:
Future Price = 3000 (1.07)1 – 3000(0.02) = 3150.

82 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 DETERMINATION OF FORWARD AND FUTURES PRICES

2.9 Currency Futures Notes

Each country has its own currency which is affected by a number

of factors including economic factors, central bank policy measures,
demand and supply available and the forex reserves. Currency value of
one country keeps on changing in relation to other country’s currency.
However, investors prefer the currency whose value is stable and strong
in a long term vision. Currency futures are for ex trading instruments
wherein the underlying asset is the two currencies future exchange rate.
h i
For ex: British Pound to US Dollar etc.
e l
D
These instruments are used as a hedging against the exchange rate

of
volatility. These are mostly purchased by investors who require foreign
currency in the future but doesn’t want to buy it today. This purchasing

ty
assures the purchaser for foreign currency pricing.

s i
Currency futures are also known as foreign exchange futures. These are

e r
contracts that are used in exchanging one currency with another currency

i
at a fixed exchange rate on a specific date in the future.
v
Currency Future Price = S e
U n(r-rf)T

,
Where:
S = Spot Price
O L
/ S
r-rf = interest rate difference between domestic and foreign currency
T = Time

O L
C
Example: The risk free rate of return in Europe is 12% whereas the

/
risk free rate if return in USA is 4%. The current exchange rate is 0.90,
E
C
compute the 8-month future price.

D
(r-rf)T
Currency Future Price = S e

©D
= 0.90 e(0.04-0.12)8/12
= 0.743
Hence, future exchange rate = $.743/euro

2.10 Commodity Future

The commodity futures are the contracts which deal with commodities
as an underlying asset. Commodity future includes:

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes (a) Agricultural commodities: These include grains, oil, meat, livestock,
etc.
(b) Metal Commodities: This category includes gold, silver, copper,
platinum, crude, gasoline, etc.
In the case of commodity future, there is no dividend yield. Moreover,
the buyer of commodity future has no storage cost as the delivery will be
taken up on a future date, thus saves storage cost. But since the person

i
is not holding the commodity, he forgoes the comfort or convenience

l h
of meeting sudden requirements, thus loses convenience yield. Thus the

futures is equal to:

D e
relationship between spot prices and future prices in case of commodity

of
Future Price = Spot Price (1+rf)t - Convenience yield + Storage cost

ty
Where;

s i
Convenience yield is the additional value gained form holding the

e r
underlying asset rather than holding a long forward or future contract.

i v
It is equal to the amount that would be received from holding the asset

It is equal to;
U n
and selling the same during shortage at higher prices.

L ,
Y = [{S+U}/F]1/T {1+R}-1
Where; S = Spot Price

S O
/
U = Storage Cost
L
O
F = Future Price

/ C
R= risk free rate of return

C EY= Yield

D Example: Suppose the spot price of crude is $ 120 per barrel and the

©D
100 per barrel is the 2-year futures price, the storage cost of crude for
a time period of two years is $ 5. The risk-free return rate equals to 5%
per annum. Compute the convenience yield.
Y = [{120+5}/100]1/2 (1.05) – 1 = 17.39%

2.11 Cost of Carry

Cost of carry is an important determinant for the existing relationship
between the spot prices and the future prices. Cost of carry includes

84 PAGE
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 DETERMINATION OF FORWARD AND FUTURES PRICES

the cost of storage plus interest charges if any for financing the asset Notes
subtracting income generated by the asset if any.
For different assets, cost of carry is computed in the following manner:
1. Non-Dividend Paying stock: Cost of carry is equal to “r” because
there is no storage cost involved in this situation and also no income
is earned.
2. For Stock Index: Cost of Carry is equal to “r-q” as income is earned
at a rate of q on the assets.

h i
3. For Currency: It is equal to “r-rf ”.
e l
D
Considering the cost of carry as C, future price for any investment asset

of
is equal to :
Fo = SoecT

ty
Where, Fo = Future Price

s i
r
So = Spot Price
C = Carry Cost
v e
T = Time
n i
U
(c-y}T
For Consumption asset: Fo= Soe
Where, Fo = Future Price

L ,
O
So = Spot Price
C = Carry Cost
/ S
T = Time

O
y is the convenience yield. L
/ C
E
IN-TEXT QUESTIONS

C
5. Investment asset is an asset with no ______ .

D
©D
6. ______ contracts have high liquidity.
7. Cost of carry is basically the ______ cost.
8. ____________ additional value gained form holding the underlying
asset rather than holding a long forward or future contract.

2.12 Basis Risk

The basis is defined as the difference between the spot price valuation and
future price valuation. It is defined as potential risk which an investment

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes trader would undertake with hedging the position by undertaking opposite
position in derivative category may be forward or future of the underlying
asset. It is the probable chances that the future price of the asset will
not move in steady correlation with the price of the underlying asset.
This will negate the benefits of hedging strategy adopted to reduce the
exposure to losses.
Basis risk often comes from systematic risk i.e. the market risk because

i
of fluctuations in the economy.

l
Basis is equal to the difference between the spot price and the future
h
having expiry on settlement date (T)
D e
price. Let b(t) represents the size of basis at date (t), for a future contract

b(t)T = S(t) – F(t)T

of
ty
where, b = basis
S = Spot price
s i
F = Future price
e r
T = Maturity Period
i v
T = specific date
U n
L ,
When: Spot price > Future Price, it is called Over Future or Premium

O
Spot Price < Future Price, it is called Under Future or Discount

/ S
Assume the spot price of wheat is $ 50 while the two month future price

L
is $51.2, then basis will be equal to -1.2

O
C
During the time gap between opening of a future contract and closing the

E /
future contract, the basis may increase or decreases. It is usually expected

C
that towards the expiry date, future prices merges with the spot prices.

D Different Types of Basis Risk

©D
1. Price Basis Risk: The risk which occurs when the prices of the asset
and the future asset do not move in correlation with each other.
2. Location Basis Risk: The risk which arises due to the difference
in the locations between underlying asset and it’s future contracts.
For example, the basis for actual petrol sold in Delhi and petrol
futures traded on a New York futures exchange may differ from
the basis amongst petrol and Delhi-traded petrol futures.

86 PAGE
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 DETERMINATION OF FORWARD AND FUTURES PRICES

3. Product Quality Basis Risk: Basis will differ when there is quality Notes
difference amongst the underlying asset and the asset as represented
by a future contract.

2.13 Arbitrage
Arbitrage can be described as a position wherein a risk-less profit is
realized by an investor by simultaneous trading in two or more markets.
Though, arbitrage opportunities are actually wanted or demanded but they
h i
are not easy to uncover, because these opportunities do not last longer
e l
D
as the prices of the securities are adjusted with each buying and selling

of
activity.
An investor can adopt arbitrage strategy only when any one of following

ty
three conditions is achieved:

s i
r
‹ The specific asset is traded differently at different markets.
‹

v e
Two assets having matching cash flows must trade at dissimilar
prices.
n i
U
‹ An underlying asset with a known price in the future, must trade

L ,
today at a dissimilar value as compared with its future price, which
is adjusted at the risk-free interest rate.

S O
For example, the spot price of silver in Delhi is INR 8000 per 100

L /
grams while the 90 days future contract of silver being traded at MCX

O
is INR 8300 per 100 grams. This reflects the arbitrage opportunity for
an individual trader.
/ C
C E
Suppose the trader purchases 100 grams of silver in cash market at a price
of INR 8000 per 100 grams and also obtains a short position (implying

D
willing to sell) for same quantity in future market at INR 8300 per 100

©D
grams.
On the expiry of the future contract, the trader shows willingness to
close the future contract by delivering the silver. Here, the trader sells
off the 100 grams of silver at a price of INR 8300. This 100 grams
of silver was purchased by trader in the cash market at a price of
INR 8000. Hence, the trader gain INR 300 per 100 grams of silver. This
gain emerges because the trader obtains two opposite positions in spot
and future market. In spot market he purchases the silver and in future

PAGE 87
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes market he sell the silver. Due to differences in the price of silver in both
cash and future market, this gain is obtained by the trader.
IN-TEXT QUESTIONS
9. An arbitrager attempts to ______ risk with the help of buying
or selling the assets.
10. ______ is entitled to receive the asset in the future.
11. ____________ represents the difference between the spot and
future prices.
h i
e l
12. ____________ of the underlying asset is called as spot price.

D
of
2.14 Summary
‹

i ty
The futures market is an international marketplace, originally

s
formed as a place for farmers and merchants to purchase and sell
r
e
commodities for either spot or future delivery.
‹
i v
Forward contracts are bilateral contracts, and hence, they are exposed
to counter party risk.
U n
,
‹ Given the absence of standardisation in forward contracts, there is

L
tiny scope for a secondary market in forwards.

O
S
‹ Futures accounts are settled (credited or debited) daily, on the basis

/
of profits or losses incurred.
L
O
‹ The forward market is like a real estate market in that any two

/ C
consenting adults can form contracts against each other.

C E ‹ A hedger attempts to lessen risk by buying or selling now in an

effort to avoid rising or declining prices.

D
©D
‹ The important players in the derivative market are hedgers and
speculators.

2.15 Answers to In-Text Questions

1. (d) All of these

2. (d) All of these
3. Standardized
4. Counter Party Default Risk

88 PAGE
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DETERMINATION OF FORWARD AND FUTURES PRICES

5. Income Notes
6. Future
7. Storage
8. Convenience Yield
9. Minimize
10. Long Position

i
11. Basis
12. Current Market Price
l h
2.16 Self-Assessment Questions
D e
1. Define concepts of Forward and Future Contracts.
of
2. What are the benefits and Limitations of Forward Contract?
i ty
3. Write short notes on the following:
r s
(a) Cost of Carry
v e
(b) Basis Risk
n i
(c) Arbitrage

, U
2.17 Suggested Readings
O L
‹
/ S
Hull, J.C. (2014). Options Futures and other Derivatives. 9th edition,
Prentice Hall of India.

O L
C
‹ Neftci, S.N. (2000). An Introduction to the Mathematics of Financial

/
Derivatives. Academic Press.

E
C
‹ Bhalla, V.K. (2012). Investment Management. New Delhi: Sultan

D
Chand.

©D
‹ Wimott, P. (2012). Quantitative Finance. Wiley & Sons.
‹ Jarrow, R. & Stuart, T. (1995). Derivative Securities. South Western.
‹ Chance, D.M., & Brooks, R. (2008). Derivatives and Risk Management
Basics. Cengage Learning India.
‹ Pliska, S. (1997). Introduction to Mathematical Finance. Wiley-
Blackwell Publishing.
‹ www.ncdex.com for details on commodity derivatives in India.
‹ www.nse-india.com for stock-based derivatives.

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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
L E S S O N

3
Hedging Strategies Using
Futures
Aditi Methi
Assistant Professor

i
IITM, GGSIPU, New Delhi

l h
Email-Id: [email protected]

STRUCTURE
D e
3.1 Learning Objectives
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3.2 Introduction
i ty
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3.1 Learning Objectives
‹ Learn the concept of hedging.
‹ Understand the meaning of short and long hedge.
‹ Calculate the Optimal Hedge Ratio.
‹ Gain Knowledge of the mechanism of cross hedging of portfolio.
‹ Know the techniques of the commodities using futures.

90 PAGE
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 HEDGING STRATEGIES USING FUTURES

3.2 Introduction Notes

The corporate units work in a complicated business climate today. Managers

frequently discover that these elements which are beyond their control
have a significant impact on the profitability of their companies. External
factors like stock prices, interest rates, exchange rates, and commodity
prices are significant among these.
Modern business has thus evolved into an environment that is more
complicated, and uncertain. Therefore, in order for the business to be
h i
properly operated, it is essential that business executives manage such
e l
D
uncertainty and risk. By spreading the risk to others who are prepared to

of
take it such as in the futures market, the futures market helps managers
decrease or control their exposure to risk. To put it another way, the

ty
managers may be able to use specific tools from the futures markets to

s i
lower and manage their pricing risks. Hedging refers to the practice of

r
minimizing or mitigating the potential risks or uncertainties associated
e
v
with financial investments, transactions, or other ventures. It involves

n i
taking actions or positions that offset potential losses or adverse effects

, U
that might occur due to changes in market conditions, prices, interest
rates, or other factors. Hedging is the term for futures trading done with

L
the intention of lowering or controlling risk.
O
/ S
In this chapter, we will discuss the nature of hedging, the fundamentals

L
of hedging, and how futures hedges can be tailored to the needs of the

O
hedger. In other words, we shall take into account several concerns

/ C
related to the placement of the hedges here. When might holding a short

E
futures position be appropriate? When would it be appropriate to buy

D C
long futures? Which futures contract is appropriate for use? What size
futures position is the best?

©D
Example A
The company X produces many gradations of automobiles. X imports
vehicle parts from Japan for this since he needs them. X believes that
the cost of cars will rise in the future as a result of rising import part
prices, which might have a big impact on this company’s profit profile.
Consequently, there is a substantial chance that prices will increase in
the future.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes As a result, the company seeks to minimise the risk that rising import
prices entail. In order to mitigate this risk arising in the future, he has
decided to participate in the derivatives market. He enters into the futures
(derivatives) market to manage his risk in the current market.
Example B
A food grain company Z predicts that 5000 quintals of food grains will
be harvested in the upcoming month. However, the corporation worries

i
that the price of grain may change in the next month. Company Z

l h
therefore anticipates suffering significant losses in the upcoming month.

D e
The company can sell grain for delivery in the following month at a
fair price by entering the derivatives and futures markets today, thereby

of
hedging the risk of price volatility. Anticipatory hedging is the term for
this method of risk management.
Example C
i ty
r s
A company treasurer plans to take out a three-month loan in the middle

v e
of August. The treasurer could worry that by the time the money is

n i
borrowed, interest rates will have increased. An increase in interest rates

U
would make borrowing more expensive. In order to have a profit offset

,
in the event that interest rates rise, a futures contract is purchased. In

O L
this case, the treasurer can implement hedging by selling futures contracts
for three months’ interest rates.

/ S
L
3.3 Concepts of Hedging
O
/ C
In its broadest definition, hedging refers to the process of defending

C Eoneself against futures loss.

D
The use of futures transactions to eliminate or reduce price risk in the

©D
spot market is more specifically understood as hedging in the context
of futures trading. In other words, a hedge is a position that is acquired
in order to temporarily replace a position in another asset (or liability)
or to protect the value of an existing position in an asset (or liability)
until the position is liquidated. According to this theory, the corporation
wants to hedge both its assets and liabilities.
Example:
A In March 2022, a Jute mill foresees a need for 10,000 units of Jute in
July 2022. The present cost of jute stands at $1000 per unit. To ensure

92 PAGE
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 HEDGING STRATEGIES USING FUTURES

stability and prevent a substantial price increase beyond $1000 per unit, Notes
the company engages in financial arrangements. Safeguarding against
potential price hikes, the mill purchases 10,000 units of jute in the futures
market, where the current rate is $1050 per unit.
When July arrives, the jute price experiences a significant surge, reaching
$1500 per unit in the spot market. The corresponding futures price for
July’s jute is recorded at $1470 per unit.

i
Now, the jute mill has two choices:
1. It can acquire its needs from the spot market and sell its futures
l h
contracts at the going rate of $1470. The transaction’s profit/loss
D e
of
profile will look like this:
Jute bought = $1,000 per candy.

ty
Sales revenue is $1470 per candy.

s i
r
Profit from selling is equal to $470 each candy, The current price

e
of jute is $1500 per candy. While the cost of the candy to the mill

v
is $1030 (1500-470) per candy.

n i
U
Therefore, futures transactions have minimised the risk of an increase

,
in price by just $30 per candy.

L
2. The mill could buy jute directly from the futures market. In this

O
S
scenario, the mill would pay $1000 for each confection, but there

/
is a chance that the same sort of jute may not be delivered when
L
O
it comes to accepting delivery.

/ C
The aforementioned example demonstrates how the corporation has pro-

E
tected itself against the danger of rising prices by purchasing futures.

D C
3.4 The Multi-Purpose Concept of Hedging

©D
Earlier, it was believed that there was just one type of hedging—routine
or naive hedging—where the trader always hedged all of his transactions
in order to cover all price risks. Hollbrook Working, on the other hand,
refuted this notion in his article “New Concepts Concerning Futures
Markets and Prices” and presented the adaptable notion of hedging, which
is now widely accepted. This theory suggests a variety of alternative uses
for the hedging.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Carrying Charge Hedging

Carrying charge hedging is a strategy employed in commodities markets
to manage price risk between the present and future delivery of a
commodity. It involves taking positions in both the physical commodity
and its corresponding futures contracts to offset the cost of carrying the
physical commodity until its delivery date. This strategy is particularly
relevant for commodities that have storage costs, interest expenses, and

i
other associated costs tied to holding the physical goods. In accordance

h
with this strategy, the stockist monitors the difference between spot

e l
and futures prices to determine whether it is sufficient to pay carrying

D
expenses, at which point the stockist purchases ready stocks. It indicates

of
that, contrary to the traditional belief that hedges are employed to guard
against loss on retained stock, traders may opt for hedging if the spread

ty
is sufficient to pay carrying expenses. In this way, H. Working asserts,

s i
“the question is not so much whether to hedge as whether to store.”
Operational Hedging
e r
i v
Operational hedging is a strategic approach that companies use to

U n
manage and mitigate various types of risks associated with their day-to-
day operations and business activities. Unlike financial hedging, which

L ,
primarily deals with managing financial market risks, operational hedging

O
focuses on reducing risks related to the operational aspects of a business.

/ S
These risks can encompass a wide range of factors, including supply

O L
chain disruptions, production issues, currency fluctuations, regulatory
changes, and more. This point of view claims that hedgers operate on

/ C
the futures market and replace it for cash or forward transactions. They

C Ebelieve that there is greater liquidity and less of a price spread between
the “bid” and “ask” prices in the futures markets.

D
©D
Selective or Discretionary Hedging
According to this theory, traders only hedge themselves on rare instances
when they anticipate negative price changes in futures, as opposed to
routinely. Instead of avoiding price risk, the goal in this case is to cover
the risk of adverse price fluctuation. Therefore, they only employ the
hedging approach when there are unfavourable price changes.
Anticipatory Hedging
This is done in order to get ready for impending sales or purchases.
A miller might hedge by buying futures in advance of impending raw

94 PAGE
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 HEDGING STRATEGIES USING FUTURES

material requirements, as opposed to a farmer who might do so by selling Notes

ahead of his crop.
In conclusion, it is clear that hedging today serves several reasons for
market players in addition to lowering or regulating price risk. In our
subsequent discussion, hedging is mostly utilised to eliminate or lessen
price risk.
The Perfect Hedging Model
The position that entirely removes the risk is referred to as the perfect
h i
hedge.
e l
D
To put it another way, a perfect hedge is when you use futures or a

of
forward position to entirely eliminate the risk to your firm. For instance,
let’s say a jewellery manufacturer wishes to lock in the price of silver for

ty
the month of June. He can achieve this by purchasing long June silver

s i
futures, which will offset the risk of rising silver prices by the gains

r
realised from the position. Similar to this, if silver prices decline, futures
e
v
losses will outweigh the savings from the silver purchase.

n i
In either scenario, the futures price serves as a lock on the net silver

, U
cost. Emphasis should be placed on the fact that only price risk—the
uncertainty around the sum that will be sold or purchased at a later

O L
date—is protected. Quantity risk is not. Without a doubt, the quantity of

S
the asset that is available at the futures date may also have an impact
on futures pricing.
L /
Example

C O
E /
Consider a company that plans to sell its 200 kg of silver inventory in
July. Silver’s spot price is $9500 per kg right now, but the company is

D C
concerned that it may drop between now and July. The firm takes a 200

©D
kg short position in June silver futures at a futures price of $9600 per
kg to protect itself against this risk. Because of the futures position, the
firm is now shielded against declining silver prices and will benefit if
silver prices do decline.
Take a look at what happens to the company’s revenue under two price
scenarios to evaluate how it is hedged:
1. In the first case, spot silver prices increase to $9700 per kg.
2. Silver drops to $9400 per kg in June in the second scenario.

PAGE 95
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes QT= Quantity

FtT= Future Price
Silver Inventory and Sales Revenue
Scenario Silver revenues = Profit/loss = Net
(PT) (QT × PT) [QT (FtT – PT)] Revenue
1. $9700 $19,40,000 200($9600–$9700) = $9,60,000
- $20,000 (Loss)
2. $9400 $18,80,000 200($9600–$9400) = $9,60,000
h i
$40,000 (Profit)
e l
D
In both cases, the corporation commits to the current futures price of

of
$9600 per kg When silver prices rise, there will be an offset futures loss,
and when silver prices fall, there will be an offset futures gain. It should

ty
be noted, however, that the company does not lock in the current spot
price of $9500 per kg.
s i
e r
In general terms, a short inventory hedge is also possible.

v
ni
Scenario Revenues Profit/loss Net Revenue

U
PT QT PT QT (FtT – FT.T ) = QT(FtT – PT) QT Ft.T

L ,
We’ll suppose for the purpose of this example that the business exchanges

O
its stock for silver on the spot market. Since the futures settlement price

S
/
at expiry is the same as the spot price (NT) due to the convergence

O L
impact on prices, the corporation would accomplish the same result if
it delivered its silver into the futures market to cover its short position.

/ CThe two fundamental processes in futures hedging are illustrated in the

C E examples above:

D 1. Hedger assesses how changes in commodity prices, security prices,

©D
interest rates, or currency rates affect company earnings.
2. Hedger opens a futures position with the opposite exposure. Risk is
therefore removed.
Before a perfect hedge can be created, a number of requirements must
be met. These are, in brief, as follows:
1. The business firm must understand precisely how a change in pricing
affects profit, and the relationship between the two must be linear.

96 PAGE
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HEDGING STRATEGIES USING FUTURES

2. The market must provide futures or forward contracts that have the Notes
following characteristics:
(a) The profit of the company will be impacted by what is written
on the underlying asset.
(b) The contract should expire on the same day that the cost of
the cited asset will have an impact on the firm’s profitability.
(c) It includes a specific amount that will have an impact on the
company.
h i
IN-TEXT QUESTIONS
e l
1. Which of the following is an example of a common hedging
D
of
technique used to manage foreign exchange risk?

ty
(a) Arbitrage (b) Swaps
(c) Short selling
i
(d) Dividend reinvestment
s
e r
2. What is the primary difference between hedging and speculation?

i v
(a) Hedging involves taking risks, while speculation avoids
risks

U n
,
(b) Hedging aims to minimize losses, while speculation aims
to maximize profits

O L
(c) Hedging is used by individual investors, while speculation

/ S
is used by institutional investors

O L
(d) Hedging requires complex financial instruments, while

C
speculation relies on simple investments

E /
3. Which of the following is an example of a commonly used

C
hedging instrument?

D
©D
(a) Stocks (b) Options
(c) Commodities (d) Real estate
4. Which of the following is a primary objective of hedging in
finance?
(a) Maximizing profits
(b) Eliminating all risks
(c) Speculating on market trends
(d) Reducing potential losses

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 5. Which of the following is a commonly used hedging instrument

to manage interest rate risk?
(a) Stocks (b) Options
(c) Treasury bonds (d) Futures contracts

3.5 The Basic Long and Short Hedges

h i
The simplest definition of hedging is taking a position in futures that is

l
the opposite of one’s position in the cash market or of a future financial
e
D
obligation one currently has or will face. The two types into which the

of
hedges can be separated are short hedges and long hedges.
Short Hedge

i ty
A short hedge, also known as a selling hedge, entails holding a short

s
position in a futures contract. To put it another way, it happens when

e r
a company or trader who intends to buy or manufacture a commodity

i v
in cash sells futures to protect their cash position. In a more general

U n
sense, this relates to a variety of things, including being short, holding
a net sold position, or a promise to fulfil. Thus, the primary goal in this

,
situation is to guard against a decrease in cash prices while maintaining
L
O
the value of the cash position. When the hedger already owns everything

S
and anticipates selling it at some point in the futures, a short hedge is
suitable.
L /
O
It is anticipated that once the short futures position is opened, any

C
/
increase (decrease) in the value of the cash position will be completely

C Eor substantially offset by a gain (loss) on the short futures position.

D
Example

©D
A US exporter who is aware that a German corporation will provide him
German marks in three months. If the mark gains value in relation to the
US dollar, the exporter will profit; if the mark loses value, the exporter
will lose money. A short futures position results in a loss if the mark’s
value rises and a gain if its value falls. As a result, the exporter’s risk
is diminished.
Example
A mine owner who also produces silver and who owns a mine is trying
to decide whether or not to start running the mine. Due to the two-month

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 HEDGING STRATEGIES USING FUTURES

production time, it is depending on the price of silver in futures. He wants Notes

to forecast his company’s profitability. He might stop producing silver
if the price of silver drops. Present date is June 10. On June 10, silver
was selling for $ 1050 per kg on the spot market, and for him, $ 1060
per kg in August’ would be a fair price. The miner intends to enter the
silver futures market in order to determine the price of “1060 per kg.”
Hedging allows him to reduce the chance that silver prices will decline
during the following two months. In anticipation of selling 50,000 kg of
silver in the next two months, he sells ten 5000 kg futures contracts for
h i
August delivery at $ 1060 per kg.
e l
Position of Short Hedge of Silver Manufacturer
D
of
Spot market Futures market

ty
June 10 June 10

i
In two months, anticipate to sell 50,000 Sell ten futures contracts for delivery
kg of silver and receive $1060 per in August at $1060 per kg.
r s
kilogramme, or $53,00,000 for the

v e
i
entire contract.
August 10 August 10

U n
,
Silver’s current spot price is $ 1070 Purchases a futures contract for $ 1070,

L
per kg, and the miner sells 50,000 kg or $5,35,00,000

O
of silver for $5,35,000 for the entire Futures loss = $ 5,000,00

/ S
contract.
Earnings = $5,00,000

O L
In this scenario, the miner has effectively mitigated their risk by engaging

/ C
in a precise hedging strategy. They achieved this by selling futures

E
contracts in June with the intention of delivering the product in August.
C
D
When the delivery date arrives, they sold the product in the spot market,

©D
UHVXOWLQJ LQ D SURILW RI ൗ 6LPXOWDQHRXVO\ LQ WKH IXWXUHV PDUNHW
the miner incurred a loss of an equivalent amount. As a result, the loss
in the futures market effectively balanced out the profit gained from the
spot market, providing a successful hedge against the potential risk of
a price decline.
Long Hedge
On the other hand, a long hedge (also known as a purchasing hedge)
entails taking a long position in a futures contract. Prior to buying the

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes underlying asset in the spot or forward market, the main goal is to
safeguard against a price increase in that asset.
It is also referred to as being long, possessing the asset outright, or having
a net bought position. Because the company already has the asset in its
inventory, it is also known as an inventory hedge.
Example
On January 10, a fund manager expects to receive $1 million, which he

i
plans to invest in a well-balanced portfolio of UK stocks. He worries that
h
l
before the money is paid a month from now, stock prices will increase.
e
D
He can visit the futures market and purchase a contract for today at 2200

of
as the current index (the I TSE 100) is at that price. By selling the FTSE
contract for March 18, he can get rid of his holding.

ty
In the aforementioned instance, the fund manager used stock index futures

s i
to protect himself against market volatility in the month that would

r
follow. Both spot markets and futures markets fall under the criteria of
e
v
“long” and “short,” which are widely used in futures trading. Although

n i
it is not essential to actually hold stock, it is evident that someone who

U
owns shares of an asset is considered to “be long” in the spot market.

L ,
Similar to this, a person who sold a forward contract is referred to as
being “short” on the spot market. In a nutshell, the table shows where

S O
long and short hedges are situated.

L /
Long v. Short Hedging

CO
Short hedger Long hedger

/
Spot market position Long Short

C EProtection needs against

Position in futures market
Price fall
Short
Price rise
Long

D D Example

© A farmer expects to have a good crop of 150 quintals, which he plans to

harvest in January. October has arrived, and the crop’s current price is
$10,000 per quintal. The farmer can make a sufficient profit at this price,
which he accepts. But he is concerned that the price will drop by the time
the harvest is ready. Therefore, at the market’s current price of $ 9500 a
quintal, he sells 150 quintals on the commodity futures exchange. Crop
prices have in fact increased throughout the month of January. 11,000
per quintal is the current spot price. Now, the farmer has two options:

100 PAGE
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School of Open Learning, University of Delhi
 HEDGING STRATEGIES USING FUTURES

1. At the current futures price of 10,500, he may purchase 200 quintals Notes
of the January crop back from the futures market. Then, at the set
amount of $11,000 per quintal, he can sell his actual crop of pepper
in the open market. Therefore, the farmer will make the following
profit or loss:
Sale under contract in January for $9,500 per quintal. Contract buys
in January at 10,500. There is a consequent net loss of $1000 per

i
quintal. Additionally, he sells his produce for 11,000 on the spot
market, and after subtracting a loss of 1,000 on a position in the
l h
e
futures market, the net amount he receives is 10,000 (11000-+9500-
10500) per quintal.
D
of
2. In the futures market, he can deliver at $9500 per quintal.

ty
In these circumstances, selling futures by those who are hedging against

i
price falls is referred to as a short hedge and is done to protect against

s
r
downward price swings.

v e
3.6 Cross Hedging
n i
, U
The assets whose prices will be hedged in all of the previously stated

O L
hedging positions were covered by futures contracts, which are set up
on those assets and expire at the exact time the hedging is to be lifted.

/ S
Occasionally, it is seen that companies want to protect themselves against
L
a specific asset but there are no available futures contracts. This condition
O
C
is referred to as asset mismatch. When the same futures term (maturity)

E /
on a particular asset is frequently unavailable, it is also referred to as a

C
maturity mismatch.

D
Regarding the various scenarios mentioned previously, there is still a chance

©D
to protect against price risk by employing related assets (commodities or
securities) or futures contracts with expiration dates other than those on
which the hedges are lifted. Cross hedges are a type of hedge. It will
be unusual for all things to line up so beautifully in real life and in the
economic sector. Therefore, a hedge in which some attributes of the spot
and futures contracts do not exactly match is called an across hedge.
When there is a mismatch, the hedge turns into a cross hedge and occurs
in the following circumstances:

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes ‹ The hedging horizon (maturity) may not coincide with the futures
expiration date.
‹ The amount to be hedged may differ from the amount of the futures
contract.
‹ The physical properties of the asset that needs to be hedged may
differ from the asset used in the futures contract.
In general, a cross-hedge won’t typically be as successful at lowering

i
risk as a straight hedge. Cross hedges, however, are frequently employed
h
l
to lower the price risk. The issue at hand is which futures contracts are
e
D
excellent candidates for a cross hedge. An effective cross-hedge, for

of
instance, would be a silver futures contract rather than a gold futures
contract if we were to hedge a portfolio of silver coins. As a result, one

ty
can examine the nature of hedging if the price of the underlying asset and

i
the price of correlated asset are the same. When correlation is perfect, it

s
r
is perfect; when correlation is close to perfection, it is cross-hedged; and

e
when correlation is negatively perfect, there will be no hedging; rather,
v
i
holding a position in the futures will increase risk.
n
U
Using Silver Futures to Hedging Silver Coins
Example
L ,
O
A firm may be concerned that the value of its collection of 100 kg of rare

/ S
silver coins would decline over the following six months if the company

O L
owns the collection. Despite the fact that there isn’t a contract for silver
coins, we are aware of the silver futures price. In order to cross-hedge

/ C
the value of our coin collection, we consider taking a short position in

C Esilver futures that expires in three months. Silver futures are currently
trading for $7600 per kilogramme. Additionally, the following is true
D about the price of silver coins and silver futures:

©D Silver coin price = 100 + 1.20 (Silver futures) +e

Where the error term, e, only accepts values of -10, 0 and 10, and both
the price of silver coins and the price of silver futures are in kilogrammes.
The aforementioned analysis shows that the price of silver in coins is
typically 20% more volatile than the price of silver in futures. Because
every ‘$1’ change in the price of silver futures corresponds to a ‘$1.20’
change in the price of silver coins. Size of the futures position, then:

102 PAGE
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School of Open Learning, University of Delhi
 HEDGING STRATEGIES USING FUTURES

Size of futures position = Hedge ratio x Size of cash position = 1.2 × Notes
l0 kg = 12 kg
We determine the hedged value of the contract to determine how this
cross hedge might operate. We take into account two values for the three-
month spot silver price, “$7500” and “$7650,” as well as three levels
(e) -10, 0, and 10.
Scenario 1: Silver Futures Price $7500
Basis Coin Value Futures Profit Hedged

h i
Error
e = - 10 10 kg. [100+1.2(7500)-10] = =12(7600-7500=+ Rs. 92,100
Value

e l
10(9090) = 90,900 Rs. 1200
D
of
e = 0 10 kg. [100+1.2(7500) + 0] = 1 2 ( 7 6 0 0 - 7 5 0 0 ) = + Rs. 92,200

ty
10(9100) = 91,000 Rs. 1200

i
e = 10 10 kg. [100+1.2(7500)+10] = 91,100 =12(7600-7500)=+ Rs. 92,300
Rs. 1200
r s
Scenario 2: Silver Futures Price $ 7650
v e
Basis Coin value
n i
Futures profit Hedged

U
error value

,
e = - 10 10 kg. [100+1.2(7650)-10] = = 12(7600-7650) = -$600 $92,100

e = 0
10(9090) = 92,700

O L
10 kg. [100+1.2(7650)+0] = = 12(7600-7650) = -$600 $92,200
10(9100) = 92,800
/ S
= 92,900
O L
e = 10 10 kg. [100+1.2(7650)+10] = 12(7600-7650) = -$600 $92,300

/ C
The hedged value of the contract (silver coin) equals 92,200 plus or minus

C E
100, regardless of the spot price of silver over the next three months. The

D
contract’s unhedged value may fall between 91,500 and 92,900. Cross

©D
hedging thereby lowers position risk.
Example
Consider the challenge encountered by a film producer who employs
silver, a crucial component in producing photographic film. Filmmaking is
a process-based industry with essentially continuous output. The delivery
months for COMEX silver futures are January, March, July, September,
and December. Consider that the film industry need silver in February,
April, and June. The expiration date of futures contracts and the hedging

PAGE 103
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes horizon do not exactly coincide. Second, evaluate the many types of
silver that are accessible through COMEX futures contracts vs the firm’s
requirements for the making of films, which call for 100% pure silver.
Hedge may not be ideal as well. Additionally, the manufacturer may find
it difficult to select one or two contracts for this amount if, for example,
he wants 7000 ounces of silver. This is because at Comex, one standard
contract is for 5000 ounces. All of these are instances of cross-hedges.

i
The Cross Hedge Equation

l h
After determining which contract has the highest correlation to the price

D e
we intend to hedge, the quantity of contracts needed to reduce risk must
then be established. A linear equation, like the one below, can be used

of
to evaluate the statistical relationship between them.

ty
P T = a + b F *T + e *T

i
where e* T is random error with zero mean, T is the expiration date of

s
r
the futures contracts and T is the date the hedge will be closed out.

v e
A maturity mismatch exists if T# T. The following timeline serves as an
example of this situation:
n i
Time line
U
L,
t T T

SO
Enter hedge Lift hedge Contract expires

L /
Enter hedge Lift hedge Contract expires

O
The formula takes into account the asset and maturity mismatch in

C
/
hedges. By assuming that b = I, et = 0, and T = T, we can interpret the

E
constant term.

DC
Consider a company with silver stock in Mumbai. Assume that shipping

©D
expenses always result in a $50 per kg increase in the price of silver
in Mumbai compared to Delhi. The silver contract specifies delivery,
location, and other details. The formula in this instance will be
PM T = a +PT
where Mumbai is mentioned in superscript.
Example
Assume a $50 differential in silver prices between Mumbai and Delhi to
illustrate the net difference between the inventory scenario in the example
of the optimal hedging mechanism.
104 PAGE
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 HEDGING STRATEGIES USING FUTURES

Silver Inventory Revenue Hedging Notes

Scenario Delhi/ New silver Futures profits Net
Mumbai Revenue Revenue
7700/7750 7,75,000 100 (7600-7700) = -10,000 $7,65,000
7400/7450 7,45,000 100 (7600-7400) = 20,000 $7,65,000

IN-TEXT QUESTIONS
6. What is cross hedging?

h i
l
(a) Hedging against multiple risks simultaneously
(b) Hedging with financial derivatives

D e
of
(c) Hedging using unrelated assets
(d) Hedging within the same asset class
7. Which of the following is an example of cross hedging?
i ty
r s
(a) Using stock options to hedge against currency risk

v e
(b) Using gold futures to hedge against oil price risk

n i
(c) Using government bonds to hedge against interest rate risk

U
(d) Using call options to hedge against stock market risk

,
L
8. What is the main challenge in cross hedging?

O
(a) Limited availability of hedging instruments
S
L /
(b) High transaction costs

O
(c) Lack of liquidity in the market

C
/
(d) Increased risk exposure

E
C
9. Which of the following factors should be considered when cross

D
hedging?

©D
(a) Asset liquidity (b) Geographic location
(c) Company size (d) Market volatility
10. What is the primary goal of cross hedging?
(a) Maximizing profits
(b) Eliminating all risks
(c) Achieving a perfect hedge
(d) Reducing risk exposure

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 3.7 Hedge Ratio

The term “hedge ratio” refers to a calculation that contrasts the size of an
overall position with the value of each hedged position. When calculating
a hedge ratio, the value of purchased or sold futures contracts is compared
to the value of the cash commodity that is being hedged.
With the help of futures contracts, investors can secure a price for a
physical good at a later time. If the hedge ratio is 1, or 100 percent, the
open position has been completely hedged. On the other hand, a hedge
h i
e l
ratio of zero, or 0%, means that there has been no hedging at all for the

D
open position. Knowing your hedge ratio is essential for risk management

of
because it allows you to calculate the amount of movement your hedging
instrument will experience to offset changes in the value of your assets

ty
or debt.

s i
Quantity of futures position
Hedge ratio =
e r
Quantity of cash position

i v
n
Hedge ratios are frequently used as a risk management tool since they

U
help you comprehend the degree of risk to which your financial assets are

L ,
exposed. Hedge ratios are useful for estimating an asset’s performance,
which can assist investors and financial analysts make smarter investment

O
decisions. Assume you are exposed to currency risk and have 10,000 INR
S
L /
in foreign equities. You could enter into a hedge to protect against losses
in this position, which can be created using a number of ways to take

C O
an opposite position from the foreign equity’s investment. If you use a

E /
currency investment to hedge 5,000 INR of stock, your hedging ratio is

C
0.5 (5,000/10,000). It implies that you have a 50% reduction in the risk

D
of currency fluctuations on your foreign stock investment.

©D
Optimal Hedge Ratio
Let’s examine the optimal hedge ratio, also known as the minimum-
variance hedge ratio. The ideal hedge ratio, which is a risk management
ratio, helps you decide how much of a hedging instrument or how much
of your portfolio should be hedged. Another way to put it is that although
the hedge ratio informs you of your existing position, the optimal hedge
ratio informs you of your desired position.

106 PAGE
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 HEDGING STRATEGIES USING FUTURES

The optimum hedging ratio formula is as follows: Notes

2SWLPDO +HGJH 5DWLR  ȡ [ ıVıI
ȡ This is the correlation coefficient between changes in your future
price and the current market price.
ıV Changes in spot price Standard Deviation (s).
ıI Changes in futures price standard deviation (f).

3.8 Summary
h i
e l
D
Hedging is a strategy for guarding against unforeseen losses in the future.

of
Hedging concepts include anticipatory hedging, operational hedging,
and carrying charge hedging. The hedger is curious about the difference

ty
in price between spot and futures prices in this case. If the spread is

s i
sufficient to cover the carrying cost, the hedger will purchase the stock.

r
While anticipatory hedging involves choosing a short or long position
e
v
based on the anticipated of price fluctuation in the future, operational

n i
hedging involves using the futures market for operations. When future and

U
spot pricing, quantity, and time are out of sync, this is known as cross

L ,
hedging. A short hedge entails taking a short position in futures, whereas
a long hedge involves taking a long (purchase) position. Basis risk is a

O
crucial consideration when choosing a hedging strategy. To reduce the
S
L /
risk in the fluctuation of the value of the overall (hedged) position, the
hedge ratio is the number of shares that should be swapped for one call

C O
or put. Additionally, it indicates the proportion of futures to cash market

E /
positions. Monitoring, adjusting, and evaluating a hedging plan are the

C
three components of hedging management.

D D
3.9 Answers to In-Text Questions
©
1. (b) Swaps
2. (b) Hedging aims to minimize losses, while speculation aims to
maximize profits
3. (b) Options
4. (d) Reducing potential losses
5. (d) Futures contracts

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 6. (c) Hedging using unrelated assets

7. (b) Using gold futures to hedge against oil price risk
8. (a) Limited availability of hedging instruments
9. (a) Asset liquidity
10. (d) Reducing risk exposure

i
3.10 Self-Assessment Questions

l h
1. Define hedging? Explain with illustrations.

D e
2. Explain the various concepts of hedging with suitable examples.

of
3. Does hedging shield the investor from potential price swings? Do

ty
you concur with this assertion? Elaborate.

s i
4. What does a hedging strategy mean to you? How will you develop
a hedging plan as an investor?
e r
i v
5. Define hedge ratio? What role does the hedge ratio play in the

U n
creation of a hedging strategy?
6. Give a thorough explanation of how the minimal variance hedge

L ,
ratio was calculated.

O
7. What are the procedures for managing a hedge? Discuss how to

S
/
evaluate a hedging strategy’s efficacy.

L
O
8. A silver dealer needs 100 kg of silver by September 20 to fulfil a

C
specific contract. The current price of silver is Rs. 9000 per 100

E / gm, while the price of silver in the futures market is Rs. 8500 per

C
100 gm. Each contract traded on NCDEX has a weight of 10 kg.

D Which form of position in the futures market should the silver

©D
trader take? Determine the net change in wealth as well.
9. By acquiring shares of SRKL Ltd., a 200 share short cash position in
ABCL Ltd. is secured. Assume that ABCL Ltd. received a change
of Rs. 10 for 19. Share price at SRKL Ltd. fluctuates by 20 rupees
per share. Calculate the size of the contract needed to reduce risk.
10. Difference Between short hedge and long hedge. Explain with
examples.

108 PAGE
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HEDGING STRATEGIES USING FUTURES

3.11 References Notes

‹ Apte, Prakash, G., International Financial Management, 3rd edition,

Tata McGraw Hill Publishing Company Ltd., New Delhi, 2005.
‹ Bhalla, V.K., International Financial Management, 2nd edition, Anmol
Publishing House, New Delhi, 2001.
‹ Dubofsky, Junior, Miller W. Thomas, Derivatives valuation and risk

i
management, Oxford University Press, New York, 2003.
‹ Fabozzi et al., Foundations of Financial Markets and Institutions,
l h
Pearson Education inc. Delhi, 2002.
D e
of
‹ Gupta, S.L., Financial Derivatives (Theory, Concepts and Problems),
Prentice Hall of India Ltd., New Delhi, 2005.

ty
‹ Hull, John C., Options, Futures and Other Derivatives, 5th edition,
Prentice Hall of India Pvt. Ltd., 2003.
s i
‹

e r
Jain et al., International Financial Management, Macmillan India
Ltd., Delhi, 2005.
i v
‹

U n
Mannur, HG, International Economics, 2nd edition, Vikas Publishing

,
House Pvt. Ltd., Delhi, 2005.
‹
Delhi, 9th edition, 2006.
O L
Pandey, I.M., Financial Management, Vikas Publishing House, New

/ S
L
‹ Redhead, Keith, Financial Derivatives: An Introduction to Futures,

O
Forwards, Options and Swaps, Prentice Hall of India, New Delhi,

C
1997.
‹
E /
Website of National Stock Exchange.

D C
3.12 Suggested Readings
‹
©D
Hull, J.C. (2014).Options Futures and other Derivatives. 9th edition,
Prentice Hall of India.
‹ Neftci, S.N. (2000). An Introduction to the Mathematics of Financial
Derivatives. Academic Press.
‹ Bhalla, V.K. (2012). Investment Management. New Delhi: Sultan
Chand.

PAGE 109
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes ‹ Wimott, P. (2012). Quantitative Finance. Wiley & Sons.

‹ Jarrow, R. & Stuart, T. (1995). Derivative Securities. South Western.
‹ Chance, D.M., & Brooks, R. (2008). Derivatives and Risk Management
Basics. Cengage Learning India.
‹ Pliska, S. (1997). Introduction to Mathematical Finance. Wiley-
Blackwell Publishing.
www.ncdex.com for details on commodity derivatives in India.
i
‹

‹ www.nse-india.com for stock-based derivatives.

l h
‹
notes.
D e
http://www.theponytail.net/DOL/DOL.htm for derivatives - based

of
i ty
r s
v e
n i
, U
O L
/ S
O L
/ C
C E
D
©D

110 PAGE
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L E S S O N

4
Introductions to Options
Rachit Jaiswal
Assistant Professor
G.T.G.D.C
Email-Id: [email protected]

STRUCTURE
h i
e l
D
4.1 Learning Objectives

of
4.2 Introduction
4.3 Pay-off for the Parties Under Option Contract
4.4 Types of Options
i ty
4.5 Put-Call Parity
r s
v e
i
4.6 Greeks
4.7 Exercising American Calls Early
U n
,
4.8 Exercising American Puts Early
4.9 Summary
O L
S
4.10 Answers to In-Text Questions

L /
4.11 Self-Assessment Questions
4.12 References
C O
E /
4.13 Suggested Readings

D C Objectives
4.1 Learning

©D
 ‹Basics

 ‹Forms
of Option.
of option.
 ‹Put-Call Parity.
 ‹Spot-Forward Parity.
 ‹Exercising American call and put.

PAGE 111
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes
4.2 Introduction
In simple word the term “Option” may be defined as a Right or choice
and it can be bought and sold like any other commodity. The buyer of
the option has only the right and not the obligation. The Option buyer
has the right to buy or sell any underlying assets like currency, stock,
or even other derivatives also, at a specific price called strike/exercise

i
price, on a specific date or during a particular period, irrespective of

h
price change in the market. Whereas the option seller takes obligation
to deliver (for call) or to take delivery (for put).
e l
D
The Option contract is a financial contract between two parties i.e.,

of
option buyer and option seller for both call option and put option. The
call buyer or long call means the holder buys the right or choice to buy

i ty
the underlying. The call seller or short call undertakes an obligation to

r s
deliver the underlying when the call buyer exercises their option to buy

e
the underlying. The call seller receives option premium from the call buyer

i v
for undertaking the obligation to deliver the stock. In the same manner,

U n
the put buyer or long put buys right or choice to sell the underlying and
put seller or short put takes obligation to take delivery when put buyer

L ,
exercise their option. The put seller receives option premium from the

O
put buyer for undertaking the obligation to take deliver the stock. The

/ S
objective behind the option trading may be for arbitrage or speculation.

O L
The buyer or seller may choose to buy/sell, call/put options as per their
market research of the underlying assets.

C
/ Parties to Option Contract
C E4.2.1

D D In option contracts, there are always two parties for the option i.e., Option

©
buyer and option seller. Seller of the option is also known as the writer
of the option. Right to buy underlying assets is known as the call option
and the Right to sell option is known as the put option. Neither the stock
exchanges nor the company’s issue or sell the option contract, it is the
seller/writer who sells the option contract and creates an option that did
not exist earlier. So, whenever a person buys a call/put option, there
must be a seller for the same option. Hence, if there are no sellers for
the option, then buyer can’t buy same option. The buyer of call option

112 PAGE
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 INTRODUCTIONS TO OPTIONS

(Right to buy) will exercise his option to buy only if the price in the Notes
market risen above the Strike Price (K) (agreed price) to make profit for
example if Strike Price (K) is Rs. 300 and market price rose to Rs. 750
the profit will be.
Profit in case of call option = Market price - Strike Price (K)
= Rs. 750 - Rs. 300 = Rs. 400/Share
And in case of put option, the buyer will exercise the option only if the
price in market goes down below the Strike Price (K), for example if
h i
Strike Price (K) is Rs. 300 and market price fallen to Rs. 150 means the
e l
D
buyer of put option can sell the share for Rs. 300 even when the price

of
fallen to Rs. 150 and can make profit of Rs. 150 share.

ty
4.2.2 Position of the Parties Under Option Contract

s i
Call option
r
Put option

e
v
Buy Right to buy underlying assets Right to sell the underlying assets

n i
Sell or Sold right to buy option (might Sold right to sell option (might

buyer exercises his option)

, U
Write be forced to sell if call option be forced to buy the underlying
assets if put option buyer exercise

O L
his option)

/ S
4.2.3 Premium for Options

O L
/ C
The seller of an option receives the premium from the option buyer

E
for the obligation to deliver shares (call option) or to take delivery of

D C
shares (put option). Loss for the option seller can be unlimited and not
restricted to premium received. It is also known as option price/option

©D
premium for an exchange traded option which currently trades in the
market. The option premium depends upon numerous factors including
the difference between the Strike Price (K) (agreed price) and the price
of underlying assets. There are two components of option price/premium
i.e., intrinsic value and time value. Intrinsic value is the price which an
investor will earn if he exercises the option to buy the security and sell
it immediately in the market at the price prevailing i.e., the difference
between the Strike Price (K) and current security price. The time value

PAGE 113
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes component of option price can be calculated by differencing between the

option price/premium and the intrinsic value.
If security price (S) and exercise/Strike Price (K) (X), the intrinsic
value of option price can be calculated by establishing the relation by
calculating the difference between security price (S) and strike/exercise
price (X), S - X (see table).
For Call Security Strike/ Intrinsic Result Explanation

i
Option Price Exercise Value = S -X

h
(S) Price (X)
Case - 1 Rs. 300 Rs. 250

e l
Rs. 50 (Positive) In the Since the market price of

D
Money the security is Rs. 300 i.e.,

of
above the exercise price, Call
option buyer will certainly
exercise his option and will

ty
earn Rs. 50/share
Case - 2 Rs. 250 Rs. 250 Rs. 0

s i
At the No need to exercise the

r
Money option
Case - 3 200 250
e
-50 (Negative) Out

v
Strike Price (K) is above

i
i.e. Rs. 0 of the the current market price

n
Money means the call buyer can

U
directly buy security from

,
the market at Rs. 200 and

O L will not exercise his option

to buy security under option

/ S at Rs. 250.

O L
IN-TEXT QUESTIONS

/ C
1. Loss of put buyer is restricted to:

CE
(a) Premium paid

D
(b) Premium received

© D (c) Strike Price (K)

(d) Market price
2. Loss of call seller is _________.
(a) Restricted to premium received
(b) Limited
(c) Unlimited
(d) Restricted to Strike Price (K)

114 PAGE
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 INTRODUCTIONS TO OPTIONS

Notes
4.3 Pay-off for the Parties Under Option Contract
Different pay-off for different parties under option contract are as follows:

4.3.1 Pay-off for Call Buyer/Long Call

The call buyer can buy shares at a Strike Price (K) when he exercises

i
his option, but the price of share fluctuates in the market and in different

h
cases prices are different. So, the pay-off for call buyers varies as per
the table given below:
e l
For example, Mr. Z buys a call option by paying a premium of Rs. 20
D
of
having Strike Price (K) Rs. 80. Suppose on expiration the market price –

ty
Table 4.1: Pay-off for a call buyer at different market price
Case Market Strike/ Exercising of Option

s i
Profit/(Loss) =

r
Price Exercise Option-If A is Premium (C) - (D)
(A) Price (B) more than B (C) Paid (D)

v e
1 60 80 No 20

n i = 0 - 20 = (20) Loss

U
2 80 80 No 20 = 0 - 20 = (20) Loss

,
3 100 80 Yes, 20 = 20 -20 = 0

4 120 80
O
Yes L
Profit = 20
20
Break-Even
= 40 - 20 =

/ S
Profit = 40 20 Profit

O L
The break-even is a point where there is no gain or loss for the party,

C
and it has different values for the call buyer/seller and put buyer/seller.

E /
The call buyer always pays premium to the other party so, break-even

C
point for call buyer will be the market price that covers premium amount.

D
Break-Even point = Exercise price/Strike Price (K) + Premium paid

©D
In above example –
Exercise price = Rs. 80
Premium paid = Rs. 20
Break-Even point/Break-Even market price
= Exercise price/Strike Price (K) + Premium paid
= Rs. 80 + Rs. 20 = Rs. 100.

PAGE 115
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes

h i
e l
D
of
i t y
Figure 4.1: Line chart showing pay-off for call buyer

4.3.2 Pay-off for Call Seller/ShortsCall

e r
i v
The call seller must deliver stock or pay the price when the call buyer

U n
decides to exercise his option. Since the seller receives the premium,

,
profit of the call seller is limited up to the premium received. Loss of

O L
call seller is unlimited. Buyer can buy share at price of Rs. 80/share when
he exercises his option, but the price of share fluctuates in the market

/ S
and in different cases, prices are different. So, the pay-off for call buyers

O L
varies as per the table given below:
For example, Mr. Y short call and receives premium of Rs. 20 having

/ C
Strike Price (K) Rs. 80.

C E
Suppose on expiration the market price –

D D Table 4.2: Pay-off for a call seller at different market price

©
Case Market Strike/ Exercising of Option Option Profit/(Loss) =
Price (A) Exercise by call buyer - If A Premium (D) - (C)
Price (B) is more than B (C) Received (D)
1 60 80 No 20 = 20 - 0 = 20
Profit
2 80 80 No 20 = 20 - 0 = 20
Profit
3 100 80 Yes, 20 = 20 -20 = 0
Loss = 20 Break-Even
4 120 80 Yes 20 = 40 - 20 =
Loss = 40 20 Loss

116 PAGE
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 INTRODUCTIONS TO OPTIONS

The break-even point or the break-even market price for a seller of call Notes
option is same as the call buyer. The call seller always receives the
premium from the other party so, break-even point for call seller will
be the market price that include premium amount. Case 3 of both the
tables 4.1 and 4.2 shows that break even market price for call buyer and
call seller is same.
Break-Even point = Exercise price/Strike Price (K) + Premium Received

i
In above example –
Exercise price = Rs. 80
l h
Premium paid = Rs. 20
D e
of
Break-Even point/Break-Even market price
= Exercise price/Strike Price (K) + Premium received
= Rs. 80 + Rs. 20 = Rs. 100.
i ty
r s
v e
n i
, U
O L
/ S
O L
/ C
C E
D
©D Figure 4.2: Line chart showing pay-off for call seller

4.3.3 Pay-off for Put Buyer/Long Put

The put buyer bought the right to sell the share at price of Rs. 80/share
when he/she exercised his/her option, but the price of share fluctuates
in the market. So, the pay-off for the put buyer varies as per the table
given below:

PAGE 117
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes For example, Mr. A buy a put option by paying a premium of Rs. 20
having Strike Price (K) Rs. 80. Suppose on expiration the market price –
Table 4.3: Pay-off for a put buyer at different market price
Case Market Strike/ Exercising of Option Profit/(Loss) = (C) - (D)
Price Exercise Option- If A is Premium
(A) Price (B) more than B (C) Paid (D)
1 40 80 Yes¹, Profit = 40 20 = 40 - 20 = 20 Profit
2 60 80 Yes², Profit = 20 20 = 20 - 20 = 0
Break-Even

h i
l
3
3 80 80 No 20 = 0 - 20 = (20)

4 100 80 No 4
20
Loss

D e
= 0 - 20 = (20)

of
Loss
5
5 120 80 No 20 = 0 - 20 = (20)

ty
Loss

s i
e r
i v
U n
L ,
S O
L /
C O
E /
D C
©D
Figure 4.3: Line chart showing pay-off for put buyer
The put buyer pays premium to the put seller so, break-even point for
put buyer will be the market price that covers premium amount.
Break-Even point = Exercise price/Strike Price (K) - Premium paid
In above example –
Exercise price = Rs. 80
Premium paid = Rs. 20

118 PAGE
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 INTRODUCTIONS TO OPTIONS

Break-Even point/Break-Even market price Notes

= Exercise price/Strike Price (K) - Premium paid
= Rs. 80 - Rs. 20 = Rs. 60.
The profit for the put buyer will start occurring only after the price in
the market goes down below Rs. 60:
1. Put buyer bought right to sell so he/she can sell for Rs. 80 under
option when market price of the share is only Rs. 40/share. Hence
the put buyer will obviously exercise his option and will earn a
h i
profit of Rs. 40.
e l
2. Same as above, can sell under option contract for Rs. 80/share under
D
of
option when market price of the share is only Rs. 60/share. Hence
the put buyer will obviously exercise his option and will earn a

ty
profit of Rs. 20.

s i
r
3. Share price under option and market are same so the put buyer may
or may not exercise the option.

v e
i
4. Put buyer bought right to sell so he/she can sell for Rs. 80 under
n
U
option when market price of the share is only Rs. 100/share. Hence

,
the put buyer will not exercise his option and will sell in the market.

L
5. Put buyer bought right to sell so he/she can sell for Rs. 80 under

O
S
option when market price of the share is only Rs. 120/share. Hence

/
the put buyer will not exercise his option and will sell in the market.
L
C O
4.3.4 Pay-off for Put Seller/Short Put

E /
C
The put seller sold the right to sell at an exercise price of Rs. 80/share,

D
now the payoff of the put seller depends upon the decision of the put

©D
buyer that whether the put buyer will exercise or not. So, the pay-off
for the put seller varies as per the table given below:
For example, Mr. B short put option and received a premium of Rs. 20
having Strike Price (K) Rs. 80. Suppose on expiration the market price
is as per table given below—

PAGE 119
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Table 4.4: Pay-off for a put seller at different market price
Case Market Strike/ Exercising Option Profit/(Loss) = (D) - (C)
Price Exercise of Option by Premium
(A) Price other party - If Received
(B) A is more than (D)
B (C)
1 40 80 Yes¹, Loss = 40 20 = 20 - 40 = -20
2 60 80 Yes, Loss = 20 20 = 20 - 20 = 0
Break-Even

h i
3 80 80 No 20 = 20 - 0 = 20

e l
D
4 100 80 No2 20 = 20 - 0 = 20

of
5 120 80 No 20 = 20 - 0 = 20

The break-even point or the break-even market price for a seller of put

ty
option is same as the put buyer. The put seller receives the premium

s i
from the other party so, break-even point for put seller will be the market

e r
price that include premium amount. Case 2 of both the tables 4.3 and 4.4

i v
shows that break even market price for call buyer and call seller is same.

n
Break-Even point = Exercise price/Strike Price (K) - Premium received

U
,
In above example –

L
Exercise price = Rs. 80

O
S
Premium received = Rs. 20

L /
Break-Even point/Break-Even market price

O
= Exercise price/Strike Price (K) - Premium paid
C
/= Rs. 80 - Rs. 20 = Rs. 60.

CE
1. In the case of a short put, the pay-off of a put seller depends upon

D D the decision of the put buyer.

When,
© Market price = Rs. 40
Exercise price = Rs. 80
Put buyer can sell stock for Rs. 80 under option contract where in
market it can be sold only for Rs. 40. So Put buyer will exercise
his option and will sell for Rs. 80 in that case put seller must take
delivery at Rs. 80. Hence the put seller will incur loss of Rs. 40.
Same for case 2 also.

120 PAGE
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 INTRODUCTIONS TO OPTIONS

2. When, Notes
Market price = Rs. 100
Exercise price = Rs. 80
Put buyer can sell stock for Rs. 80 under option contract where in
market it can be sold for Rs. 100. So Put buyer will surely not
exercise his option and will sell for Rs. 100 in that case premium
received will be profit.

h i
e l
D
of
i ty
r s
v e
n i
, U
O L
/ S
L
Figure 4.4 : Line chart showing pay-off for put seller

O
C
Illustration 1: Mr. M bought a call option for 250 shares in TIS Ltd at a

/
premium of Rs. 40 per share having 3-month expiration, with an exercise
E
C
price of Rs. 600 per share. He also bought a put option for 200 shares

D
of the same company at a premium of Rs. 10 per share with an exercise

©D
price of Rs. 500. Calculate the profit or loss for Mr. M would make if
the market price at the end of 3 months is Rs. 400.
Solution:
Market price at the end of 3-month expiration = Rs. 400/share
Strike Price (K) of call option = Rs. 600/share
Strike Price (K) of put option = 500/share

PAGE 121
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes For the call option, the Strike Price (K) is more than the market price.
Mr. M should not exercise the call option.
For the put option, the Strike Price (K) is more than the market price.
Mr. M should exercise the put option. Buy from the market at Rs. 400/
share and sell under put option at Rs. 500/share.
Gain from Put contract = (500 - 400) × 200 shares = 20,000
Less: Premium Paid under
(i) Call Option = Rs. 40/shares × 250 = 10,000
h i
(ii) Put option = Rs. 10/shares × 200 = 2,000 = 12,000
e l
Profit
D
8,000

of
Illustration 2: Mr. X bought a call option for 200 shares in ABC Ltd

ty
on a premium of Rs. 60 per share with a Strike Price (K)/exercise price

i
of Rs. 550. Calculate the profit or loss that Mr. X would make assuming

s
r
the market price on expiration becomes:
(a) Rs. 400.
v e
(b) Rs. 600.
n i
U
Solution: Mr. X bought a call option means he has a right or choice to
,
L
buy share at Rs. 550/share when—

O
(a) He can buy the same from the market at Rs. 400 which is less than

S
L /
the exercise price. So, he will not exercise the option to buy shares
at Rs. 550.

C O
Profit or loss = Gain from option contract - option premium paid

E / = 0 - Rs. 60 premium/share × 200 share = Rs. 12,000 Loss

D C (b) In this case he can buy the same from the market for Rs. 600 per

©D
share. Buying under option contract is cheaper than buying from
the market. So, he will buy share at Rs. 550 per share under option
contract and sell into the market for Rs. 600 per share.
Profit or loss = Gain from option contract - Premium paid
= (Selling Price - Buying Price) × Number of shares - Premium Paid
= (600-550) × 200 - 60 × 200 = Rs. 2000 loss

122 PAGE
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 INTRODUCTIONS TO OPTIONS

IN-TEXT QUESTIONS Notes

3. The break-even point of a call seller will be:

(a) Strike Price (K) – Premium Paid
(b) Strike Price (K) – Premium Received
(c) Strike Price (K) + Premium Paid
(d) Strike Price (K) + Premium Received
4. Mr. John short a put option on a Strike Price (K) of Rs. 520
h i
and received premium of Rs. 120; At what market price, Mr.
e l
D
John will face a break-even:

of
(a) Rs. 640
(b) Rs. 400
(c) Rs. 280
i ty
(d) Rs. 760
r s
v e
4.4 Types of Options
n i
, U
There are two basic forms of options based on their time for exercising:
American and European.

O L
4.4.1 American Style Option
/ S
O L
C
An option that gives the holder a privilege to exercise option at any time

/
between the date of purchase and the expiration date is called an American
E
C
style option. All exchange traded options are American style options.

D
©D
4.4.2 European Style Option
An option that can be exercised only on expiration date known as
European style option. Most of the option contracts traded in India follow
European style.

PAGE 123
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 4.5 Put-Call Parity

One of the most important theories in option pricing is put-call parity.
It establishes a relation between the price of put and call that have the
same underlying assets. Put call parity theory requires the same underlying
assets, expiration and Strike Price (K). Since European options can only
be exercised on expiration this theory is valid only for European options.
St + Pt = Ct + X/(1 + r)t

h i
l
OR
t
St = {Ct + X/(1 + r) } - Pt
D e
of
OR
X/(1 + r)t = St + Pt- Ct
Where,
i ty
r s
St = Spot Price (S) (S) of underlying assets

v e
Ct = Long European Call Option Price

n i
Pt = Short European Put Option Price
t

U
X/(1+r) = Present value of the Strike Price (K), discounted from

,
L
the date of expiration

O
r = Discount rate (often risk-free rate)

S
/
t = time to expiration

L
O
In case of dividend paying stock, the present value of dividend, discounted

C
at risk free rate should be deducted from St + Pt and the parity formula
/
CE
becomes:
St + Pt í '   UI   &t + X/(1+r)t

D D If the above relation fails to hold between the variables that creates an

©
opportunity for arbitrage. The formula given above also helps to find
the value of any one variable if we know the value of the other three
variables. This relation proves that the value of forward contract and
a portfolio of long European call with short European put must be
equal for the same underlying assets, expiration and Strike Price (K). If
the value of both portfolios is not equal, then this creates an opportunity
for traders to employ strategies to make money.

124 PAGE
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 INTRODUCTIONS TO OPTIONS

For better understanding, let consider a situation: Notes

St (Spot Price (S) of underlying assets) = Rs. 100
Ct (Long Call Option Price/Premium paid) = Rs. 10
Pt (Short Put Option Price/Premium received) = Rs. 10
X (Strike Price (K)) = Rs. 110
r (Discount rate i.e., risk free rate) = 10%
t = time to expiration

h i
Let us check whether put call parity relation holds or not by putting the
e l
D
values in the formula:

of
St + Pt = Ct + X/(1 + r) t
100 + 10 = 10 + 110/(1 + 10%)1
110 = 110, Hence the parity holds.
i ty
r s
Now, Let Us check whether the value of forward contract and a portfolio
of long call with short put are equal or not:
v e
n i
Suppose different market price under different situations.

U
Table A: Value of Long Call Option

,
L
Value of a long call or we can say call buyer can be calculated by

O
analyzing whether the call buyer will exercise his option or not.

/S
Case Market Strike/ Exercisation Option Value of Long

L
Price (A) Exercise of Long Call Premium Call = (C) - (D)

O
Price (B) Option: If A is Paid (D)

C
more than B, (C)
1 200

E /110 Yes¹, Profit = 90 10 = 90 - 10 = 80

C
2 150 110 Yes², Profit = 40 10 = 40 - 10 = 30

D
3 100 110 No³ 10 = 0 - 10 = (10)

D
4 50 110 No4 10 = 0 - 10 = (10)

© Table B: Value of Short Put/Option

Value of a short put can be measured by the viewpoint of the put buyer
to understand whether the put buyer will exercise the option or not.
Case Market Strike/ Exercisation of Option Value of Short
Price (A) Exercise short put: If B is Premium Put = (D) - (C)
Price (B) more than A, (C) Received (D)
1 200 110 No 10 = 10 - 0 = 10
2 150 110 No 10 = 10 - 0 = 10

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Case Market Strike/ Exercisation of Option Value of Short

Price (A) Exercise short put: If B is Premium Put = (D) - (C)
Price (B) more than A, (C) Received (D)
3 100 110 Yes¹, Loss = 10 10 = 10 - 10 = 0
4 50 110 Yes², Loss = 60 10 = 10 - 60 = (50)
Table C: Value of Forward Contract
Traders will buy in the spot market and will hold the underlying assets for
1 year. At the end of 1 year, traders will sell the assets in the market.

h i
l
Case Spot Holding Cost for 1 Total Market Value of Forward

e
Price year = 100*10/100 Cost (C) Price (D) Contract =

D
(S) (A) = 10 (B) (D) - (C)

of
1 100 10 110 200 = 200 - 110 = 90
2 100 10 110 150 = 150 - 110 = 40

ty
3 100 10 110 100 = 100 - 110 = (10)
4 100 10 110

s i 50 = 50 - 110 = (60)
Now, Let Us check whether:
e r
i v
Value of long call + Value of short put = Value of forward contract

n
Table A + Table B = Table C

U
,
Case Value of Value of Value of Table A + Holds the

L
long call short put forward Table B = Parity

O
(Table A) (Table B) contract Table C True/False

S
(Table C)
1

L / 80 10 90 80 + 10 = 90 TRUE

O
2 30 10 40 30 + 10 = 40 TRUE

C
3 -10 0 -10 -10 + 0 = -10 TRUE

/
CE
-10 + (-50)
4 -10 -50 -60 = -60 TRUE

D D Illustration 3: The current market price of XYZ Ltd. is Rs. 380 and call
option for the same stock exercisable at Rs. 440 in one-year exercisable

© period. The risk-free interest rate is 10% and the value of the call option
is Rs. 20. Find out the value of the put option?
Solution
Current Spot Price (S) (St) = Rs. 380
Exercise Price (X) = Rs. 440
Risk free Interest rate (r) = 10% = 0.1
Value of call option (Ct) = Rs. 20

126 PAGE
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 INTRODUCTIONS TO OPTIONS

Value of the put option can be calculated using put call parity theory. Notes
St + Pt = Ct + X/(1+r)t
380 + Pt = 20 + 440/(1 +.1)1
Pt = 20 + 400 - 380 = Rs. 40
If the price of the put option is not equals to Rs. 40, then there will be
an arbitrage opportunity for the trader. Arbitrage is only possible when
markets are not efficient.

h i
l
Illustration 4: Mr. John has gathered the following information about
the European option with the same underlying having 2-year expiration
from the market for his research.
D e
of
Put option: Price Rs. 8 per share; Exercise price Rs. 100.

ty
Call option: Price Rs. 5 per share; Exercise price Rs. 100.

s i
The current market price of the share is Rs. 90, the risk-free rate is 5%.
p.a.
e r
i v
Suppose there is no payment of dividend in this 2 year. Is there an

n
arbitrage opportunity? If yes, show the arbitrage strategy in pay-off table.

U
,
Solution:

O L
It is important to know whether a put call parity holds or not. If put call
parity does not hold, there is an opportunity for arbitrage (risk less profit).

/ S
Current Spot Price (S) (St) = Rs. 90

O
Exercise Price (X) = Rs. 100 L
/ C
Risk free Interest rate (r) = 5%

C E
Value of call option (Ct) = Rs. 5

D
Value of put option (Pt) = Rs. 8

©D
St + Pt = Ct + X/(1 + r)t
90 + 8 = 5 + 100/(1 +.05)2
  
The above calculation shows that put call parity does not hold then there
is an opportunity for arbitrage. Now the question is how? The call option
is under-priced in comparison to put so buy a call and sell put.

PAGE 127
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes At T0 Buy a call option as well as sell a put option and invest X/(1 +
r)t i.e., 100/(1 +.05)2 = 90.7 also short sell the share at current price of
Rs. 90. On expiration the amount invested on t = 0, will mature to
Rs. 100 and short sell at t = 0, will be bought at market price.
Cash Inflow-Outflow Table
t = 0 t = T If Strike t = T If Strike
Price (K) < Price (K) >

i
Market Price Market Price

h
Premium received on put sell 8.00 0.00 Market Price - 100
Short sell of share 90.00 -Market Price

e l
-Market Price

D
Premium on Call -5.00 Market price - 100 0.00

of
invest X/(1+r)t i.e., 100/(1+.05) -90.70 100.00 100.00
2 = 90.7

ty
Net Inflow 2.30 0.00 0.00

s i
4.6 Greeks
e r
i v
Greeks are the collection of statistical values that can be helpful for

n
investors to understand the behaviour of the stock like how stock has
U
,
performed in the past and with this information investors can make

L
decisions for the future price movement. The statistical information helps

O
the investor to make strategies for the options. However, the investor must

S
/
remember the statistical values calculated on past data and cannot surely

O L
predict the future movement of stock. Some of the statistical measures
that affect the value of options are:

C
/ Delta
C E4.6.1

D D It measures the sensitivity of option value toward the small changes in

©
the value of underlying assets. Delta value 1 explains that the perfectly
positive correlation between the option value and the price of underlying
assets means if the price of underlying goes up by 10%, then the option
value will also go up by 10%. Delta of the call option is positive (varies
between 0 to 1) whereas the delta of the put option is negative (varies
between -1 to 0) because there is a positive relation between the option
value and the underlying while there is a negative relation between the
option value and underlying assets.

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 INTRODUCTIONS TO OPTIONS

4.6.2 Gamma Notes

It measures the sensitivity of Delta toward a small change in the value of

underlying assets. It is also called delta of delta. If the value of gamma
is very high, then a very small change in value of underlying assets will
crash the option value.

4.6.3 Theta

h i
Theta measures the change in value of option or option premium due to
e l
D
time decay. The value of theta moves from buyer to seller as the time

of
passes. So, theta is good for the seller as time to expiration moves to
zero and bad for the buyer.

4.6.4 Vega
i ty
r s
e
It measures the sensitivity of option value toward the change in implied
v
i
volatility. Delta measures the sensitivity based on historical data while
n
U
Vega measures sensitivity based on anticipated volatility.

4.6.5 Rho
L ,
S O
L /
Rho measure is the sensitivity of option value toward a 1% change in
rate of risk-free rate. Rho value 0.4 indicates that if there is 1% change

O
in interest rate, the option value will change by 0.4%.
C
E / Values of an Option
C
4.6.6 Factor Affecting

D
©D
The value of an option depends upon several variables like value of
underlying, time, interest rate etc:
(a) Interest Rate: Impact of changes in interest can be calculated using
the put call parity theory as it affects the present value of Strike
Price (K). Higher interest rates will reduce the present value and
the put price. Keeping all other variables constant, the interest rate
will positively affect the call price and it will negatively affect the
put price. Hence when there is an increase in interest rate, the call
price will go up while the put price will go down.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes (b) Change in price of underlying assets: A change in price of underlying,

directly impacts the value of option. The price of the underlying is
positively correlated with the call option and negatively correlated
with the put option. If the price of the underlying goes up the call
price will also go up and if the price of the underlying goes down
the price of the call option will also go down. In the same manner,
if the price of underlying assets goes up, the price of the put option
will go down and if the price of the underlying goes down, the
price of the put option goes up.
h i
e l
(c) Volatility in stock price: Statistical volatility measures the volatility

D
of stock based on past price movement and tells the volatility

of
behaviour of stock. Since the statistical volatility is based on past
data it cannot explain the future volatility of the stock. Every option

ty
trader must do his own research to measure the volatility for the

s i
stock. Statistical volatility is positively correlated to both the call

e r
and put option. When a stock is highly volatile, the price of call

i v
and put both will fluctuate more.

U n
(d) Time till expiry: Time is the most important variable in determining
the value of option price. The price of the option goes down if there

L ,
is no significant change in the underlying. Day by day the value

O
of options moves towards zero. So, for a call seller, it is good if

/ S
there is no change in the price of stock and for call buyer time

O L
works like an enemy.
(e) Option Strike Price (K): Options having favourable Strike Price (K)

/ C
are traded at higher option premium than option having unfavourable

C E Strike Price (K). Favourable Strike Price (K) means

D
for call buyer, Strike Price (K) < current market price i.e. In the

©D
money option,
for put buyer, Strike Price (K) > current market price i.e. In the
money option,
for call seller, Strike Price (K) > current market price i.e. In the
money option,
for put seller, Strike Price (K) < current market price i.e. In the
money option.

130 PAGE
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 INTRODUCTIONS TO OPTIONS

(f) Dividend: Dividends are paid in cash to the shareholder, and it result Notes
in outflow of resources. Dividend payouts affect the option price in
the manner that after dividend payment net worth of the company
goes down and will result in lower market price of the stock. As
the market price goes down, the demand for calls will decrease
and the call price will also go down. Dividend payment positively
affect the put option and adversely affect the call option.

IN-TEXT QUESTIONS

h i
5. The value of the option depends upon which factor:
e l
(a) Interest rate
D
of
(b) Price of underlying assets

ty
(c) Volatility
(d) All of the above
s i
e r
6. The relation between the price of underlying assets and call
option is:
i v
(a) Positive

U n
,
(b) Negative
(c) both (a) and (b)

O L
S
(d) None of the above

L /
7. Rho measure the sensitivity of option value towards change in:
(a) Time
C O
/
(b) Risk free rate
E
D C
(c) Value of underlying assets
(d) Implied volatility

©D
8. Delta of delta is called:
(a) Delta
(b) Gamma
(c) Theta
(d) Vega
9. Vega measures sensitivity between option value and volatility
calculated on:

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes (a) Historical data

(b) Anticipated data
(c) Both of the above Strike Price (K)
(d) None of the above

4.7 Exercising American Calls Early

h
Early exercise of option is only possible with American style option in
i
e l
which an option can be exercised on or before the date of expiration of

D
option. Because of this facility to exercise the option before the expiry,

of
American options are regularly higher priced than European options.
Earlier in this unit, we have seen that option pricing consists of intrinsic

i ty
value and time value component. For a non-dividend paying stock, early

s
exercise of call option results in cash payment to other party which incur
r
e
interest cost that can be avoided easily by exercising the option on expiry.

i v
Similarly for a dividend paying stock, the early exercise of call option

n
before the day when stock goes ex-dividend, dividend received on stock
U
,
must have higher value than the interest cost that holder incur due to early

L
exercise of option. Early exercise of American call option is justified,

O
only when dividend received on stock is high enough to cover the interest

S
/
cost due to early payment of Strike Price (K).

O L
4.8 Exercising American Puts Early
/ C
C ESame as earlier, American style put options can be exercised on or before
the date of expiration and it provides holders an immediate cash inflow
D
©D
of (X - S). The amount received from the early exercise of put option
can be invested to earn interest till the expiration but early exercise of
American put eliminates the time value of put. Therefore, holder must
ascertain that the interest earned from the amount received from early
exercise of American put is high enough to cover the time value of the
put sacrificed. For a dividend paying stock, dividend decreases the value
of stock and increases the exercise price so early exercise of American
put is less likely.

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 INTRODUCTIONS TO OPTIONS

4.9 Summary Notes

 ‹Options are the rights that can be bought and sold between two parties
i.e., buyer and seller by paying a premium to the other party.
 ‹A call option gives the right to the buyer to buy a specific underlying
at a specific price at a specific time or during a period whereas a
put option gives the right to the buyer to sell a specific underlying
asset at a specific price at a specific time or during the period.

h i
l
 ‹Call/Put buyer buys the right not the obligation. The Call/Put seller
takes the obligation to deliver/take deliveries when the other party
exercises his/her option. In return of taking obligation under option
D e
of
contract the call/put seller receives the premium paid by the buyer.

ty
 ‹Call/putbuy also known as long call/long put. Whereas call/put sell

i
known as short call/short put.
 ‹Writer: Seller of call/put option.
r s
v e
Measures how price moves around the mean price.
i
 ‹Volatility:

 ‹Option
n
premium or option price have two components i.e., intrinsic

U
value and time value. Intrinsic value is the difference between the
security price and exercise price.
L ,
 ‹The
O
value of an option can be either positive or zero but cannot be

S
/
negative.
 ‹There
L
are two forms of option, American and European. The American
O
C
option can be exercised any time on or before the expiration whereas

/
the European option can only be exercised on the expiration date.
E
C
 ‹Put-call parity theory establishes relation between the call, put and

D
underlying assets that have the same expiration, Strike Price (K)

©D
and underlying.
 ‹Option price calculated using various variables like price of the
underlying stock, interest rates, time to expire etc.

4.10 Answers to In-Text Questions

1. (a) Premium paid

2. (c) Unlimited

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 3. (d) Strike Price (K) + Premium Received

4. (b) Rs. 400
5. (d) All of the above
6. (a) Positive
7. (b) Risk free rate
8. (b) Gamma
9. (b) Anticipated data
h i
e l
4.11 Self-Assessment Questions
D
of
1. What do you mean by the term “Option”? Explain the main forms

ty
of options.

s i
2. Explain the right and obligation for both call buyer and seller.

e r
3. What is Put-Call Parity? Explain the circumstances and strategy for
arbitrage.
i v
n
4. What are the different factors that affect option value?
U
,
5. What are the different types of Geeks in options?

L
6. Briefly discuss the break-even point for call and put buyer/seller
O
S
with an example.

L /
7. What are the different components of option value?

O
8. The current market price of UV ltd is Rs. 480 and call option for
C
E / the same stock exercisable at Rs.330 in one-year exercisable period.
The risk-free interest rate is 10 % and the value of the call option

D C is Rs. 15. Find out the value of the put option?

©D
9. Mr. B bought a call option for 350 shares in TIS Ltd at a premium
of Rs. 60 per share having 3-month expiration, with an exercise
price of Rs. 800 per share. He also bought a put option for 300
shares of the same company at a premium of Rs. 20 per share with
an exercise price of Rs. 600. Calculate the profit or loss for Mr. M
would make if the market price at the end of 3 months is Rs. 700.
10. Find out the Spot Price (S) of share when exercise price is Rs. 550
in one-year exercisable period and value of call and put are Rs. 35
and Rs. 45, respectively.

134 PAGE
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 INTRODUCTIONS TO OPTIONS

11. Mr. C bought a call option for 300 shares in ABC Ltd on a premium Notes
of Rs. 80 per share with a Strike Price (K)/exercise price of Rs. 650.
Calculate the profit or loss that Mr. X would make assuming the
market price on expiration becomes:
(a) Rs. 400.
(b) Rs. 600.
12. The current market price of XYZ ltd share is Rs. 580 and call option
for the same stock exercisable at Rs. 330 in one-year exercisable
h i
period. The risk-free interest rate is 10 % and the value of the call
e l
D
option is Rs. 25. Find out the value of the put option?

of
13. Mr. Z has collected the following information about the European
option with the same underlying having 2-year expiration from the

ty
market for his research.
Put option: Price Rs. 18 per share; Exercise price Rs. 200.
s i
e r
Call option: Price Rs. 15 per share; Exercise price Rs. 200.

i v
The current market price of the share is Rs. 160, the risk-free rate
is 5%. p.a.
U n
L ,
Suppose there is no payment of dividend in this 2 year. Is there an
arbitrage opportunity? If yes, show the arbitrage strategy in pay-off
table.
S O
L /
O
4.12 References

/ C
E
 ‹Strategic Financial Management by CA K.M. Bansal and CA Anjali

C
Agarwal, Taxmann.
 ‹Referencer
D on Strategic Financial Management by G sekar & B

©D
saravana Prasath, Paduka’s.
 ‹https://www.blackwellpublishing.com/content/kolb5thedition/chapter_15_
solution.pdf
 ‹https://corporatefinanceinstitute.com/resources/derivatives/early-exercise/

 ‹Security Analysis and Portfolio Management, P. Chandra, Tata McGraw

Hill.
 ‹Investment Management by V.K. Bhalla, S. Chand & Company Ltd.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 4.13 Suggested Readings

 ‹Intermediate Financial Management. Brigham, E.F., & Daves, South-
Western.
 ‹InternationalFinancial Management. Resnick, B. G., & Eun, C. S.
McGraw Hill International.
 ‹Strategic Financial Management by CA K.M. Bansal and CA Anjali

i
Agarwal, Taxmann.
 ‹References on Strategic Financial Management by G sekar & B
l h
saravana Prasath, Paduka’s.
D e
of
 ‹Security Analysis and Portfolio Management, P. Chandra, Tata McGraw
Hill.

ty
 ‹Investment Management by V.K. Bhalla, S. Chand & Company Ltd.

s i
e r
i v
U n
L ,
S O
L /
C O
E /
D C
©D

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L E S S O N

5
Basic Option Pricing:
The Binomial Option
Pricing Model
i
Ankit Suri

l h
Atal Bihari Vajpayee School of Management and Entrepreneurship

D e
Jawaharlal Nehru University
Email-Id: [email protected]

of
Yogesh Sharma
Atal Bihari Vajpayee School of Management and Entrepreneurship

i ty
Jawaharlal Nehru University

s
Email-Id: [email protected]
r
v e
STRUCTURE
n i
5.1 Learning Objectives
, U
L
5.2 Introduction to Option Pricing

O
5.3 Conceptualizing Binomial Option-Pricing Model (BOPM)
S
L /
5.4 Calculating Option Prices Using BOPM
5.5 Summary

C O
/ Questions
5.6 Answers to In-Text Questions

E
C
5.7 Self-Assessment

D D
5.8 References
5.9 Suggested Readings
©
5.1 Learning Objectives
 ‹To understand the fundamental concepts of option pricing, including the importance
of option pricing in financial derivatives.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes  ‹To describe the binomial option-pricing model, including its assumptions
and how to construct a binomial tree for option pricing.
 ‹To understand the calculation of option prices using the binomial
model, including pricing call, and put options.
 ‹To recognize the limitations of the binomial model.

5.2 Introduction to Option Pricing

h i
l
Options are a type of financial derivatives which gives the right to the

D e
buyer (and not the obligation) to buy or sell an underlying asset at a
specific price (known as the strike price) on or before a specific date

of
(known as the expiration date). The underlying assets can be Stocks,
Indices, Exchange-Traded Funds, Commodities, Currencies or Bonds.
Options are classified into two types:
i ty
r s
1. Call Options: A call option gives the holder the right (but not the

v e
obligation), to purchase an underlying asset at the strike price on

n i
or before the expiration date. Call options are typically used by

U
investors who believe that the price of the underlying asset will

seller.
L ,
rise. Call options are purchased by paying a premium to the option

S O
2. Put Options: A put option gives the option holder the right (but

L /
not the obligation) to sell an underlying asset at the strike price

O
on or before the expiration date. Put options are typically used by

/ C
investors who believe that the price of the underlying asset will

E
decline. Put options are also purchased by paying a premium to

D C the option seller.

Put/Call options can be either American style options, which means they

©D
can be exercised anytime till the expiry date, or they can be European
style options, which can only be exercised on the expiry date and not
before that.

5.2.1 Potential Profitability of the Option Holder

The stated and pre-determined price at which the holder of an option
may buy the underlying asset or sell it (in the case of a call and put
option, respectively) is known as the strike price, also known as the
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 BASIC OPTION PRICING: THE BINOMIAL OPTION PRICING MODEL

exercise price. It is specified at the time the option is formed and is one Notes
of the most crucial parts of an option contract. The connection between
an option’s strike price and the market price of the underlying asset is
denoted by the words “out of the money” (OTM) and “in the money”
(ITM). This is what they signify:
If the price at which the underlying asset is presently trading makes it
challenging for the option holder to exercise the option and profit from

i
doing so, the option is said to be “out of the money” (OTM). This shows
that the market price of the underlying asset for a call option is less
l h
e
than the strike price. This shows that the market price of the underlying
asset for a put option is higher than the strike price. In other words, if
D
of
the option were to be exercised at the current market price, the holder
would suffer a loss.

i
When the price of the underlying asset makes exercising the option
ty
r s
beneficial for the option holder and possibly profitable, the option is

e
said to be “in the money” (ITM). This shows that the market price of

v
n i
the underlying asset for a call option is higher than the strike price. This
shows that the strike price of a put option is below the current market

U
value of the underlying asset. In other words, if the option were exercised
,
L
at the current market price, the option holder would profit. Being “in

O
the money” or “out of the money” for an option has an impact on the

/ S
option holder’s prospective profitability and capacity to make decisions.

O L
Due to its inherent worth, an in-the-money option often has a larger value
or premium than an out-of-the-money option. When deciding whether to

/ C
exercise, sell, or hold an option for future price movements, traders and

E
investors frequently look at its ITM/OTM status.

C
D
Some of the factors that determine an option’s value and pricing include

©D
the striking price, the time remaining until the option expires, the current
market price of the underlying asset, and the underlying asset’s price
volatility. Despite being out of the money, or when the stock price is
below the exercise price, a call option may still be worth something. Even
though the call option is currently out of the money and would result in
a loss if exercised immediately, there is always a chance that the stock
price will increase significantly before the expiration date to allow for a
profitable exercise. The call option’s value is created by the possibility
that the stock price will increase and it will become lucrative.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes In addition to the expiration date, the price of the underlying stock is
also taken into account when determining the value of the option. The
value of the option may change as time passes and the expiration date
approaches, reflecting the option’s diminishing time value and the potential
for stock price fluctuations.
An out-of-the-money call option’s worst-case scenario is when it expires
worthless. This means that the maximum loss for the option holder is
only as much as the option premium. The option holder may choose to

h i
maintain the option until it expires even though there is always a chance

e l
that the stock price may increase and the option will become lucrative.

D
of
5.2.2 Factors Affecting Option Value

ty
There are majorly six factors that affect the value of the put option and
the call option as written below:
s i
e r
1. Market Price (M): It is the prevailing price of the underlying asset

v
in the market.

n i
2. Exercise price (X): The exercise price (also the strike price) is the

,
option is exercised. U
price at which the underlying asset can be bought/sold when the

O L
 9RODWLOLW\ RI WKH SULFH į  Volatility refers to the fluctuation in

/ S
the price of the underlying asset. Higher the fluctuation, higher the

L
volatility.

O
4. Time to expiration (T): The time remaining until the option’s

C
/
expiration date.

CE
5. Interest rate (R): The prevailing interest rate in the market. This

D
rate is used as a discount rate for calculating the present value of

D
the exercise price of the option.

© 6. Dividend rate of the stock (D): If the underlying stock pays dividends
the same amount is depicted in the market price of the stock as a
deduction.
The Table below shows the effect of the above six factors on the call
and put option value:

140 PAGE
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 BASIC OPTION PRICING: THE BINOMIAL OPTION PRICING MODEL

Table 5.1: Determinants of Call and Put Option Notes

Determinant Call Option Put Option
Current market Positive relationship: Higher Negative relationship: Lower
price of the the current market price, higher the current market price, higher
underlying asset the call option value the put option value
Strike price Negative relationship: Lower Positive relationship: Higher
the strike price, higher the call the strike price, higher the
option value put option value
Time remaining Positive relationship: Higher Positive relationship: Higher
h i
until expiration the time remaining, Higher the the time remaining, Higher
e l
D
call option value the put option value

of
Volatility of Positive relationship: Higher Positive relationship: Higher
the underlying the volatility, higher the call the volatility, higher the put

ty
asset’s price option value option value

i
Interest rates Positive relationship: Higher Negative relationship: Higher
the interest rates, higher the
r s
the interest rates, lower the

e
call option value put option value
Dividends Negative relationship: Higher
i v
Positive relationship: Higher
the dividends, lower the call
option value
U n
the dividends, Higher the put
option value

IN-TEXT QUESTIONS
L ,
S O
/
1. A put option gives the holder the right, but not the obligation,

L
to sell an underlying asset at a specified price within a specified
time period.

C O (True/False)

E /
2. The price of a call option increases as the strike price increases;
all other factors held constant. (True/False)

D C
©D
5.2.3 Importance of Option Pricing
Option pricing is essential as it enables market participants to accurately
assess the value of options, make informed investment decisions, and
manage their risk exposure effectively:
The key reasons for pricing financial derivatives specifically options are:
1. Fair Valuation: Options can be fairly valued thanks to option pricing.
Investors and traders must determine an option’s fair value in order
to determine whether it is overpriced, undervalued, or reasonably

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes priced. Accurate option pricing supports prudent capital and risk
management, as well as enables market players to make well-
informed choices on the purchase or sale of options.
2. Risk Management: Option pricing is an essential instrument for risk
management. Investors and traders may evaluate the possible risk
and return of their option investments by appropriately pricing their
options. For instance, investors may manage their risk exposure and

i
make wise investing decisions by utilising option pricing models
to determine the maximum loss or gain that could result from an
l h
e
options position.

D
3. Trading Strategies: For developing and putting into practice a

of
variety of trading strategies, option pricing is crucial. The prospective
profitability of various options trading techniques, such as covered

i ty
calls, protected puts, straddles, and spreads, is evaluated by traders

r s
using option pricing models. The ability to detect prospective trading

e
opportunities and successfully execute strategy is made possible by

v
accurate option pricing.

n i
U
4. Arbitrage Opportunities: In order to locate and take advantage of

,
arbitrage opportunities, option pricing is essential. Arbitrage is the

O L
practise of profiting from price differences between similar assets
or between marketplaces. With the use of accurate option pricing,

/ S
traders may spot mispriced options and purchase and sell options

O L
to take advantage of the difference in price and generate risk-free
profits.

/ C
E
In the real world, mismatches in prices of assets or commodities

C
across different markets can present an opportunity for risk-free

D
profit, a concept known as arbitrage. Arbitrage is a strategy used

©D
by investors and traders to take advantage of price discrepancies
in various markets without exposing themselves to any risk.
Suppose there are two markets, Market A and Market B, both selling
the same commodity, say gold. In an efficient market, the price of
gold in both markets should be the same. However, due to various
factors such as transaction costs, information delays, or differences
in supply and demand dynamics, the prices in these two markets
can sometimes diverge.

142 PAGE
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BASIC OPTION PRICING: THE BINOMIAL OPTION PRICING MODEL

Now, assume that at a given moment: Notes

In Market A, the price of 10 gm of gold is Rs. 50,000
In Market B, the price of 10 gm of gold is Rs. 50,500
This price discrepancy creates an arbitrage opportunity. An arbitrageur
can exploit this situation by following these steps:
Purchase gold in Market A at Rs. 50,000 per 10 gm.

i
Simultaneously sell the same amount of gold in Market B at Rs.
50,500 per 10 gm.
l h
By doing so, the arbitrageur pockets an instant profit of Rs. 500
per 10 gm without taking on any risk. This is because they have
D e
of
made both transactions at the same time, effectively locking in the
profit. Since there is no risk involved (no market movements or

i ty
price changes are required for the profit), this is known as a risk-
free profit.
r s
v e
Arbitrage opportunities like this tend to be short-lived in efficient

i
markets, as other traders would quickly take advantage of the price
n
U
discrepancy, which in turn would drive the prices back to their

,
equilibrium levels.

L
It’s important to note that real-world arbitrage opportunities are

O
S
more complex and often involve transaction costs, regulatory

/
considerations, and market inefficiencies. To successfully execute
L
O
arbitrage strategies, investors need to be quick, well-informed,

C
and equipped with sophisticated tools and systems. As markets

E /
have become more efficient with advancements in technology and

C
increased competition, risk-free arbitrage opportunities have become

D
less common, and most investors now seek to manage and balance

©D
risks while pursuing profits.
5. Market Efficiency: Option pricing helps to make markets more
effective. The degree to which prices of financial assets represent
all information available is referred to as market efficiency. Since
it helps to ensure that options are priced appropriately based on
the underlying asset’s current market conditions and other relevant
factors, accurate option pricing facilitates effective price discovery
in the options market.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 6. Investment Performance: A key component of assessing investment

success is option pricing. Option pricing is used by investors and
portfolio managers to evaluate the performance of their options
investments and compare them to their investment goals and
benchmarks. Investors may monitor the success of their options
holdings and decide on their investment strategy with the help of
accurate option pricing.

5.3 Conceptualizing Binomial Option-Pricing Model

h i
(BOPM)
e l
D
of
The Binomial Option-Pricing Model (BOPM) is a popular and widely
used mathematical model for pricing options. It was created in 1979 by

ty
Cox, Ross, and Rubinstein and has since grown into a crucial instrument

s i
for pricing financial derivatives. A discrete temporal and discrete state

e r
model called the BOPM offers a quick and easy technique to determine

v
the potential cost of choices.

n i
In the world of financial derivatives, the significance of option pricing

U
cannot be emphasised. Options are financial agreements that provide the

,
L
holder the right, but not the responsibility, to buy/sell (in the case of

O
a call/put option) an underlying asset at a certain price, known as the

/ S
striking price or exercise price, within a present time frame. For different

L
market players, such as investors, traders, and financial institutions, option

O
pricing is essential because it helps them create trading strategies, manage

C
/
risks, and make educated investment decisions.

C EThe Binomial Option Pricing Model is a popular method used to determine

the fair value of options and derivatives. It’s particularly useful when
D
©D
dealing with options on stocks, currencies, or other financial instruments.
The model is based on a discrete-time framework, which means we break
time into a series of short intervals, or periods, allowing us to analyze
price movements step by step.
BOPM is frequently utilised in the financial sector because of its ease of
use and versatility. By taking into account the probabilistic price changes
of the underlying asset across discrete time steps, it offers a framework
for evaluating options. To make the valuation process simpler, the model
makes specific assumptions about discrete time and state, risk-neutral

144 PAGE
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 BASIC OPTION PRICING: THE BINOMIAL OPTION PRICING MODEL

pricing, and binomial distribution of stock price movements. BOPM enables Notes
the computation of option prices at each node of the tree, resulting to the
determination of the option’s theoretical value by creating a binomial tree
to represent the potential stock price changes and corresponding option
values. For the notion of BOPM to make sense, one must comprehend
the underlying premises and how a binomial tree is built. In the next
sections, we will explore the key assumptions of BOPM and the step-by-
step process of constructing a binomial tree for option pricing.

h i
5.3.1 Assumptions of BOPM
e l
D
of
The Binomial Option-Pricing Model (BOPM) relies on several key
assumptions that simplify the valuation process and make it a powerful

ty
tool for option pricing:

s i
1. Discrete Time and Discrete State Model: BOPM makes the underlying

e r
asset’s price and the passage of time into distinct stages as a

i v
premise. This indicates that the model takes into account a limited

n
number of time periods and potential changes in the underlying

, U
asset’s price throughout each period. In contrast to continuous time
models, this discrete time and discrete state assumption enables a

O L
more controllable and computationally efficient valuation procedure.

/ S
2. Risk-Neutral Pricing Assumption: BOPM bases its option pricing on

O L
the supposition that the market is risk-neutral, i.e., that investors have
no regard for risk. As a result, it is easy to calculate predicted option

/ C
values in a straightforward manner using risk-neutral probabilities

C E
that are obtained from the probability of the various potential stock
price moves in the binomial tree. A major idea in BOPM is risk-

D
neutral pricing, which is applied to discount future projected option

©D
prices to their current value.
3. Binomial Distribution of Stock Price Movements: A binomial
distribution of potential price movements results from the assumption
made by BOPM that the stock price can only increase or decrease
by a specific proportion at each time step. Since there are only
two possible outcomes (up or down) for each time step, this makes
modelling stock price movements simpler. The option values at each

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes node of the binomial tree are determined using the probabilities
connected with these movements.
4. Absence of Arbitrage Opportunities: BOPM bases its assumptions
on the idea that there are no arbitrage possibilities in the market,
which means it is impossible to benefit risk-free from price disparities.
This presumption guarantees that the model generates consistent,
realistic, and non-profitable option pricing.

i
BOPM is a rather straightforward and understandable model for option

l
pricing because to these presumptions. When utilising BOPM for pricing
h
D e
options in actual applications, it is vital to keep in mind that these
assumptions could not always accurately reflect the dynamics of financial

of
markets. As a result, their limitations should be taken into account.

ty
The creation of a binomial tree for option pricing, a crucial step in using

i
BOPM to determine option prices, will be covered in the next section.

s
IN-TEXT QUESTIONS
e r
i v
3. Which of the following is an assumption of the Binomial Option
Pricing Model?
U n
,
(a) The underlying asset’s price follows a continuous geometric

L
Brownian motion

O
S
(b) The underlying asset’s price can only move up or down

L /
by a fixed percentage each time period

C O (c) The option can be exercised at any time before expiration

E / (d) The risk-free rate of return is constant over the life of

the option

D C 4. One of the assumptions of the Binomial Option Pricing Model

©D
is that there are no transaction costs, taxes, or restrictions on
short-selling. (True/False)

5.3.2 Hedge Ratio in Binomial Tree for Option Pricing

In the Binomial Option Pricing Model (BOPM), which determines the
value of options, the hedging ratio is a key idea. It is a measure of the
price sensitivity of the option to the value of the underlying asset. The
units of the asset that must be purchased or sold in order to balance the

146 PAGE
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 BASIC OPTION PRICING: THE BINOMIAL OPTION PRICING MODEL

risk involved with holding the option is specifically represented by the Notes
hedge ratio.
Let us first go through the fundamentals of the BOPM to better grasp
the hedging ratio. By simulating the price evolution of the underlying
asset through time, the BOPM is a mathematical model that is used to
evaluate options. The model implies that the likelihood of the underlying
asset going up or down is known and that the price of the asset may

i
only change by a fixed amount throughout each time period. Using these
presumptions as a basis, the model works backwards from the expiration
l h
e
date to determine the price of the option at each point in time.
When an investor decides to purchase or sell the underlying asset in
D
of
order to hedge their position in the option, the hedge ratio comes into
play. Hedging entails taking a different position in the underlying asset

i ty
to balance off the risk of owning the option. By doing this, the investor

r s
can safeguard themselves against losses in the event that the price of the
underlying asset declines.

v e
The hedging ratio is denoted mathematically as:
n i
U
+ ǻ&ǻ6

,
ZKHUH+LVWKHKHGJHUDWLRǻ&LVWKHFKDQJHLQWKHRSWLRQSULFHDQGǻ6
L
O
is the change in the price of the underlying asset. The hedge ratio shows

S
how many units of the underlying asset is to be bought or sold to fully

L /
hedge the position in the option.

O
For example, let us say we own a call option on a stock with a strike

C
/
price of Rs. 50 and a current price of Rs. 45. The option has a delta

C E
of 0.7, which means in case of every Rupee increase in the underlying
asset value, there will be an increase in the option price of Rs. 0.70. To
D
hedge our position in the option, we would need to buy 0.7 units of the

©D
stock for every 1 unit of the option we own. If the stock price were to
increase to Rs. 50, the option price would increase by Rs. 3.5 (Rs. 0.70
× 5), and our hedge position in the stock would increase in value by
Rs. 3.5 as well, fully offsetting any potential losses in the option.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 5.3.3 One-Step and Two-Step Decision Trees

One-step Binomial Tree:
The one-step binomial tree is a simplified version of the Binomial Option
Pricing Model (BOPM) that consists of only one time step. It serves
as an elementary building block for understanding option pricing in a
discrete-time framework.

i
In the one-step binomial tree, we assume that the underlying asset can

l h
only take two possible price movements over a single time period: it can

D e
either go up by a certain factor (usually denoted by “u”) or go down
by another factor (often denoted by “d”). The tree has two nodes: the

of
starting node, which represents the current price of the underlying asset,
and two terminal nodes, which represent the possible asset prices at the
end of the time period.
i ty
r s
Let us imagine we want to build a one-step binomial tree to price a call

e
option on a stock that is now selling at Rs. 100 with a strike price of

v
n i
Rs. 105. We estimate that there is an equal chance that the stock price
will increase by 10% or decrease by 10% during the course of the
upcoming month.
, U
O L
We may build the one-step binomial tree shown below starting from the
current stock price of Rs. 100:

/ S
O L
/ C
C E
D
©D At each node, we calculate the value of the call option by taking the
maximum of two values: the difference between the current stock price
and the strike price, and zero. For instance, the call option value at the
up node is max (110-105, 0) = 5. The call option value at the down node
is max (90-105, 0) = 0.
The option value at the root node is then determined by working backwards
from the end of the tree. The discounted anticipated value of the two

148 PAGE
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 BASIC OPTION PRICING: THE BINOMIAL OPTION PRICING MODEL

potential outcomes in this situation—which is (0.5 × 5 + 0.5 × 0)/ (1 + r), Notes

where r is the risk-free interest rate—is the option value at the root node.
Two-step Binomial Tree:
The Two-Step Binomial Tree is an extension of the basic Binomial Option
Pricing Model (BOPM) that introduces an additional level of time steps
to enhance the precision of option valuations. This approach allows for a
more refined estimation of option prices by dividing the time to expiration

i
into smaller intervals.
Let’s break down the key features and steps of the Two-Step Binomial
l h
Tree:
D e
of
Time Step Division:
In the traditional BOPM, the time to expiration is discretized into only

ty
two periods, represented by the initial time and the expiration date.

s i
However, in the Two-Step Binomial Tree, we introduce an intermediate

e r
step by dividing the time between the initial time and the expiration date

i v
into two smaller intervals. This results in three time periods: the initial

Constructing the Binomial Tree:

U n
time, the intermediate time, and the expiration date.

L ,
With three time periods, the Two-Step Binomial Tree has more nodes than

O
the standard binomial tree. The tree is built in a similar manner to the

S
L /
original BOPM, but now it includes additional nodes for the intermediate
time period. Starting from the initial price of the underlying asset, we

O
calculate the potential price movements at both the intermediate and
C
assumption.
E /
expiration dates using the up and down factors derived from the volatility

D C
Risk-Neutral Probability:

©D
As in the standard BOPM, we use the risk-neutral probability at each time
step to calculate the option’s expected value. This risk-neutral probability
ensures that the expected return on the option is equal to the risk-free rate.
Backward Induction:
Using backward induction, we calculate the option’s payoff at each leaf
node of the tree at the expiration date. Then, we work our way backward
through the tree, calculating the option’s expected value at the intermediate
time nodes based on the discounted expected value of the next period’s

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes nodes. Finally, we repeat the process to obtain the option’s initial fair
value at the initial time node.
By introducing an additional time step, the Two-Step Binomial Tree
provides a more precise estimation of option prices compared to the
standard BOPM, especially when the time to expiration is relatively long.
The added flexibility of the Two-Step Binomial Tree allows it to handle
more complex payoffs and option structures, such as American options
or options with multiple exercise dates, more effectively.

h i
l
Let us imagine we want to build a two-step binomial tree to price a call

D e
option on a stock that is now selling at Rs. 100 with a strike price of
Rs. 105. We estimate that there is an equal chance that the stock price will

of
increase by 10% or decrease by 10% during the course of the upcoming
month. We may build the two-step binomial tree shown below starting

ty
with the current stock price of Rs. 100:

s i
e r
i v
U n
L ,
S O
L /
C O
/
We use the same approach as in the one-step binomial tree example to

E
determine the value of the call option at each node. For instance, the call

D C option value at the up-up node is max (121-105, 0) = 16, the call option
value at the up-down node is max (99-105, 0) = 0, the call option value

©D
at the down-up node is 0, and the call option value at the down-down
node is max (81-105, 0) = 0.
We can simply sum these probability values because the up-down and
down-up nodes both display the same value of the call option with 0.25
probability each. The option value at the root node is then determined by
working backwards from the end of the tree. The discounted anticipated
value of the three possibilities in this scenario, which is (0.5 × 0 +
0.25 × 16 + 0.25 × 0)/(1 + r), is the option value at the root node. r is
the risk-free interest rate.

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 BASIC OPTION PRICING: THE BINOMIAL OPTION PRICING MODEL

The option price can be determined once the option value at the root Notes
node has been computed. Simply put, the option price is the option value
at the root node’s present value, discounted at the risk-free interest rate.
For instance, if the risk-free interest rate is 3% and the option value at
the root node is Rs. 6, the option price is Rs. 16/(1 + 0.03) = Rs. 15.53.
It is essential to remember that the amount of steps employed in the tree
building affects how accurate the binomial tree model is. In general, the

i
accuracy of the option pricing will increase with the number of stages
employed. The computational complexity of the model is also increased
l h
e
by a greater number of stages, though. In practice, a balance must be
struck between accuracy and computational efficiency.
D
IN-TEXT QUESTIONS
of
ty
5. Which of the following statements is true regarding the hedge
ratio in the context of options trading?
s i
e r
(a) Hedge ratio represents the percentage of the underlying

i v
asset that should be held to offset changes in the option
price

U n
,
(b) A higher hedge ratio means a stronger negative correlation

O L
between the option price and the underlying asset price
(c) Hedge ratio is the ratio of the change in the option price

/ S
to the change in the underlying asset price

O L
(d) Hedge ratio is always equal to 1

/ C
6. In a two-step decision tree, what is the purpose of the first stage?

E
(a) To calculate the expected payoff for each possible outcome
C
D
in the second stage

©D
(b) To identify the initial investment and its potential returns
(c) To determine the decision that maximizes expected payoff
in the second stage
(d) To identify the possible outcomes and their probabilities
in the second stage

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 5.4 Calculating Option Prices using BOPM

In the BOPM mathematical model, the potential outcomes of an option
are represented by a binomial tree. In this concept, an option’s value is
determined by the expected value of its payment at any given moment.
By splitting the time period into a number of equal chunks and assuming
that the price of the underlying asset may only go up or down at each
interval, the binomial tree is created. The volatility of the underlying
asset is a factor that affects how much the price will move up or down.
h i
e l
The risk-neutral probability, which assumes that the anticipated return on

D
the underlying asset is equal to the risk-free rate, is used to determine

of
the likelihood of an upward advance.
Calculation of Probability

i ty
In the Binomial Option Pricing Model (BOPM), the probability calculation

r s
is a crucial step that helps determine the option’s expected value at each

e
node of the binomial tree. The probability is a risk-neutral probability,

v
n i
meaning it is adjusted so that the expected return on the option is equal
to the risk-free rate. This risk-neutral assumption simplifies the pricing

, U
process by effectively removing investors’ risk preferences from the

L
equation.

O
The formula for calculating the risk-neutral probability in the BOPM
S
L /
depends on the assumption of price movements in the underlying asset.
There are two commonly used methods: the “up” and “down” factors

C O
and the “up factor only” method. Both methods use the concept of the

E /
risk-neutral probability, but they approach it differently.

C
Using “Up” and “Down” Factors:

D Let’s denote the “up” factor as “u” and the “down” factor as “d.” These

©D
factors represent the potential price movements of the underlying asset
in each time step. Typically, we assume that the asset’s price can either
go up by a factor of “u” or down by a factor of “d” at each time step.
The risk-neutral probability of an “up” movement, denoted as “p,” is
calculated as follows:
p = [exp(r ×ǻW   G@  X  G
where:
r is the risk-free interest rate,

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 BASIC OPTION PRICING: THE BINOMIAL OPTION PRICING MODEL

ǻW LV WKH WLPH LQWHUYDO EHWZHHQ WLPH VWHSV Notes

exp() is the exponential function,
u is the “up” factor representing the asset’s price increase, and
d is the “down” factor representing the asset’s price decrease.
The risk-neutral probability of a “down” movement, denoted as “1 - p,”
is simply the complement of “p.”

i
Using “Up Factor Only”:
Alternatively, we can use a simplified formula when we only consider
l h
the “up” factor (u) in the BOPM. In this case, the “down” factor (d) is
set to its reciprocal (1/u).
D e
The risk-neutral probability of an “up” movement, denoted as “p,” is
of
ty
calculated as follows:

s
p = exp(r ×ǻW   G  X  G   H[S U ×ǻW   
i
where:
e r
r is the risk-free interest rate,
i v
U n
ǻW LV WKH WLPH LQWHUYDO EHWZHHQ WLPH VWHSV
exp() is the exponential function, and

L ,
O
u is the “up” factor representing the asset’s price increase.

/ S
In both methods, the risk-neutral probability “p” is used to calculate the

O L
expected value of the option at each node of the binomial tree during the
backward induction process, leading to the final valuation of the option

/ C
at the initial node of the tree.

C E
There are typically four steps involved in the process of calculating option

D
prices using the Binomial Option Pricing Model (BOPM):

©D
1. Construct the Binomial Tree: This involves dividing the time
interval into a number of equal parts and using a parameter known
as volatility to determine the size of the upward and downward
movements of the underlying asset.
2. Calculate the Up and Down Factors: Using the stock’s volatility,
the time period for each step in the model, and the risk-neutral
probability of an up or down move, we can calculate the up and
down factors in the model.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes To calculate the up and down factors in the Binomial Option Pricing
Model, we use the stock’s volatility, the time period for each step
in the model, and the risk-neutral probability of an up or down
move.
The up factor (u) is calculated as HA ı¥ǻW ,
ZKHUHıLVWKHVWRFN¶VDQQXDOL]HGYRODWLOLW\ǻWLVWKHWLPHSHULRGIRU
each step in the model, and e is the mathematical constant 2.71828.
The down factor (d) is simply the reciprocal of the up factor:
h i
d = 1/u.
e l
D
For example, if the stock’s volatility is 20%, the time period for each

of
step is 1 year/12 months = 1/12, and the risk-neutral probability
of an up or down move is 0.5, we can calculate the up and down

ty
factors as follows:

s i
X  HA ı¥ǻW   HA ¥    

e r
d = 1/u = 0.9868

i v
These up and down factors can then be used to construct the binomial

U n
tree for the stock price, and to calculate the expected payoffs of

,
the option at each node of the tree.

L
3. Calculate the Option Payoff: Based on the constructed binomial

O
S
tree, the option payoff is calculated at the end of the maturity period

/
for each possible outcome.
L
O
4. Work Backward to Calculate the Option Value at Each Node:

/ C
Starting from the end of the binomial tree, the option value is

E
calculated at each node by taking the discounted expected value

D C of the two possible outcomes at that node.

©D
5. Calculate the Option Price: The option price is determined by
taking the option value at the root of the binomial tree.
Consider a call option on a stock with a strike price of Rs. 50, a term of
1 year, and a volatility of 20% to demonstrate the BOPM. The risk-free
rate is 5%, and the current stock price is Rs. 45.
In order to simulate potential price changes of the stock over time, we
must first build a binomial tree. We may assume a risk-neutral probability
of 0.5 for each node in the tree since the likelihood of moving up the
tree or down it is the same. The stock price at each node of the tree

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 BASIC OPTION PRICING: THE BINOMIAL OPTION PRICING MODEL

will either increase or decrease by a factor of u or d during the course Notes

of the two time periods.
Using the given volatility of 20%, we can calculate the up and down
factors as follows:
X  HA ı¥ǻW   HA ¥    
d = 1/u = 0.8681
Using the current stock price of Rs. 45, we can calculate the two possible
prices at the end of the first time period:
h i
Up = 45 × 1.1519 = Rs. 51.83
e l
Down = 45 × 0.8681 = Rs. 39.06
D
We can then calculate the two possible prices at the end of the second
of
ty
time period:
Up-Up = 51.83 × 1.1519 = Rs. 59.70
s i
Up-Down = 51.83 × 0.8681 = Rs. 44.99
e r
Down-Down = 39.06 × 0.8681 = Rs. 33.90
i v
U n
Next, we need to calculate the payoffs of the call option at each node of

,
the tree. The payoff of a call option is the underlying asset value – the

L
exercise price of the option or zero, whichever is greater.

O
S
At the end of the second time period, the payoffs are:

L /
Up - Up = max (0, 59.70 - 50) = Rs. 9.70

O
Up - Down = max (0, 44.99 - 50) = Rs. 0

C
/
Down-Down = max (0, 33.90 - 50) = Rs. 0
E
C
Using the risk-neutral probabilities, we can then calculate the expected

D
payoff of the call option at the end of the first time period:

©D
Expected payoff at t = 1 : (0.5 × Rs. 9.7) + (0.5 × Rs. 0) = Rs. 4.85
We can then discount this expected payoff back to the current time, using
the risk-free rate. The present value of the expected payoff is:
Present value of expected payoff: Rs. 4.85/(1 + 0.05) ^1 = Rs. 4.619
Therefore, the price of the call option at the current time, using the
Binomial Option Pricing Model, is approximately Rs. 4.619.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes
IN-TEXT QUESTIONS
7. The up and down factors used in the binomial option pricing
model are not determined based on the expected future price
of the underlying asset. (True/False)

5.5 Summary

h
Options are financial derivatives which provides the right (and not the
i
e l
obligation) to the purchaser of the option to buy/sell an underlying asset

D
at a given price and time. As a type of derivative, options derive their

of
value from the underlying asset. They are frequently employed for both
market speculation and risk management. Financial derivatives’ option

ty
pricing is a key feature that enables investors to protect themselves against

s i
market risks. A common technique for pricing options is the binomial

r
option-pricing model, which is based on the assumption of continuous
e
v
volatility and the creation of a binomial tree for option pricing. The

n i
model makes it possible to calculate option prices, including call and

U
put option pricing, making it a crucial tool for investors trying to make

,
educated portfolio selections.

L
O
The binomial model does, however, have certain drawbacks, including

S
the assumption of continuous volatility and the challenge of effectively

L /
simulating real-world circumstances. Investors may choose how to use the

O
model to their investing plans by being aware of the model’s advantages

/ C
and disadvantages.

C E5.6 Answers to In-Text Questions

D
©D
1. True
2. False
3. (b) The underlying asset’s price can only move up or down by a
fixed percentage each time period
4. True
5. (c) Hedge ratio is the ratio of the change in the option price to the
change in the underlying asset price

156 PAGE
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BASIC OPTION PRICING: THE BINOMIAL OPTION PRICING MODEL

6. (d) To identify the possible outcomes and their probabilities in the Notes
second stage
7. False

5.7 Self-Assessment Questions

1. How do option prices impact financial derivatives, and how can

i
an understanding of option pricing help mitigate risks in financial
markets?
l h
2. What are the assumptions behind the binomial option-pricing model,
D e
of
and how do these assumptions impact the accuracy of option prices?
3. Suppose you hold a call option on a stock with a strike price of

ty
Rs. 80. The stock is currently selling at Rs. 90, and the option has

s i
a delta of 0.7. If you want to hedge your position by trading the

r
underlying stock in the market then what is the hedge ratio, and
e
v
how many units of the stock do you have to trade to fully hedge
your position in the option?
n i
, U
4. Suppose you hold a put option on a stock with a strike price of
Rs. 120. The current price of the underlying stock is Rs. 100, and

O L
the option has a delta of -0.5. You want to hedge your position by

S
trading the underlying stock. What is the hedge ratio, and how many

L /
units of the stock should you trade to fully hedge your position in

O
the option?

/ C
5. How can we construct a binomial tree for option pricing, and how

C E
does this tree help us understand the underlying asset’s potential
price movements?

D
©D
6. Can you explain the difference between a call and a put option, and
how do we calculate their prices using the binomial model?
7. What are the limitations of the binomial option-pricing model, and
how can we address these limitations when making investment
decisions?
8. A stock has a volatility of 25% and its current price is Rs. 60.
Calculate the up and down factors if the stock price can either go
up by 10% or go down by 5% in one year.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 9. A stock has a volatility of 30% and its current price is Rs. 80.
Calculate the up and down factors if the stock price can either go
up by 15% or go down by 10% in six months.
10. Suppose a stock has a current price of Rs. 100. In the next year, the
stock price can either go up by 20% or go down by 10%. Draw
the binomial tree for this scenario with two-time steps.
11. Consider a call option with a strike price of Rs. 50 on a stock that

i
has a current price of Rs. 45. The stock price can either go up by
10% or go down by 5% in one year. Draw the binomial tree for
l h
this scenario with three-time steps.

D e
of
5.8 References
 ‹Benninga,

i ty
S., & Wiener, Z. (1997). The binomial option pricing

r s
model. Mathematica in Education and Research, 6, 27-34.
 ‹Boyle,
e
P., & Schwartz, E. S. (1977). Options valuation with
v
i
random discrete-time processes. Journal of Financial Economics,
n
U
5(1), 67-81.
 ‹Cox,
,
J. C., Ross, S. A., & Rubinstein, M. (1979). Option pricing: A

L
simplified approach. Journal of financial Economics, 7(3), 229-263.
 ‹Hillier,

S O
D., & Grinblatt, M. (2002). Financial markets and corporate

L /
strategy. Irwin/McGraw-Hill.

C O
 ‹Clewlow, L., & Strickland, C. (1999). Implementing derivatives

/
models. John Wiley & Sons.

C E5.9 Suggested Readings

D
©D
 ‹Bhole, L M. (2004) Financial Institutions and Markets 4th edition,
Tata McGraw-Hill, New Delhi.
 ‹Dothan, U. (1990), Prices in Financial Markets, Oxford University
Press, New York.
 ‹Hull, John, (2002) Options, Futures and other Derivatives, Prentice-
Hall of India, New Delhi.
 ‹Sheldon Natenberg, (2014), Option Volatility and Pricing Strategies,
McGraw-Hill.

158 PAGE
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L E S S O N

6
Asset Price Random Walks
Sunakshi Chadha
Assistant Professor
IITM, GGSIPU
Email-Id: [email protected]
Aditi Methi

h i
Assistant Professor

e l
IITM, GGSIPU

D
Email-Id: [email protected]

STRUCTURE
of
Learning Objectives
i ty
s
6.1
6.2 Introduction
e r
6.3 Assumption of the Random Walk Theory
i v
6.4 Implication of the Theory
U n
,
6.5 Criticism
6.6 (I¿FLHQW 0DUNHW +\SRWKHVLV
O L
S
6.7 E.F. FAMA Model
6.8 &ULWLFLVP RI (0+
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6.9
C O
,PSDFW RI (I¿FLHQW 0DUNHW +\SRWKHVLV DQG 5DQGRP :DON
6.10 Summary
E /
6.11
6.12
D C
Answers to In-Text Questions
Self-Assessment Questions

©D
6.13 References
6.14 Suggested Readings

6.1 Learning Objectives

 ‹Understand the concept of asset price random walks and its implications for financial
markets.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes  ‹Identify the characteristics of asset price random walks.

 ‹Understand the different forms of market efficiency.
 ‹Apply the knowledge of asset price random walks to analyze historical
price data, identify investment opportunities, and make informed
investment decisions.

6.2 Introduction

h i
l
The random walk hypothesis states it this way that the movement in asset

D e
prices follows a random walk meaning that prices changes are random
and unpredictable. It is more or less like efficient market hypothesis. As

of
per this theory, the changes in prices of different assets are independent
of each other and they are in fact even independent of the past price

i ty
movements which means that the fundamental and technical analysis
holds untrue.
r s
e
Fundamental analysis means analysing the economy, industry and company
v
i
before making the asset portfolio while the technical analysis means the
n
U
understanding the trends of past prices to predict the future prices on

,
the basis of chartists.

O L
Thus, the theory is evident of the fact that the momentum does not
generally exist and calculation of past trends of prices does not predict the

/ S
future. This idea is also better known as weak efficient market hypothesis.
History
O L
/ C
Although the broad notion that security prices fluctuate randomly dates

C Eat least as far back as Bachelier (1900), the application of the random
walk hypothesis to stock prices is typically linked with Samuelson (1965).

D The fundamental premise of the idea is that information is assimilated by

©D
securities markets very effectively. When news breaks concerning a certain
security or the market in general, it spreads swiftly and is immediately
reflected in the price of that security. Investment managers in droves
seize on any news that might impact a security’s value. They make sure
that security prices accurately represent all available information via
trading. As a result, using such information to generate winning trades
is impossible.

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As shown in the Figure 6.1, Notes

The asset prices are not following any pattern, they are rather independent
of each other.

h i
e l
D
of
i ty
r s
v e
i
Figure 6.1

U n
6.3 Assumptions of the Random Walk Theory

L ,
1. The market is supreme and independent and no individual investor

S O
can influence it and predict it.

L /
2. Asset prices are absorbing all the information quickly leaving no

O
scope of manipulation.

C
/
3. All investors are having free access to the information.

E
C
4. Market quickly adjusts itself to the changes from the equilibrium

D
level due to the forces of demand and supply.

©D
5. The prices of different assets are moving independent manner leaving
no scope of influencing or arbitrage.
6. Nobody is having access to insider information.
7. Investors behave in the rational manner.
8. Institutional investors or funds managers have to follow the market
and cannot influence it.
9. There are large numbers of buyers and sellers making it to be a
perfect competition.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 6.4 Implication of the Theory

1. As it is already stated that it is impossible to predict the movement
of asset prices so it is impossible for an investor in the market to
outperform or beat in the long run however in the short run the
advantage can be taken by quickly taking benefit of the public
information.
2. As there are large number of investors that are existing as stated

h i
and every investor will be spending time in different tenure so it

e l
is possible for a smart investor to outperform in the short run by

D
strategically investing in the assets when the price is low and selling

of
when the price is high in the short run.
3. This is to be argued that random walk theory is based on unrealistic

i ty
assumption that the prices movement of asset is random or there is

s
no pattern however, there are large number of factors affecting the
r
e
prices making it difficult to find out the set pattern but that does

i v
not mean that the pattern does not exist.

IN-TEXT QUESTIONS
U n
,
1. Which of the following statements best describes a random
L
O
walk in the context of asset prices?

/ S
(a) Asset prices move in a predictable pattern

O L
(b) Asset prices follow a completely random and unpredictable
pattern

/ C
E
(c) Asset prices exhibit a mix of predictable and random

C
movements

D (d) Asset prices only move in one direction, either upward

©D
or downward
2. The Efficient Market Hypothesis (EMH) suggests that:
(a) Asset prices are always efficient and reflect all available
information
(b) Asset prices are completely random and unpredictable
(c) Asset prices can deviate from their fundamental values,
creating investment opportunities

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 ASSET PRICE RANDOM WALKS

(d) Asset prices follow a predetermined path based on historical Notes

data
3. Which of the following is NOT a characteristic of a random
walk-in asset prices?
(a) Serial correlation in price movements
(b) Lack of predictability in future price changes

i
(c) Random shocks and news affecting prices
(d) Price changes are independent and identically distributed
l h
D e
of
6.5 Criticism

ty
The fundamental critique of random walk theory is that it ignores the

i
influence of market participants’ behavior and actions on prices and

r s
outcomes, oversimplifying the complexity of financial markets. Non-random

e
factors like changes in interest rates or governmental restrictions, as well
v
also affect prices.
n i
as unethical activities like insider trading and market manipulation, can

, U
Market experts contend that contrary to the theory’s claim that past prices

O L
are not helpful, historical patterns and trends might in fact offer useful
information about future prices. They contend that market psychology

/ S
can be identified through technical analysis. Other investors have also

L
refuted the theory by citing instances of successful stock pickers who
O
C
have regularly outperformed the market over time.

E /
Another criticism is that a random walk implicitly assumes that all investors

C
have access to the same information, but in fact certain investors (such

D
big, institutional investors) have access to more and better information.

©D
In fact, knowledge asymmetries that make markets inefficient have been
discovered in real-world marketplaces:
 ‹Because the share market is supposed to be efficient, market
prices cannot be underpriced or overpriced, according to the EMH
theory.
 ‹The difficulty with the random walk theory is that stock prices would
be rational if the industry were hypothetically efficient, as proposed
by EMH (and changes are not necessarily out of the blue).

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes  ‹In contrast, if somehow the random walk theory is correct, the
assumption invalidates the EMH’s proposal because it implies that
the share market is irrational.
 ‹The assertion that the share market corrects itself instantly once fresh
data is revealed publicly is also a flaw in the random walk theory.

6.6 Efficient Market Hypothesis

The efficient market hypothesis was developed by Eugene Fama who
h i
e l
was of the opinion that the asset prices will always be trading at the fair

D
value and also it makes it impossible for the investors to purchase the

of
undervalued stock or to sell the overvalued asset. Thus, it can be said
that expert selection of asset is not possible and in fact getting higher

ty
return is merely by chance.

s i
r
This theory states that financial and derivatives market is efficient in the

e
sense that the prices will reflects all the changes in the information and

i v
will always automatically adjust to the changes. This is just an extension

U n
to the random walk theory by posing that the new information is random
and it states that the speed at which the movements in prices appears

L ,
and speed at which the prices reach equilibrium is dependent on the

O
efficiency of the market. Efficiency here means the speed at which the

/ S
information about the assets or securities is disseminated and the asset

O L
prices are adjusted in an unbiased manner. Thus, it means the value of
the asset will be the fair value or intrinsic value or the present value of

/ C
the future prospects.

C EThe basis of the EMF model is dependent on the rationality of investors

D
who are constant reading and assimilating the new and available information.

©D
Assumptions of the EMF:
1. There are many buyers and sellers in the market.
2. The fund managers are rational and, on an average, they are making
wise decisions of buying and selling of assets.
3. There is perfect information about the profits and market trends.
4. The information is equally available to all the investors.
5. The investors are making use of the available information to analyse
the economy company.

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6. And are rapidly adjusting to make numerous profits and to maximize Notes
the investors competition.
A market is said to be efficient if the asset prices reflect the available
information. So the prices and information that is reflected is as follows:
1. All the past information/past events that have already taken place.
2. All the information that is already been announced but something
that is yet to be implemented.
3. All the information that has been generated but is not yet publicly
h i
available or it is better known as inside information.
e l
D
of
i ty
r s
v e
n i
, U
O L
/ S
O L Figure 6.2

/ C
As Shown in the Figure 6.2, it is clearly stated that the efficient market

C E
will adjust itself to the good news at the time 0 and if there is a delay
in adjustment then the market is considered to be the inefficient market

D
and hence, the assimilation of information has not been done properly.

©D
So, in inefficient market, it will take certain days for the adjustment of
information.
In an efficient market, the prices are reflecting all these good and bad
information with a time lapse and they are quick enough to absorb all the
information and thus super normal profits cannot be made by investors
in generally.

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Notes As already stayed the efficient market hypothesis is merely an extension to

the Random walk theory. Random walk theory is not necessarily efficient
and it is basically also known as weak form of market efficiency.
Now coming to the point of three forms of market efficiency as per the
Efficient market hypothesis:

h i
e l
D
of
i ty
r s
v e
n i
U
L,
Figure 6.3

O
As stated in Figure 6.3 the market efficiency is of three types:

/ S
Weak form market efficiency

L
Semi strong form of market efficiency
O
C
Strong form of market efficiency

E /
In the Figure 6.3, the circles are hereby representing the amount of

D C information that each form has and thereby it means that strong form
covers all kinds of information from basic to inside information:

© D 1. Weak form (Random walk)

2. This form of market efficiency reflects all the market information
and it also means that it is a reflection of all the past information
and the historical data and thus making it impossible to make the
abnormal profits by using the past price information and thus the
rate of return are independent and the past return has no significance
on the future rates.

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As per this form of market efficiency, the fundamental analysis, that used Notes
to provide information of company, industry and economy and hence this
and technical analysis does not work.
The tests work can be further categorized as:
1. Statistical Tool of Independence: This assumes that the rate of return
is independence and hence the test can check the independence are
statically correlation or independent tests. (Runs test can also be

i
used for the measurement of weak form efficiency.)
2. Trading tests or the filter rule can be used because this form states
l h
that the past returns are not indicative of future results which shows
D e
of
that after transaction costs, an investor cannot earn an abnormal
return. The weak form discards the technical analysis because there

ty
is no value of studying past prices and hence there is no utility of

i
technical analysis. There is nothing that could be gained from the

s
r
studying the past prices.

v e
3. Semi Strong form of Market Efficiency: In this form of market

n i
efficiency, the current prices not just the past prices both of them

U
are reflected in the market prices thus making it easier to reflect
the publicly known information.

L ,
O
It also means that as soon as information is publicly available, it is

S
absorbed in the prices and thus it means that this information may

L /
be in the form of financial statements or the balance sheet or any

O
other publications. All this information can also be related to the

/ C
products, marketing, earnings, prices etc. and thus as soon as the

E
information is available, the investors will buy or sell the assets

D C
on the basis of type and nature of information. This form includes
the weak form efficiency.

©D
In other words, it can state that this form of efficiency is indicative of
all the publicly available information. And the statistical tests that can
be done to find out this are:
1. Event Tests: This is the test in which the security or set prices before
or after an event are such as earnings impacting the efficiency and
thus the investor will not be able to reap an extra return by an
event.

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Notes 2. Time Series Analysis: This is the method in which time series
predicts returns on the basis of historical data and checking that an
investor is unable to make abnormal profits from this information,
Strong Form of Efficiency:
This is the form that reflects that the market is super-efficient in the
sense that both the public and private information is reflected in the
prices automatically and thus reducing the possibility of insider trading .

i
all the public and private information is inclusive of insider information,
is reflected in market prices.
l h
D e
Strong form does not say it is impossible to get an abnormally high
return, that’s because there are always outliers in the averages.

of
Private information here means the inside information that is known to

ty
company management and not yet known to public and for example like

i
knowledge that the earnings are going to be higher this time is unavailable

s
r
to the general public.

v e
It may be noted that high level officers of the company might get benefit

n i
of inside information but the real cost is high in terms of breach of trust,

U
breach of fiduciary responsibility and thus making it difficult to sustain

,
the profits in long run.

O
IN-TEXT QUESTIONS L
/ S
4. The Efficient Market Hypothesis (EMH) states that:

L
CO
(a) All market participants have equal access to information

/
(b) Asset prices are always in equilibrium with their fundamental

E
values

D C (c) Market prices reflect all available information

D
(d) Market participants can consistently earn abnormal returns

© 5. The EMH is classified into three forms. Which of the following

is NOT one of those forms?
(a) Weak-form EMH (b) Semi-strong form EMH
(c) Strong-form EMH (d) Moderate-form EMH
6. According to the weak-form of the EMH:
(a) All publicly available information is already reflected in
stock prices

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(b) Stock prices fully incorporate all historical price patterns Notes

(c) Stock prices reflect all publicly available information,

including historical prices
(d) Stock prices are driven solely by investor sentiment and
irrational behaviour
7. The strong-form of the EMH argues that:

i
(a) Stock prices are always efficient and reflect all available
information
l h
(b) Stock prices reflect all publicly available information but
not private information
D e
(c) No one can consistently earn abnormal returns, even with
of
ty
access to private information

s i
(d) Stock prices are determined by fundamental analysis and
company-specific factors
e r
i v
6.7 E.F. FAMA Model
U n
L ,
The Fama and French Three-Factor Model, often known as the Fama
French Model, is an asset pricing model that builds on the Capital Asset

S O
Pricing Model (CAPM) by including size risk and value risk elements in

L /
addition to the market risk factor that is present in CAPM. It was created

O
in 1992. This model takes into account the recurring outperformance

C
of markets by value and small-cap stocks. The model corrects for this

E /
tendency of outperforming, which is expected to improve its usefulness

C
as a tool for assessing management performance.

D
The Fama-French model seeks to explain stock returns through three

©D
variables: market risk, small-cap firms’ outperformance compared to large-
cap companies, and high book-to-market value companies’ outperformance
vs low book-to-market value companies. The approach is justified by the
observation that high value and small-cap companies frequently beat the
market as a whole.
Tests for Checking Efficiency
Market efficiency tests examine whether particular investing methods
provide extra profits. Some tests also take execution feasibility and

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes transaction costs into account. A test of market efficiency is always a

test of both the effectiveness of the model used to predict returns and
the market’s efficiency.
When an analysis of market efficiency finds evidence of excess returns, it
may be a sign that the market is inefficient, the model used to calculate
expected returns is flawed, or both.
The method selected will be greatly influenced by the investment strategy

i
being examined. There are many different approaches to test for market
efficiency.
l h
1. Event Analysis
D e
of
An event study is made to look at how the market responds to and
the excess returns associated with particular information occurrences.

ty
Informational occasions can be firm-specific (such as earnings

s i
or dividend releases) or market-wide (such as macroeconomic
disclosures).
e r
i v
First, determine the event: The event that will be researched is

U n
explicitly stated, together with the precise day that it was disclosed.
Secondly, Collecting Returns: Returns are gathered for each of the

L ,
sampled companies around the event dates once the dates are known.

O
Two choices must be taken in order to proceed.

/ S
The analyst must first choose whether to gather returns surrounding

O L
the event on a weekly, daily, or shorter timescale. This will be
determined in part by how accurately the event date is specified.

/ C
E
Thirdly, the returns, by period, around the announcement date, are

C
adjusted for market performance and risk to arrive at excess returns

D
for each firm in the sample. For instance, if the capital asset pricing

©D
model is used to control for risk -
Excess Return on day t = Return on day t - Beta × Return on market
on day t
2. Runs Test
The run test, also known as the Geary test, is a non-parametric
test that evaluates the likelihood that the random walk hypothesis
holds true by tabulating and comparing the frequency of consecutive
positive and negative returns to its sampling distribution (Campbell

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et al. 1997; Gujarati 2003). The recurring occurrence of the same Notes
value or category of a variable is referred to as a run. The kind of
the run and the length are the two characteristics used to index it.
Runs on the stock price can be neutral, negative, or neither. The
length is the number of consecutive runs of a particular type.

6.8 Criticism of EMH

Because it is often difficult to understand correctly the implications of
h i
the EMH, I present a few of the most common misinterpretations:
e l
1. Analysts like Warren Buffet have outperformed the market despite
D
of
the EMH’s assumption that investors cannot. Therefore, the EMH
must be wrong. The EMH indicates that investors cannot constantly

ty
outperform the market; there will be moments when, by chance, an

s i
asset will outperform the market, making this interpretation wrong.

e r
It is also conceivable to continuously exceed the market by a little

i v
margin. A fund manager might have a 50% chance of outperforming

n
the market the next year. His chances of outperforming the market

, U
twice in a run are 25%, and his chances of outperforming the market
eight times in a row are 4%. As a result, 4 fund managers out of

O L
1000 will regularly outperform the market for eight consecutive

S
years.

L /
2. The weak version of the EMH asserts that technical analysis is

O
unhelpful for forecasting future stock returns. However, the fact that

C
/
financial analysts are still in demand suggests that their services

C E
are necessary. Consequently, the EMH must be false. This claim
is untrue because a financial analyst may create a portfolio that

D
fits each client’s risk tolerance, as opposed to a random stock

©D
selection that is unlikely to satisfy specific risk preferences. Second,
financial analysis is crucial to the effectiveness of markets because
it enables investors to detect mispriced equities by taking use of
fresh information. Arbitrage opportunities disappear when there is
competition among numerous investors, since stock prices instantly
adapt to reflect any new information, resulting in market efficiency.
3. The EMH must be incorrect because stock prices are constantly
fluctuating randomly. The fact that stock prices are constantly

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes changing is evidence in support of the EMH, because new information

appears almost continuously in the form of opinions, news stories,
announcements, expectations, and even lack of news. The constant
arrival of new information causes the continuous adjustment of
prices, as the EMH claims.
4. If the EMH is valid, all investors will need to be able to gather,
evaluate, and understand fresh information in order to appropriately

i
change stock prices. However, the majority of investors lack formal

h
financial expertise. The EMH must thus be false. All 6 traders do

e
not need to be informed in order to use the EMH. To properly
l
D
analyse fresh information and update stock prices, a very small

of
group of experts is required.
Thereafter, additional investors can trade on the updated prices without

i ty
having to follow the underlying factors that caused the price shift:
 ‹Market

r s
Anomalies: It refers to a situation where there is a difference

e
between the trajectory of a market price as established by efficient

v
n i
market hypothesis and its behaviour in reality. This proves that market
does not remain efficient at all times. Investors have outperformed

, U
the market meaning that this is quite evident for the critic of passive

L
approach of EMH.
 ‹Behavioural

S OEconomies: It dismisses the idea that all market

L /
participants are rational. It emphasizes that different circumstances
may put stress on individuals, forcing them to make irrational

O
decisions and which means that the traders may commit errors and
C
/ can also get influenced by their personality traits.

E6.9 Impact of Efficient Market Hypothesis and Random

C
D Walk
©D Market participants who have been in favour of this theory are more
passive in nature and will be going for the investment in index funds
and exchange traded funds.
Behavioural Asset Pricing:
In order to overcome the problems of random walk and efficient market
hypothesis, the modern technique of asset pricing is Behavioural Asset
pricing.

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This includes: Notes

 ‹Investor Sentiments: It is clearly known that investor perceptions
and behaviour impact the returns majorly and thus, the traditional
theory had little role of that but this theory considered this important
aspect as well.
 ‹Representative Bias: The theory assumes that heuristics involves
individual taking investment decisions on the basis of superficial

i
characteristics and thus like investing in good company will give
good return.
l h
Conclusion:
D e
of
In my perspective, the EMH only partially explains the random walk
because knowledge would make the walk less random; hence, if important

ty
information about the company is swiftly disseminated, changes in price

s i
will frequently appear random. But why is there such randomness? The

r
same idea that describes Brownian motion can also be used to explain the
e
v
random walk of stocks and other financial instruments. Robert Browning,

n i
a botanist, made the first observation of Brownian motion, or the random

U
movement of microscopic particles suspended in a fluid, in 1827. He

,
noted that this motion persisted even for a liquid at equilibrium.

L
6.10 Summary
S O
L /
Asset price random walks propose that the movement of asset prices

C O
is characterized by randomness and unpredictability. According to this

E /
theory, future price changes cannot be reliably predicted based on past

C
price movements or historical data. This concept is closely related to the

D
Efficient Market Hypothesis (EMH), which states that asset prices reflect

©D
all available information and, therefore, it is difficult to consistently
outperform the market. In asset price random walks, there is a lack of
predictability in future price changes. This means that even with access to
all relevant information, it is challenging to determine the direction and
magnitude of an asset’s price movement. Random shocks and news play a
significant role in driving asset prices. Unexpected events or announcements
can quickly change market sentiment, leading to price fluctuations that
are difficult to anticipate. Another characteristic of random walks is that

PAGE 173
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes price changes are assumed to be independent and identically distributed.

Each price change is not influenced by past price movements, and the
distribution of price changes remains consistent over time. This implies
that attempting to time the market or predict short-term price movements
solely based on historical patterns is unlikely to yield consistent results.
Understanding asset price random walks has implications for investment
strategies. It challenges the effectiveness of technical analysis, which relies
on historical price patterns and indicators to predict future price movements.
Instead, a focus on fundamental analysis, which assesses the underlying
h i
e
value and prospects of an asset, may be more reliable. However, it is
l
D
important to acknowledge that real-world markets may deviate from perfect

of
randomness. Factors such as market inefficiencies, investor behaviour,
and the influence of institutional investors can introduce deviations from

ty
the theoretical random walk model. Therefore, while asset price random

s i
walks provide a useful framework, a comprehensive approach to market

r
analysis should consider other market dynamics as well.
e
i v
n
6.11 Answers to In-Text Questions

, U
1. (c) Asset prices exhibit a mix of predictable and random movements

O L
2. (a) Asset prices are always efficient and reflect all available

S
information

L /
3. (a) Serial correlation in price movements

C O
4. (c) Market prices reflect all available information

E / 5. (d) Moderate-form EMH

D C 6. (c) Stock prices reflect all publicly available information, including

historical prices

© D 7. (c) No one can consistently earn abnormal returns, even with access
to private information

6.12 Self-Assessment Questions

1. What does the concept of asset price random walks propose?
2. How does asset price random walks relate to the Efficient Market
Hypothesis?

174 PAGE
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 ASSET PRICE RANDOM WALKS

3. What is the implication of asset price random walks on predictability Notes

of future price changes?
4. What role do random shocks play in asset price random walks?
5. How does the assumption of independence and identical distribution
apply to asset price random walks?
6. How does asset price random walks challenge the effectiveness of
technical analysis?
7. What is the significance of fundamental analysis in the context of
h i
asset price random walks?
e l
8. How do real-world markets potentially deviate from perfect asset
D
of
price random walks?
9. What is the relationship between market efficiency and asset price
random walks?
i ty
r s
10. How does the weak-form efficient market hypothesis align with the
concept of asset price random walks?
v e
n i
U
6.13 References
‹
L ,
ALEXANDER, SIDNEY S. “Price Movements in Speculative

O
Markets: Trends or Random Walks,” II (May, 1961), 7-26.

S
‹

L /
---. “Price Movements in Speculative Markets: Trends or Random

O
Walks, Number 2,” ibid., V (Spring, 1964), 25-46.
‹

/ C
COOTNER, PAUL H. (ed). The Random Character of Stock Market

E
Prices. Cambridge: M.I.T. Press, 1964. An excellent compilation of

1963.
D C
research on the theory of random walks completed prior to mid-

©D
‹ COOTNER, PAUL H. “Stock Prices: Random vs. Systematic Changes”,
Industrial Management III, (Spring, 1962), 24-45.
‹ FAMA, EUGENE F. “The Behavior of Stock-Market Prices,” Journal
of Business, XXXVIII (January, 1965), 34-105.
‹ FISHER, L., and LORIE, J. H. “Rates of Return on Investments in
Common Stocks,” Journal of Business, XXXVJI (January, 1964),
1-21.

PAGE 175
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes ‹ GODFREY, MICHAEL D., GRANCER, CLIVE W. J., and

MORGENSTERN, OSKAR. “The Random Walk Hypothesis of
Stock Market Behavior,” Kyklos, XVII (January, 1964), l-30.
‹ GRANGER, CLIVE W. J., and MORGENSTERN, 0. “Spectral Analysis
of New York Stock Market Prices,” Kyklos, XVI (January, 1963),
I-27.
‹ KENDALL, M. G. “The Analysis of Economic Time Series,” Journal

i
of the Royal Statisticol Society (Series A), XCVI (1953), 11-25.

l h
MOORE, ARNOLD. “A Statistical Analysis of Common-Stock Prices.”
e
‹

D
Unpublished Ph.D. dissertation, Graduate School of Business,

of
University of Chicago (1962).
‹ “A Study of Mutual Funds.” Prepared for the Securities and Exchange

ty
Commission by the Wharton School of Finance and Commerce.

s i
Report of the Committee on Interstate and Foreign Commerce.

r
Washington, DC.: Government Printing Office, 1962
e
i v
n
6.14 Suggested Readings
‹
, U
Hull, J.C. (2014). Options Futures and other Derivatives. 9th edition,

L
Prentice Hall of India.

O
S
Neftci, S.N. (2000). An Introduction to the Mathematics of Financial
/
‹

L
Derivatives. Academic Press.
‹

C O
Bhalla, V.K. (2012). Investment Management. New Delhi: Sultan

/
Chand.

CE
‹ Wilmott, P. (2012). Quantitative Finance. Wiley & Sons.

D
‹ Jarrow, R. & Stuart, T. (1995). Derivative Securities. South Western.

© D ‹ Chance, D.M., & Brooks, R. (2008). Derivatives and Risk Management

Basics. Cengage Learning India.
‹ Pliska, S. (1997). Introduction to Mathematical Finance. Wiley-
Blackwell Publishing.
‹ www.ncdex.com for details on commodity derivatives in India.
‹ www.nse-india.com for stock-based derivatives.
‹ http://www.theponytail.net/DOL/DOL.htm for derivatives-based notes.

176 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
L E S S O N

7
Valuation of Derivatives
in Continuous Time
CS Upasana Gutt
Assistant Professor

i
Dyal Singh College, Karnal

l h
Email-Id: [email protected]

STRUCTURE
D e
7.1 Learning Objectives
of
7.2 Introduction
i ty
7.3 Black-Scholes Pricing Model
r s
7.4 Extension of Black-Scholes Formula
v e
7.5 Valuation of Option on Stock Indices
n i
7.6 Valuation of Currency

, U
L
7.7 Valuation of Futures
7.8

S O
Sensitivity Analysis (The Greeks)
7.9 +HGJLQJ RI 2SWLRQV
L /
O
7.10 Summary
7.11
/ C
Answers to In-Text Questions
7.12

C E
Self-Assessment Questions
References and Suggested Readings
D
7.13

©D
7.1 Learning Objectives
 ‹Explain valuation of option using BSM model.
 ‹Apply formula of BSM model in valuation of options.
 ‹Discuss the Extension of Black-Scholes formla.
 ‹Explain Valuation of option on Stock Indices, Futures and Currency.
 ‹List different Greek options.

PAGE 177
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes  ‹Learn applications of different hedging strategies using futures and

options.

7.2 Introduction
This lesson will help you to understand the Black-Scholes model for
valuation of options. The various sub sections of this lesson will cover
valuation of option on Stock Indices, Currency and Futures. We will also
learn sensitivity analysis, implied volatility using (The Greeks). Through
h i
e
this unit you will also be learning hedging of options and hedging of
l
D
futures.

7.3 Black-Scholes Pricing Model

of
i ty
In 1970, a significant contribution was made by Fischer Black, Myron

r s
Scholes, and Robert C Merton in the pricing of stock options by developing

v e
“The Balck–Scholes Model”. This also known as “The Black-Scholes-

n i
Merton Model” because Robert C Merton was the one to put this idea at

U
first and then Fischer Black and Myron Scholes proposed the equation

,
and the model.
The Model
O L
/ S
The BSM is a mathematical equation that assesses the theoretical value of

L
pricing bonds, stocks, etc. based on six primary variables - type of option

O
(call or put), stock price, strike price, risk-free rate, volatility and time.).

C
/
It offers a mathematical model of the financial market’s derivatives. The

C Eprimary goal of the model is to hedge different buying and selling options
of the invested assets while minimising losses or maximising gains.

D
©D
BSM model equation:-
The value of Call
C = S. N(d1) – X. e-rt. N(d2)
d1 = (In 6[   U ı2 [ W ı  ¥W
d2 = d1  ı  ¥W
Where,
N = Cumulative normal distribution function

178 PAGE
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School of Open Learning, University of Delhi
 VALUATION OF DERIVATIVES IN CONTINUOUS TIME

In = Natural logarithm, i.e. log to base e Notes

e = exponential term (2.7183)
S = Spot price of the stock - It refers to the current market value of
stock. It might be challenging to determine the exact price, therefore,
closing market price is taken into account in some cases.
X = Exercise price of the option - It is the price at which the option
holder has the right to buy or sell an owned security.
r = Annual risk-free rate of return - It is the constant rate of return on
h i
an riskless-asset.
e l
t = Time to expiry of the option - It is the time span (in years) until the
D
of
available option expires.
ı $QQXDO YRODWLOLW\ RI WKH VWRFN

i
If “t” is in years, then “o” and “r” should also be expressed in annual
ty
terms
r s
Assumptions and Limitations
v e
n i
While the model has been widely used and forms the basis for options

U
pricing theory, it does have several assumptions and thus making this

,
L
model’s limitations. Here are some of them:

O
1. Efficiency in Markets: The Black-Scholes model assumes that the

/ S
markets are efficient which means all relevant information gets

O L
reflected in the price of the underlying security. In reality, markets
may not always be perfectly efficient, and there can be information

/ C
asymmetry or market frictions that affect option prices.

E
2. Constant Volatility: The model assumes that the volatility of the
C
D
return of underlying security is constant over life of an option.

©D
However, in practice, volatility can vary over time, leading to
potential inaccuracies in the model’s predictions. Various extensions,
such as the use of stochastic volatility models, have been proposed
to address this limitation.
3. Continuous Trading: The model assumes continuous trading, meaning
that there are no transaction costs or restrictions on trading. In
reality, transaction costs, liquidity issues, and trading restrictions
can impact options pricing and trading strategies.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 4. Log-normal Distribution: The Black-Scholes model assumes log-

normal distribution is impacting the returns of the underlying security.
While this assumption is often reasonable for short periods, it may
not hold over longer time horizons, as asset returns can exhibit
skewness and kurtosis that are not captured by the model.
5. No Dividends or Other Cash Flows: The model assumes that the
underlying security does not pay dividends or any other cash flows
during the life of an option. This assumption is not valid for options
on stocks that pay dividends or for certain types of derivative
h i
securities.
e l
D
6. Risk-free Interest Rate: The model assumes that rate of risk-free

of
securities are known and are constant over the life of an option.
In practice, interest rates can vary and may introduce uncertainty

ty
into the model’s pricing calculations.

s i
r
7. No Transaction Costs and No Taxes: The Black-Scholes model

e
assumes no transaction costs or taxes, which can significantly affect

i v
option trading profitability and real-world pricing.

n
8. No Market Manipulation: The model assumes that there is no market
U
,
manipulation or other forms of market irregularities. However, in

L
reality, these market manipulation and other factors can impact

O
prices and invalidate many of the model’s assumptions.

S
Example

L /
O
Let’s assume the option has 103 days to expiration, and the annualized

C
risk free rate corresponding to this option life is 4.63%. Current stock

E /
price (S) = $13.62, Strike price on the option = $15, Standard deviation

C
(stock prices) = 81%

D Here,

©D
Option life = 103/365 = 0.2822
Inputting these numbers into the model, we get:
d1 = (In (13.62/15.00) + (0.463 + .812  î    ¥  
d2      ¥  
Using the normal distribution, we can estimate the N(d1) and N(d2)
N(d1) = .5085
N(d2) = .3412

180 PAGE
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School of Open Learning, University of Delhi
 VALUATION OF DERIVATIVES IN CONTINUOUS TIME

The value of the call can now be estimated: Notes

C = S. N(d1 ) – X. e-rt. N(d2)
C = 13.62 (.5085) – 15 e-(0.463)(0.2822) (0.3412)
= $1.87
Assuming that the estimate of standard deviation used is correct, call is
overvalued since the call is trading at $2.

IN-TEXT QUESTION

h i
1. Assumptions under Black Scholes model will not include:
e l
(a) Inefficiency in Markets
D
of
(b) Constant Volatility

ty
(c) Continuous Trading
(d) Log-Normal Distribution
s i
e r
7.4 Extension of Black-Scholes Formula
i v
U n
It is very important to be aware of the assumptions and limitations while

L ,
using the Black-Scholes model for valuation. The Black-Scholes formula
has been extended and modified in various ways to account for additional

O
factors and complexities in option pricing. Some notable extensions of
S
the Black-Scholes model include:
L /
O
1. Dividends: The Black-Scholes model assumes that the underlying

/ C
security does not pay dividends. However, in reality, many securities pay

E
dividends. To incorporate dividend payments into the model, modifications

D C
have been made to adjust the formula’s parameters.
There are two ways in which dividends can be incorporated in the model:

©D
1. When options are short term:
When the life of an option is short, one approach to deal with
dividends is to estimate the present value of all the expected
dividends that will be paid by the underlying security during the
option life and subtract it from the current value of the asset in
the model.
Modified stock price = Stock Price – PV of expected dividends
(during life span of option)

PAGE 181
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes However, it becomes impractical to estimate the present value of

dividends when the life of an option is long. Therefore we need
to use an alternative approach.
2. When Options are Long Term:
When the life of an option is long, alternate approach to deal with
dividends is to modify the Black-Scholes model to take dividends
into account.
Actual Model
h i
C = S. N(d1) – X. e-rt. N(d2)
e l
With d1 (In 6[   U  ı2 î W  ı  ¥W
D
Adjusted Model
of
ty
C = S. e-yt N(d1) – X. e-rt. N(d2)

s i
With d1 (In 6[   U\  ı2 î W  ı  ¥W
Where,
e r
i v
“y” = dividend yield calculated by Dividends/Current value of the
asset
U n
L ,
2. Implied Volatility: Implied volatility is the level of volatility implied
by the market prices of options i.e. forecast of likely movements in a

S O
stock price. The Black-Scholes model assumes the volatility is constant.

L /
In practice, however, volatility cannot be constant is varying over time.

O
Implied. In fact traders and investors use this implied volatility to estimate

C
the future volatility of the underlying security.

E /
Various extensions to the Black-Scholes model have been developed to

D C incorporate implied volatility:

©D
 ‹The Black-Scholes-Merton model
 ‹Volatility smile/skew models.
3. Stochastic Volatility Models: This model expands upon the Black-Scholes
framework by allowing volatility itself to be a stochastic process. These
models capture the empirical observation that volatility can change over
time. Notable stochastic volatility models introduce additional stochastic
factors and equations to model the dynamics of both the underlying
security price and its volatility.

182 PAGE
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School of Open Learning, University of Delhi
 VALUATION OF DERIVATIVES IN CONTINUOUS TIME

Models include the: Notes

 ‹SABR (Stochastic Alpha Beta Rho) model
 ‹Heston model
4. Jump Diffusion Models: Jump diffusion models are used to capture
sudden and significant price movements, or jumps, in the underlying
security. These models extend the Black-Scholes model by incorporating
a jump component, which allows for more accurate pricing of options in

i
markets with occasional large price jumps. Examples of jump diffusion
models include the Merton jump diffusion model and the Bates model.
l h
5. Market Frictions without transaction cost: The Black-Scholes model
assumes no market frictions and no transaction costs. However, in real-
D e
of
world trading, transaction cost, bid-ask spreads, and other market frictions
can significantly impact option pricing. Various extensions have been

ty
developed to incorporate these costs and frictions into option pricing

s i
models, such as the Roll-Geske-Whaley model and the Hoggard-Whalley-
Wilmott model.
e r
i v
6. Path-Dependent Options: Black-Scholes model assumes that payoff of

U n
an option depends solely on the final price of the underlying security at
expiration. On the other hand, Path-dependent options have payoffs which

,
depend on the entire price path of the underlying security during the life
L
O
of an option. Barrier options, Asian options, and look back options are

S
some of the examples of path-dependent options. Monte Carlo simulations

L /
or finite difference methods are methods used in pricing these options as

O
their valuation requires more complex mathematical techniques.

/ C
These various extensions and variations of the BSM model aim to provide

E
more accurate valuation of options by considering additional factors and

C
market conditions. Each extension has its own assumptions, complexities,

D
and mathematical techniques associated with it.

©D
IN-TEXT QUESTION
2. _________ are used to capture sudden and significant price
movements, or jumps, in the underlying asset.
(a) Stochastic Volatility Model
(b) Jump Diffusion Model
(c) Dividend Model
(d) Heston Model

PAGE 183
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes
7.5 Valuation of Option on Stock Indices
Options on stock indices work similarly to options on individual stocks
but are settled based on the performance of an index of underlying stock
rather than a single stock. Here are some key points about options on
stock indices:
1. Underlying Security: The underlying security of an index option is

i
a stock market index such as Nifty, BSE. The value of the index

l
option changes with change in movement of the underlying index.
h
e
2. Contract Specifications: Index options are standardized contracts
D
of
traded on options exchanges. Each contract typically represents a
specified value of the underlying index. Contract specifications

ty
include the expiration date, strike price intervals, and exercise style
(e.g., European or American).

s i
r
3. Settlement: Index options are usually cash-settled, meaning no
e
v
physical delivery of the underlying index occurs. Upon exercise

n i
or expiration, the option’s value is settled in cash, based on the

U
differences between the strike price and the index level.

,
4. Pricing and Valuation: The valuation of index options are similar to
L
O
valuation of individual stock options. Therefore, the Black-Scholes

S
model and all other option pricing models can be used to estimate

L /
the fair value of an index option. However, due to the multiple

O
components of an index (diverse stocks), index options tend to have

/ C
different characteristics and pricing dynamics compared to options

E
on individual stocks.

D C 5. Index Option Strategies: Similar to stock options, various strategies

can be employed with index options, including buying or selling

©D
calls and puts, as well as more complex strategies like spreads,
straddles, and collars. These strategies can be used for speculation,
hedging, or income generation.
6. Market Index Volatility: Volatility, which measures the expected
price fluctuation of the index, plays a crucial role in valuating
index options. Higher market volatility generally leads to higher
option premiums, as there is a greater likelihood of large index
movements.

184 PAGE
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School of Open Learning, University of Delhi
 VALUATION OF DERIVATIVES IN CONTINUOUS TIME

7. Index Option Trading Hours: Index options typically have specific Notes
trading hours that coincide with the trading hours of the underlying
index. These hours may differ from the regular trading hours of
individual stocks.
Valuation Using Black - Scholes Model and Interpretation
Example
Let’s assume the current level of the Nasdaq index is 4,000, and there is

i
a European call option priced at $150 with a strike price of 4,100 and
an expiration date of six months. The interest rate of risk free securities
l h
is 2%, and the index’s implied volatility is 20%.

D e
of
C = S × N(d1) – X × e^(-r×T) × N(d2)
d1  >OQ 6;   U  ıA  î7@  ı î VTUW 7

ty
d2 = d1 ± ı î VTUW 7

s i
r
d1  >OQ      A  î@   î VTUW 
d1 = –0.3289
v e
d2 = d1 ± ı î VTUW 7
n i
d2 = –0.5007
, U
N(d1) = 0.3703

O L
S
N(d2) = 0.3085

L /
C = 4000 × 0.3703 – 4100 × e^(-0.02×0.5) × 0.3085
C = $192.84
C O
E /
Therefore, the value of the call option on the Nasdaq index is $192.84.

C
If the level of an index increases above the strike price of 4,100, the

D D
option will become more valuable. Conversely, if the level of an index
decreases, the option will become less valuable.

©
7.6 Valuation of Currency
The currencies can be valued in number of ways depending on the context.
Here are two commonly used approaches:
1. Relative Valuation:
This approach takes into account exchange rate between two currencies
and thus comparing the value of one currency to another currency.

PAGE 185
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Formula
Exchange rate = (Price of Currency X in Currency Y) / (Price of
Currency Y in Currency X)
Example
Let’s assume the price of 1 US dollar is 0.85 Euros, the exchange
rate would be:
Exchange rate = (1/0.85) = 1.1765 USD/EUR

h i
l
This means that 1 Euro is worth 1.1765 US dollars.
2. Purchasing Power Parity (PPP) Valuation:

D e
of
This approach compares the value of a currency to its purchasing
power. It assumes that the exchange rate should reflect the relative

ty
prices of goods and services in different countries.
Formula
s i
e r
PPP exchange rate = Price of basket of goods in Currency X / Price

i v
of basket of goods in Currency Y
Example
U n
,
Let’s assume a basket of goods and services in the US costs $100

O L
and the same basket of goods and services in the UK costs £80,
the PPP exchange rate would be:

/ S
L
PPP exchange rate = ($100/£80) = $1.25/£

O
This means that according to PPP, 1 pound should be worth $1.25.

/ C
Both of these approaches have their own advantages and limitations, and

C Ethey are often used together to gain a better understanding of currency

valuation.
D
©D
7.7 Valuation of Futures
Futures refer to contracts in which buyer has an obligation to purchase an
underlying security, and the seller has an obligation to sell an underlying
security at a predetermined price and date in the future. The value of
futures is determined by the market price of the underlying security, the
time to expiration, and the cost of carrying.

186 PAGE
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 VALUATION OF DERIVATIVES IN CONTINUOUS TIME

Example Notes
Let’s assume the market price of crude oil is $80 per barrel, and a futures
contract for one barrel of crude oil expiring in three months is priced
at $85. The difference between the market price and the futures price is
known as the “basis.” and in this case, the basis is $5.
Before the expiration of the futures contract, with an increase in market
price of crude oil to $90 per barrel, the value of the futures contract will

i
also increase. Assuming the basis remains the same, the futures contract
will be worth $90 + $5 = $95. (95 is the value without calculating its
l h
present worth).

D e
of
On the other hand let’s assume if before the expiration of the futures
contract the market price of crude oil decreases to $70 per barrel before,

ty
the value of the futures contract will decrease. Assuming the basis remains

i
the same, the futures contract will be worth $70 + $5 = $65. (65 is the

s
r
value without calculating its present worth).
Formula:
v e
FV = S + (F - S) × (1 + r)^t
n i
Where:
, U
FV: The value of futures to be calculated

O L
S: The spot price (current market price) of the underlying security

/ S
L
F: The futures price of the underlying security

O
r: The interest rate on risk free securities

C
/
t: The time to expiration of the futures contract

E
C
Example

D
Let’s assume the current market price of crude oil is $80 per barrel, and

©D
a futures contract for one barrel of crude oil expiring in six months is
priced at $85. (risk-free interest rate is 2%.)
FV = S + (F - S) × (1 + r)^t
= 80 + (85-80) × (1 + 0.02) ^0.5
= 85 × 1.01
= $85.85.

PAGE 187
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 7.8 Sensitivity Analysis (The Greeks)

Greek options refer to a type of financial instrument used in the derivatives
market. These options are known for possessing unique features that
are not found in traditional options, which makes them popular among
investors and traders who are looking for more adaptive and flexible
tools for managing their risks.
Greek options derive their name from the use of Greek letters to represent
the various factors that determine their pricing and behaviour.
h i
e l
Specifically, the five Greek variables are Delta, Gamma, Theta, Vega,
and Rho.
D
of
Each of these variables plays an important role in determining the option

ty
price, the degree of price movement, the time decay, the implied volatility,

i
and the interest rate sensitivity. In contrast to traditional options, which

r s
only take into account combinations of different strike price and the

e
expiration date, Greek options are more complex and dynamic, allowing

v
conditions.
n i
investors to adjust their positions more easily based on changing market

Delta:
, U
L
Delta measures price sensitivity of options to changes in the price of the
O
S
underlying security. It explains an extent to which the price of the option

L /
will change for every $1 change in the price of the underlying security.

O
The delta value for an option can range from 0 to 1 for call options and

C
from -1 to 0 for put options. It is a very important concept in options

E /
trading as it helps traders to understand the risk and potential rewards

C
associated with their trades.

D Example

©D
Let’s assume a call option on stock XYZ with a delta of 0.4. If the price
of stock XYZ increases by $1, the price of an option will increase by
approximately $0.40. If the price of stock XYZ decreases by $1, the price
of an option will decrease by approximately $0.40.
On the other hand, let’s assume a put option on stock XYZ with a delta
of -0.4. If the price of stock XYZ increases by $1, the price of an option
will decrease by approximately $0.40. If the price of stock XYZ decreases
by $1, the price of an option will increase by approximately $0.40.

188 PAGE
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 VALUATION OF DERIVATIVES IN CONTINUOUS TIME

Gamma Notes
Gamma measures the rate of change in the delta of an option for every
$1 change in the price of the underlying security. It explains an extent to
which the delta of the option will change for every $1 change in the price
of the underlying security. Gamma values are highest for at-the-money
options and decrease as the option moves further in or out of the money.
Example
Let’s assume a call option on stock XYZ with a gamma of 0.05. With
h i
an increase of the price of stock XYZ by $1, the delta of an option will
e l
D
increase by approximately 0.05. This means that if the option had a delta

of
of 0.6 before the stock price increases, it would now have a delta of
approximately 0.65. Similarly, with decrease in the price of stock XYZ

ty
by $1, the delta of the option will decrease by approximately 0.05.

s i
On the other hand, let’s assume a put option on stock XYZ with a gamma

r
of -0.03. With an increase of the price of stock XYZ by $1, the delta
e
v
of an option will decrease by approximately 0.03. This means that if

n i
the option had a delta of -0.4 before the stock price increases, it would

U
now have a delta of approximately -0.43. Similarly, with decrease in

approximately 0.03.
L ,
the price of stock XYZ by $1, the delta of the option will increase by

Theta
S O
L /
Theta measures the rate of change in the price of an option for every

O
day that passes. Other things remaining constant, it explains It explains

C
/
an extent to which the option price will decrease as time passes. Theta

C E
values are negative for all options, Thus, the option price will decreases
with passage of time.
D
©D
Example
Let’s assume there is a call option on stock XYZ with a theta of -0.03.
If one day passes and all other factors remain unchanged, the price of
an option will decrease by approximately $0.03. Therefore, if the option
was priced at $2.00 today, it would be priced at approximately $1.97
tomorrow provided the price and implied volatility of the underlying
security does not change.
On the other hand, let’s assume a put option on stock XYZ with a theta
of -0.05. If one day passes and all other factors remain unchanged, the

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes price of an option will decrease by approximately $0.05. Therefore, if

the option was priced at $3.00 today, it would be priced at approximately
$2.95 tomorrow provided the price and implied volatility of the underlying
security does not change.
Vega
Vega measures the rate of change in the price of an option for every 1%
change in implied volatility. It explains an extent to which the option

i
price will increase or decrease with the change in the implied volatility

l h
of the underlying security. Vega values are positive for all options (call

e
or put). With an increase in implied volatility, option price increases.

D
of
For example,
Let’s assume there is a call option on stock XYZ with a vega of 0.10.

ty
With an increase in the implied volatility of stock XYZ by 1%, there will

s i
be an increase in the option’s price by approximately by approximately

r
$0.10. Therefore, if the option was priced at $2.00 with an implied
e
v
volatility of 20%, it would be priced at approximately $2.10 with an
implied volatility of 21%.
n i
, U
On the other hand, let’s assume a put option on stock XYZ with a vega
of 0.08. With an increase in the implied volatility of stock XYZ by 1%,

O L
there will be an increase in the option’s price by approximately $0.08.

S
Therefore, if the option was priced at $3.00 with an implied volatility

L /
of 20%, it would be priced at approximately $3.08 with an implied

O
volatility of 21%.
Rho
/ C
C ERho measures the rate of change in the price of an option for every 1%

D
change in interest rate. It explains an extent to which the option price

©D
will increase or decrease with increase or decrease in interest rates. Rho
values - positive for call option and negative for put option. With an
increase in the option price. interest rates increase for call options and
with the decrease in the option price, interest rates increase for put options.
For example, A call option on stock XYZ with a rho of 0.05. If interest
rates increase by 1%, the option’s price will increase by approximately
$0.05. Therefore, if the option was priced at $2.00 with an interest rate
of 3%, it would be priced at approximately $2.05 with an interest rate
of 4%.

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 VALUATION OF DERIVATIVES IN CONTINUOUS TIME

On the other hand, let’s consider a put option on stock XYZ with a rho Notes
of -0.03. If interest rates increase by 1%, the option’s price will decrease
by approximately $0.03. Therefore, if the option was priced at $3.00 with
an interest rate of 3%, it would be priced at approximately $2.97 with
an interest rate of 4%.
Advantages and Limitations of Greek Options
Flexibility: One of the main advantage of Greek options is their flexibility

i
and ability to adapt to different market scenarios.
For example,
l h
Delta measures the rate of price change in the option value relative to
D e
of
the underlying security, allowing investors to hedge against potential
losses or volatility.

ty
Gamma measures the rate of change in Delta, indicating how quickly the

s i
option value can change as the underlying security moves. This means

e r
that investors can adjust their positions dynamically based on the market

i v
conditions, such as when they expect significant price movements or
price consolidations.

U n
Hedging: Another significant advantage of Greek options is their ability

L ,
to manage risks more efficiently. For instance,

O
Theta measures the rate of time decay, indicating how much the option

S
/
value will lose as the expiration date approaches.

L
O
With Greek options, investors can take advantage of the time decay effect

C
by selling options that have a higher Theta, generating income while

E /
limiting their exposure to potential losses.

D C
Vega measures the implied volatility, allowing investors to adjust their
positions according to changes in market sentiment and expectations.

©D
Limitations
Complex: Greek options also have certain drawbacks that investors must
consider. One of the primary concerns is the complexity of the model,
which requires a deep understanding of the underlying principles and
formulas. This means that investors who are not familiar with the Greek
variables may face difficulties in analyzing, pricing, and managing their
options. Moreover, because Greek options are more flexible and dynamic,

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes they may require more active management, which can increase transaction
costs and reduce profitability.
In conclusion, Greek options are a unique financial instrument that
offers investors and traders more flexibility, adaptability, and efficiency
in managing their risks and returns. By taking into account the various
Greek variables, investors can adjust their positions dynamically based
on changing market conditions and expectations, while also mitigating

i
potential losses and generating income. However, they also require a more

l h
advanced level of knowledge and expertise, and a careful assessment of the

e
potential costs and benefits. Overall, Greek options represent a valuable

D
tool for those who are looking for more advanced options strategies and

of
are willing to take calculated risks.

ty
IN-TEXT QUESTIONS

s i
3. ___________ measures the rate of change in the price of an

e r
option for every 1% change in the implied volatility. Stochastic

i v
Volatility Model.
(a) Delta

U n
,
(b) Vega
(c) Gamma

O L
S
(d) Rho

L /
4. Rho values are ________ for call options and ________ for put

C Ooptions.

/ (a) Positive, positive

CE
(b) Negative, negative

D D (c) Positive, negative

©
(d) Negative, positive

7.9 Hedging of Options

Hedging is an investment strategy that involves taking a position in the
markets to offset potential losses in another position. Options and futures
are popular instruments used for hedging.

192 PAGE
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 VALUATION OF DERIVATIVES IN CONTINUOUS TIME

Hedging of Options Notes

Hedging of options refers to the use of other financial instruments or
strategies like buying put options, using futures contracts, and implementing
option spreads to reduce the risk of options position. This is done by
taking an offsetting position to the options or underlying security.
For example, if an investor has purchased a call option to buy 60 shares
of a stock at a certain price, they may choose to hedge their position by

i
selling an equivalent amount of the stock at the same time. If the stock
price does not move in their favour, they will still profit from the stock
l h
sold to hedge the position.

D e
of
These strategies can help manage risk and protect against potential losses.
Different strategies that can be used to hedge options positions are as

ty
follows:

s i
1. Buying Put Options: This involves buying put option on the same

e r
underlying security as the call option to limit the potential losses.

i v
If the price of an underlying security falls below the strike price of

the losses.
U n
call options, the value of put option will increase, thereby offsetting

L ,
2. Selling Call Options: This involves taking a short position in call

O
option on the same underlying security as the long position in call

/ S
option. By doing so, an investor could earn premium income and

O L
reduce the overall cost of their options position.
3. Hedging with Futures Contracts: Futures contracts are commonly

/ C
used to hedge options positions. If an investor holds a call option,

E
they can sell futures contracts to protect themselves for a potential
C
D
decline in the value of a underlying security.

©D
4. Implementing Option Spreads: This involves creating a position
that includes both the options - call and put but with different strike
prices and/or expiration date. The goal is to limit the potential
losses and increase the potential gains of the options position. Some
common types of spreads are:
(a) Vertical Spread: This involves buying and selling of two
options of same type either call or put on the same underlying
security with the same expiration date but with different strike

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes prices. The goal is to limit potential losses while also lowering
the cost of the position.
(b) Horizontal Spread: Also known as a calendar spread, this
involves buying and selling of two options of same type
on same underlying security with the same strike price but
different expiration dates. The goal is to profit from the fact
that shorter-term options tend to have higher time decay than

i
longer-term options.

l h
(c) Diagonal Spread: This involves buying and selling two options

D e
of the same type on the same underlying security, but with
different strike prices and expiration dates. The goal is to

of
take advantage of differences in the time decay of the two
options.

i ty
(d) Butterfly Spread: A butterfly spread involves buying and

r s
selling three options of same underlying security, with same

e
expiration date but different strike prices. The goal is to create
v
i
a position that profits from a specific range of prices for the
n
U
underlying security.

L ,
(e) Condor Spread: Similar to a butterfly spread, but this spread
involves buying and selling four options of the same underlying

S O
security, with same expiration date but different strike prices.

/
The goal is to profit from a specific range of prices for the
L
O
underlying security, but with a wider range than a butterfly

C
spread.

E / (f) The Collar Strategy: This strategy involves buying both a

D C protective put and selling a covered call . The loss of the put
option is partially offset by the gain obtained from the call

©D
option.
Hedging with Futures:
Futures are commonly used for hedging, especially in the commodities
and currencies markets. Futures contracts provide a way to lock in a price
for a stock or currency at a future date. This can be done in two ways:
1. Long Futures: This involves buying a futures contract to lock in a
price for a commodity or currency for future delivery. If the price

194 PAGE
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 VALUATION OF DERIVATIVES IN CONTINUOUS TIME

of the stock or currency rises, the investor will be benefited from Notes
the increase in price.
2. Short Futures: This involves selling a futures contract to lock in a
price for a commodity or currency for future delivery. If the price
of the stock or currency drops, the investor be benefited from the
decrease in price.
In both cases, the investor can speculate on the price movements of an

i
underlying security, or use futures to hedge a previously held position
to offset potential losses. Hedging with futures also allows investors to
l h
take advantage of leverage, allowing them to control a larger position
with less capital. However, it is important to note that futures trading
D e
of
involves significant risk, and investors should be aware of the potential
for significant losses.

i ty
s
IN-TEXT QUESTIONS

e r
5. _____________ involves buying and selling two options of the

i v
same type on the same underlying asset, with the same strike
price but different expiration dates.

U n
,
(a) Collar Spread
(b) Vertical Spread

O L
S
(c) Condor Spread

L
(d) Horizontal Spread /
O
6. If the price of the commodity or currency rises, the investor

C
/
benefits from the increase in price. Choose right strategy:

E
C
(a) Short Future

D
(b) Long Future

©D
(c) Both
(d) None

7.10 Summary
1. The BSM is a mathematical equation that assesses the theoretical
value of pricing bonds, stocks, etc. based on six primary variables

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Formula:
C = S. N(d1) – X. e-rt. N(d2)
d1 - (In 6[   U  ı2 î W  ı  ¥W
d2 - d1  ı¥W
2. Assumption of BSM model are –
 ‹Efficiency in Markets
 ‹Constant Volatility

h i
 ‹Continuous Trading
e l
D
 ‹Log-Normal Distribution

of
 ‹No Dividends Or Other Cash Flows

ty
 ‹Risk-Free Interest Rate
 ‹No Transaction Costs Or Taxes

s i
 ‹No Market Manipulation.
e r
i v
3. The Black-Scholes formula has been extended and modified in

U n
various ways to account for additional factors and complexities in
option pricing. Extensions included:
 ‹Dividend

L ,
 ‹Implied

S O
Volatility


L /
‹Stochastic Volatility Model

O
 ‹Jump Diffusion Model

/ C ‹Transaction Costs and Market Frictions

CE
 ‹Path-Dependent Options.

D D 4. Key points about options on stock indices include:

‹Underlying security
©


 ‹Contract Specifications, Settlement

 ‹Pricing and Valuation
 ‹Index Option Strategies
 ‹Market Index Volatility
 ‹Index Option Trading Hours

196 PAGE
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 VALUATION OF DERIVATIVES IN CONTINUOUS TIME

5. The five Greek variables are Delta, Gamma, Theta, Vega, and Rho Notes
and each of these variables plays an important role in determining
the option price, the degree of price movement, the time decay, the
implied volatility, and the interest rate sensitivity:
 ‹Delta measures an option’s price sensitivity to change in the
price of an underlying security.
 ‹Gamma measures the rate of change in the delta of an option

i
for every $1 change in the price of an underlying security.
 ‹Theta measures the rate of change in the price of an option
l h
for every day that passes.

D e
of
 ‹Vega measures the rate of change in the price of an option for
every 1% change in the implied volatility.

ty
 ‹Rho measures the rate of change in the price of an option for
every 1% change in the risk free interest rates.
s i
r
6. Hedging is an investment strategy that involves taking a position in
e
v
the markets to offset potential losses in another position. Options

n i
and futures are popular instruments used for hedging.

as follows:-
, U
7. Different strategies that can be used to hedge options positions are

 ‹Buying put options

O L
 ‹Selling call options
/ S
 ‹Hedging
L
with futures contracts

CO
 ‹Implementing option spreads
 ‹The

E /
collar strategy

D C
8. Futures contract is a contract that provides a way to set a price of
a commodity or currency at a future date. These can be used as

 © D
hedging tool in two ways:
‹Long Future
 ‹Short Future

7.11 Answers to In-Text Questions

1. (a) Inefficiency in markets
2. (b) Jump Diffusion Model

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 3. (b) Vega

4. (c) Positive, negative
5. (d) Horizontal Spread
6. (b) Long Future

7.12 Self-Assessment Questions

1. Explain Black-Scholes model in detail.
h i
e l
2. Explain limitations of Black Scholes Model. What are the extensions

D
of BSM Model which help to resolve these limitations?

of
3. How dividend can be incorporate in BSM model?

ty
4. Explain sensitivity analysis using Greek options.

s i
5. What is hedging? How hedging can be done using options and
futures?
e r
i v Readings
n
7.13 References and Suggested

U
 ‹Hull,
,
J.C. (2014). Options Futures and other Derivatives. 9th edition,

L
Prentice Hall of India.
 ‹Neftci,

S O
S.N. (2000). An Introduction to the Mathematics of Financial

L /
Derivatives. Academic Press.

C O
E /
D C
© D

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m MK PKS 08092023 199

L E S S O N

8
Financial Engineering
Yogesh Sharma
Atal Bihari Vajpayee School of Management and Entrepreneurship
Jawaharlal Nehru University
Email-Id: [email protected]
Ankit Suri
Atal Bihari Vajpayee School of Management and Entrepreneurship
h i
Jawaharlal Nehru University
e l
D
Email-Id: [email protected]

STRUCTURE
of
8.1 Learning Objectives
i ty
r s
e
8.2 Introduction
8.3 Construction of Option Strategies
i v
8.4 Betting of Price Changes
U n
8.5 Exotic Options
L ,
O
8.6 Summary

/ S
8.7 Answers to In-Text Questions

L
8.8 Self-Assessment Questions
O
C
8.9 References

E /
8.10 Suggested Readings

D C Objectives
8.1 Learning
 ‹To
©D understand the construction of options strategies and their payoffs in different
market scenarios.
 ‹To familiarize with exotic options such as compound, binary, barrier, and Asian options.
 ‹To analyse options involving multiple assets and their potential benefits and risks.
 ‹To apply financial engineering concepts to design and implement options strategies.
 ‹To evaluate the role of risk and return in options strategies and make informed
investment decisions.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 8.2 Introduction

Financial engineering is a dynamic and evolving field that plays a
crucial role in the modern financial landscape. It includes the use of
mathematical and computational methods in the design, development,
and administration of novel financial products, approaches, and solutions.
This chapter provides a thorough knowledge of the relevance of financial
engineering as a discipline in the field of finance by delving into its idea,

i
usage, applications, importance, and ramifications. Financial engineering
h
l
combines exact mathematical models, statistical analysis, and computing
e
D
tools to create complex financial products and strategies. It acts as a link

of
between conventional finance and quantitative methodologies. It makes it
possible for businesses, investors, and financial institutions to successfully

ty
manage risk, maximise profits, and take advantage of market opportunities.

s i
One of the main applications of financial engineering is the creation of

r
options strategies that are suited to certain market conditions. Practitioners
e
v
may create methods that profit from market changes by using mathematical

n i
models, whether they are betting on a significant price fall or a minor

, U
price gain. These techniques increase investors’ adaptability by enabling
them to customise their portfolios to reflect their particular risk profiles

L
and investment goals. Exotic options, which are specialised derivative
O
S
contracts with unique properties, are also a part of financial engineering.

L /
Compound, binary, barrier, and Asian options, among others, each provide

O
distinctive payoffs and risk exposures, allowing investors to create more

C
intricate and specialised investing strategies. These exotic options give

E /
investors other tools for risk management, position hedging, and exploring

C
non-traditional investing opportunities.

D The development of Collateralized Debt Obligations (CDOs) is a prime

©D
example of financial engineering. Financial institutions created CDOs in
the early 2000s as intricately constructed products that group diverse debt
instruments, such Mortgage-Backed Securities (MBS), into tranches with
differing levels of risk and return. Then, investors looking for exposure
to various risk profiles purchased these tranches. Financial engineers
evaluated the performance and risk characteristics of the underlying assets
using mathematical models to establish the proper risk distribution across
the tranches. Financial engineers might design CDOs to offer various

200 PAGE
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 FINANCIAL ENGINEERING

degrees of risk and return to meet the desires of various investors by Notes
analysing the correlations and probabilities associated with the default
or prepayment of the underlying mortgages.
Synthetic CDOs were developed as a result of financial engineering
innovation, where the underlying assets were derivatives based on
mortgages rather than genuine mortgages. The intricacy of these items
was so increased further. However, the 2008 financial crisis exposed the

i
drawbacks and dangers of these sophisticated financial products. Financial
engineers’ fundamental hypotheses and models didn’t adequately account
l h
e
for the possible systemic risks, which resulted in substantial losses and
later regulatory changes.
D
of
Derivatives like options and futures are also created and priced as a
part of financial engineering. For instance, mathematical formulae are

i
used in options pricing models, such as the Black-Scholes model, to
ty
r s
determine the fair value of options depending on variables including

e
the price of the underlying asset, the strike price, the amount of time to

v
n i
expiry, volatility, and the risk-free rate. Investors and traders may use
these models to make educated judgments regarding option pricing and

U
related risks. Risk management is another area where financial engineering
,
L
is essential. Value at Risk (VaR) and stress testing are two approaches

O
used by financial engineers to evaluate and manage risks in investment

/ S
portfolios and financial institutions. VaR estimates the maximum potential

O L
loss under normal market conditions, while stress testing simulates extreme
scenarios to evaluate the resilience of portfolios or institutions during

/ C
periods of market turmoil.

E
The capacity of financial engineering to simplify risk management and
C
D
enable the development of novel financial products is what makes it so

©D
significant. Financial engineers can measure and reduce risks associated
with complex financial instruments and portfolios by using cutting-edge
mathematical methodologies. They can create models to improve investment
strategies, estimate the probability of unfavourable occurrences, and
assess the effect of market factors on portfolios. Financial engineering
has effects that go beyond conventional investment management. The
larger financial system is significantly impacted, with effects on market
dynamics, liquidity management, and regulatory issues. To ensure market
stability and safeguard investors’ interests, the creation and deployment of

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes complex financial products require strong risk management frameworks

and regulatory monitoring.

8.3 Construction of Option Strategies

The profit or loss that an option holder might experience upon expiration
depending on the value of the underlying asset is referred to as the
payout of an option. It stands in for the monetary results of executing
or keeping the option contract.
h i
e l
To illustrate the concept of payoff, let’s consider a call option on a stock

D
with a strike price of Rs. 50. The table below demonstrates the potential

of
payoffs based on different scenarios at expiration:

ty
Stock Price at Expiration Payoff
Rs. 40

s i Re. 0

r
Rs. 45 Re. 0
Rs. 50
v e Re. 0
Rs. 55
n i Rs. 5

U
Rs. 60 Rs. 10
Rs. 65

L , Rs. 15

O
In this case, the call option gives the buyer the choice, but not the duty,

S
to purchase the shares at the Rs. 50 strike price. The option premium

L /
has already been paid and is not taken into account for determining the

O
payment. The call option expires worthless with a payment of zero rupees

/ C
if the stock price at expiration is less than the strike price (Rs. 50). Due

E
to the fact that there is no profit to exercising the option to purchase the

D C stock at a price greater than its market value, this is the case.
The option is in-the-money when the stock price rises over the strike

©D
price. As the stock price grows, the payout climbs linearly. For example,
if the stock price is Rs. 55 at expiration, the option holder can purchase
the shares at Rs. 50 and sell it in the market right away for Rs. 55,
earning a payout of Rs. 5.
The payment grows in line with the stock price’s continued ascent. For
instance, if the stock price is Rs. 60 at expiration, the option holder can
purchase the shares at Rs. 50 and sell it for Rs. 60, earning a Rs. 10

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 FINANCIAL ENGINEERING

payment. Similar to this, an investment of Rs. 65 will return Rs. 15 in Notes

profit. It’s crucial to understand that an option’s payout is limited since the
possible profit for the option holder is restricted to the difference between
the stock price and the strike price. On the other hand, the maximum loss
a buyer of an option can sustain is the amount of the option premium.
Understanding the payoff of an option is crucial for option holders as
it helps them assess the profitability of their positions at expiration and
make informed decisions regarding exercising or selling the option.

h i
l
Investors use option strategies, which are pre-determined combinations

e
of options contracts, to achieve certain investing goals or control risk.
These tactics entail the concurrent purchase and/or disposal of a number
D
of
of options contracts, sometimes with different strike prices, expiration
dates, and underlying assets. Option strategies are created to profit from

ty
various market conditions, act as hedging tools, or produce revenue

s i
via option premiums. Investors may tailor their holdings to match their

e r
perspective on the market, level of risk tolerance, and investing objectives

i v
by developing option strategies. These tactics give investors the chance to

U n
profit from changes in the value of the underlying asset, prevent losses,
safeguard their current holdings, or earn money via option premiums.

IN-TEXT QUESTIONS
L ,
S O
1. Payoff in options strategies is solely determined by the price of

L /
the underlying asset at the time of expiration. (True/False)

O
2. Risk and return are significant factors to consider when designing

C
/
options strategies. (True/False)

C E
3. Financial engineering concepts cannot be applied to design and
implement customized options strategies. (True/False)

D D
Following are the most popular option strategies:

©
8.3.1 Long Call
A call option is purchased as part of the long call strategy in order to
profit on a prospective rise in the underlying asset’s price. Investors can
benefit from price increases while keeping their risk to the amount of
the option premium.

PAGE 203
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes

h i
e l
D
of
Figure 8.1 : Long Call Option Strategy

i ty
Consider a scenario in which an investor buys a call option with a strike

r s
price of Rs. 55 and a premium of Rs. 2 on a stock that is now trading at

e
Rs. The investor can exercise the call option and purchase the stock at the

v
n i
strike price if the stock price at expiry increases to Rs. 60. The amount
of their profit per share would be (Rs. 60 - Rs. 55 - Rs. 2) = Rs. 3.

, U
8.3.2 Long Put

O L
/ S
The goal of the long put strategy is to make money if the price of the

O L
underlying asset drops. Put options are bought by investors to hedge
against downside risk or make bets on declining prices.

/ C
C E
D
©D

Figure 8.2 : Long Put Option Strategy

204 PAGE
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 FINANCIAL ENGINEERING

Assume the same stock is trading at Rs. 50, and an investor buys a put Notes
option with a strike price of Rs. 45 and a premium of Rs. 3. If the stock
price at expiration falls to Rs. 40, the investor can exercise the put option
and sell the stock at the strike price. Their profit would be (Rs. 45 -
Rs. 40 - Rs. 3) = Rs. 2 per share.

8.3.3 Covered Call

A covered call strategy is selling a call option while also holding the
h i
underlying asset. With this approach, investors can profit from the option
e l
D
premium while perhaps reducing their upside potential. An investor uses

of
the Covered Call strategy by taking a long position in the underlying
stock and selling call options at the same time. One call option is

ty
typically written (sold) for every 100 shares of the underlying stock held

i
by the investor. Each call option reflects the buyer’s right, but not their
s
r
responsibility, to buy the underlying stock within the stated time frame

e
v
at the specified strike price.

n i
The Covered Call strategy is often employed when the market is neutral

, U
to slightly positive. It is appropriate when the investor thinks the
underlying stock’s price will either remain comparatively steady or just

O L
slightly increase. The investor makes a quick profit by selling call options

S
and collecting the premiums. However, the investor’s potential gain on

L /
the stock position is only as high as the call options’ strike price. The

O
investor can be forced to sell the shares at the striking price if the stock

/ C
price rises above the price at which the option was granted, forgoing

E
additional possible profits.

D C
©D

Figure: 8.3 : Covered Call Option Strategy

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Consider an investor who sells a call option with a strike price of 65
and a premium of 2 and owns 100 shares of a stock selling at 60 rupees.
The investor keeps the premium as profit if the stock price is still below
the strike price at expiration. The investor could, however, be required
to sell the shares at the strike price if the stock price surpasses Rs. 65.

8.3.4 Protective Put

h i
A protective put strategy is used to hedge against potential losses in an

e l
existing stock position. Investors purchase put options to limit downside

D
risk while allowing for potential gains.

of
i ty
r s
v e
n i
, U
O L
/ S
O L Figure 8.4 : Protective Put Option Strategy

/ C
Assume an investor owns 200 shares of a stock trading at Rs. 80 and

C Epurchases put options with a strike price of Rs. 75 and a premium of

Rs. 3. If the stock price falls to Rs. 70, the investor can exercise the
D
©D
put option and sell the stock at the strike price, limiting their loss to
(Rs. 80 - Rs. 75 - Rs. 3) = Rs. 2 per share.
IN-TEXT QUESTIONS
4. The payoff in options strategies depends on:
(a) The strike price of the options
(b) The expiration date of the options
(c) The price of the underlying asset at expiration
(d) All of the above

206 PAGE
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 FINANCIAL ENGINEERING

5. A call option with a strike price of Rs. 50 is not exercised Notes

when the market price of the underlying asset is:
(a) Rs. 45
(b) Rs. 50
(c) Rs. 55
(d) Any price above Rs. 50

h i
8.3.5 Long Straddle
e l
Buying a call option and a put option with the same strike price and
D
of
expiration date at the same time is known as a long straddle strategy.
No matter which way prices go significantly, this method makes money.

i ty
When an investor anticipates considerable price volatility in the underlying

s
asset but is unsure of the direction of the price movement, they will use
r
e
this technique. Let’s go through the Long Straddle idea in more detail:

i v
Regardless of whether the price swings up or down, the Long Straddle

n
strategy seeks to profit from big price changes in the underlying asset.
U
,
An investor uses the Long Straddle method by simultaneously buying

L
call and put options with the same expiration date and strike price. For

O
both alternatives, the investor must pay premiums.

S
L /
The Long Straddle trading technique performs well when the investor
expects substantial price volatility for the underlying asset. It is employed

C O
when a shareholder anticipates a substantial change in the stock price

/
but is unsure about the movement’s direction.
E
C
The Long Straddle strategy’s risk is constrained to the call and put option

D
premiums. The investor may incur losses as a result of the erosion of

©D
option premiums over time, especially if the price of the underlying
asset is generally steady and does not vary much. However, if the stock
price makes a substantial shift in either direction, the potential payoff is
essentially limitless.
A Long Straddle approach has two places when it is profitable. The
total premiums paid are added to the strike price to get the higher
breakeven point and subtracted from the strike price to determine the
lower breakeven point. For the strategy to be successful, the stock price

PAGE 207
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes at expiry must be higher than the upper breakeven point or lower than
the lower breakeven point.
Let’s consider an investor who purchases a call option and a put option
on Stock XYZ with a strike price of Rs. 100 and pays a premium of
Rs. 5 for each option. If the stock price at expiration is Rs. 110, the call
option will be in-the-money with a profit of Rs. 5 (Rs. 110 - Rs. 100 -
Rs. 5). Similarly, the put option will expire out-of-the-money and result

i
in a loss of Rs. 5. The net payoff for the Long Straddle strategy in this

h
scenario is Rs. 0. However, if the stock price at expiration is Rs. 90,

e l
the call option will expire out-of-the-money with a loss of Rs. 5, while

D
the put option will be in-the-money with a profit of Rs. 5 (Rs. 100 -

of
Rs. 90 - Rs. 5). The net payoff in this case is also Rs. 0.
The Long Straddle approach relies heavily on time. When a big change

i ty
in the stock price occurs during the option’s life, the technique is most

s
profitable. Due to time decay, the choices’ values could go lower as
r
e
time goes on. The level of anticipated volatility, the price of the options

i v
(premiums), and the amount of time to expiry should all be carefully

U n
considered when putting a long straddle strategy into practise. The
investor may incur losses as a result of the erosion of option premiums

L ,
over time if the underlying asset remains steady because this technique

O
needs a big price movement to be lucrative. The Long Straddle strategy

/ S
provides investors with the opportunity to profit from significant price

L
movements in the underlying asset while maintaining a neutral stance on

O
the direction of the price movement. However, it is important to carefully

C
/
assess the market conditions, volatility expectations, and risk tolerance

C Ebefore employing this strategy.

D
©D

Figure 8.5 : Long Straddle Option Strategy

208 PAGE
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 FINANCIAL ENGINEERING

8.3.6 Bull Call Spread Notes

A bull call spread involves buying a call option with a lower strike price
and simultaneously selling a call option with a higher strike price. This
strategy is used when the investor expects a moderate upward movement
in the underlying asset’s price.
Bull Call Spread

h i
e l
D
of
i ty
r s
v e
n i
U
Figure 8.6 : Bull Call Option Strategy

,
Suppose an investor believes that the price of Stock XYZ, currently
L
O
trading at Rs. 50, will experience a moderate increase in the near future.

S
To implement a Bull Call Spread strategy, the investor executes the
following trades:
L /
O
- Buy a call option with a strike price of Rs. 45 for a premium of

C
/
Rs. 4.

E
- Sell a call option with a strike price of Rs. 55 for a premium of
C
D
Rs. 2.

©D
Let’s calculate the payoffs and profits at expiration for different stock
prices:
Stock Price Call Option Call Option Total Payoff Net Profit
at Expiration 1 Payoff 2 Payoff
Rs. 40 Rs. 0 Rs. 0 Rs. 0 -Rs. 2
Rs. 45 Rs. 0 Rs. 0 Rs. 0 -Rs. 2
Rs. 50 Rs. 5 Rs. 0 Rs. 5 Rs. 3
Rs. 55 Rs. 10 Rs. 0 Rs. 10 Rs. 8
Rs. 60 Rs. 15 -Rs. 5 Rs. 10 Rs. 8

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes If the stock price at expiration is below the strike price of Rs. 45 (e.g.,
Rs. 40, Rs. 45), both call options expire worthless. The investor loses the
total premium paid, which is Rs. 2 (Rs. 4 for Call Option 1 paid minus
Rs. 2 for Call Option 2 received). The net loss is -Rs. 2.
If the stock price at expiration is at the strike price of Rs. 45, Call
Option 1 is in-the-money and has a payoff of Rs. 0 (stock price - strike
price = Rs. 45 - Rs. 45 = Rs. 0). Call Option 2 expires worthless. The
total payoff is Rs. 0, and the net profit is -Rs. 2 (total premium paid).

h i
If the stock price at expiration is between the strike prices of Rs. 45 and

e l
Rs. 55 (e.g., Rs. 50), Call Option 1 is in-the-money and has a payoff
of Rs. 5 (Rs. 50 - Rs. 45). Call Option 2 expires worthless. The total
D
of
payoff is Rs. 5, and the net profit is Rs. 3 after subtracting the total
premium paid.

ty
If the stock price at expiration is at or above the strike price of Rs.

i
60, Call Option 1 is in-the-money and has a payoff of Rs. 15 (Rs. 60 -

s
r
Rs. 45). Call Option 2 is also in-the-money, resulting in a payoff of -

e
Rs. 5. The total payoff is Rs. 10, and the net profit is Rs. 8 (Rs. 10 -

v
i
total premium paid).

8.3.7 Bear Put SpreadU n

L ,
O
Purchasing a put option with a higher strike price while concurrently

/ S
selling a put option with a lower strike price is known as a bear put

L
spread. This tactic is used when the investor forecasts a modest decline

O
in the price of the underlying asset.

C
E / Bear Put Spread

D C
© D

Figure 8.7 : Bear Put Option Strategy

210 PAGE
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 FINANCIAL ENGINEERING

Consider a stock trading at Rs. 60. An investor buys a put option with Notes
a strike price of Rs. 65, paying a premium of Rs. 4. Simultaneously,
the investor sells a put option with a strike price of Rs. 55, receiving a
premium of Rs. 2. If the stock price at expiration is Rs. 58, the investor
can exercise the higher strike put option, resulting in a profit of (Rs. 65 -
Rs. 58 - Rs. 4) = Rs. 3 per share. The lower strike put option would
expire worthless.

i
IN-TEXT QUESTIONS
6. The payoff of a call option is positive when the:
l h
(a) Market price of the underlying asset is above the strike
D e
of
price
(b) Market price of the underlying asset is below the strike

ty
price

s i
(c) Market price of the underlying asset is equal to the strike
price
e r
(d) Option is out of the money
i v
U n
7. The maximum potential loss for a put option buyer is:

,
(a) The premium paid for the option
L
O
(b) The difference between the strike price and the market

/ S
price of the underlying asset
(c) Unlimited

O L
C
(d) Zero

/
8.3.8 ButterflyESpread

D C
©D
Combining a bull spread plus a bear spread results in a butterfly spread.
It is built by concurrently purchasing and letting go of options with three
distinct strike prices. This tactic is used when the investor anticipates
little change in the underlying asset’s price.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes

h i
e l
D
of
Figure 8.8 : Butterfly Spread Option Strategy
Suppose a stock is trading at Rs. 70. An investor buys a call option with

i ty
a strike price of Rs. 65, paying a premium of Rs. 4. Simultaneously, the

s
investor sells two call options with a strike price of Rs. 70, receiving a
r
e
premium of Rs. 2 for each option. Lastly, the investor buys a call option

i v
with a strike price of Rs. 75, paying a premium of Re. 1.
Stock Price
at Expiration Payoff
U n
Call Option 1 Call Option 2
Payoff
Call Option 3
Payoff
Total
Payoff
Net
Profit
Rs. 60 Re. 0

L , Re. 0 Re. 0 Re. 0 -Re. 0

O
Rs. 65 Re. 0 Re. 0 Re. 0 Re. 0 -Re. 0

/ S
Rs. 70 Rs. 5 Re. 0 Re. 0 Rs. 5 Rs. 4

L
Rs. 75 Rs. 10 -Rs. 10 Re. 0 Re. 0 -Re. 1

O
Rs. 80 Rs. 15 -Rs. 20 Rs. 5 Re. 0 -Re. 1

/ C
If the stock price at expiration is Rs. 60, None of the call options will be

C Eexercised. Hence, the total payoff will be Re. 0. However, the investor
have to pay Re. 1 as premium (Rs. 4 paid as premium on first call option,

D Rs. 2 each received on selling two call options, and Re. 1 paid on buying

©D
the third call option). Therefore, the net payoff will be a loss of Re. 1.
If the stock price at expiration is Rs. 65, None of the call options will be
exercised. Hence, the total payoff will be Re. 0. However, the investor
have to pay Re. 1 as premium (Rs. 4 paid as premium on first call option,
Rs. 2 each received on selling two call options, and Re. 1 paid on buying
the third call option). Therefore, the net payoff will be a loss of Re. 1.
If the stock price at expiration is Rs. 70, only first call option will be
exercised giving the payoff of Rs. 5. Hence, the total payoff will be

212 PAGE
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 FINANCIAL ENGINEERING

Rs. 5. However, the investor have to pay Re. 1 as premium (Rs. 4 paid Notes
as premium on first call option, Rs. 2 each received on selling two call
options, and Re. 1 paid on buying the third call option). Therefore, the
net payoff will be a loss of Rs. 4.
If the stock price at expiration is Rs. 70, Call option 1 and 2 will be
exercised, call option 1 will give a net payoff of Rs. 10, and on call
option 2 the investor will lose Rs. 10. Hence, the total payoff will be

i
Re. 0. However, the investor have to pay Re. 1 as premium (Rs. 4 paid
as premium on first call option, Rs. 2 each received on selling two call
l h
e
options, and Re. 1 paid on buying the third call option). Therefore, the
net payoff will be a loss of Re. 1.
D
8.3.9 Iron Condor of
i ty
s
A bull put spread and a bear call spread are combined to form an iron

e r
condor. It is made by simultaneously selling put and call options that

i v
are out of the money and purchasing more out-of-the-money put and call

n
options. When an investor anticipates the underlying asset to move inside

U
a certain price range, they will use this technique.

,
O L
/ S
O L
/ C
C E
D
©D
Figure 8.9 : Iron Condor Option Strategy
Consider a stock trading at Rs. 80. An investor sells a put option with a
strike price of Rs. 75, receiving a premium of Rs. 3. Simultaneously, the
investor buys a put option with a strike price of Rs. 70, paying a premium
of Re. 1. Additionally, the investor sells a call option with a strike price

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes of Rs. 85, receiving a premium of Rs. 2. Finally, the investor buys a
call option with a strike price of Rs. 90, paying a premium of Rs. 1. If
the stock price at expiration is Rs. 80, the investor’s profit would be the
premiums received (Rs. 3 + Rs. 2) - (Rs. 1 + Rs. 1) = Rs. 3 per share.

8.4 Betting of Price Changes

i
8.4.1 Betting on a Large Price Decrease

l h
D e
This tactic entails adopting a negative attitude and speculating that the price
of an underlying asset will sharply decline. To profit from a significant

of
drop in prices, investors can use a variety of derivative instruments,
such as buying put options, selling futures contracts, or executing bear

ty
spread tactics. When investors anticipate adverse market circumstances,

s i
economic downturns, or particular events that might cause a big decline

e r
in the asset’s price, this method makes sense. Investors that wager on a

i v
significant price decline hope to benefit when the asset’s value declines
below their projected levels.

U n
Put options are a common derivative instrument utilised in this technique.

L ,
Investors who purchase put options have the option, but not the duty, to

O
sell the underlying asset at the striking price and within the expiration

/ S
date at the stipulated price. Investors can execute the put options and

O L
sell the asset at a higher price if the asset’s price falls noticeably below
the strike price, making them money.

/ C
In order to build a net position that gains from a decline in the asset’s

C Eprice, investors can also use bear spread tactics, which entail concurrently

D
purchasing and selling options with various strike prices or expiry dates.

©D
Bear put spreads, bear call spreads, and ratio spreads are a few examples.
These strategies allow investors to limit their potential losses while still
profiting from a decline in the asset’s price.

8.4.2 Betting on a Small Price Increase

This approach, which has a positive perspective, includes gambling that
an underlying asset’s price will somewhat rise. To profit from little price
gains, investors can utilise derivative instruments like buying call options,

214 PAGE
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 FINANCIAL ENGINEERING

engaging into long futures contracts, or utilising bull spread techniques. Notes
Investors often use this tactic when they believe that favourable market
circumstances, favourable economic conditions, or particular events might
result in further increases in the asset’s value. Investors strive to profit
from the asset’s steady increase in value while minimising their negative
risk by betting on a tiny price increase.
Call options are frequently employed in this tactic. Investors who purchase

i
call options have the opportunity, but not the duty, to purchase the
underlying asset at the strike price and on the expiration date at the stated
l h
e
price (strike price). Investors can execute the call options and purchase
the asset at a lower market price, benefitting from the price difference,
D
of
if the asset’s price rises as expected.
In order to build a net position that gains from an increase in the asset’s

i ty
price, investors can also use bull spread tactics, which entail concurrently

r s
purchasing and selling options with various strike prices or expiry dates.

e
Ratio spreads, bull call spreads, and bull put spreads are a few examples.

v
let investors reduce their potential losses.
n i
While still benefiting from an increase in the asset’s price, these techniques

IN-TEXT QUESTIONS
, U
O L
8. The primary goal of a long straddle strategy is to:

/ S
(a) Generate income from the premiums received

L
(b) Profit from a significant increase in the underlying asset’s
O
C
price

E /
(c) Profit from a significant decrease in the underlying asset’s

C
price

D
(d) Profit from volatility or a significant move in either direction

©D
of the underlying asset’s price
9. The maximum potential loss for a long straddle strategy is:
(a) The premium paid for both the call and put options
(b) The difference between the strike price and the market
price of the underlying asset
(c) Unlimited
(d) Zero

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 8.5 Exotic Options

Exotic options, often referred to as complicated options or non-standard
options, are derivative contracts that have special features and structures
in addition to the traits of conventional options. These alternatives are
frequently altered to fit certain risk profiles or investment objectives. Exotic
options provide investors more freedom and the chance to customise the
options to meet their own demands.
Various types of Exotic options are defined below:
h i
e l
8.5.1 Compound Options
D
of
Compound options are a sort of derivative contract that provide the holder

ty
the choice to purchase or sell another option, but not the responsibility to

s i
do so. A compound option is an option on an option, to put it another way.

r
Investors can expose themselves to higher degrees of risk and uncertainty
e
v
in the financial markets because to this distinctive characteristic. Let’s

n i
explore the idea of compound choices in further depth:

U
The underlying option, also known as the primary option, and the

,
L
overlaying option, sometimes known as the secondary option, make up

O
compound options. The underlying option gives the owner the power to

S
purchase or sell the underlying asset at a defined price (the strike price)

L /
within a certain window of time (the expiration date). As opposed to the

O
underlying option, the overriding option gives the holder the right but

/ C
not the responsibility to exercise it.

C ECall compound options and put compound options are the two categories
of compound options. The right to purchase a call option (the underlying
D
©D
option) is provided by a call compound option, and the right to purchase
a put option (the underlying option) is provided by a put compound
option. In both situations, the right to execute the underlying option is
provided by the underlying option. Compound options’ main objective is
to give investors a way to profit from circumstances when there is doubt
about whether the underlying option will be exercised. Compound options
provide investors additional flexibility and adaptation to shifting market
circumstances by allowing them to postpone their choice on whether to
purchase or sell the underlying asset until a later time.

216 PAGE
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 FINANCIAL ENGINEERING

Due to the added layer of flexibility, compound options have a more Notes
complicated pricing and valuation than standard options. The prices of
the underlying and underlying options, the strike prices, the remaining
time to expiration, and the volatility of the underlying asset all affect the
value of a compound option. When there is doubt regarding the viability
or profitability of executing the underlying option, compound options are
frequently employed. They can be used in situations involving contingent
claims, where the choice to execute the underlying option depends on
certain occurrences or results. Real estate, commodities markets, project
h i
investments, and other fields where adaptability and risk management are
e l
D
essential find uses for compound options.

of
Like other derivatives, compound options have inherent risks. The
possibility of incorrect pricing and unexpected results is increased by the

ty
complexity of their pricing and valuation as well as the added layer of

s i
flexibility. Before investing in compound option trades, investors should

e r
carefully examine their level of risk tolerance, undertake comprehensive
analysis, and seek expert guidance.
i v
8.5.2 Binary Options
U n
L ,
O
Binary options are a sort of derivative financial contract that offers investors

S
a defined reward if the underlying asset fulfils certain requirements by

L /
the expiration date. These choices are referred to as “binary” since the

O
possible result is either a predetermined monetary sum or nothing at all.

/ C
Binary options provide a clear-cut and easy approach to engage in the

E
financial markets. Let’s delve more into the idea of binary options:

D C
A “cash-or-nothing” option or a “asset-or-nothing” option are the two
outcomes that binary options can have. If the option expires in-the-money

©D
(i.e., the requirement is satisfied) in a cash-or-nothing binary option, the
investor will get a specified sum of money. In an asset-or-nothing binary
option, if the option expires in-the-money, the investor obtains the value
of the underlying asset. Binary options can be either call options or put
options, much as conventional options. If the value of the underlying
asset is higher at expiration than the strike price of a call binary option,
the investor will get a predetermined dividend. Contrarily, a put binary

PAGE 217
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes option offers a preset reward if the value of the underlying asset is lower
at expiration than the strike price.
The expiration time and date for binary options have been set in advance.
Depending on the condition provided, the option is either in-the-money
or out-of-the-money at expiry. For instance, in a call binary option, the
option is in-the-money and the investor receives the specified payout if
the price of the underlying asset is higher than the strike price at expiry.

i
The set payoff is one of the primary characteristics of binary options.

l h
Prior to making a deal, the investor is aware of the payoff amount, which

e
has been predetermined. The investor may lose their whole investment

D
if the option expires in the red (out-of-the-money). If the option expires

of
in-the-money, its fixed payout form enables simpler risk management
and possibly large rewards.

i ty
8.5.3 Barrier Option
r s
v e
i
A form of derivative contract known as a barrier option has a certain

n
price level, or the barrier, which, if exceeded, can alter the features and

, U
payment of the option. These choices are common in the financial markets
because they offer flexibility and the chance to adjust the risk-reward

O L
profile to the individual demands of the investor.

/ S
Barrier options can have different types of barriers, such as:

O L
- Up-and-In Barrier: The option becomes active (in-the-money) only
if the underlying asset price reaches or exceeds the barrier level

/ C
during the option’s lifetime.

CE
- Up-and-Out Barrier: The option becomes null and void (knocked

D
out) if the underlying asset price reaches or exceeds the barrier

© D level during the option’s lifetime.

- Down-and-In Barrier: The option becomes active (in-the-money)
only if the underlying asset price falls below the barrier level during
the option’s lifetime.
- Down-and-Out Barrier: The option becomes null and void (knocked
out) if the underlying asset price falls below the barrier level during
the option’s lifetime.

218 PAGE
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 FINANCIAL ENGINEERING

Investors have more freedom with barrier options than with regular ones. Notes
These options may be customised to certain risk profiles and market
expectations by including barrier levels. Investors may limit risk, customise
their exposure to market fluctuation, and perhaps achieve more favourable
risk-reward profiles by using barrier options. A barrier option’s reward
structure is determined by the kind of barrier and whether it has been
crossed. If the barrier is crossed, the option can be declared void and
have no reward. If the barrier is not crossed, the option functions like
a conventional option, with the price of the underlying asset at expiry
h i
determining how much it will pay out.
e l
D
Options for barriers are frequently used for risk management. Barrier

of
options, for instance, might be used by a business to protect itself from
negative changes in the price of its underlying assets. If the barrier level

ty
is achieved or broken, these options can offer protection by minimising

i
losses or producing gains. Barrier options may also be used by investors
s
r
to convey certain market viewpoints or to make money by writing (selling)

v e
these options. Due to the added characteristic of the barrier level, the

i
pricing and valuation of barrier options may be more complicated than
n
U
those of regular options. Barrier option pricing is affected by a number of

,
variables, including the price of the underlying asset, volatility, remaining

O L
time until expiration, and the chance that the barrier will be broken.
Sophisticated models and mathematical techniques, such as Monte Carlo

/ S
simulations, are often employed to value these options accurately.

O L
Barrier alternatives have advantages and disadvantages. They offer flexibility
and tailored risk management, but there is also a chance that the barrier

/ C
will be crossed and the choice will be rendered useless. Before trading

E
or purchasing these derivatives, investors should properly analyse them,
C
D
carefully evaluate their risk appetite, and completely comprehend the

©D
peculiarities of barrier options.
IN-TEXT QUESTIONS
10. Exotic options are standardized contracts traded on organized
exchanges. (True/False)
11. Compound options are options on options. (True/False)
12. Barrier options provide the holder with the right, but not the
obligation, to buy or sell an underlying asset if a specified
price level is breached. (True/False)

PAGE 219
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 8.5.4 Asian Options

Asian options are a sort of derivative contract that derives its value from
an underlying asset’s average price over a given time period rather than
the asset’s price at a particular instant in time. In order to control risk
and expose oneself to price movements over a specific time period, these
options are often utilised in the financial markets. Asian options take into
account the asset’s average price over a certain time period as opposed to

i
typical options, which are settled according to the price of the underlying
h
l
asset at expiry. Depending on the specifics of the contract, the average
e
D
time may range from a few days to many months.

of
There are two main types of Asian options:
- Asian Call Option: This type of option provides the holder with

i ty
the right, but not the obligation, to buy the underlying asset at a

s
predetermined price (strike price) based on the average price of the
r
e
asset over the averaging period.

i v
- Asian Put Option: This type of option provides the holder with

n
the right, but not the obligation, to sell the underlying asset at a
U
,
predetermined price (strike price) based on the average price of the

L
asset over the averaging period.

O
The average price of the underlying asset can be calculated in different
S
L /
ways, including arithmetic mean and geometric mean. The choice of
calculation method depends on the specific contract terms and market

C O
conventions.

E /
C
8.6 Summary

D D A thorough grasp of the creation of options strategies, the use of exotic

© options, the analysis of options involving numerous assets, and the

assessment of risk and return in options strategies may be found in
financial engineering. To give readers the information they need to create
and implement successful options strategies, the chapter explores essential
ideas and methods of financial engineering. The creation of options
strategies is explored in the first section of the chapter, with an emphasis
on how well they perform in various market conditions. Readers learn
how to effectively use options to profit from market changes, whether

220 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 FINANCIAL ENGINEERING

they are betting on a significant price fall or a little price increase. By Notes
understanding the construction and payoffs of options strategies, investors
can tailor their portfolios to match their risk profiles and investment
objectives.
The chapter carefully examines exotic options, such as compound, binary,
barrier, and Asian options. These options have special characteristics that
give investors more flexibility and risk-management tools. Readers learn

i
about the features and possible advantages of these exotic choices through
thorough explanations and examples, enabling them to investigate more
l h
e
sophisticated investing methods. The chapter also examines the study of
options with numerous assets. The possible advantages and hazards of
D
of
these options, which depend on the performance of a number of underlying
assets, are explained to readers. Investors can evaluate these options’

ty
eligibility for inclusion in diverse investment portfolios effectively by
understanding the complexities of these options.
s i
e r
The chapter’s main goal is to help readers create and use options strategies

i v
by applying financial engineering ideas. Readers are given the skills

U n
to create novel financial products and solutions that optimise risk and
return profiles by utilising mathematical models, statistical analysis, and

L ,
computer methodologies. The need of using financial engineering concepts

O
to develop reliable and specific options strategies is emphasised in this

/ S
chapter. Finally, the chapter places a strong emphasis on assessing risk and

O L
reward in options strategies. Readers get the ability to evaluate critically
the risk profiles and possible rewards linked to various options strategies.

/ C
Readers may choose wisely and match their investment strategies with

C E
their risk tolerance and return objectives by understanding the role of
risk and return in investing decisions.

D
©D
8.7 Answers to In-Text Questions

1. False
2. True
3. False
4. (d) All of the above
5. (a) Rs. 45

PAGE 221
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 6. (a) Market price of the underlying asset is above the strike price
7. (a) The premium paid for the option
8. (d) Profit from volatility or a significant move in either direction
of the underlying asset’s price
9. (a) The premium paid for both the call and put options
10. False
11. True

h i
12. True
e l
D
of
8.8 Self-Assessment Questions

ty
1. Analyze the benefits and risks associated with options strategies

i
involving multiple assets, such as spreads and straddles.

s
r
2. Consider a stock trading at Rs. 100, and an investor purchase both
e
v
a call option and a put option with a strike price of Rs. 100, each
with a premium of Rs. 5.
n i
U
Create a payoff Table for the following stock prices at expiry:

L,
Rs. 90 Rs. 95 Rs. 100 Rs. 105 Rs. 110 Rs. 115

O
3. An investor owns 100 shares of a stock trading at Rs. 150 and

S
L /
decides to implement a covered call strategy. They sell a call option
with a strike price of Rs. 160 and receive a premium of Rs. 8.

C O
Create a payoff table for the following stock prices at expiration:

E / Rs 140. Rs. 150 Rs. 160 Rs. 170 Rs. 180 Rs. 190

D C 4. Describe the construction of a straddle options strategy and explain

the potential payoffs in different market scenarios.

© D 5. Compare and contrast compound options and binary options, highlighting

their key features and differences.
6. Explain the concept of a barrier option and discuss how the presence
of a barrier level affects the payoff structure of the option.
7. Evaluate the role of risk and return in options strategies and discuss
how investors can make informed investment decisions by considering
factors such as volatility, time decay, and market conditions.

222 PAGE
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 FINANCIAL ENGINEERING

8. An investor owns 200 shares of a stock trading at Rs. 75 and Notes

purchases a put option with a strike price of Rs. 70 for a premium
of Rs. 3. Create a payoff table for the following stock prices at
expiration:
Rs. 60 Rs. 65 Rs. 70 Rs. 75 Rs. 80 Rs. 85
9. An investor executes a long straddle strategy on a stock trading at
Rs. 200. They purchase both a call option and a put option with a

i
strike price of Rs. 200, each with a premium of Rs. 10. Create a
payoff table for the following stock prices at expiration:
l h
Rs. 180 Rs. 190 Rs. 200 Rs. 210 Rs. 220 Rs. 230
D e
of
10. An investor implements an iron condor strategy on a stock trading
at Rs. 120. They sell a call option with a strike price of Rs. 130

ty
and receive a premium of Rs. 6. Additionally, they sell a put option

s i
with a strike price of Rs. 110 and receive a premium of Rs. 4. To

r
protect against potential losses, they purchase a call option with
e
v
a strike price of Rs. 140 for a premium of Rs. 2 and a put option

n i
with a strike price of Rs. 100 for a premium of Rs. 2. Create a

U
payoff table for the following stock prices at expiration:

L,
Rs. 100 Rs. 110 Rs. 120 Rs. 130 Rs. 140 Rs. 150

O
11. Discuss the potential benefits and risks of exotic options, such as

S
/
Asian options, and explain how these options can be utilized in

L
specific market scenarios.

O
C
12. Explain how options strategies can be used to manage portfolio risk

/
and enhance returns, considering factors such as diversification,
E
C
hedging, and risk-reward profiles.

D D
13. Discuss the importance of understanding implied volatility and its
impact on options pricing, and explain how volatility strategies can

©
be incorporated into options trading.
14. Analyze the potential impact of factors such as interest rates,
dividends, and market liquidity on options strategies, and discuss
how these factors should be considered in strategy design and
implementation.

PAGE 223
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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 8.9 References

 ‹Brown, K. C., & Harlow, W. V. (2011). Financial Engineering: A
Complete Guide to Financial Innovation. John Wiley & Sons.
 ‹Neftci, S. N. (2008). An Introduction to Financial Engineering.
Academic Press.
 ‹McNeil, A. J., Frey, R., & Embrechts, P. (2015). Quantitative Risk

i
Management: Concepts, Techniques, and Tools (Rev. ed.). Princeton
University Press.
l h
 ‹Benninga,
e
S. (2014). Financial Modeling (4th ed.). MIT Press.
D
of
 ‹Brandimarte, P. (2008). An Introduction to Financial Engineering:
Options and Corporate Finance. Springer.

i ty
s
8.10 Suggested Readings

e r
v
 ‹Hull, J. C. (2017). Options, Futures, and Other Derivatives (10th
ed.). Pearson.
n i
 ‹Beder,
U
T. S. (2011). Financial Engineering: The Evolution of a

,
Profession. John Wiley & Sons.
 ‹Brandimarte,

O L
P. (2006). Numerical Methods in Finance and Economics:

S
A MATLAB-Based Introduction. John Wiley & Sons.
 ‹Neftci,
L /
S. N. (2000). An Introduction to the Mathematics of Financial

O
Derivatives (2nd ed.). Academic Press.

C
E /
 ‹Joshi, M. S. (2008). The Concepts and Practice of Mathematical

C
Finance (2nd ed.). Cambridge University Press.

D  ‹Taleb, N. N. (1997). Dynamic Hedging: Managing Vanilla and Exotic

©D
Options. John Wiley & Sons.

224 PAGE
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F:\Jobs 2023\Books 2023\MBAFT-6301_L1_Samp
2023\MBAFT-6301_L1_Samples_Sept23\Z:\SOL
mples_Sept23\Z:\SOL DU-2023\7408_Financial Derivatives\7408_FD-03.indd
m MK PKS 08092023 225

L E S S O N

9
Swaps Transactions
Dr. Narander Kumar Nigam
Assistant Professor
Shaheed Sukhdev College of Business Studies
Email-Id: [email protected]

STRUCTURE
h i
e l
D
9.1 Learning Objectives

of
9.2 Introduction
9.3 Swap
9.4 Interest Rate Swaps
i ty
9.5 Types of Interest Rate Swap
r s
v e
i
9.6 Currency Swaps
9.7 Types of Currency Swaps
U n
,
9.8 %HQH¿WV RI 6ZDSV

L
9.9 Pricing and Valuation of Interest Rate Swaps
O
9.11 Credit Default Swaps / S
9.10 Pricing and Valuation of Currency Swaps

O L
9.12 Valuation of Credit Default Swaps

/ C
9.14 Answers toEIn-Text Questions
9.13 Summary

D C
D
9.15 References

©
9.16 Suggested Readings

9.1 Learning Objectives

 ‹Understand the fundamental concept of swap contracts and their evolution in the
financial market.

PAGE 225
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes  ‹Explain the key components of a swap agreement, including the

parties involved, cash flow exchange, payment dates, and calculation
methods.
 ‹Analyze and compare the characteristics of forward contracts and
swaps, highlighting the advantages and differences between the two
instruments.
 ‹Evaluate the role of swaps as essential tools for managing risk and

i
optimizing investment strategies in derivatives markets.
 ‹Design and construct swap agreements for different scenarios,
l h
D e
considering variables such as interest rates, exchange rates, and

of
commodity prices.
 ‹Identify their unique features and applications and assess the significance

ty
and popularity of plain vanilla interest rate swaps and fixed-for-

s i
fixed currency swaps in the financial industry.

e r
By addressing these learning objectives, learners will develop a comprehensive

i v
understanding of swaps, enabling them to grasp the underlying concepts,

U n
apply their knowledge to practical scenarios, and critically evaluate the
benefits and challenges of these financial instruments.

L ,
O
9.2 Introduction

/ S
L
The advent of swap contracts in the early 1980s marked the beginning

O
of a remarkable growth trajectory in the market. Over time, swaps have

/ C
evolved to become a pivotal component of derivatives markets, occupying

E
a central position in financial transactions.

D C A swap is an agreement between two companies (or two counterparties),

conducted over the counter, to exchange future cash flows. The agreement

©D
specifies the dates of payment and outlines the calculation method for
determining these cash flows, typically involving interest rates, exchange
rates, or other market variables. A basic example of a swap can be illustrated
by a forward contract. For instance, if a company enters into a forward
contract on March 1, 2022, to purchase 500 ounces of silver at $25 per
ounce in one year, the contract can be viewed as a swap. The company
agrees to pay $12,500 on March 1, 2022, and receive 500X, where X
represents the market price of one ounce of silver on that particular date.
This swap allows the company to subsequently sell the sale upon receipt.
226 PAGE
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 SWAPS TRANSACTIONS

Unlike forward contracts, which involve cash flow exchanges on a single Notes
future date, swaps typically entail multiple future cash flow exchanges.
This chapter focuses on exploring the design, utilization, and valuation
of swaps. Specifically, the discussion primarily centers around two
commonly employed swaps: plain vanilla interest rate swaps and fixed-
for-fixed currency swaps.
By delving into the intricacies of swaps, this chapter offers a comprehensive

i
understanding of their structure, applications, and the methods used to
assess their value. It encompasses the exploration of interest rate swaps,
l h
e
currency swaps, commodity swaps, equity swaps, and credit default swaps.
The chapter aims to provide insights into the knowledge, pricing, and
D
of
valuation aspects associated with these various types of swaps.

9.3 Swap
i ty
r s
e
A swap is a financial derivative contract in which two parties agree to

i v
exchange cash flows or financial instruments over a specified period of

n
time. Swaps are typically traded over the counter (OTC), as they are

two parties.
, U
customized agreements (rather than standardized contracts) between the

O L
The most common type of swap is an interest rate swap (IRP), in which

/ S
two parties agree to exchange fixed and floating cash flows (interest rate

O L
payments) based on a notional amount. In this type of swap, one party
pays a fixed interest rate to the counterparty on the predetermined notional

/ C
capital, while the other party pays a floating interest rate payment on

E
the same notional capital.

C
D
Other types of swaps include currency swaps, commodity swaps, equity

©D
swaps, and credit default swaps (CDS). Currency swaps involve the exchange
of principal and interest payments denominated in different currencies.
Commodity swaps allow parties to exchange cash flows based on the
price fluctuations of commodities such as oil, natural gas, or agricultural
products. Equity swaps involve the exchange of cash flows based on the
performance of underlying stocks or stock indices. Credit default swaps
are financial contracts that allow investors to hedge against or speculate
on the creditworthiness of a particular entity, such as a corporation or
sovereign government.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Swaps are used by market participants to manage risk, hedge exposures,
speculate on market movements, and customize their financial positions.
The terms and conditions of a swap, including payment dates, calculation
methodologies, and termination provisions, are agreed upon by the parties
involved in the contract.

9.4 Interest Rate Swaps

h
Interest rate swaps are a popular and widely utilized form of derivative
i
e l
contract in financial markets. They allow two parties to exchange future

D
interest rate cash flows based on an agreed notional amount (no capital

of
exchange in Interest rate swaps). In an interest rate swap, one counterparty
normally pays a fixed interest rate while the other pays a floating interest

ty
rate tied to a benchmark, such as MIBOR.

s i
The primary objective of interest rate swaps is to offer flexibility in

e r
managing interest rate exposure while achieving desired cash flow

i v
characteristics. These swaps provide market participants with a means

n
to effectively navigate the impact of interest rate fluctuations on their

, U
financial positions. By exchanging future interest rate cash flows, parties
can adapt their cash flow profiles to align with their specific needs and
objectives.
O L
/ S
Furthermore, interest rate swaps allow participants to benefit from

O L
comparative advantage. Each counterparty may have a unique advantage
or preference regarding the type of interest rate (fixed or floating) they

/ C
can access at more favourable terms. By engaging in an interest rate

C Eswap, the parties can leverage their respective strengths, enabling one
counterparty to benefit from fixed-rate payments and the other from

D floating-rate payments. This comparative advantage allows both parties

©D
to optimize their borrowing or lending costs and enhance their overall
financial positions.
In essence, interest rate swaps serve as versatile tools that offer flexibility
in managing interest rate exposure, tailor cash flow characteristics to
specific requirements, and leverage comparative advantage to achieve
optimal financial outcomes for the involved parties.

228 PAGE
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 SWAPS TRANSACTIONS

Overall, interest rate swaps serve as valuable tools for managing interest Notes
rate exposure, enhancing financial flexibility, and optimizing risk and
return profiles in a variety of financial transactions.

9.5 Types of Interest Rate Swap

These are the three main types of interest rate swaps used in financial
markets:
1. Fixed-for-Floating Interest Rate Swap
h i
2. Floating-for-Fixed Interest Rate Swap
e l
3. Basis Interest Rate Swap (Floating-for-Floating Interest)
D
of
Fixed-for-Floating Interest Rate Swap: This is the most common type
of interest rate swap. In Fixed-for-Floating Interest Rate Swap, one party

i ty
(or first party) agrees to pay a fixed interest rate on a notional principal

s
amount for a given period, while the other party (second party) agrees
r
e
to pay a floating interest rate based on a reference rate (such as MIBOR

i v
rate). The purpose of this swap is to exchange fixed-rate cash flows for
floating-rate cash flows or vice versa.

U n
Floating-for-Fixed Interest Rate Swap: This type of swap is just the

L ,
opposite of the fixed-for-floating swap. Here, one party (first party) agrees

O
to pay a floating interest rate based on some reference rate, while the

/ S
other party (second party) agrees to pay a fixed interest rate. This swap

O L
allows the parties to exchange their existing floating-rate cash flows for
fixed-rate cash flows or vice versa.

/ C
Basis Interest Rate Swap: This swap involves the parties exchanging

C E
floating interest rates based on different reference rates. For example,
one party might pay a floating rate based on MIBOR, while the other
D
©D
party pays a floating rate based on the 91 days T-bill. The purpose of
this swap is to allow the parties to take advantage of differences in the
pricing or yield of different reference rates.

MIBOR
MIBOR (Mumbai Interbank Offered Rate) is the benchmark interest
rate at which banks in Mumbai, India offers short-term funds to each
other. It serves as a reference rate for various financial transactions,
including loans, derivatives, and swaps, providing an indicator of the
prevailing market interest rates in Mumbai’s interbank lending market.

PAGE 229
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes MIBOR plays a crucial role as a reference rate for loans in interna-
tional financial markets. To illustrate its usage, let’s consider a 5-year
bond with an interest rate specified as the 3-month MIBOR rate plus
0.25% per annum. The bond’s lifespan consists of 20 periods, each
lasting 3 months. At the beginning of each period, the interest rate
is determined as 0.25% per annum higher than the 3-month MIBOR
rate. The interest payment is made at the end of each period.
Illustration 1

h i
In this hypothetical 3-year swap initiated on Jan 1, 2020, between Wipro
e l
D
and Infosys, the terms of the agreement are as follows: Wipro agrees to

of
pay Infosys a fixed interest rate of 5% per annum on a principal amount
of INR 100 Crores, while Infosys agrees to pay Wipro the 3-month

ty
MIBOR rate on the same principal. Wipro assumes the role of the fixed-

i
rate payer, while Infosys takes on the role of the floating-rate payer.
s
e r
According to the agreement, payments are exchanged every 3 months. The

i v
fixed interest rate of 5% per annum is quoted with quarterly compounding,

n
ensuring periodic interest payments based on this rate. The floating-rate

, U
payments made by Infosys to Wipro are determined by the prevailing
3-month MIBOR rate, reflecting market conditions.

O L
The diagram visually represents the structure of the swap, illustrating

/ S
the flow of payments and the respective roles of Wipro as the fixed-rate

L
payer and Infosys as the floating-rate payer.

O
The first payment exchange occurs three months after the initiation of the
C
E /
agreement, on April 1, 2020. Wipro, as the fixed-rate payer, pays Infosys
INR 1.25 crores, representing the interest on the notional principal1 of

D C 5.00%

©D
INR 100 Crores
Wipro (Notional Infosys
Principal)

MIBOR Rate

Figure 9.1: Interest rate swap between Wipro and Infosys

1. The principal itself is not exchanged, for this reason, it is termed the notional principal,
or just the notional.

230 PAGE
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 SWAPS TRANSACTIONS

INR 100 crores for three months at a fixed rate of 5.00%. On the other Notes
hand, Infosys, as the floating-rate payer, pays Wipro INR 1.025 crores,
calculated based on the 3-month MIBOR rate of 4.1% prevailing on
January 1, 2020. (Calculations: Infosys pays Wipro 0.25 (3 months) ×
0.041 (MIBOR on Jan. 1, 2020) × INR 100 = INR 1.025 cr.
The second payment exchange takes place on July 1, 2020, six months
after the initiation of the agreement. Wipro pays INR 1.25 crores to

i
Infosys as a fixed payment. Meanwhile, Infosys pays Wipro INR 1.175
crores, determined using the 3-month MIBOR rate of 4.7% prevailing on
l h
e
April 1, 2020. Suppose that the 3-month MIBOR rate on April 1, 2020, is
4.7%. Infosys pays 0.25 (3 months) × 0.047 (MIBOR on April 1, 2020)
D
of
× INR 100 = INR 1.175 cr. to Wipro.
Table 9.1: Cash Flows (in Crores) of Wipro and Infosys.

ity
Date Three-month Wipro - Floating Infosys – Fixed Net cash
MIBOR rate cash flow cash flow

r s flow#

e
(In %) Received (3) received (4) (3-4)

i v
(In Crores) (In Crores)

n
Jan. 1, 2020 4.10

U
April 1, 2020 4.70 1.025 1.25 - 0.225
July 1, 2020
Oct. 1, 2020
5.20

L
5.40 , 1.175
1.300
1.25
1.25
-0.075
0.050
Jan. 1, 2021

S O
5.50 1.350 1.25 0.100
April 1, 2021
July 1, 2021
L / 5.80
4.10
1.375
1.450
1.25
1.25
0.125
0.200
Oct. 1, 2021

C O 4.70 1.025 1.25 - 0.225

Jan. 1, 2022
April 1, 2022
E / 5.20
5.40
1.175
1.300
1.25
1.25
-0.075
0.050

D C
July 1, 2022 5.50 1.350 1.25 0.100

©D
Oct. 1, 2022 5.80 1.375 1.25 0.125
Jan. 1, 2024 1.450 1.25 0.200
# Negative cash flow represents a payment from Wipro to Infosys; Positive cash flow represents
a payment from Infosys to Wipro.

This payment exchange pattern continues for a total of 12 exchanges

throughout the swap agreement. The fixed payments remain constant
at INR 1.25 crores. On each payment date, the floating-rate payments
are calculated based on the 3-month MIBOR rate three months prior to
the payment date. The swap is structured such that one party remits the

PAGE 231
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes difference between the two payments to the other party. In this example,
Wipro pays Infosys INR -0.225 crores (1.025 crores - 1.25 crores) on
April 1, 2020, and INR -0.075 crores (1.175 crores - 1.25 crores) on
July 1, 2020.
Throughout the swap, the payment exchanges reflect the fixed and
floating interest rates, creating a mechanism for transferring the interest
rate differential between the two parties.

h i
l
9.6 Currency Swaps

D e
A currency swap is a financial arrangement between two parties to

of
exchange interest rate cash flows (similar to IRP) as well as the capital
amount (not similar to IRP) in one currency for an equivalent amount in

ty
another currency. To control currency exposure, get finance in a different

s i
currency, and so forth, the parties perform a currency swap. Parties agree

e r
on the exchange capital and interest payment cash flows in a currency

i v
swap. In a currency swap, parties initially exchange capital amounts, then

n
periodically exchange pre-agreed interest payments, then at maturity, they

, U
repay their capital amounts. Currency swaps are extensively employed
by multinational corporations, large institutions, and investors to manage

O L
foreign exchange risks and meet funding requirements.

/ S
L
9.7 Types of Currency Swaps

C O
These are some of the types of currency swaps. Each type serves different

E /
purposes and provides flexibility in managing currency risks, interest rate

C
risks, or accessing funding in different currencies:

D 1. Fixed-for-Fixed Currency Swap

©D
2. Fixed-for-Floating Currency Swap
3. Amortizing Currency Swap
4. Non-Deliverable Currency Swap
Fixed-for-Fixed Currency Swap: In a Fixed-for-Fixed Currency Swap,
parties initially exchange an equal amount of money (in common currency)
for a period of time. Then, parties agree to exchange fixed interest
payments in different currencies for the said period, and at the end, they

232 PAGE
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 SWAPS TRANSACTIONS

pay back the same amount of capital. For example, Party A might pay a Notes
fixed interest rate in USD, while Party B pays a fixed interest rate in INR.
The principal amount is exchanged at the beginning and end of the swap.
Fixed-for-Floating Currency Swap: In this swap, parties initially
exchange an equal amount of money (in common currency) for a period
of time. During swap life, one party makes fixed interest payments in one
currency while receiving floating interest payments in another currency,

i
and at the end, they pay back the same amount of capital. The floating
interest rate is typically based on some reference rate such as MIBOR
l h
e
or 91 Days T-bills etc. This type of swap allows parties to hedge against
interest rate fluctuations or to take advantage of differences in interest
D
of
rates between currencies.
Amortizing Currency Swap: In an amortizing currency swap, parties

i ty
initially exchange an equal amount of money (in common currency) for a

r s
period of time. During the swap life, parties exchange interest payments

e
along with the principal amount, in such a way, the principal amount is

v
n i
gradually reduced to zero over time through a series of scheduled payments.
This type of swap allows parties to align the repayment structure with
their specific needs or obligations.
, U
O L
Non-Deliverable Currency Swap: This type of swap is used when one or
both parties cannot deliver the underlying currencies due to regulatory or

/ S
operational restrictions. Instead, the swap is settled in a specified reference

O
and the prevailing spot rate. L
currency based on the difference between the agreed-upon exchange rate

/ C
E
Illustration 2

D C
In this hypothetical 3-year swap initiated on Jan 1, 2020, between Intel
and Infosys, the terms of the agreement are as follows: Intel agrees to pay

©D
Infosys $1 lakh at a fixed interest rate of 5% per annum to Infosys in
the USA, while Infosys agrees to pay Intel INR 80 lakh (USDINR= 80)
at a fixed interest rate of 8% per annum in INDIA. According to the
agreement, payments are exchanged every 3 months. The fixed interest
rate is quoted with quarterly compounding.
Figure 9.2 visually represents the structure of the swap, illustrating the
flow of payments and the respective roles of Intel and Infosys.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes According to the agreement, the principal amount (i.e., 1 lakh USD and
80 lakhs INR) is exchanged initially then interest payments are exchanged
every 3 months.
The first payment exchange occurs on Jan 1, 2020, after the initiation of
the agreement. Intel pays Infosys the principal amount of $1 lakh, and
in return, Infosys pays Intel INR 80 lakhs.
The second transaction, or the first interest payment exchange, takes place

i
three months after the initiation of the agreement, on April 1, 2020. Intel
pays Infosys INR 1.60 lakh, representing the interest on the principal
l h
D e
of INR 80 lakh for three months at a fixed rate of 8.00%. On the other
hand, Infosys pays Intel $1250 for three months at a fixed rate of 5.00%.

of
The calculation for Infosys’ payment to Intel is as follows: Infosys pays
Intel 0.25 (3 months) × 0.05 × $1,00,000 = $1250.

i ty
Intel

r
$1 Lakh
s Infosys

e
Beginning

i v
INR 80 Lakh

U n
,
Intel Infosys

O L
During

/S
Interest Payments

O L
/ C
E
DC
Intel Infosys

©D
INR 80 Lakhs
End

$ 1 Lakh

Figure 9.2: Interest rate swap between Intel and Infosys

In the given swap agreement, the payment exchange pattern consists of
a total of 13 exchanges. The fixed payments throughout the swap remain

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 SWAPS TRANSACTIONS

constant at INR 1.6 lakh and $1250. Only the differential amount is Notes
exchanged between the parties on each payment date.
For example, on April 1, 2020, Intel pays Infosys an amount of INR
60,000 (1,60,000 – 1250 x 80 (assumed fixed exchange rate throughout
the swap)). This pattern continues until Jan 1, 2024.
On the final payment date, Jan 1, 2024, Intel pays Infosys the principal
amount of INR 80 lakh, while Infosys pays Intel $1 lakh.
Table 9.2: Cash Flows (in Lakhs) of intel and Infosys

h i
Date Inter - Received Infosys –Received Net cash
e l
D
(3) (In lakhs) (4) (In Lakhs) flow# (3-4)

of
Jan. 1, 2020 INR 80 $ 1
April 1, 2020 $ 0.125 INR 1.60 INR 60000

ty
July 1, 2020 $ 0.125 INR 1.60 INR 60000
Oct. 1, 2020 $ 0.125 INR 1.60

s i
INR 60000
Jan. 1, 2021 $ 0.125 INR 1.60

e r INR 60000

v
April 1, 2021 $ 0.125 INR 1.60 INR 60000
July 1, 2021 $ 0.125
n
INR 1.60
i INR 60000

U
Oct. 1, 2021 $ 0.125 INR 1.60 INR 60000

,
Jan. 1, 2022 $ 0.125 INR 1.60 INR 60000
April 1, 2022
July 1, 2022
$ 0.125
$ 0.125
O L INR 1.60
INR 1.60
INR
INR
60000
60000
Oct. 1, 2022 $ 0.125
/ S INR 1.60 INR 60000
Jan. 1, 2024 $1.125

O L INR 81.60 INR 60000

/ C
# Calculations are based on fix exchange rate system, however in the floating exchange regime

E
calculations are based on the current exchange rate.

D C
9.8 Benefits of Swaps

©D
Swaps are versatile financial instruments that offer several benefits to
market participants. These agreements allow parties to exchange cash
flows, interest rates, or other variables, providing flexibility and risk
management opportunities. Swaps have gained popularity due to their
ability to tailor financial exposures and optimize cash flows. In this
context, let’s explore some key benefits of swaps.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 1. Risk Management/Hedging: Swaps allow parties to manage and

mitigate various risks such as interest rate risk, currency risk, and
credit risk. By swapping their exposure with another party, they
can effectively hedge against adverse movements in these risks.
2. Comparative Advantage: Swaps allow parties to access different
markets or financial instruments and raise funds at potentially more
competitive rates compared to those offered by banks or financial

i
institutions. (Ref. Illustration 3)

l h
3. Flexibility: Swaps offer customization and tailoring flexibility to

D e
meet specific needs. Parties can negotiate and agree on various
terms, such as the notional amount, payment dates, interest rates,

of
and currencies, to align with their specific requirements.

ty
4. Desire Obligation: Swaps can help in managing cash flows by

i
transforming fixed payments into floating payments or vice versa.

s
r
This can be particularly useful for entities with fixed payment

e
obligations who wish to align their cash flows with flexible payment
v
obligations.
n i
U
5. Arbitrage: Swaps can facilitate arbitrage by taking advantage of

L ,
pricing discrepancies between markets or financial instruments. Parties
can exploit these discrepancies to generate profits without taking on

S O
significant market risks.

L /
6. Access to Foreign Capital: Swaps allow parties to access alternative

O
sources of funding. For instance, a company may enter into a currency

/ C
swap to obtain financing in a foreign currency at more favorable

E
terms than available in the domestic market.

D C 7. Liquidity Management: Swaps can provide liquidity benefits by allowing

parties to set desired timings of payment of assets or liabilities. This

©D
can improve liquidity management and facilitate portfolio rebalancing.
It’s important to note that while swaps offer various benefits, they also
involve risks, and parties should carefully assess and understand the terms
and potential implications before entering into such agreements.
Illustration 3
Suppose Intel (USA) requires funds for its Indian segment, and Infosys
(IND) requires funds for its USA segment. Both companies have the

236 PAGE
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 SWAPS TRANSACTIONS

option to borrow funds from banks in both countries, but the interest Notes
rates offered in each market differ. Here are the interest rates offered by
banks in both countries:
Table 9.3: Interest rates offered to Intel and Infosys in USA and India
USA IND
Intel 4% 7.6%
Infosys 6% 8%
Comparatively, Intel has a lower interest rate advantage in the USA

h i
compared to India, while Infosys has a lower interest rate advantage in
India compared to the USA. However, the funding requirement for Intel
e l
is in India, and Infosys requires funds for its operations in the USA.
D
of
Furthermore, if they borrow funds in a currency other than their required

ty
location, they expose themselves to currency rate risk. Secondly, can

i
they borrow funds in the required location at a cheaper rate than what

s
r
is offered by banks/financial institutions?

v e
The solution to these two issues is a currency swap. Through a currency

n i
swap, they can avoid currency rate risk and raise funds at a better rate

U
than banks/financial institutions offer.

L ,
Intel can borrow funds from the USA at an interest rate of 4% per annum
(due to the comparative advantage), while Infosys can borrow funds from

S O
India at an interest rate of 8% per annum (also due to the comparative
advantage).
L /
O
(Insight: Infosys has a comparative advantage in India because the interest

/ C
rate gap between the USA and India is smaller compared to the USA.

E
While Infosys is offered an interest rate that is 2% higher in the USA,

D C
in India it is offered only a 0.4% higher interest rate. Therefore, one
can argue that compared to the USA, the interest rate gap is narrower in

©D
India, giving Infosys a comparative advantage in terms of interest rates.)
Here’s how the currency swap agreement could work:
Intel will borrow funds from the USA @ 4%, and Infosys will borrow
funds from India @ 8%. Intel and Infosys have decided to enter into a
currency swap agreement to take advantage.
Step 1: Calculation of Total Comparative Advantage (TCA):
 ‹Intel borrows funds in the USA at a rate that is 2% lower than what
is offered to Infosys.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes  ‹Infosys borrows funds in India at a rate that is 0.4% higher than
what is offered to Intel.
 ‹TCA = 2% - 0.4% = 1.6%.
Step 2: The decision to share TCA (Total Comparative advantage) will
depend on demand and supply. In this case, the sharing will be equal,
i.e., 0.8% each.
Step 3: Intel will transfer funds to Infosys in the USA at a rate of 4.8%.

h i
Step 4: Infosys will transfer funds to Intel in India at a rate of 7.6%.
Please note:
e l
D
1. The funds exchanged by the companies should be in the same

of
common currency.

ty
2. The funds exchanged should be for the same duration.

s i
In this way, they hedge against counterparty risk and currency risk.
For Intel:
e r
i v
Intel will pay 4% p.a. to the bank in the USA, 7.6% p.a. to Infosys in

U n
India, and receive 4.8% p.a. from Infosys in the USA. After adjusting
the cash inflow and outflow, Intel’s effective rate will be 6.8% in India,

L ,
which is 0.8% less than the rate offered by the bank (Bank rate – 7.6%)

O
in India.
For Infosys:
/ S
O L
Infosys will pay 8% p.a. to the bank in India, 4.8% p.a. to Intel in the

C
USA, and receive 7.6% p.a. from Intel in India. After adjusting the cash

E /
inflow and outflow, Infosys’ effective rate will be 5.2% in the USA,

C
which is 0.8% less than the rate offered by the bank (Bank rate – 6%)

D in the USA.

©D 9.8.1 Equity Swap

An equity swap is a financial derivative product in which two parties
agree to exchange the cash flows derived from equity assets, and the
interest rate (can be either fixed or flexible, such as MIBOR (Mumbai
Inter-Bank Offer Rate)). This type of swap allows the holders to gain
exposure to the performance of a stock or equity index without actually
owning the underlying assets.

238 PAGE
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 SWAPS TRANSACTIONS

In an equity swap, one party receives cash flows that are equal to the Notes
performance of the equity, which can include dividends, capital appreciation,
and other cash flows associated with the underlying equity. In return, that
party pays a fixed or floating interest rate to the other party.
It’s important to note that the specific terms of an equity swap can vary
depending on the contract and the parties involved. The equity swap may
involve factors such as the notional amount, duration, reference equity or

i
index, payment frequency, and any additional provisions. These contracts
are typically customized just like forward contracts to meet the specific
l h
e
needs and objectives of the parties involved.
Illustration 4
D
Suppose that a financial institution has agreed to receive cash flows
of
ty
driven from equity and pay based on the MIBOR Quarterly settlement.
The terms of this equity swap are as follows:

s i
Equity Index = Nifty 50
e r
v
Floating Rate = 3-month MIBOR
Notional Principal = 1 Cr.
n i
Term of Swap
Swap agreement date
=
=
3 Year
Jan 1, 2020
, U
Settlement period = Quarterly
O L
/ S
Table 9.4: Summary of Cash flow in an equity swap
Date Equity
receiver
O L
Equity
receiver (3)
Interest rate
receiver
Interest rate Net cash
receiver (4) flow (3-4)
(In %)
/ C (In lakhs) (in %) (In Lakhs) (In Lakhs)

CE
Jan. 1, 2020 4.10
April 1, 2020 6.00% 6.00 4.70 1.025 4.975

D
July 1, 2020 -3.00% -3.00 5.20 1.175 -4.175

D
Oct. 1, 2020 5.00% 5.00 5.40 1.300 3.700

©
Jan. 1, 2021
April 1, 2021
July 1, 2021
3.00%
2.75%
9.00%
3.00
2.75
9.00
5.50
5.80
4.10
1.350
1.375
1.450
1.650
1.375
7.550
Oct. 1, 2021 1.00% 1.00 4.70 1.025 -0.025
Jan. 1, 2022 4.50% 4.50 5.20 1.175 3.325
April 1, 2022 -3.25% -3.25 5.40 1.300 -4.550
July 1, 2022 4.00% 4.00 5.50 1.350 2.65
Oct. 1, 2022 6.00% 6.00 5.80 1.375 4.625
Jan. 1, 2024 8.00% 8.00 1.450 6.550

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes At the beginning of the first payment on April 1, 2020, the 3-month
MIBOR is 4.1% (dated January 1, 2020). During the first three-month
period, the Nifty 50 generated a return of 6% in terms of total return,
including dividends, capital appreciation, and other cash flows associated
with the underlying equity.
The equity leg cash flow is calculated as follows:
1 crore × 6% = 6 lakhs
The interest leg cash flow is calculated as follows:

h i
e
1 crore × 4.1% × 0.25 (quarter adjustment) = 1.025 lakhs
l
D
In total, the “equity receiver” will receive 4.975 lakhs on April 1, 2020.

of
The second payment exchange takes place on July 1, 2020, which is six
months after the initiation of the agreement.

i ty
The equity leg cash flow is calculated as follows:
1 crore × -3% = -3 lakhs
r s
v e
The interest leg cash flow is calculated as follows:

n i
1 crore × 4.7% × 0.25 (quarter adjustment) = 1.175 lakhs

U
In total, the “equity receiver” will pay 4.175 lakhs on July 1, 2020.
,
O L
This payment exchange pattern continues for a total of 12 exchanges
throughout the swap agreement.

/ S
L
9.9 Pricing and Valuation of Interest Rate Swaps
O
/ C
Valuation of an interest rate swap involves determining the present value

C Eof future cash flows associated with the swap. Initially, an interest rate

D
swap is generally close to zero in value when it is first initiated. However,

©D
as the swap continues and time progresses, its value may fluctuate and
become positive or negative.
As we know, in interest rate swaps principal payments are not exchanged.
However, for the purpose of valuation, we can assume principal payments
are both received and paid at the end without changing their value. By
doing this, the value of the interest rate swap from the point of view of
the floating rate payer is:
Swap value = Present value of floating rate cash flow - Present value
of Fix-rate cash flow

240 PAGE
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 SWAPS TRANSACTIONS

The value of the interest rate swap from the point of view of the Fix Notes
ratepayer is:
Swap value = Present value of Fix-rate cash flow - Present value of
floating rate cash flow
Illustration 5
A financial institution has entered into an interest rate swap, where
it agrees to pay the 6-month MIBOR rate and receive 6% per annum
(compounded semi-annually) on a notional principal amount of INR 100
h i
crores. The remaining term of the swap is 1.75 years. The 3-month, 9-month,
e l
D
15-month, and 21-month MIBOR rates, all compounded continuously,

of
are 9%, 9.5%, 10%, and 10.5%, respectively. The 6-month MIBOR rate
at the most recent payment date was 9.5% (compounded semi-annually).

ty
Table 9.5: The Valuation of interest rate swaps
Year Fix Cash Floating Cash Discount
s i
PV Fix Cash PV floating
Flow (In cr.) flow (In cr.) Factor Flow

e r Cash Flow

v
0.25 3 104.75 0.977751237 2.933253712 102.4194421
0.75 3 0.931229056

n i
2.793687167

U
1.25 3 0.882496903 2.647490708

,
1.75 103 0.832143814 85.71081282

O L 94.08524441 102.4194421

S
The fixed-rate cash flows of 3, 3, 3, and 103 are on the four payment

/
dates. The discount factor for these cash flows is, respectively, e-0.09×0.25,
L
O
e-0.0095×0.75, e-0.1×1.25, and e-0.105×1.75 are shown 4th column of the above table.

C
The present value (PV) of fix rate cash flow is 94.08524441.

E /
The floating rate cash flow can be valued as though it produces a cash

D C
flow of 104.75 in three months. The present value (PV) of floating rate
cash flow is 102.4194421.

©D
Value of the swap = 94.08524441 – 102.4194421 = - 8.33419769
If the financial institution had been in the reverse position of paying
a fixed interest rate and receiving a floating interest rate, the value of
the swap would be a positive 8.33419769 crore. Please note that these
calculations do not consider day count conventions and holiday calendars.
Please note that: Valuation of the swap can be calculated through the
FRAs method.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 9.10 Pricing and Valuation of Currency Swaps

Valuation of a currency swap involves determining the present value
of future cash flows associated with the swap. Initially, the value of a
currency swap is generally close to zero. However, as the swap continues
and time progresses, we will observe fluctuation in currency value, and
hence swap value may fluctuate and become positive or negative. The
value of the currency swap is:
Swap value = Present value of foreign currency cash flow - Present value
h i
of domestic currency cash flow × Spot Fx rate.
e l
Illustration 6
D
of
Suppose a financial institution from India has entered into a currency

ty
swap with a USA-based financial institution. The Indian interest rate is

i
9% per annum, compounded continuously, while the US interest rate is

s
r
4% per annum, also compounded continuously. The financial institution

e
entered into the currency swap some time ago, whereby it receives a fixed
v
i
rate of 5% per annum in dollars and pays a fixed rate of 8% per annum
n
U
in INR, with payments made annually. The principal amounts involved

,
in the swap are 80 crore and 10 million dollars. The remaining duration

O L
of the swap is 3 years, and the current exchange rate is 75 INR per $1.
Table 9.6: Valuation of currency swaps

/ S
L
Year Cash Flow in PV of $ Cash Flow in INR PV of INR

O
$ (In millions) (In millions) (In millions) (In millions)

C
1 0.5 0.48039472 6.4 5.84916

E
2
/ 0.5 0.461558173 6.4 5.345729

C
3 0.5 0.443460218 6.4 4.885629

D
3 10 8.869204367 80 61.07036

©D
10.25461748 77.15088
Present value of foreign currency cash flow = $10.25461748 (in million)

Present value of domestic currency cash flow 77.15088 ×10 =

75
$10.28678363 (in million)
Swap value = $10.25461748 - $10.28678363 = -0.03217
Please note that: Valuation of the currency swap can be calculated through
the FRAs method.

242 PAGE
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 SWAPS TRANSACTIONS

9.11 Credit Default Swaps Notes

The Credit Default Swap (CDS) is a financial derivative contract that

values credit risk or it functions as a form of insurance that protects
against credit risk2. The CDS contract is used to transfer the credit risk
of an entity (such as corporate or sovereign) from the CDS buyer to the
CDS seller. In the case of a credit event, seller will pay the difference
of face value and current value of the notional amount. It is a privately
negotiated bilateral contract that involves four main components:
h i
1. The Reference Obligation,
e l
2. The Notional amount
D
of
3. The Premium (referred to as “Spread”).

ty
4. The contract also specifies a predetermined Maturity date.
In a CDS, the buyer of protection agrees to make periodic payments to
s i
the seller of protection. If a “credit event” occurs and the contract is
e r
v
terminated, the seller of protection generally compensates the buyer. The

n i
credit event refers to a predefined trigger, such as Bankruptcy, restructuring,

U
etc, or other specified financial distress related to the Reference Obligation.

,
L
Overall, a credit default swap acts as a financial instrument that allows

O
parties to transfer and mitigate credit risk through an agreement where

/ S
one party provides protection against potential credit events in exchange

L
for regular payments from the other party.

O
Example: In the case of a 10,000,000 USD credit default swap (CDS),

C
E /
if the reference entity files for bankruptcy protection, the buyer of
protection would inform the seller. Subsequently, a dealer poll would be

C
conducted to assess the value of the reference obligation. For example,
D
©D
if the estimated value is determined to be 20% of the initial value (par),
the seller of protection would compensate the buyer with 8,000,000 USD.
Illustration 7
Let’s consider a scenario where a protection buyer acquires 3-year
protection on a company with a default swap spread of 200 basis

2. Credit risk pertains to the likelihood of experiencing a financial loss due to the borrower’s
inability to repay a loan. In essence, it encompasses the risk associated with the possibility
that a lender may not receive the expected principal and interest payments. This can lead
to a disruption in cash flows and necessitate additional expenses for the collection process.

PAGE 243
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes points (bp). The protection has a face value of INR 10 crore, resulting
in quarterly payments/annual payments of approx. INR 50,000/2,00,000.
Suppose that after a short period, the reference entity (Company) experiences
a credit event, and the CTD (Cheapest to Deliver) asset associated with
the reference entity has a recovery price of 45% of face value. The
payment breakdown is as follows:

i
CDS Buyer CDS Seller

l h
Quarterly payments/annual payments = 50,000/2,00,000.

e
During

Default swap spread

D
of
ity
CDS Seller

s
CDS Buyer

r
Credit Event

e
100-Recovery Price of CTD3 Asset

i v
U n
L , Figure 9.3: Visually represents the structure of the CDS
 ‹CDS

S O Seller compensates to CDS buyer = 5.5 crore (10 × (100%-

L / 45%))

O
 ‹CDS buyer pays the accrued premium payment up to the credit event

C
date.

E /
D C 9.12 Valuation of Credit Default Swaps

©D
The valuation of Credit Default Swaps (CDS) involves estimating the
fair value of these financial instruments. There are several approaches
to CDS valuation, including:
Market-based approach: This approach relies on market prices or quotes
for similar CDS contracts to determine the fair value. Market participants
use these prices as a benchmark for valuing CDS contracts.
3. CTD; cheapest to delivery, in a Physical Delivery CDS, the protection buyer can choose the
cheapest asset for delivery and receive the face value in cash. In a Cash Settled CDS, the
economic value remains the same at a credit event, but settlement is made in cash.

244 PAGE
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 SWAPS TRANSACTIONS

Credit risk model approach: This approach involves using credit risk Notes
models, such as structural models or reduced-form models, to estimate
the probability of default and expected recovery rate. These models take
into account factors such as the creditworthiness of the reference entity,
market conditions, and the term structure of interest rates.
Pricing based on credit spreads: Credit spreads represent the difference
between the yield on a risky asset (e.g., a corporate bond) and a risk-free

i
asset (e.g., a government bond). By analyzing market credit spreads and
adjusting for factors such as credit risk, time to maturity, and liquidity,
l h
e
CDS valuations can be derived.
Monte Carlo simulation: This method involves simulating various
D
of
scenarios of credit events and their associated cash flows over time. By
aggregating these simulated cash flows and discounting them back to
present value, the fair value of the CDS can be estimated.
i ty
r s
It’s important to note that CDS valuation can be complex and may involve

e
considering various market factors, credit risk models, and assumptions.
v
i
Valuation methodologies may vary depending on market conditions, market
n
U
liquidity, and the specific terms of the CDS contract.

L ,
(For a detailed understanding of the Valuation of CDS please refer to
“OPTIONS, FUTURES, AND OTHER DERIVATIVES” by author; John
C. Hull)
S O
IN-TEXT QUESTIONS
L /
O
1. Which of the following best describes an interest rate swap?

C
/
(a) An exchange of principal amounts between two parties
E
C
(b) A derivative contract where parties exchange interest

D payments

©D
(c) A contract where parties exchange foreign currencies
(d) A contract to exchange commodities at a future date
2. Currency swaps involve the exchange of:
(a) Interest payments between parties in the same currency
(b) Principal amounts at different exchange rates
(c) Equity shares of two companies
(d) Commodities at a fixed price

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 3. What is the primary focus of a commodity swap?

(a) Exchange of interest rate payments
(b) Exchange of principal amounts
(c) Exchange of commodities’ price returns
(d) Exchange of foreign currencies
4. Equity swaps involve the exchange of:
(a) Fixed interest payments for floating interest payments
h i
e
(b) Equity returns of different companies or indices
l
D
(c) Principal amounts at different exchange rates

of
(d) Commodity price returns

ty
5. The valuation of a swap at its inception is usually:

s i
(a) The sum of present value of future cash flows

e r
(b) The difference between parties’ principal amounts

i v
(c) A fixed percentage of the notional amount

U n
(d) The spot price of the underlying asset

against?
L ,
6. What does a Credit Default Swap (CDS) provide protection

S O
/
(a) Interest rate changes

L
(b) Currency fluctuations

CO
(c) Default on a specific credit instrument

E/
(d) Changes in commodity prices

DC
7. How is the premium for a credit default swap typically expressed?

©D
(a) As a percentage of the notional amount
(b) As a fixed interest rate
(c) As the present value of future default payments
(d) As a function of equity returns
8. What is the key difference between an interest rate swap and
a currency swap?
(a) Interest rate swaps involve exchange of principal amounts;
currency swaps involve interest payments

246 PAGE
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School of Open Learning, University of Delhi
 SWAPS TRANSACTIONS

(b) Interest rate swaps involve interest payments; currency Notes

swaps involve exchange of principal amounts
(c) Interest rate swaps involve exchange of commodities;
currency swaps involve equity returns
(d) Interest rate swaps involve currency exchange; currency
swaps involve commodity exchange
9. Which factor affects the valuation of an interest rate swap?

h i
l
(a) Commodity price fluctuations
(b) Equity index performance
D e
of
(c) Credit risk of counterparties
(d) Foreign exchange rate changes
10. Counterparty risk in swaps refers to:
i ty
r s
(a) The risk of changes in the underlying asset’s value

v e
(b) The risk of default by one of the swap parties

n i
(c) The risk of interest rate fluctuations

U
(d) The risk of foreign exchange rate changes
,
9.13 Summary
O L
/ S
O L
Interest rate swaps and currency swaps are two common types of financial
instruments used in markets. An interest rate swap involves one party

/ C
paying a fixed interest rate on a notional principal for a specific period

C E
while receiving interest at a floating rate on the same principal. In a
currency swap, one party pays interest on a principal amount in one

D
currency and receives interest on a principal amount in another currency.

©D
Principal amounts are typically not exchanged in an interest rate swap,
whereas in a currency swap, principal amounts are exchanged at the
beginning and end of the swap.
Interest rate swaps can be used to convert between floating-rate and fixed-
rate loans or investments. Currency swaps allow for loans or investments
to be denominated in different currencies. Valuation of swaps can be done
by decomposing the swap into bond positions or by considering it as a
portfolio of forward contracts.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes However, financial institutions entering into offsetting swaps with different
counterparties face credit risk. If one counterparty defaults while the
institution has a positive value in its swap with that counterparty, the
institution incurs losses as it still has to honor its agreement with the
other counterparty. Therefore, managing credit risk is crucial, including
evaluating counterparties’ creditworthiness and implementing risk mitigation
strategies.

9.14 Answers to In-Text Questions

h i
e l
D
1. (b) A derivative contract where parties exchange interest payments

of
2. (b) Principal amounts at different exchange rates
3. (c) Exchange of commodities’ price returns

i ty
4. (b) Equity returns of different companies or indices

r s
5. (a) The sum of present value of future cash flows

v e
6. (c) Default on a specific credit instrument

n i
7. (a) As a percentage of the notional amount

U
8. (b) Interest rate swaps involve interest payments; currency swaps

,
L
involve exchange of principal amounts

O
9. (c) Credit risk of counterparties

/ S
10. (b) The risk of default by one of the swap parties

O L
C
9.15 References
/
CE
 ‹Hull, J. C. (2018). Options, Futures, and Other Derivatives. Pearson.

D
 ‹Kolb, R. W. (2014). Understanding derivatives: Markets and infrastructure.

© D John Wiley & Sons.

 ‹Fabozzi, F. J., & Mann, S. V. (Eds.). (2011). The Handbook of Fixed
Income Securities. McGraw-Hill.
 ‹Sadr, A., & Abounoori, E. (2014). Pricing and Valuation of Credit
Default Swaps. International Journal of Economics, Commerce and
Management, 2(8), 1-12.

248 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 SWAPS TRANSACTIONS

 ‹Assefa, M., & Mohd-Zamil, N. (2019). Pricing and valuation of Notes

interest rate swaps: Evidence from Ethiopian banking sector. Journal
of African Business, 20(1), 97-119.

9.16 Suggested Readings

 ‹“Swaps and Other Derivatives” by Richard R. Flavell
„ This comprehensive book provides an in-depth understanding of
various types of swaps, including interest rate swaps, currency
h i
swaps, commodity swaps, and equity swaps. It covers the
e l
D
mechanics, pricing, and valuation of these swaps, along with

of
real-world examples and case studies.
 ‹“The Handbook of Fixed Income Securities” by Frank J. Fabozzi
„

i
This widely regarded handbook covers a range of fixed-
ty
r s
income securities, including interest-rate swaps. It delves into

e
the mechanics and strategies behind swap transactions and

i v
provides insights into pricing and valuation methodologies.

n
The book is highly regarded in the finance industry.

U
,
 ‹“Mastering the ISDA Master Agreements: A Practical Guide for

O L
Negotiation” by Paul Harding and Christian Johnson
While this book focuses on the International Swaps and
S
„

L /
Derivatives Association (ISDA) Master Agreements, it offers
valuable insights into the legal aspects of swaps transactions.

C O
It covers interest rate swaps, currency swaps, and other

E /
derivatives, helping readers understand the documentation and

C
legal frameworks involved.
 ‹“Credit
D
Default Swaps: Trading, Investing, and Risk Management”

©D
by Geoff Chaplin
„ This book specifically focuses on credit default swaps (CDS)
and provides a comprehensive overview of CDS trading,
investing, and risk management. It covers the mechanics
of CDS transactions, valuation methodologies, and market
practices, making it a valuable resource for understanding
and analyzing credit risk.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes  ‹“Swaps and Financial Derivatives: Theory, Practice, and Pricing” by

Satyajit Das
„ This book offers a broad overview of swaps and other financial
derivatives. It covers interest rate swaps, currency swaps,
commodity swaps, and equity swaps, providing insights into
their mechanics, pricing models, and valuation techniques. It
also explores the applications of swaps in managing risk and

i
creating investment strategies.

l h
D e
of
i ty
r s
v e
n i
, U
O L
/ S
O L
/ C
C E
D
©D

250 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
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L E S S O N

10
Value at Risk
Shalini Girdhar
Assistant Professor
IITM, GGSIPU
Email-Id: [email protected]

i
Aditi Methi

l h
Assistant Professor

D e
IITM, GGSIPU
Email-Id: [email protected]

STRUCTURE of
i ty
s
10.1 Learning Objectives
10.2 Introduction
e r
10.3 Normal Linear VaR
i v
10.4 Historical Simulation
U n
10.5
L ,
Value at Risk for Option Portfolios

O
10.6 Quadratic Model
10.7 Monte Carlo Simulation
/ S
10.8
O L
Stress Testing and Back Testing

C
10.9 Summary
10.10
E /
Answers to In-Text Questions
10.11
D C
Self-Assessment Questions

©D
10.12 References
10.13 Suggested Readings

10.1 Learning Objectives

‹ Understand the concept of VaR and its importance in risk management.
‹ Differentiate between different methods of calculating VaR, such as Normal linear
VaR, Historical simulation, and Monte Carlo simulation.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes ‹ Comprehend the specific considerations and challenges involved in

calculating VaR for option portfolios.
‹ Explore the application of the Quadratic model in assessing portfolio
risk and potential losses.
‹ Understand the principles and techniques of stress testing in evaluating
portfolio resilience and identifying vulnerabilities.

10.2 Introduction
h i
e
Value at Risk (VaR), can be understood as “new technique of risk l
D
management,” is a metric that is used to forecast the biggest potential

of
losses over a given period of time. It is a tool frequently used in investment
research by commercial banks and financial institutions to gauge the size

i ty
and likelihood of future losses in portfolios. VaR is a tool used by risk

r s
managers to gauge and manage the degree of risk exposure. Value at risk

e
(VaR) is an effort to give senior management a single number that sums

i v
up all of the risk in a portfolio of financial assets. Financial institutions

U n
as well as corporate treasurers and investment managers now frequently
employ it. VaR is also used by central bank regulators to calculate the

L ,
amount of capital a bank must maintain to reflect the market risks it is

O
taking. The Chapter define the VaR measure and outline the two primary

/ S
methods for computing it in this chapter. These are the model-building

O L
methodology and the historical simulation approach. Both financial and
non-financial businesses frequently use both. Which of the two is superior

/ C
is a matter of debate.

D CE Market
Risk

© D Volatility
Confidence
Level

VaR

252 PAGE
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School of Open Learning, University of Delhi
 VALUE AT RISK

The manager of a portfolio of financial instruments is interested in Notes

making a statement of the following kind when utilising the value-at-risk
measure: “We are X percent certain that we will not lose more than V
dollars in the next N days.”
The portfolio’s VaR is represented by the variable V. It depends on two
variables: X, the confidence level, and N, the time horizon. The manager
is X% positive that the loss level over N days will not be exceeded.

i
Regulators use N = 10 and X = 99 to determine a bank’s market risk
capital. They concentrate on the loss level over a 10-day period that is
l h
anticipated to be exceeded only 1% of the time, which the bank require
to maintain capital that is at least three times this VaR figure.
D e
of
i ty
r s
v e
n i
, U
Figure

O L
S
VaR is typically defined as the loss corresponding to the (100 — X) th

L /
percentile of the distribution of the change in the value of the portfolio

O
over the next N days when N days is the time horizon and X% is the

/ C
confidence level. When N = 5 and X = 97, for instance, it represents

E
the third percentile of the distribution of changes in the portfolio’s value

D C
during the following five days. VaR is shown in Figure for a scenario
where the change in portfolio value is roughly normally distributed.

©D
VaR is a desirable metric since it is simple to comprehend. What it
essentially asks is, “How bad can things get?” All senior managers desire
an answer to this query.

10.3 Normal Linear VaR

Normal Linear VaR, also known as parametric VaR, is a method for
calculating Value at Risk (VaR) using a normal distribution assumption.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes VaR is a risk measurement tool that estimates the maximum potential
loss of an investment or portfolio over a specific time period at a given
confidence level.
To calculate Normal Linear VaR, the following steps are typically followed:
1. Define the Time Horizon: Determine the time period for which you
want to estimate VaR (e.g., one day, one week, one month).
2. Determine the Confidence Level: Choose the desired confidence
level for VaR. Common choices include 95% and 99%.
h i
e
3. Estimate the Mean and Standard Deviation: Calculate the mean
l
D
(expected return) and standard deviation (volatility) of the investment

of
or portfolio returns over the defined time horizon. These estimates
can be based on historical data or other appropriate methods.

ty
4. Calculate the Z-Score: The z-score represents the number of standard

s i
deviations away from the mean that corresponds to the chosen

e r
confidence level. For example, for a 95% confidence level, the

i v
z-score is approximately 1.645, and for a 99% confidence level,

U n
the z-score is approximately 2.33.
5. Calculate the VaR: Multiply the z-score by the standard deviation to

L ,
obtain the VaR. The formula is: VaR = z-score × standard deviation.

O
6. The resulting VaR value represents an estimate of the potential loss

S
L /
in the investment or portfolio over the specified time horizon at
the chosen confidence level. For example, if the calculated VaR is

O
$10,000 with a 95% confidence level, it means that there is a 5%
C
/ chance of losing more than $10,000 over the defined time period.

CE
7. It’s important to note that Normal Linear VaR assumes a normal

D
distribution of returns, which may not always hold true in real-world

© D scenarios where asset returns can exhibit non-normal characteristics

such as fat tails or skewness.
The purpose of this part is to provide a basic explanation of the three
main VaR models by using them to calculate the VaR of a relatively
straightforward portfolio with a stake of $1,000 per point on the S&P
500 index. We utilise the case study to demonstrate how the three models
construct the portfolio return distribution in different ways and to provide
the reader with some understanding of why various VaR models produce
various results.

254 PAGE
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 VALUE AT RISK

10.4 Historical Simulation Notes

One common technique for calculating VaR is historical simulation. It

entails making direct use of historical data to predict potential future
events. Let’s say we want to determine the VaR for a portfolio utilising
a 500-day data window, a 99% confidence level, and a one-day time
horizon. Finding the market factors affecting the portfolio is the first
stage. These will often include things like interest rates, equity prices,
and currency rates. Then, we gather information on the changes in these
h i
market factors over the previous 500 days. This gives us 500 potential
e l
D
outcomes for what might occur between now and tomorrow. The percentage

of
changes in the Scenario 1’s
Table 10.1: Data for VaR historical simulation calculation

i ty
DAY Market Market . . . Market

s
Variable 1 variable 2 Variable N
0 20.33 0.1132 . . .

e r 65.37

v
1 20.78 0.1159 . . . 64.91
2 21.44 0.1162

n i
. . . 65.02

U
3 29.97 0.1184 . . . 64.9

,
.......... .......... .......... .......... ..........
498
499
25.72
25.75
O L
0.1312
0.1323
. . .
. . .
62.22
61.99
500 25.85
/ S 0.1343 . . . 62.10

L
Table 10.2: Scenarios generated for tomorrow (Day 501) using data in Table

/ CO
Scenario Market Market . . . Market Portfolio

E
Number Variable 1 Variable 2 Variable N Value

C
($ millions)

D
1 26.42 0.1375 . . . 61.66 23.71

D
2 26.67 0.1346 . . . 62.21 23.12

©
3 25.28 0.1368 . . . 61.99 22.94
.......... .......... .......... .......... .......... ..........
499 25.88 0.1354 . . . 61.87 23.63
500 25.95 0.1363 . . . 62.21 22.87
In scenario 1, all variables have the same values as they did on the first
day we collected data; in scenario 2, they have the same values as they
did on the second day; and so on. We determine the dollar difference
between the portfolio’s current value and its value tomorrow for each

PAGE 255
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes scenario. This establishes a probability distribution for changes in our

portfolio’s value on a daily basis.
The first percentile of the distribution represents the fifth-worst daily
change. The loss when we reach this first percentile point is the estimation
of VaR.
We are 99% positive that we won’t suffer a loss higher than our VaR
estimate if the last 500 days serve as a reliable indicator of what might

i
occur tomorrow.
In Tables 10.1 and 10.2, the historical simulation methodology is
l h
D e
demonstrated. The observations on market variables during the previous

of
500 days are shown in Table 10.1. The observations are made at a specific
time of the day, typically near the end of trade. The first day for which

ty
we have data is designated as Day 0; the second, Day 1; and so forth.
Day 500 is today, and Day 501 is tomorrow.

s i
r
If the percentage changes between today and tomorrow are the same
e
v
as they were between Day i—1 and Day i for, Table 1 < i’^500. Table

n i
10.2 displays the values of the market variables tomorrow. Table 10.2’s

U
first row displays the market variables’ values for tomorrow under the

L ,
assumption that their percentage changes from today to tomorrow will be
the same as those between Day 0 and Day 1; If their percentage changes

S O
between Day 1 and Day 2 occur, the second row displays the values of

/
market variables tomorrow; and so on. Table 10.2 contains 500 rows
L
O
representing the 500 situations taken into account.

/ C
Assume that today is Day m and define i;, as the value of a market

E
variable on Day i. According to the ith scenario, the market variable’s

D C value tomorrow will be

vi

©D
= Vm
v i −1
M equals 500 in our example. The current value of the first variable,
v500, is 25.85. Additionally, v0 = 20.33 and Vi = 20.78. Therefore, the
first scenario’s initial market variable’s value I
20.78
25.85 × 20.33 = 26.42
The value of the portfolio tomorrow for each of the 500 possibilities is
displayed in the last column of Table 10.2. The portfolio’s current value

256 PAGE
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School of Open Learning, University of Delhi
 VALUE AT RISK

is known. Let’s say it is $23.50 million. For all the various portfolios, Notes
we can determine the change in value between today and tomorrow
scenarios. It is +$210,000 for Scenario 1, +$380,000 for Scenario 2, and
so on. The rankings of these value changes follow. The one-day 99%
VaR represents the fifth-worst loss.
The N-day VaR for a 99% confidence level is computed as -J times the
one-day VaR, as was indicated in the previous section. The most recent

i
500 days of data would be used to update the VaR estimate in our case
every day. Think about what happens on Day 501, for instance. Think
l h
about what happens on Day 501, for instance. We are able to calculate
a new value for our portfolio by discovering new values for each market
D e
of
variable.4 The process we have discussed is then used to determine a
new VaR. We make use of market-related data from Day 1 to Day 501.

ty
(The Day 0 values of the market variables are no longer used, giving us

s i
the necessary 500 observations on the percentage changes in the market

e r
variables). In a similar manner, we calculate VaR on Day 502 using data
from Day 2 through Day 502, and so on.
i v
U n
10.5 Value at Risk for Option Portfolios

L ,
O
Calculating Value at Risk (VaR) for option portfolios requires a more

S
complex approach compared to the quadratic model used for individual

L /
assets. Option portfolios involve multiple positions with interdependencies,

O
nonlinear payoffs, and potential correlation effects. One commonly used

/ C
method for estimating VaR in option portfolios is the Delta-Gamma

E
approximation.

D C
The Delta-Gamma approximation considers the first and second-order
derivatives of the portfolio’s value with respect to the underlying asset

©D
price. The formula for estimating VaR using this approach is as follows:
9D5   'HOWD î 6    î *DPPD î 6A  î ] î ı
Here:
VaR represents the Value at Risk.
Delta is the portfolio’s overall Delta, which measures the sensitivity of
the portfolio’s value to changes in the underlying asset price.

PAGE 257
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Gamma is the portfolio’s overall Gamma, which measures the rate of
change of Delta with respect to changes in the underlying asset price.
S is the current price of the underlying asset.
z is the z-score corresponding to the desired confidence level.
ı LV WKH HVWLPDWHG VWDQGDUG GHYLDWLRQ RI WKH DVVHW¶V UHWXUQV
It’s important to note that estimating Delta and Gamma for complex
option portfolios requires advanced techniques such as numerical methods
or simulations. Additionally, the approach assumes that the underlying
h i
e
asset price follows a normal distribution, which may not always hold
l
D
true in practice.

of
Here’s a simplified numerical example to demonstrate the concept:
Assume you have an option portfolio with a Delta of 0.75, a Gamma of

i ty
0.05, the current price of the underlying asset (S) is $100, and you want

r s
to calculate VaR at a 95% confidence level (z = 1.645) with an estimated
VWDQGDUG GHYLDWLRQ ı  RI 

v e
i
Substituting the values into the formula:
n
U
VaR = -(0.75 × 100) - (0.5 × 0.05 × 100^2) × 1.645 × 0.02

L
= -75 - 825 × 1.645 × 0.02
,
O
= -75 - 27.01725
= -102.01725
/ S
O L
So, the VaR for the option portfolio at a 95% confidence level would be

C
approximately -$102.02.

E /
Keep in mind that this is a simplified example, and in practice, estimating

D C VaR for option portfolios requires a more sophisticated approach,

considering various factors such as implied volatilities, correlations, and

©D
potential non-linearities of option payoffs.
Here are some important aspects to consider when calculating VaR for
option portfolios:
1. Portfolio Composition: Analyze the composition of the option
portfolio in terms of underlying assets, option types (e.g., calls
or puts), maturities, and strike prices. Different options may have
different risk profiles and sensitivities to market movements.

258 PAGE
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 VALUE AT RISK

2. Sensitivities: In addition to Delta and Gamma, consider other option Notes

sensitivities such as Vega (sensitivity to changes in implied volatility),
Theta (time decay), and Rho (sensitivity to interest rate changes).
These sensitivities provide insights into how the portfolio’s value
may change under various market conditions.
3. Correlation: Account for correlation among the underlying assets
and option positions within the portfolio. Correlation measures

i
the degree to which the values of different assets move together.
Incorporating correlation helps capture the joint risk exposure of
l h
e
the portfolio accurately.
4. Historical Data or Simulations: VaR calculations for option portfolios
D
of
often involve using historical data or simulation techniques. Historical
data allows you to assess how the portfolio would have performed
under past market conditions. Simulations, such as Monte Carlo
i ty
r s
simulations, generate a range of possible market scenarios and

e
estimate the portfolio’s performance based on those scenarios.

v
i
5. Risk Factors and Distributions: Determine the key risk factors
n
U
impacting the option portfolio, such as underlying asset prices

,
and implied volatilities. Understand the distributional assumptions

O L
underlying the risk factors, as it affects the VaR estimation. Common
assumptions include normal distribution, log-normal distribution, or

/ S
empirical distributions derived from historical data.

O L
6. Confidence Level: Choose an appropriate confidence level that

C
aligns with your risk tolerance and regulatory requirements. The

E /
confidence level determines the probability of VaR being breached

C
within a given time horizon. Higher confidence levels (e.g., 99%)

D
correspond to a more conservative estimate but may lead to higher

©D
capital requirements.
7. Backtesting: Validate the accuracy of the VaR model by comparing
the estimated VaR with actual portfolio losses over a specified period.
Backtesting helps assess the model’s performance and identify any
shortcomings or areas for improvement.
It’s important to note that VaR is just one measure of risk, and it has its
limitations. It provides an estimate of potential losses under normal market
conditions but may not capture extreme events or tail risk adequately.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Therefore, it’s advisable to complement VaR analysis with stress testing
and scenario analysis to evaluate the portfolio’s resilience under adverse
market conditions.
Overall, estimating VaR for option portfolios is a complex task that requires
advanced mathematical models, accurate data, and careful consideration
of the various factors influencing the portfolio’s risk profile.

i
10.6 Quadratic Model

l h
e
The linear model is an approximation when a portfolio contains options.

D
The gamma of the portfolio is not taken into consideration. As we know

of
gamma is the rate of change of the delta with regard to the market variable,
and delta is the rate of change of the portfolio value with respect to the

ty
market variable. Gamma quantifies the curve in the relationship between

s i
a market variable’s underlying value and the portfolio value.

e r
The effect of a nonzero gamma on the probability distribution of the

i v
portfolio’s value is depicted in Figure 10.1. The probability distribution

U n
tends to be positively skewed when gamma is positive and negatively
skewed when gamma is negative. Figures 10.2 and 10.3 show how this

L ,
result came about. The relationship between the price of the underlying

O
asset and the value of a long call option is depicted in Figure 10.2. An

/ S
example of an option position with positive gamma is a long call. The

O L
graph demonstrates that the probability distribution for the option price
is positively skewed when the probability distribution for the price of

/ C
the underlying asset at the end of a day is normal. The link between

C Ethe value of a short call position and the cost of the underlying asset is
depicted in Figure 10.3. The gamma of a short call position is negative.

D We can see that in this instance, a normal distribution for the underlying

©D
asset’s price at the end of a day is translated into a negatively skewed
distribution for the value of the option position.
The left tail of the probability distribution of the portfolio value has a
significant impact on the VaR for a portfolio. The VaR is determined,
for instance, from the value in the left tail below which only 1% of
the distribution exists when the confidence level is 99%. A positive-
gamma portfolio typically has a less pronounced left tail than the normal
distribution, as shown in Figures 10.1a and 10.1b. When assuming that

260 PAGE
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 VALUE AT RISK

the distribution is normal, we are more likely to arrive at an excessively Notes

high VaR. Similar to the normal distribution, a negative-gamma portfolio
has a tendency to have a heavier left tail, as shown in Figures 10.1b and
10.3. If the distribution is assumed to be normal, we will probably arrive
at a VaR that is too low.
We may relate SP to the Sxt’s using both the delta and gamma measurements
to obtain an estimate of VaR that is more precise than the one provided

i
by the linear model. Take into account a portfolio that is reliant on a
single asset with a price of S. Assume that a portfolio’s gamma is T and
l h
e
its gamma is A.
1
δ P = Δδ S + Γ (δ S )
2

D
of
2

i ty
r s
v e
n i
, U
O L
Figure 10.1: Probability distribution for value of portfolio:

S
(a) positive gamma, (b) negative gamma

L /
C O
E /
D C
©D

Figure 10.2: Translation of normal probability distribution for asset into

probability distribution for value of a long call on asset

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes

h i
e l
Figure 10.3: Translation of normal probability distribution for asset into

D
probability distribution for value of a short call on asset

of
is an improvement over the approximation in equation (10.3).

ty
δS
δx =
S
i
( s)
1

e r
Setting reduces this to δ P = sΔδ x + S 2 Γ δ x
2
(10.6)

v
2

i
įP is not normal, Assuming that įx is normal with mean zero and standard
n
U
deviation V the first three moments of įP are:

L , E(įP) =
1 2 2
S Γσ

O
2

S
3 4 2 4

/
E[(įP)2] = S2'2V2 + S Γσ

L
4
9 4 2 4 15 6 3 6

C O E[(įP)3] = S Δ Γσ + S Γ σ
2 8

E / A normal distribution can be fitted to the first two moments. The assumption
that 8P is normal is not optimal, but it is preferable to completely ignoring

D C gamma, as was already mentioned. A different strategy is to combine the

©D
three moments with the Cornish-Fisher expansion.
Equation (10.6) changes for a portfolio with n underlying market variables
when each instrument in the portfolio depends on just one of the market
variables.
n n
1
δ P = ∑ Si Δ iδ xi + ∑ Si2Γ i (δ xi ) 2
i =1 i =1 2

262 PAGE
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 VALUE AT RISK

where A and F are the portfolio’s delta and gamma with respect to the Notes
n’th market variable, and S is the value of the ith market variable. This
equation assumes the more generic form where individual instruments in
the portfolio may be dependent on many market variables.
n n n
1
δ P = ∑ Si Δ iδ xi + ∑ ∑ Si S j Γ ijδ xiδ x j (10.7)
i =1 i =1 j =1 2
where Γ ij is a “cross gamma” defined as

Γ ij =
∂2 P
h i
∂S i ∂S j
e l
Equation (10.7) can be shown as
D
of
n n n
δ P = ∑ α iδ xi + ∑ ∑ β ijδ xiδ x j

ity
i =1 i =1 j =1
(10.8)

s
1
where α i = Si Δ i and β ij = Si S j Γ ij
2
e r
Equation (10.8) can be used to determine moments for SP, however it is
i v
not as straightforward to use as equation (10.5).

U n
IN-TEXT QUESTIONS

L ,
O
1. Which VaR method assumes that asset returns follow a normal

S
distribution?

L /
(a) Historical simulation

O
(b) Monte Carlo simulation
C
/
(c) Normal linear VaR
E
C
(d) Quadratic model

D
2. Which VaR calculation approach utilizes past data to estimate

©D
potential losses?
(a) Stress testing
(b) Monte Carlo simulation
(c) Normal linear VaR
(d) Historical simulation

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 3. VaR for option portfolios takes into account:

(a) Historical data only
(b) Stress test results
(c) Option pricing models and volatility
(d) Quadratic equations
4. Which method uses random sampling to model and analyze
complex systems?

h i
(a) Backtesting
e l
D
(b) Monte Carlo simulation

of
(c) Historical simulation
(d) Stress testing

i ty
5. What is the purpose of backtesting in the context of VaR models?

r s
(a) To estimate VaR using historical data

v e
i
(b) To evaluate the resilience of portfolios

n
(c) To compare estimated VaR with actual portfolio losses

U
,
(d) To simulate extreme scenarios

L
6. Backtesting is used to:

O
S
(a) Assess the accuracy of VaR models

L /
(b) Determine the mean and standard deviation of returns

CO
(c) Calculate option prices for portfolios

E/
(d) Conduct stress testing on portfolios

D C 10.7 Monte Carlo Simulation

© D We can apply the model-building strategy utilizing Monte Carlo simulation
to produce the probability distribution for SP as an alternative to the
methods previously discussed. Let’s say we want to figure out a portfolio’s
one-day VaR. The steps are as follows:
1. Value the portfolio today according to standard practice utilizing
market variables’ current values.

264 PAGE
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 VALUE AT RISK

2. Take a single sample from the multivariate normal probability Notes

distribution.
3. Calculate the value of each market variable at the end of a day using
the values of the Sxt’s that were sampled.
4. In the customary manner, revalue the portfolio at the conclusion of
the day.
5. To find a sample SP, subtract the value computed in step 1 from
the value in step 4.
h i
6. Frequently repeat steps 2 through 5 to create a probability distribution
e l
D
for SP.

of
The appropriate percentile of the probability distribution of SP is used
to calculate the VaR. Consider the case when we do the aforementioned

ty
calculation on 5,000 different sample values of SP. The SP value for

s i
the 50th worst outcome is equal to the 1-day VaR of 99%; the SP value

e r
for the 250th worst outcome is equal to the 1-day VaR of 95%; and so

i v
on. The 1-day VaR multiplied by V/ typically regarded to equal the
TV-day VaR.

U n
,
Due to the need to repeatedly revalue a company’s entire portfolio, which

O L
may include hundreds of thousands of distinct instruments, Monte Carlo
simulation has the downside of being slow. The Monte Carlo simulation

/ S
can thus go directly from step 2 to step 5 without the need for a full

simulation approach.
O L
revaluation of the portfolio. This approach is also known as partial

C
/ and Back Testing
E
10.8 Stress Testing
C
D
©D
Many businesses perform what is known as a stress test of their portfolio
in addition to computing a VaR. Stress testing is determining how the
portfolio would have fared in the face of some of the most alarming market
fluctuations witnessed during the previous 10 to 20 years. For instance,
a business might set the percentage changes in all market indicators to
those on October 19, 1987 (when the S&P 500 moved by a variance
of 22.3 standard deviations) in order to assess the effects of a dramatic
movement in U.S. equity prices. If the corporation decides that this is too
excessive, it may chose January 8, 1988 (when the S&P 500 moved by

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 6.8 standard deviations). The firm may set the percentage changes in all
market indicators to those on April 10, 1992 (when 10-year bond yields
changed by a standard deviation of 7.7) in order to assess the impact of
severe fluctuations in U.K. interest rates.
Stress testing can be seen as a means to account for severe events that
occur occasionally but are essentially unachievable based on the expected
probability distributions for market variables. One such extreme occurrence

i
is a daily variation in a market variable of five standard deviations. In

l h
practise, it is not unusual to observe a five standard deviation daily change

e
once or twice every 10 years, contrary to the assumption of a normal

D
distribution that it occurs once every 7,000 years. With the probability

of
distributions proposed for market variables, stress testing can be seen as
a technique to adjust for severe occurrences that do happen occasionally

ty
but are essentially unavoidable. One such severe event is a daily market

s i
movement with a five-standard deviation range. In the case of a normal

e r
distribution, it occurs once every 7,000 years, but in actuality, it is not

i v
unusual to observe a five-standard-deviation daily change once or twice
every 10 years.

U n
Whatever the approach employed to determine VaR, back testing serves

L ,
as a crucial reality check. It requires evaluating the VaR estimations’

O
historical performance. Let’s say we are determining a 1-day 99% VaR.

/ S
Back testing would entail determining how frequently the loss in a day

O L
exceeded the calculated 1-day 99% VaR. We can be fairly confident in
the calculation procedure for VaR if this happened on 1% or less of the

/ C
days. The methodology is questionable if it occurred on, say, 7% of days.

C E10.9 Summary
D
©D
Value at Risk (VaR) is a widely used risk management measure that
estimates potential losses in an investment or portfolio. Several approaches
and techniques are employed to calculate and analyse VaR, including
Normal linear VaR, Historical simulation, VaR for option portfolios,
Quadratic model, Monte Carlo simulation, stress testing, and backtesting.
Normal linear VaR is a method that assumes asset returns follow a normal
distribution and calculates VaR based on the mean and standard deviation
of returns. Historical simulation, on the other hand, uses past data to

266 PAGE
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 VALUE AT RISK

create a distribution of potential outcomes and estimate VaR based on Notes

desired confidence levels. VaR for option portfolios involves considering
the complexities of options, such as volatility and option pricing models,
to calculate potential losses. The Quadratic model utilizes quadratic
equations to assess the relationships between different assets or factors
and estimate portfolio risk. Monte Carlo simulation employs random
sampling to generate numerous scenarios and estimate VaR by analysing
resulting portfolio values or returns. Stress testing subjects’ portfolios
to extreme scenarios to evaluate resilience and identify vulnerabilities.
h i
Backtesting evaluates VaR models by comparing estimated VaR with actual
e l
D
portfolio losses during a specific period. It helps assess the accuracy

of
and effectiveness of the VaR model. These techniques and methods offer
different perspectives on assessing and managing potential risks associated

ty
with investment portfolios, contributing to comprehensive risk analysis
and decision-making in finance.
s i
e r
10.10 Answers to In-Text Questions
i v
1. (c) Normal linear VaR
U n
2. (d) Historical simulation
L ,
O
3. (c) Option pricing models and volatility
4. (b) Monte Carlo simulation
/ S
O L
5. (c) To compare estimated VaR with actual portfolio losses

/ C
6. (a) Assess the accuracy of VaR models

C E
10.11 Self-Assessment Questions
D
©D
1. What is Value at Risk (VaR) and why is it important in risk
management?
2. How does Normal linear VaR differ from other VaR calculation
methods?
3. Explain the concept of Historical simulation in VaR estimation.
4. What are the key considerations when calculating VaR for option
portfolios?

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 5. How does the Quadratic model contribute to risk assessment in

finance?
6. Describe the basic principles of Monte Carlo simulation in VaR
analysis.
7. How does stress testing help in evaluating the resilience of investment
portfolios?
8. What is the purpose of backtesting in the context of VaR models?

h i
9. Can you provide an example of how Normal linear VaR is calculated?

e
10. How does Monte Carlo simulation overcome limitations of otherl
VaR estimation methods?
D
of
11. How does Historical simulation method estimate Value at Risk (VaR)
and what are its advantages and limitations?

i ty
12. What are the main factors considered when calculating Value at
Risk for option portfolios?
r s
v e
13. How does Monte Carlo simulation differ from other VaR estimation

n i
methods, and what are its benefits and drawbacks?

U
14. What is the purpose of stress testing in risk management, and how

,
L
does it complement VaR analysis?

O
15. Can you explain the process of backtesting VaR models and its

/ S
significance in evaluating the accuracy of risk estimates?

O L
10.12 References

/ C
C E ‹Boudoukh, J., M. Richardson, and R. Whitelaw, “The Best of Both
Worlds,” RISK, May 1998, pp. 64-67.

D
©D
 ‹Dowd, K., Beyond Value at Risk: The New Science of Risk Management,
Wiley, New York, 1998. Duffle, D., and J. Pan, “An Overview of
Value at Risk,” Journal of Derivatives, 4, no. 3 (Spring 1997), 7-49.
 ‹Embrechts, P., C. Kluppelberg, and T. Mikosch, Modeling Extremal
Events for Insurance and Finance, Springer, New York, 1997. Frye,
J., “Principals of Risk: Finding VAR through Factor-Based Interest
Rate Scenarios,” in VAR: Understanding and Applying Value at
Risk, Risk Publications, London, 1997, pp. 275-88.

268 PAGE
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 VALUE AT RISK

 ‹Hendricks, D., “Evaluation of Value-at-Risk Models Using Historical Notes

Data.” Economic Policy Review, Federal Reserve Bank of New
York, 2 (April 1996), 39-69.
 ‹Hopper, G., “Value at Risk: A New Methodology for Measuring Portfolio
Risk,” Business Review, Federal Reserve Bank of Philadelphia,
July/August 1996, 19-29. Hua, P., and P. Wilmott, “Crash Courses,”
RISK, June 1997, pp. 64-67.

i
 ‹Hull, J. C, and A. White, “Value at Risk When Daily Changes
in Market Variables Are Not Normally Distributed,” Journal of
l h
Derivatives, 5 (Spring 1998), 9-19.

D e
of
 ‹Hull, J. C, and A. White, “Incorporating Volatility Updating into the
Historical Simulation Method for Value at Risk,” Journal of Risk,

ty
1, No. 1 (1998), 5-19.
 ‹Jackson,

s i
P., D. J. Maude, and W. Perraudin, “Bank Capital and Value

r
at Risk,” Journal of Derivatives, 4, No. 3 (Spring 1997), 73-90.
e
 ‹Jamshidian,

i v
F., and Y. Zhu, “Scenario Simulation Model: Theory and

 ‹Jorion,
U n
Methodology,” Finance and Stochastics, 1 (1997), 43-67.
P., Value at Risk: The New Benchmark for Controlling Market

L ,
Risk, Irwin, Burr Ridge, IL, 1997. Risk Publications, “Value at

O
Risk,” RISK supplement, June 1996.

/ S
10.13 Suggested Readings
O L
 ‹Hull,

/ C
J.C. (2014). Options Futures and other Derivatives. 9th edition,

E
Prentice Hall of India.

C
D
 ‹Neftci, S.N. (2000). An Introduction to the Mathematics of Financial

©D
Derivatives. Academic Press.
‹ Bhalla, V.K. (2012). Investment Management. New Delhi: Sultan
Chand.
 ‹Wilmott, P. (2012). Quantitative Finance. Wiley & Sons.
 ‹Jarrow, R. & Stuart, T. (1995). Derivative Securities. South Western.
 ‹Chance, D.M., & Brooks, R. (2008). Derivatives and Risk Management
Basics. Cengage Learning India.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes  ‹Pliska, S. (1997). Introduction to Mathematical Finance. Wiley-

Blackwell Publishing.
 ‹www.ncdex.com for details on commodity derivatives in India.
 ‹www.nse-india.com for stock-based derivatives:
 ‹http://www.theponytail.net/DOL/DOL.htm for derivatives-based notes.

h i
e l
D
of
i ty
r s
v e
n i
, U
O L
/ S
O L
/ C
C E
D
©D

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L E S S O N

11
Credit Risk
Dr. Sachin Gupta
Assistant Professor
Department of Business Administration
Mohanlal Sukhadia University, Udaipur Raj
Email-Id: [email protected]

h i
STRUCTURE
e l
D
of
11.1 Learning Objectives
11.2 Introduction
11.3 Understanding Credit Risk
i ty
11.4 Bond Prices and the Probability of Default
r s
11.5 Historical Default Experience
v e
11.6 Reducing Exposure to Credit Risk
n i
U
11.7 Collateralized Debt Obligation (CDO)
11.8 Regulation and Risk Management,

O L
11.10 Credit Risk in Emerging/ S
11.9 Case Studies and Real-World Examples

L
Markets

C O
11.11 Credit Risk in the Post-COVID-19 Era
11.12 Summary
/
11.13 Answers toEIn-Text Questions

D C Questions
11.14 Self-Assessment
D
11.16©Suggested Readings
11.15 References

11.1 Learning Objectives

‹ Understand the Concept of Credit Risk: Define credit risk and its importance in
financial markets, identifying the potential risk of loss arising from borrower default.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes ‹ Explore Bond Prices and the Probability of Default: Examine the
relationship between bond prices and credit risk, and understand
how credit risk influences bond yields.
‹ Analyze Historical Default Experience: Study historical default data
and its significance in assessing credit risk and predicting default
probabilities.
‹ Explore Methods for Reducing Exposure to Credit Risk: Learn

i
about diversification as a risk mitigation strategy and the role of
credit analysis in effective risk management.
l h
‹

D e
Examine Credit Risk Hedging Instruments: Understand the

of
mechanics, benefits, and risks of credit default swaps (CDS), total
return swaps (TRS), and credit spread options.

ty
‹ Study Collateralized Debt Obligations (CDOs): Explore the structure,

s i
mechanics, and role of CDOs in financial markets, as well as the

r
lessons learned from the 2008 financial crisis.
e
‹

i v
Assess Credit Risk in Emerging Markets: Analyze the challenges

U n
and opportunities of credit risk assessment in emerging economies,
including sovereign credit risk.
‹

L ,
Understand the Implications of the COVID-19 Pandemic on

O
Credit Risk: Explore how the pandemic impacted credit defaults,

/ S
non-performing loans, and liquidity stress, and its implications for

O L
investors and financial institutions.
Examine the Changing Dynamics of Credit Risk Management:
C
‹

E / Study advancements in data analytics, ESG integration, stress testing,

and regulatory implications for credit risk management.

D C ‹ Identify Future Trends in Credit Risk Management: Predict future

©D
developments in credit risk management, including the integration
of technology, regulation, and sustainable practices.
By the end of this chapter, learners should have a comprehensive
understanding of credit risk, its assessment, management, and implications
in different contexts, providing them with valuable knowledge for making
informed decisions in the financial industry.

272 PAGE
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 CREDIT RISK

11.2 Introduction Notes

Credit risk is a fundamental concept in the world of finance, representing

the potential for financial loss resulting from a borrower’s failure to
meet its debt obligations. It is a critical aspect that impacts investors,
financial institutions, and corporations worldwide. Understanding credit
risk and implementing effective risk mitigation strategies is essential
for maintaining financial stability, optimizing investment decisions, and
ensuring the overall health of the financial system. Altman et al. (2017).
h i
e l
D
11.2.1 Background
The concept of credit risk has been a crucial part of financial systems
of
ty
throughout history. The origins of credit risk assessment can be traced

i
back to ancient civilizations, where merchants and traders extended

s
r
credit to one another based on trust and reputation. As financial markets

v e
evolved, credit risk analysis became more sophisticated, and credit rating

i
agencies emerged to provide standardized measures of creditworthiness.
n
U
Duffie & Singleton (1999).

L ,
The importance of credit risk was underscored during significant financial
crises, such as the Great Depression of the 1930s and the global financial

S O
crisis of 2008. These events highlighted the far-reaching implications of

/
credit risk on the stability of financial markets and the need for robust
L
O
risk management practices. Jorion (2001).

/ C
In the modern era, credit risk has gained even more prominence with the

E
proliferation of complex financial instruments and the globalization of

D C
financial markets. The interconnectivity of the global economy has made
credit risk a global concern, where the default of one major borrower

©D
can have ripple effects across multiple financial institutions and markets.
Merton (1974).
The study of credit risk has also evolved significantly, with extensive
research and academic contributions in the field. Researchers have
developed sophisticated models and methodologies to assess credit risk,
taking into account various factors such as credit ratings, financial ratios,
macroeconomic conditions, and market sentiment. Stein (1999).

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 11.3 Understanding Credit Risk

Credit risk is a critical aspect of the financial landscape, representing
the potential for loss resulting from a borrower’s failure to meet its
debt obligations. It is a multidimensional concept that affects a wide
range of financial instruments, including bonds, loans, and derivatives.
Understanding credit risk is essential for investors, financial institutions,
and lenders as it directly impacts their risk exposure and decision-making
processes. Basel Committee on Banking Supervision (2000).
h i
e l
D
11.3.1 Definition of Credit Risk

of
Credit risk, also known as default risk or counterparty risk, is the risk that

ty
a borrower or counterparty will fail to fulfil its contractual obligations,

i
such as making interest payments or repaying the principal on time. It

s
r
can arise in various financial transactions, including loans, bonds, credit

v e
derivatives, and trade finance. The key concern in credit risk is the

i
possibility of loss due to the borrower’s inability to meet its financial
n
U
commitments, which can lead to a decrease in the value of the financial

,
instrument and potential financial losses for the creditor. Löffler (2003).

L
Credit risk is a dynamic concept, influenced by factors such as the
O
S
creditworthiness of the borrower, macroeconomic conditions, industry-

/
specific factors, market sentiment, and regulatory changes. Credit rating
L
O
agencies play a crucial role in assessing and quantifying credit risk by

C
providing credit ratings that indicate the likelihood of default for specific
/
E11.3.2 Sources of Credit Risk
issuers or debt instruments.

D C
©D There are various sources of credit risk that can affect the creditworthiness
of borrowers and the overall stability of financial markets. Some of the
primary sources of credit risk include: Kealhofer et al. (1997):
‹ Financial Health of Borrowers: The financial health of borrowers is
a fundamental determinant of credit risk. Weak financial performance,
high leverage, declining cash flows, and low liquidity can indicate
heightened credit risk for a borrower.

274 PAGE
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 CREDIT RISK

‹ Macroeconomic Conditions: Changes in the overall economy can Notes

impact credit risk. Economic downturns, recessions, or unfavourable
market conditions can lead to higher default rates, increasing credit
risk across various sectors.
‹ Industry-Specific Factors: Credit risk can vary across industries
depending on their sensitivity to economic fluctuations, competitive
landscape, and regulatory environment. Some industries may have

i
inherently higher credit risk due to their business models and market
dynamics. Merton (1974).
l h
‹ Market Sentiment: Investor perception and market sentiment can
influence credit risk. Negative news or market rumours about a
D e
of
borrower’s financial health can lead to increased credit risk, affecting
its ability to access funding.
‹
i ty
Sovereign Risk: Credit risk can extend beyond individual borrowers

r s
to include sovereign risk, which is the risk of a country defaulting

e
on its debt obligations. Sovereign credit risk can affect the entire
v
i
financial system and have significant implications for global markets.
n
, U
11.3.3 Importance of Credit Risk Assessment

O L
Credit risk assessment is a critical process for various stakeholders in

/ S
the financial industry. It serves several essential purposes:
‹

O L
Investment Decision-Making: Investors, such as bondholders or

C
lenders, use credit risk assessment to evaluate the creditworthiness of

E /
potential borrowers and issuers before making investment decisions.

C
Credit ratings provided by rating agencies offer standardized measures

D
of credit risk, assisting investors in making informed choices.

©D
‹ Risk Management: Financial institutions need to assess and manage
credit risk to maintain financial stability and ensure the safety of their
portfolios. Effective credit risk management involves diversifying
credit exposure, setting risk limits, and implementing risk mitigation
strategies. Sironi (2003).
‹ Regulatory Compliance: Financial regulators often require banks and
other financial institutions to adhere to specific capital adequacy
standards based on their credit risk exposure. Adequate credit risk
assessment is essential for compliance with regulatory requirements.
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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes ‹ Pricing and Valuation: Credit risk affects the pricing and valuation
of financial instruments. Higher credit risk is associated with higher
yields to compensate investors for taking on increased risk.
Understanding credit risk and its sources is vital for making informed
investment decisions, managing financial portfolios, and ensuring regulatory
compliance. By evaluating credit risk effectively, investors and financial
institutions can navigate the challenges posed by credit risk and optimize

i
their risk-return trade-offs.

l h
11.4 Bond Prices and the Probability of Default
D e
of
Understanding the relationship between bond prices and the probability
of default is essential for investors, as it directly impacts their investment

ty
decisions and risk management strategies. This section explores how

s i
credit risk influences bond valuation, yield, and the significance of credit

e r
ratings in assessing default probability. Hull (2016).

v Risk
11.4.1 Bond Valuation andiCredit
U n
L ,
Bond valuation is a crucial aspect of fixed-income investing, and credit
risk plays a significant role in determining the bond’s price. When

S O
investors consider purchasing a bond, they assess the creditworthiness of

L /
the issuer to determine the likelihood of default. Bonds issued by entities

O
with strong credit profiles are considered safer investments and, therefore,

C
attract higher demand, leading to higher bond prices. Jarrow (2005)

E /
On the other hand, bonds issued by entities with weaker credit profiles

D C are perceived as riskier investments, and investors demand higher yields

to compensate for the increased credit risk. As a result, the bond’s price

© D decreases, reflecting the higher return required by investors to take on

additional credit risk.

11.4.2 Yield and Credit Risk

The yield of a bond is another crucial component influenced by credit
risk. Yield represents the annual return an investor can expect to earn
on a bond, expressed as a percentage of its face value. Yield and bond

276 PAGE
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School of Open Learning, University of Delhi
 CREDIT RISK

prices have an inverse relationship - as bond prices rise, yields decrease, Notes
and vice versa. Merton (1974).
For high credit quality bonds, such as those issued by governments or
highly-rated corporations, yields are relatively low because investors
are willing to accept lower returns due to the perceived safety of the
investment. Conversely, bonds with lower credit quality offer higher
yields to attract investors who are willing to take on greater credit risk

i
in exchange for higher potential returns.

l h
11.4.3 Credit Ratings and their Significance
D e
of
Credit ratings are a crucial tool in assessing the creditworthiness of issuers
and their debt instruments. Credit rating agencies, such as Standard &

ty
Poor’s, Moody’s, and Fitch, assign credit ratings to issuers based on their

s i
evaluation of the issuer’s ability to meet their debt obligations. Jorion
(2001).
e r
i v
Credit ratings typically use a combination of letters and symbols to indicate

U n
credit quality. For example, Standard & Poor’s uses the following letter-
based credit rating scale: AAA, AA, A, BBB, BB, B, CCC, CC, C, and

L ,
D. AAA represents the highest credit quality, indicating a low probability

O
of default, while D indicates that the issuer has already defaulted.

/ S
Credit ratings are crucial for investors as they provide standardized measures

O L
of credit risk, allowing them to compare the creditworthiness of different
issuers and make informed investment decisions. Institutional investors

/ C
and regulatory bodies often have specific requirements regarding the

E
credit ratings of bonds eligible for investment or regulatory compliance.
C
D
©D
11.4.4 Relationship Between Bond Prices and Default
Probability
The relationship between bond prices and default probability is central to
understanding credit risk dynamics. As the probability of default increases,
investors demand higher yields to compensate for the added credit risk.
Consequently, the bond’s price decreases, reflecting the lower perceived
value of the bond due to the higher probability of default. Löffler (2003)

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Researchers have developed various models to estimate the relationship

between bond prices and default probability. One widely used model is
the Merton Model, developed by Robert C. Merton in 1974. The Merton
Model uses the stock price, strike price, time to maturity, and risk-free
rate to estimate the probability of default and, subsequently, the bond’s
credit spread.
The relationship between bond prices and default probability is a crucial

i
consideration for investors, as it guides their investment decisions and

l h
helps them effectively manage credit risk exposure. By understanding the

e
impact of credit risk on bond valuation and yield, investors can make

D
informed choices that align with their risk appetite and financial objectives.

11.5 Historical Default Experience of

i ty
s
Examining historical default experience provides valuable insights into

e r
credit risk behaviour under different economic conditions and industry-

i v
specific factors. This section explores default rates during economic

n
cycles, sector-specific default patterns, the importance of historical default

& Xing (2004).

, U
data analysis, and the lessons learned from past credit crises. Vassalou

11.5.1 DefaultO
L
/ S Rates and Economic Cycles

O L
Default rates often exhibit cyclical patterns closely linked to broader

C
economic cycles. During periods of economic expansion and prosperity,

E /
default rates tend to be relatively low as businesses benefit from favourable

C
economic conditions, increased consumer spending, and improved cash

D D flows. As a result, borrowers are more likely to meet their debt obligations,
leading to lower default rates.

© Conversely, during economic downturns or recessionary periods, default

rates tend to increase as businesses face financial challenges, declining
revenues, and reduced cash flows. Unemployment rises, consumer spending
decreases, and market uncertainties create an environment where borrowers
may struggle to meet their debt commitments, resulting in higher default
rates. Altman & Saunders (1998).

278 PAGE
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 CREDIT RISK

The relationship between default rates and economic cycles highlights Notes
the importance of economic conditions in assessing credit risk. Investors
and lenders need to consider macroeconomic indicators and trends when
evaluating the creditworthiness of borrowers and managing credit risk
exposure.

11.5.2 Sector-Specific Default Experience

Credit risk can vary significantly across different industries and sectors.
h i
Each industry has its own unique dynamics, susceptibility to economic
e l
D
fluctuations, and risk factors that influence default rates. Certain industries

of
may exhibit lower default rates due to their defensive nature, stable cash
flows, or essential services, making them less sensitive to economic

ty
downturns. Duffie & Singleton (2003).

s i
On the other hand, industries that are highly cyclical, heavily leveraged,

e r
or exposed to specific regulatory or market risks may experience higher
default rates during challenging economic periods.
i v
U n
Analyzing sector-specific default experience provides valuable insights
into the relative credit risk of different industries, enabling investors to

L ,
make informed decisions and manage sector-specific risk exposure.

S OAnalysis
/
11.5.3 Historical Default Data

O L
Analyzing historical default data is essential for understanding credit

/ C
risk patterns and identifying trends. Researchers and market participants

C E
use historical default data to develop credit risk models, stress tests, and
risk management strategies. By examining default rates over various time

D
periods and economic cycles, analysts can gain a deeper understanding

©D
of credit risk dynamics and the impact of economic conditions on default
probabilities. Jarrow et al. (2005).
The analysis of historical default data also involves identifying factors
that contributed to past credit crises or significant default events. By
understanding the root causes of these events, market participants can
implement measures to prevent or mitigate similar risks in the future.

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Notes 11.5.4 Lessons from Past Credit Crises

The study of past credit crises provides valuable lessons for investors,
financial institutions, and policymakers. Historical credit crises, such as
the global financial crisis of 2008, have highlighted the potential systemic
risks posed by excessive credit expansion, lax lending practices, and
inadequate risk management. Mian & Sufi (2009).
Lessons from past credit crises include the importance of:

h i
l
‹ Prudent Credit Risk Management: Implementing robust credit

on borrowers and issuers.

D e
risk assessment practices and conducting thorough due diligence

of
‹ Diversification: Spreading credit exposure across different sectors,

ty
industries, and geographic regions to mitigate the impact of defaults

i
from any single entity.
‹
r s
Stress Testing: Regularly assessing the resilience of portfolios to

v e
adverse economic scenarios and potential credit events.
‹

n i
Regulation: Implementing effective regulatory frameworks to monitor

U
and address systemic credit risk and prevent excessive risk-taking.

,
L
Examining historical default experience provides invaluable insights into

O
credit risk behaviour and helps investors and financial institutions make

/ S
informed decisions. By understanding default patterns during economic

L
cycles and sector-specific trends, market participants can better manage

O
credit risk and navigate the challenges posed by changing economic

C
/
conditions and market dynamics. Additionally, drawing lessons from past

C Ecredit crises can inform risk management practices and contribute to a

more resilient financial system.

D
©D
11.6 Reducing Exposure to Credit Risk
Reducing exposure to credit risk is crucial for investors and financial
institutions to safeguard their portfolios and ensure financial stability. This
section explores various risk mitigation strategies, including diversification,
credit analysis, Credit Default Swaps (CDS), Total Return Swaps (TRS),
and credit spread options. Stein (1999).

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 CREDIT RISK

11.6.1 Diversification as a Risk Mitigation Strategy Notes

Diversification is a fundamental risk management strategy that involves

spreading investments across different assets, industries, and geographic
regions. By diversifying their portfolios, investors can reduce their exposure
to the credit risk of any single borrower or issuer. If one investment
experiences a credit event or default, the impact on the overall portfolio
is mitigated by the presence of other investments.
Diversification allows investors to benefit from the potential positive
h i
performance of different assets while minimizing the impact of negative
e l
D
events. It is particularly effective in reducing unsystematic risk, which is

of
specific to individual companies or issuers and can be diversified away.
Hull (2016).

i ty
s
11.6.2 Credit Analysis and its Role in Risk Management

e r
v
Credit analysis is a critical component of credit risk management, involving

n i
the evaluation of borrowers’ creditworthiness and the likelihood of default.

U
Financial institutions and investors conduct thorough credit analyses to

bonds or loans.
L ,
assess the risks associated with extending credit or investing in specific

S O
Credit analysis typically involves examining financial statements, cash flow

L /
projections, industry dynamics, management quality, and macroeconomic

O
conditions. By performing comprehensive credit analysis, investors can

/ C
identify high-quality borrowers with low default probabilities and make

E
informed investment decisions. Jorion (2001).

D C
11.6.3 Credit Default Swaps (CDS)

©D
Credit Default Swaps (CDS) are financial derivatives that allow investors
to transfer credit risk from one party to another. In a CDS contract,
one party (the protection buyer) pays a premium to another party (the
protection seller) in exchange for protection against the credit risk of a
specified issuer. If a credit event, such as a default, occurs for the issuer,
the protection seller compensates the protection buyer for the loss.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 11.6.3.1 Mechanics of CDS

In a CDS, the protection buyer does not need to own the underlying bond
or debt instrument of the specified issuer. They are essentially buying
insurance against default. The CDS contract’s notional amount represents
the value of the underlying debt, and the premium is paid regularly by
the protection buyer to the protection seller.
11.6.3.2 Benefits and Risks of CDS
CDS can be beneficial for investors and financial institutions as they
h i
l
provide a way to manage credit risk without having to sell the underlying
e
D
bond or loan. They allow investors to hedge against credit risk exposure

of
or speculate on changes in creditworthiness.
However, CDS also come with risks. The protection seller assumes credit

ty
risk, and if multiple credit events occur simultaneously, the protection

s i
seller may face significant losses. Additionally, the use of CDS and their

r
potential for speculative trading has been a subject of scrutiny during
e
v
financial crises. Löffler (2003).

n i
U
11.6.4 Total Return Swaps (TRS)
,
O L
Total Return Swaps (TRS) are financial contracts in which one party
exchanges the total return of an asset, such as a bond or loan, with

/ S
another party. TRS can be used to gain exposure to the performance of
L
an asset without owning it outright.
O
/ C
11.6.4.1 Advantages of TRS

C ETRS allows investors to gain exposure to the credit risk of an asset

without purchasing the asset itself. It provides flexibility in managing

D credit risk exposure, as investors can enter into TRS contracts on a wide

©D
range of assets.
11.6.4.2 Risk Considerations of TRS
While TRS can be a useful tool for managing credit risk, it comes with
counterparty risk. If the counterparty to the TRS contract defaults, the
investor may face losses. Therefore, careful due diligence and credit analysis
of the counterparty are essential when engaging in TRS transactions.

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 CREDIT RISK

11.6.5 Credit Spread Options Notes

Credit spread options are financial derivatives that allow investors to

trade the credit spread (the difference between the yield of a bond and
a risk-free rate) on a specific bond or debt instrument. Merton (1974).
11.6.5.1 Characteristics of Credit Spread Options
Credit spread options provide investors with a way to profit from changes

i
in credit spreads without owning the underlying bond. They can be used
for speculation or as a risk management tool to hedge credit risk exposure.
l h
11.6.5.2 Applications of Credit Spread Options
D e
of
Investors can use credit spread options to take advantage of credit market
movements or to protect against adverse changes in credit spreads. They

ty
are particularly useful in managing credit risk in bond portfolios.

s i
Diversification, credit analysis, Credit Default Swaps (CDS), Total

e r
Return Swaps (TRS), and credit spread options are effective tools for

v
reducing exposure to credit risk. By utilizing these strategies and financial

n i
instruments, investors and financial institutions can manage credit risk

of their portfolios.
, U
effectively, optimize their risk-return trade-offs, and enhance the resilience

O L
S
11.7 Collateralized Debt Obligation (CDO)

L /
O
Collateralized Debt Obligation (CDO) is a complex financial product that

C
played a significant role in the 2008 financial crisis. CDOs are structured

E /
products that package various debt instruments, such as mortgages,

C
corporate bonds, and loans, into different tranches based on their credit

D
quality. This section explores the structure and mechanics of CDOs, the

©D
role of CDO managers, credit enhancement mechanisms in CDOs, and
criticisms and lessons from the 2008 financial crisis. Carey et al. (1993)

11.7.1 CDO Structure and Mechanics

A CDO is a structured investment vehicle that pools a diversified portfolio
of debt instruments, known as collateral, and then issues different classes
of securities, or tranches, to investors. The cash flows generated by the

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes underlying collateral assets are used to pay interest and principal to the
investors of each tranche.
The CDO structure typically consists of three main tranches:
(a) Senior Tranches: These tranches have the highest credit quality and
priority in receiving cash flows from the underlying collateral. They
are considered the safest and have lower yields compared to other
tranches.
(b) Mezzanine Tranches: These tranches are intermediate in credit
h i
l
quality, sitting between the senior and equity tranches. They offer
e
D
higher yields than the senior tranches but are riskier.

of
(c) Equity Tranches: These tranches have the lowest credit quality and
absorb any losses from the underlying collateral. They offer the

ty
highest potential returns but are the riskiest.

s i
The senior tranches receive their payments first, followed by the mezzanine

e r
tranches, and finally, the equity tranches. This payment waterfall reflects

i v
the risk-return profile of each tranche. Duffie & Singleton (2003).

U n
11.7.2 Role of CDO Managers

L ,
O
CDOs are actively managed by CDO managers, also known as collateral

S
managers or asset managers. The CDO manager is responsible for selecting

L /
the pool of underlying assets, structuring the CDO, and making decisions

O
regarding the management of the collateral.

/ C
CDO managers play a crucial role in determining the credit quality and

C E
performance of the CDO. They are responsible for monitoring the performance
of the underlying assets, managing cash flows, and implementing credit

D D enhancement mechanisms. CDO managers aim to optimize the risk and

©
return profile of the CDO to meet the objectives of the investors.
However, the role of CDO managers has been criticized for potential
conflicts of interest, as they may have incentives to prioritize their own
fees over the best interests of the CDO investors. Gorton & Pennacchi
(1995).

284 PAGE
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11.7.3 Credit Enhancement Mechanisms in CDOs Notes

Credit enhancement mechanisms are employed in CDOs to improve the

credit quality of the different tranches and increase their credit ratings.
These mechanisms aim to attract investors by providing additional
protection against potential losses from the underlying collateral. Some
common credit enhancement mechanisms include:
(a) Over collateralization: The value of the underlying assets in the
CDO exceeds the value of the issued debt securities, providing a
h i
cushion against potential losses.
e l
D
(b) Subordination: The different tranches have varying levels of seniority,

of
with the more junior tranches absorbing losses before the senior
tranches. This hierarchical structure enhances the credit quality of
the senior tranches.
i ty
r s
(c) Reserve Accounts: Cash reserves are set aside to cover potential

e
losses or shortfalls in cash flows from the underlying collateral.

v
n i
(d) Credit Default Swaps (CDS): CDOs may use CDS contracts to

U
transfer the credit risk of specific assets to other parties, such as

,
insurance companies or other investors.

L
These credit enhancement mechanisms aim to reduce the credit risk of
O
S
the CDO tranches and enhance their marketability to a wider range of
investors. Löffler (2003).
L /
C O
/
11.7.4 Criticisms and Lessons from the 2008 Financial
Crisis
C E
D
The 2008 financial crisis exposed significant flaws in the CDO market

©D
and raised several criticisms, including:
(a) Complexity and Lack of Transparency: The complexity of CDO
structures and the lack of transparency in the underlying assets
made it challenging for investors and regulators to assess the true
credit risk exposure.
(b) Ratings Agencies’ Role: Credit rating agencies assigned high credit
ratings to many CDO tranches that were later downgraded dramatically
during the crisis, leading to significant losses for investors.

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Notes (c) Systemic Risk: The high degree of interconnectedness among financial
institutions through CDO exposures amplified the impact of defaults,
contributing to systemic risk.
(d) Moral Hazard: Some financial institutions may have underestimated
the risks associated with CDOs, assuming that government bailouts
would protect them from the consequences of their risky activities.
Lessons from the 2008 financial crisis include the need for improved

i
risk assessment, increased transparency, and better regulation of complex

l
financial products like CDOs. The crisis highlighted the importance of
h
D e
conducting thorough due diligence on the underlying collateral, managing
conflicts of interest among CDO managers, and implementing proper risk

of
management practices. Longstaff & Rajan (2008).

ty
The 2008 financial crisis raised significant concerns about the complexity

i
and risks associated with CDOs. While CDOs can serve as risk management

s
r
tools, their design, rating process, and proper regulation are crucial to

e
prevent excessive risk-taking and protect investors and the broader financial
v
i
system from potential systemic risks.
n
, U
11.8 Regulation and Risk Management

O L
Effective regulation and risk management are crucial for maintaining

/ S
financial stability and mitigating systemic credit risk. This section explores

O L
the Basel Accords and their impact on credit risk management, the role
of stress testing in assessing credit risk resilience, and the role of central

/ C
banks in mitigating systemic credit risk. Allen et al. (2009).

E
C 11.8.1 Basel Accords and their Impact on Credit Risk
D D Management
© The Basel Accords are a series of international banking regulations
developed by the Basel Committee on Banking Supervision (BCBS) to
enhance the stability and soundness of the global banking system. The
two most significant accords are Basel I, Basel II, and Basel III:
‹ Basel I: Introduced in 1988, Basel I focused primarily on credit
risk and established minimum capital requirements based on credit
risk weights assigned to different asset classes. The standardized

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 CREDIT RISK

approach of Basel I led to oversimplification and did not consider Notes

the riskiness of individual assets adequately.
‹ Basel II: Implemented in 2007, Basel II aimed to improve risk
sensitivity by introducing three pillars - minimum capital requirements,
supervisory review, and market discipline. It allowed banks to use
internal models (the Internal Ratings-Based approach) to assess
credit risk, enabling more accurate risk measurement and capital

i
allocation.
‹ Basel III: Developed as a response to the 2008 financial crisis, Basel
l h
III further strengthened capital requirements and introduced additional
capital buffers to enhance resilience during economic downturns.
D e
of
It also introduced a comprehensive framework for liquidity risk
management.

i
The Basel Accords have significantly impacted credit risk management
ty
r s
practices within financial institutions by promoting risk-sensitive capital

e
requirements and encouraging better risk measurement and management
v
i
techniques. Basel Committee on Banking Supervision. (2011).
n
11.8.2 Stress Testing and its Role in U
Resilience
L , Assessing Credit Risk

S O
L /
Stress testing is a risk management technique used to assess the resilience
of financial institutions and portfolios under adverse economic scenarios.

C O
Stress tests involve subjecting a bank’s balance sheet to severe hypothetical

/
stress events, such as a severe recession or a sharp rise in default rates.
E
C
For credit risk assessment, stress tests evaluate the impact of adverse

D
economic conditions on a bank’s credit portfolio. These tests help

©D
identify potential vulnerabilities and weaknesses in a bank’s credit risk
management practices and capital adequacy. They also assist regulatory
authorities in evaluating the overall health and stability of the banking
system. Kroszner et al. (2007).
Stress testing has become a critical tool in credit risk management,
providing insights into how financial institutions would fare during periods
of economic turmoil and allowing them to take proactive measures to
strengthen their risk management practices. Cihak et al. (2012).

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Notes 11.8.3 Role of Central Banks in Mitigating Systemic Credit

Risk
Central banks play a crucial role in mitigating systemic credit risk, which
is the risk of widespread defaults or failures in the financial system that
can lead to significant economic disruptions. They are responsible for
maintaining financial stability and ensuring the smooth functioning of
the financial markets. Santos (2012).

h i
l
Central banks employ various measures to address systemic credit risk:

D e
(a) Monetary Policy: Central banks adjust interest rates and conduct
open market operations to influence credit availability and economic

of
activity. By setting appropriate monetary policies, central banks aim
to manage credit growth and prevent excessive risk-taking.

i ty
(b) Lender of Last Resort: Central banks act as lenders of last resort,

r s
providing emergency liquidity to financial institutions facing liquidity

v e
crises. This prevents bank runs and financial panics, reducing
systemic credit risk.
n i
U
(c) Macroprudential Regulation: Central banks and regulatory authorities

L ,
implement macroprudential policies to address systemic risks and
vulnerabilities in the financial system. These policies may include

S O
capital buffers, loan-to-value ratios, and other measures to limit

/
excessive credit growth.
L
O
(d) Supervision and Oversight: Central banks supervise and regulate

/ C
financial institutions to ensure they adhere to prudential standards and

E
risk management best practices. They conduct regular assessments

D C of banks’ credit risk exposures and capital adequacy.

©D
(e) Crisis Management: In times of financial stress, central banks
work with other regulatory authorities and governments to develop
strategies for managing systemic credit risk. This may involve
providing financial assistance, implementing resolution measures,
or coordinating international efforts.
Regulation and risk management are crucial elements in safeguarding
financial stability and mitigating credit risk in the banking system. The
Basel Accords, stress testing, and the role of central banks are essential

288 PAGE
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 CREDIT RISK

components of the regulatory framework aimed at enhancing risk resilience Notes

and protecting against systemic credit risk. By adopting effective risk
management practices and regulatory oversight, financial institutions can
better withstand economic downturns and contribute to a more stable and
resilient financial system.

11.9 Case Studies and Real-World Examples

h i
l
11.9.1 Enron Corporation: A Case of Corporate Credit Risk
Enron Corporation was an American energy company that was once
D e
of
considered one of the most innovative and successful companies in the
world. However, in the early 2000s, Enron’s financial condition began to

ty
deteriorate, leading to its eventual bankruptcy in December 2001. Fusaro
& Miller (2002).
s i
e r
Credit risk played a significant role in Enron’s downfall. The company

i v
used off-balance-sheet transactions and special purpose entities (SPEs) to

U n
hide its debt and inflate its profits artificially. These complex financial
structures allowed Enron to conceal its true financial position from
investors and creditors. Fox (2003)
L ,
O
Enron’s credit risk exposure increased as it engaged in high-risk and

S
L /
speculative trading activities. The company took substantial positions in
energy markets and derivatives, leaving it vulnerable to price fluctuations

O
and market volatility. When energy prices declined, Enron faced mounting
C
/
losses, leading to a liquidity crisis. Lev & Dubner (2005).

E
C
The lack of transparency in Enron’s financial reporting and its aggressive

D
accounting practices contributed to the erosion of investor confidence.

©D
Credit rating agencies downgraded Enron’s debt rapidly, making it difficult
for the company to refinance its obligations and access capital markets.
As Enron’s creditworthiness deteriorated, its lenders and counterparties
grew increasingly concerned about the company’s ability to meet its
debt obligations. Ultimately, Enron’s credit risk exposure and financial
mismanagement led to its bankruptcy, resulting in significant losses for
its investors, creditors, and employees.

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Notes 11.9.2 The 2008 Financial Crisis and Subprime Mortgage-

Backed CDOs
The 2008 financial crisis was one of the most severe financial crises in
history, leading to a global recession. One of the primary triggers of the
crisis was the collapse of the subprime mortgage market and its impact
on subprime mortgage-backed collateralized debt obligations (CDOs).
Gorton (2010).

h i
l
The crisis originated from the U.S. housing market, where a housing

D e
bubble had formed due to lax lending standards and a surge in subprime
mortgage lending. Many financial institutions packaged these subprime

of
mortgages into complex structured products known as CDOs, which were
then sold to investors. Rajan (2010).

i ty
Credit risk in these subprime mortgage-backed CDOs was not adequately

r s
assessed. The underlying mortgages were of poor quality, and many

e
borrowers were unable to repay their loans, leading to a wave of defaults

v
n i
and foreclosures. As a result, the value of subprime mortgage-backed
CDOs plummeted, causing significant losses for investors.

, U
The credit risk exposure was exacerbated by the use of financial leverage

O L
and the interconnectedness among financial institutions. Many banks and
financial institutions had significant exposures to subprime mortgage-

/ S
backed CDOs, either directly or indirectly through complex financial

L
instruments like credit default swaps (CDS). Lowenstein (2010).

O
C
The widespread losses in subprime mortgage-backed CDOs triggered a

E /
liquidity crisis and a loss of confidence in the global financial system.

C
Major financial institutions faced insolvency and required government

D
bailouts to survive. The crisis had severe consequences, including a

©D
sharp contraction in economic activity and widespread unemployment.
Shiller (2012).
The 2008 financial crisis highlighted the importance of robust credit risk
assessment, transparency in financial reporting, and effective regulation
and risk management in the financial industry.
The 2008 financial crisis and the collapse of subprime mortgage-backed
CDOs serve as a stark reminder of the significance of credit risk in the
financial system. The crisis underscored the need for more robust risk

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management practices, better regulation, and improved transparency to Notes

prevent excessive risk-taking and systemic credit risk.

11.10 Credit Risk in Emerging Markets

Emerging markets present unique challenges and opportunities when it
comes to assessing credit risk. These markets are characterized by higher
levels of economic and political uncertainty, less developed financial
systems, and greater volatility compared to developed markets. This
h i
e
section explores the challenges and opportunities in assessing credit risk
l
D
in emerging markets and the impact of sovereign credit risk on bond

f
markets.

o
ty
11.10.1 Challenges and Opportunities in Assessing Credit
Risk in Emerging Markets
s i
e r
v
11.10.1.1 Lack of Robust Credit Data

n i
Emerging markets often lack comprehensive and reliable credit data, making

U
it challenging to assess the creditworthiness of borrowers and issuers.

,
L
Limited access to historical financial information and credit records can

O
hinder credit risk analysis. Eichengreen et al. (2005).

/ S
11.10.1.2 Sovereign Risk Interconnectedness

L
Sovereign credit risk in emerging markets can have a significant impact on
O
C
other sectors, including corporates and financial institutions. Government

/
policies, fiscal deficits, and political stability are critical factors affecting
E
C
credit risk in these markets.

D
11.10.1.3 Currency Risk

©D
Emerging markets frequently experience currency volatility, which can
affect the credit risk of foreign currency-denominated debt. Exchange
rate fluctuations can impact borrowers’ ability to service debt, leading
to increased credit risk.
11.10.1.4 Legal and Regulatory Environment
The legal and regulatory framework in emerging markets may be less
developed or less transparent, posing challenges in enforcing creditor
rights and recovering assets in case of default. Gulde et al. (2003).

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 11.10.1.5 Diverse Economic and Industry Structure

Emerging markets encompass a wide range of economies and industries,
each with its unique risks and challenges. Credit risk assessment must
account for the specific characteristics of each sector. Reinhart & Rogoff
(2009).
Despite these challenges, assessing credit risk in emerging markets also
presents opportunities:

i
(a) Higher Yield Potential: Emerging market debt instruments often offer
h
l
higher yields compared to developed markets, providing attractive
e
D
investment opportunities for yield-seeking investors.

of
(b) Growth Potential: Emerging markets are typically associated with
higher economic growth rates, potentially leading to improved

ty
creditworthiness for borrowers and issuers in these markets.

s i
(c) Diversification Benefits: Investing in emerging market debt can

e r
provide diversification benefits for portfolios heavily weighted

i
toward developed market assets.
v
U n
11.10.2 Impact of Sovereign Credit Risk on Bond Markets

L ,
O
Sovereign credit risk has a significant impact on bond markets, particularly

S
in emerging markets where the government’s creditworthiness plays a

L /
central role. A country’s credit rating and perceived risk of default can

O
influence the pricing and demand for its sovereign bonds.

/ C
When a sovereign credit rating is downgraded or concerns arise about

C E
a government’s ability to service its debt, investors may demand higher
yields to compensate for the increased credit risk. This results in a decrease

D D in bond prices and an increase in borrowing costs for the government.

©
Sovereign credit risk can also spill over into corporate bond markets.
In emerging markets, corporate issuers may be closely linked to the
government or face similar macroeconomic challenges. Consequently, a
deterioration in sovereign credit risk can lead to a broader deterioration
in credit risk across the corporate sector, impacting corporate bond prices
and credit spreads. Spiegel & Yamori (2002).
Credit risk in emerging markets requires a nuanced approach that accounts
for the unique challenges and opportunities these markets present. Investors

292 PAGE
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 CREDIT RISK

and financial institutions must carefully evaluate economic and political Notes
conditions, currency risk, and the impact of sovereign credit risk to make
informed decisions when investing in emerging market debt

11.11 Credit Risk in the Post-COVID-19 Era

The COVID-19 pandemic had far-reaching effects on the global economy,
financial markets, and credit risk. As the world moves into the post-
COVID-19 era, credit risk management faces new challenges and requires
h i
adaptations to address the evolving economic landscape. This section
e l
D
explores the credit risk implications of the pandemic and the changing

of
dynamics of credit risk management. Claessens & Kodres (2014).

ty
11.11.1 Credit Risk Implications of the Pandemic

s i
The COVID-19 pandemic had several credit risk implications:

e r
i v
(a) Increased Credit Defaults: Many businesses and individuals faced

n
severe financial strain during lockdowns and economic disruptions.

, U
This led to an increase in credit defaults across various sectors,
particularly in industries directly affected by travel restrictions and
L
social distancing measures, such as hospitality, tourism, and retail.
O
/ S
(b) Rising Non-Performing Loans (NPLs): Banks and financial institu-

L
tions experienced a surge in non-performing loans as borrowers

O
struggled to repay their debts. This posed challenges to the banking

C
/
sector’s asset quality and profitability.

E
(c) Sovereign Credit Risks: Governments worldwide implemented
C
D
stimulus packages and incurred significant debts to support their

©D
economies during the pandemic. The long-term implications of these
increased debts on sovereign credit risk and fiscal sustainability
remain a concern. Dang & Phan (2020).
(d) Liquidity Stress: The pandemic-induced market volatility and
uncertainty put strains on liquidity in financial markets, particularly
for corporate borrowers and investors in illiquid assets. Georgieva
(2021).

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes (e) Sector-Specific Risks: Certain sectors, such as technology and

healthcare, witnessed increased demand and growth during the
pandemic. Credit risk assessments needed to consider the divergent
performance and outlook of various sectors.

11.11.2 Changing Dynamics of Credit Risk Management

The COVID-19 pandemic accelerated changes in credit risk management:

h
(a) Greater Emphasis on Stress Testing: Stress testing became cruciali
e l
for assessing the resilience of financial institutions and portfolios

D
to adverse economic scenarios. Institutions had to evaluate their

of
capacity to withstand sudden economic shocks.
(b) Improved Data Analytics: Advanced data analytics and technology

i ty
played a vital role in credit risk assessments, enabling more accurate

r s
and timely information for decision-making. Singh & Subramanian

e
(2021).

i v
(c) Heightened Focus on ESG Factors: Environmental, Social, and

U n
Governance (ESG) factors gained prominence in credit risk management.

,
Investors and lenders increasingly consider the environmental and

O L
social impact of their investments, recognizing the importance of
sustainable practices.

/ S
(d) Enhanced Risk Mitigation Strategies: Financial institutions reeval-
L
uated risk mitigation strategies and employed hedges, credit default
O
C
swaps, and other instruments to manage credit risk effectively.

E /
(e) Agility and Flexibility: The pandemic underscored the importance

D C of agility and flexibility in credit risk management. Institutions had

to adapt quickly to changing market conditions and evolving risks.

©D
COVID-19 pandemic highlighted the need for agile and data-driven credit
risk management. Financial institutions must continue to adapt to the
evolving economic conditions and adopt robust risk assessment practices
to navigate the post-pandemic era successfully. As uncertainty remains,
a proactive approach to credit risk management is essential to support
economic recovery and ensure the stability of financial markets.

294 PAGE
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CREDIT RISK

IN-TEXT QUESTIONS Notes

1. Credit risk refers to:

(a) The potential risk of loss arising from market volatility
(b) The potential risk of loss arising from the failure of a
borrower to meet its financial obligations
(c) The potential risk of loss arising from geopolitical events
(d) The potential risk of loss arising from changes in interest

h i
rates

e l
D
2. The relationship between bond prices and the probability

of
of default is such that:
(a) As bond prices increase, the probability of default decreases

i ty
(b) As bond prices decrease, the probability of default decreases

r s
(c) As bond prices increase, the probability of default increases

v e
(d) There is no relationship between bond prices and the
probability of default
n i
U
3. Credit default swaps (CDS) allow investors to:

,
L
(a) Transfer credit risk to another party in exchange for

O
premium payments

/ S
(b) Exchange one bond for another

L
(c) Hedge against changes in interest rates
O
C
(d) Short-sell stocks

E /
4. Historical default experience provides valuable insights for

C
credit risk assessment by:

D
©D
(a) Identifying the credit rating of a borrower or issuer
(b) Calculating the credit spread of a bond
(c) Assessing the resilience of financial institutions under
stress scenarios
(d) Analyzing the frequency and severity of credit defaults
across different asset classes and time periods

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 5. Diversification as a risk mitigation strategy involves:

(a) Concentrating investments in a single asset or sector
(b) Spreading investments across different assets or asset
classes
(c) Reducing credit risk by increasing leverage
(d) Ignoring credit risk altogether
6. Collateralized Debt Obligations (CDOs) are structured financial

h i
products that pool various:

e l
D
(a) Equities and stocks

of
(b) Commodities and futures
(c) Debt instruments, such as mortgages or corporate loans
(d) Real estate properties
i ty
r s
7. Credit risk in emerging markets is characterized by:

v e
i
(a) Low levels of economic and political uncertainty

n
(b) Highly developed financial systems

U
,
(c) Low volatility compared to developed markets

O L
(d) Higher levels of economic and political uncertainty and
less developed financial systems

/ S
L
8. The COVID-19 pandemic led to an increase in credit:

C O (a) Yields

/ (b) Interest rates

CE
(c) Defaults

D D (d) Credit ratings

©
9. Stress testing in credit risk management is used to:
(a) Measure the return on investment of a credit portfolio
(b) Assess the resilience of financial institutions and portfolios
under adverse economic scenarios
(c) Determine the credit rating of a borrower or issuer
(d) Calculate the credit spread of a bond

296 PAGE
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CREDIT RISK

10. The Basel Accords have a significant impact on: Notes

(a) Market volatility

(b) Credit risk management and capital adequacy requirements
(c) Credit default swaps (CDS)
(d) Collateralized Debt Obligations (CDOs)
11. The integration of Environmental, Social and Governance
(ESG) factors in credit risk management refers to considering:

h i
(a) Geopolitical risks
e l
D
(b) Exchange rate fluctuations

of
(c) Sustainability practices and social impact of investments

ty
(d) Credit rating agencies’ assessments
12. Scenario analysis in credit risk management is used to:
s i
e r
(a) Measure the impact of specific economic scenarios on a

i v
portfolio’s performance

n
(b) Predict the future interest rate movements

U
,
(c) Assess the creditworthiness of borrowers

L
(d) Evaluate the profitability of a financial institution

O
S
13. Sovereign credit risk refers to the risk associated with a

L /
government’s ability to meet its:

O
(a) Regulatory requirements

C
/
(b) Financial obligations

E
C
(c) Environmental commitments

D
(d) Economic growth targets

©D
14. Credit spread options are options contracts that provide the
buyer with the right but not the obligation to:
(a) Exchange one bond for another
(b) Buy or sell credit risk exposure at a specified credit spread
level
(c) Hedge against changes in interest rates
(d) Short-sell stocks

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes 15. The role of financial institutions in credit risk management

includes:
(a) Ignoring credit risk due to market volatility
(b) Transferring credit risk to other parties
(c) Assessing the creditworthiness of borrowers and issuers
(d) Focusing solely on profit maximization without considering

i
risk exposure

l h
11.12 Summary
D e
11.12.1 Recapitulation of Key Findings
of
i ty
In this comprehensive study on credit risk, we explored various aspects

r s
related to credit risk, including bond prices and the probability of default,

e
historical default experience, reducing exposure to credit risk, credit default
v
n i
swaps, total return swaps, credit spread options, and collateralized debt
obligation (CDO). We also examined credit risk in emerging markets and

, U
the implications of the COVID-19 pandemic on credit risk management.
Adrian & Shin (2010).

O L
Key findings from this study include:

/ S
L
‹ Credit risk is the potential for loss arising from the failure of a

O
borrower or issuer to meet its financial obligations.
‹

/ CBond prices are influenced by credit risk, with riskier bonds trading

C E at higher yields to compensate investors for taking on higher credit

risk.

D
©D
‹ Historical default experience provides valuable data to assess credit
risk, allowing investors and financial institutions to better understand
the probability of default across different asset classes.
‹ Diversification, credit analysis, and risk management strategies are
essential for reducing exposure to credit risk.
‹ Credit default swaps (CDS), total return swaps (TRS), and credit
spread options are financial instruments used for hedging credit
risk exposure and improving risk-adjusted returns.

298 PAGE
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 CREDIT RISK

‹ Collateralized debt obligations (CDOs) are complex structured products Notes

that played a role in the 2008 financial crisis, raising concerns about
transparency and risk management.
‹ Emerging markets present both opportunities and challenges in credit
risk assessment, with higher yields and growth potential but limited
data and higher volatility.
‹ The COVID-19 pandemic had significant credit risk implications,

i
including increased defaults, rising NPLs, sovereign credit risks,
liquidity stress, and sector-specific risks.
l h
11.12.2 Implications for Investors and Financial Institutions
D e
The findings of this study have several implications for investors and
of
ty
financial institutions:

s i
Investors should carefully assess credit risk when making investment
r
‹

e
decisions, considering factors such as credit ratings, historical default
data, and the economic outlook.
i v
‹

U n
Diversification remains a key risk management strategy for investors

,
to mitigate the impact of credit defaults on their portfolios.
‹

O L
Financial institutions should enhance credit risk assessment and stress
testing capabilities to better withstand economic shocks, such as

/ S
those experienced during the COVID-19 pandemic.
‹

O L
The pandemic highlighted the importance of agility and flexibility

C
in credit risk management, requiring institutions to adapt quickly

/
to changing market conditions.
E
D C
11.12.3 Future Trends in Credit Risk Management

©D
The future of credit risk management is likely to be shaped by several
trends:
(a) Advancements in Data Analytics: Increasingly sophisticated data
analytics and artificial intelligence will enable more accurate and
real-time credit risk assessments.
(b) Integration of ESG Factors: Environmental, Social, and Governance
(ESG) considerations will become integral to credit risk management
as investors and financial institutions prioritize sustainable practices.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes (c) Emphasis on Scenario Analysis: Scenario-based stress testing will

gain importance to assess the resilience of portfolios to various
economic and market scenarios.
(d) Enhanced Regulation: Regulators are expected to impose stricter
requirements on financial institutions’ risk management practices
to ensure financial stability.
(e) Increased Focus on Cybersecurity: Cyber risks will be integrated

i
into credit risk management, given the growing importance of
digitalization and technology in financial services.
l h
D e
The future of credit risk management will revolve around data-driven
approaches, ESG integration, stress testing, regulatory compliance, and

of
cybersecurity. As the financial landscape continues to evolve, staying at
the forefront of risk management practices will be crucial for investors

i ty
and financial institutions to navigate uncertainties successfully and ensure
the stability of the global financial system.
r s
v e
i
11.13 Answers to In-Text Questions
n
U
1. (b) The potential risk of loss arising from the failure of a borrower
,
L
to meet its financial obligations

O
2. (c) As bond prices increase, the probability of default increases

S
L /
3. (a) Transfer credit risk to another party in exchange for premium
payments

C O
/
4. (d) Analyzing the frequency and severity of credit defaults across

E
different asset classes and time periods

D C 5. (b) Spreading investments across different assets or asset classes

©D
6. (c) Debt instruments, such as mortgages or corporate loans
7. (d) Higher levels of economic and political uncertainty and less
developed financial systems
8. (c) Defaults
9. (b) Assess the resilience of financial institutions and portfolios
under adverse economic scenarios
10. (b) Credit risk management and capital adequacy requirements
11. (c) Sustainability practices and social impact of investments

300 PAGE
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 CREDIT RISK

12. (a) Measure the impact of specific economic scenarios on a portfolio’s Notes
performance
13. (b) Financial obligations
14. (b) Buy or sell credit risk exposure at a specified credit spread
level
15. (c) Assessing the creditworthiness of borrowers and issuers

11.14 Self-Assessment Questions

h i
e l
D
1. What is credit risk, and why is it important for investors and

of
financial institutions?
2. Explain the relationship between bond prices and the probability of

ty
default. How does credit risk influence bond yields?

s i
r
3. What are credit default swaps (CDS) and how do they help in
managing credit risk?

v e
i
4. How does historical default experience provide valuable insights for
n
U
credit risk assessment?

L ,
5. Describe the role of stress testing in credit risk management. Why
is it crucial, especially in the post-COVID-19 era?

S O
6. What are the challenges and opportunities in assessing credit risk
in emerging markets?
L /
O
7. How did the COVID-19 pandemic impact credit risk, and what are

C
/
the implications for investors and financial institutions?

E
8. Discuss the changing dynamics of credit risk management, including
C
D
advancements in data analytics, ESG integration, and stress testing.

©D
9. Explain the concept of collateralized debt obligations (CDOs) and
their role in the 2008 financial crisis.
10. How do central banks play a role in mitigating systemic credit risk?

11.15 References
‹ Altman, E. I., Iwanicz-Drozdowska, M., Laitinen, E. K., & Suvas,
A. (2017). Emerging markets and credit risk. International Review
of Financial Analysis, 50, 1-6.

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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes ‹ Duffie, D., & Singleton, K. J. (1999). Modeling term structures of

defaultable bonds. The Review of Financial Studies, 12(4), 687-720.
‹ Jorion, P. (2001). Value at Risk: The New Benchmark for Managing
Financial Risk. McGraw-Hill.
‹ Merton, R. C. (1974). On the Pricing of Corporate Debt: The Risk
Structure of Interest Rates. Journal of Finance, 29(2), 449-470.
‹ Stein, R. M. (1999). A Unified Approach to Credit Risk Measurement.
Journal of Banking & Finance, 23(1), 1-30.
h i
‹

e l
Basel Committee on Banking Supervision. (2000). Principles for the

D
Management of Credit Risk.

of
‹ Kealhofer, S., McQuown, J., & Vasicek, O. (1997). Credit Metrics
- Technical Document. J.P. Morgan & Company.
‹

i ty
Löffler, G. (2003). An Introduction to Credit Risk Modeling. Chapman
& Hall/CRC.
r s
‹

v e
Sironi, A. (2003). An Analysis of European Banks’ SNDs Portfolios.

i
Journal of Banking & Finance, 27(12), 2343-2369.
n
U
‹ Hull, J. C. (2016). Options, Futures, and Other Derivatives (9th ed.).
Pearson.

L ,
O
‹ Jarrow, R. A., van Deventer, D. R., & Wang, R. (2005). Term Structure

S
Derivatives of Credit Risk. Journal of Banking & Finance, 29(2),

L
531-554.
/
‹

C O
Altman, E. I., & Saunders, A. (1998). Credit Risk Measurement:

/
Developments over the Last 20 Years. Journal of Banking & Finance,

C E 21(11-12), 1721-1742.

D
‹ Duffie, D., & Singleton, K. J. (2003). Credit Risk: Pricing, Measurement,

©D
and Management. Princeton University Press.
‹ Mian, A., & Sufi, A. (2009). The Consequences of Mortgage Credit
Expansion: Evidence from the U.S. Mortgage Default Crisis. The
Quarterly Journal of Economics, 124(4), 1449-1496.
‹ Vassalou, M., & Xing, Y. (2004). Default Risk in Equity Returns.
The Journal of Finance, 59(2), 831-868.
‹ On the Pricing of Corporate Debt: The Risk Structure of Interest
Rates. Journal of Finance, 29(2), 449-470.

302 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
CREDIT RISK

‹ Stein, R. M. (1999). A Unified Approach to Credit Risk Measurement. Notes

Journal of Banking & Finance, 23(1), 1-30.
‹ Carey, M., Prowse, S., Rea, J. D., & Udell, G. F. (1993). The
Economics of the Private Equity Market. Federal Reserve Bulletin,
79(8), 591-601.
‹ Gorton, G. B., & Pennacchi, G. G. (1995). Banks and Loan Sales:
Marketing Non-marketable Assets. Journal of Monetary Economics,

i
35(3), 389-411.
Longstaff, F. A., & Rajan, U. (2008). An Empirical Analysis of the
l h
e
‹

D
Pricing of Collateralized Debt Obligations. The Journal of Finance,

of
63(2), 529-563.
‹ Allen, F., Babus, A., & Carletti, E. (2009). Financial Crises: Theory

ty
and Evidence. Annual Review of Financial Economics, 1(1), 97-116.
‹

s i
Basel Committee on Banking Supervision. (2011). Basel III: A Global

e r
Regulatory Framework for More Resilient Banks and Banking
Systems. Bank for International Settlements.
i v
‹

U n
Cihak, M., Demirgüç-Kunt, A., Feyen, E., & Levine, R. (2012).
Benchmarking Financial Systems: A New Approach. World Bank

L
Policy Research Working Paper, 6175.
,
‹

S O
Kroszner, R. S., Laeven, L., & Klingebiel, D. (2007). Banking Crises,

84(1), 187-228.
L /
Financial Dependence, and Growth. Journal of Financial Economics,

C O
Santos, J. A. C. (2012). The Role of Stress Testing in Supervisory
/
‹

E
Frameworks. Journal of Financial Perspectives, 1(2), 39-63.
‹

D C
Fusaro, P. C., & Miller, R. M. (2002). What Went Wrong at Enron:
Everyone’s Guide to the Largest Bankruptcy in U.S. History. John

©D
Wiley & Sons.
‹ Fox, L. (2003). Enron: The Rise and Fall. John Wiley & Sons.
‹ Lev, B., & Dubner, S. J. (2005). Freakonomics: A Rogue Economist
Explores the Hidden Side of Everything. William Morrow.
‹ Gorton, G. (2010). Slapped by the Invisible Hand: The Panic of
2007. Oxford University Press.
‹ Rajan, R. G. (2010). Fault Lines: How Hidden Fractures Still Threaten
the World Economy. Princeton University Press.

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School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes ‹ Lowenstein, R. (2010). The End of Wall Street. Penguin Books.

‹ Shiller, R. J. (2012). Finance and the Good Society. Princeton
University Press.
‹ Eichengreen, B., Hausmann, R., & Panizza, U. (2005). The Pain
of Original Sin. In B. Eichengreen & R. Hausmann (Eds.), Other
People’s Money: Debt Denomination and Financial Instability in
Emerging Market Economies (pp. 29-70). University of Chicago

i
Press.

l h
Gulde, A. M., Schulze-Ghattas, M., & Wolf, H. C. (2003). Currency
e
‹

D
Board Arrangements: Issues and Experiences. IMF Occasional Paper,

of
214.
‹ Reinhart, C. M., & Rogoff, K. S. (2009). This Time is Different:

ty
Eight Centuries of Financial Folly. Princeton University Press.
‹

s i
Spiegel, M. M., & Yamori, N. (2002). Economic Performance and

e r
Political Regimes: The Experience of the Twentieth Century. Economic
Inquiry, 40(2), 248-257.
i v
‹

U n
Claessens, S., & Kodres, L. (2014). The Regulatory Responses to
the Global Financial Crisis: Some Uncomfortable Questions. IMF

L ,
Working Paper, 14(46).
‹

S O
Dang, T. L., & Phan, H. V. (2020). The Economic Impact of the

L /
COVID-19 Pandemic on Developing Asia. Asian Development
Review, 37(2), 84-102.

C O
Georgieva, K. (2021). Averting a COVID-19 Debt Disaster. International
/
‹

CE
Monetary Fund Blog.
‹ Singh, R. K., & Subramanian, K. (2021). Impact of COVID-19 on

D D Banking Sector of India: An Analysis. International Journal of

Business and Globalisation, 27(1), 38-50.
© ‹ Adrian, T., & Shin, H. S. (2010). The Changing Nature of Financial
Intermediation and the Financial Crisis of 2007-2009. Annual Review
of Economics, 2(1), 603-618.
‹ Crouhy, M., Galai, D., & Mark, R. (2014). The Essentials of Risk
Management. McGraw-Hill Education.
‹ Fender, I., & Lewrick, U. (2015). Adding it all up: the macroeconomic
impact of Basel II and outstanding reform issues. In Bank for

304 PAGE
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School of Open Learning, University of Delhi
CREDIT RISK

International Settlements (Ed.), Globalisation and inflation dynamics Notes

in Asia and the Pacific (pp. 227-253). BIS Papers No. 82.
‹ Löffler, G. (2003). An Introduction to Credit Risk Modeling. Chapman
& Hall/CRC.
‹ Schroeck, G. (2011). The Basel Handbook: A Guide for Financial
Practitioners. Wiley Finance.

11.16 Suggested Readings

h i
‹ “Credit Risk Modeling using Excel and VBA” by Gunter Löffler and
e l
Peter N. Posch.
D
of
‹ “The Essentials of Risk Management” by Michel Crouhy, Dan Galai,

ty
and Robert Mark.
‹

s i
“Credit Risk Management: Basic Concepts” by Tony Van Gestel and
Bart Baesens.
e r
‹

i v
“Credit Risk: Models and Management” by David Lando.
‹

U n
“Advanced Credit Risk Analysis and Management” by Ciby Joseph.

,
‹ “The Basel Handbook: A Guide for Financial Practitioners” by Gerhard
Schroeck.

O L
S
‹ “Principles for the Sound Management of Operational Risk” by the

/
Basel Committee on Banking Supervision (BCBS).
L
O
‹ “Handbook of Corporate Debt Instruments” by Moorad Choudhry.
‹

/ C
“Credit Risk Frontiers: Subprime Crisis, Pricing, and Hedging” by

E
Tomasz R. Bielecki and Damiano Brigo.

C
D
‹ “The Oxford Handbook of Credit Derivatives” edited by Alexander

©D
Lipton and Andrew Rennie.

PAGE 305
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 Glossary
Abnormal Returns: Returns that exceed what would be expected based on the risk and
return relationship predicted by financial models. In an efficient market, it is difficult to
consistently achieve abnormal returns.
American Option: Can be exercised any time on or before the expiry.
Arbitrage: Simultaneously entering into sell and purchase transactions of the specific
h i
asset in two or more markets to mitigate the associated risk.
e l
D
Asian Options: Exotic options with a payoff based on the average price of the underlying

of
asset over a specified period.
Asset Price Random Walk: The theory that suggests the movement of asset prices follows

i ty
a random and unpredictable pattern, with future price changes not influenced by past price

s
movements or historical data.

e r
Backtesting: Backtesting is the process of evaluating the performance of a risk model or

i v
strategy using historical data. In the context of VaR, backtesting involves comparing the

n
estimated VaR with actual portfolio losses during a specific period to assess the accuracy
U
,
and effectiveness of the VaR model.

O L
Barrier Options: Exotic options with a feature that activates or deactivates the option’s
payoff based on the underlying asset’s price crossing a pre-set barrier level.

/ S
L
Basis: Basis is defined as the difference between the spot and future prices.

O
Benefits and Risks: The advantages and potential drawbacks associated with options

/ C
strategies involving multiple assets, including the potential for increased returns or losses.

C E
Binary Options: Exotic options with a fixed payoff determined at expiration, depending
on whether a specific condition is met.
D
©D
Binomial Option-Pricing Model: A widely used method for pricing options, based on the
assumption of constant volatility and the construction of a binomial tree for option pricing.
Binomial Tree: A graphical representation of the possible outcomes of an option at each
point in time.
Bond Markets: Markets where bonds, which are debt securities, are bought and sold.
Bonds: Fixed-income securities representing loans made by investors to issuers, typically
governments or corporations.
Break-Even: Point at which no risk and no loss.

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 MBAFT 7408 FINANCIAL DERIVATIVES

Notes BSM Model: A mathematical equation that assess the theoretical value
of pricing securities.
Call Options: An option that gives the holder the right and not an
obligation to buy an underlying stock.
Caps and Floors: Derivative products used to hedge against changes in
interest rates by setting maximum (caps) or minimum (floors) interest rates.
Collateralized Debt Obligation (CDO): A structured financial product

i
that pools various debt instruments, such as mortgages or corporate loans,
h
l
and issues different tranches of securities based on their credit risk.
e
D
Compound Options: Exotic options that give the holder the right to buy

of
or sell another option at a predetermined price.
Computational Tools: Software programs and algorithms used to perform

ty
calculations, simulate scenarios, and optimize options strategies in financial
engineering.
s i
e r
Constant Volatility: An assumption made in the binomial model that the

i v
volatility of the underlying asset remains constant.

U n
Construction of Options Strategies: The process of selecting and combining

,
options contracts based on market conditions and desired outcomes.

L
Cost of Carry: It is the storage cost plus the interest cost if any for

O
S
financing the asset minus the income generated from the asset.

L /
Credit Default Swaps (CDS): Financial contracts that allow investors

O
to transfer the credit risk of a specific asset or entity to another party in

/ C
exchange for periodic premium payments.

C ECredit Derivatives: Instruments used to manage credit risk, including

credit default swaps and Collateralized Debt Obligations (CDOs).
D
©D
Credit Risk: The potential risk of loss arising from the failure of a
borrower or issuer to meet its financial obligations.
Credit Spread Options: Options contracts that provide the buyer with
the right but not the obligation to buy or sell credit risk exposure at a
specified credit spread level.
Cross Hedge: A cross hedge occurs when a futures contract is used to
hedge against price movements in a related but not identical asset.

308 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 GLOSSARY

Currency Swap: A currency swap is a financial arrangement between two Notes

parties to exchange interest rate cash flows (similar to IRP) as well as
the capital amount (not similar to IRP) in one currency for an equivalent
amount in another currency.
Cybersecurity: Measures and practices implemented to protect computer
systems and networks from security breaches and cyber threats.
Data Analytics: The use of advanced data analysis techniques, including

i
artificial intelligence and machine learning, to gain insights and make
informed decisions.
l h
D
Delivery Price: The pre-fixed/pre-negotiated price of the specific underlying
e
of
asset at which the forward contract will settle in the future time.
Derivative: A financial instrument whose value is derived from an

ty
underlying asset.

s i
Diversification: A risk management strategy that involves spreading

e r
investments across different assets or asset classes to reduce overall risk.

i v
Efficient Market Hypothesis (EMH): A theory that asserts that asset

U n
prices always reflect all available information, making it impossible to
consistently predict future price movements and earn abnormal returns.

L ,
Environmental, Social and Governance (ESG) Factors: Criteria used

O
to evaluate a company’s environmental impact, social responsibility, and

S
corporate governance practices.

L /
O
European Option: Can be exercised only on expiration.

/ C
Exotic Options: Non-standard options contracts with unique features and

E
payoffs, including compound options, binary options, barrier options, and
Asian options.

D C
©D
Exposure: The amount of financial risk faced by an investor or financial
institution due to potential losses from credit defaults.
Financial Engineering Concepts: Mathematical models, quantitative
methods, and computational tools used to design and implement options
strategies.
Financial Engineering: The application of mathematical and computational
techniques to design, create, and manage financial products and strategies.
Financial Intermediaries: Institutions that facilitate the flow of funds
between savers and borrowers in financial markets.

PAGE 309
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Financial Markets: Platforms where buyers and sellers trade financial
assets.
Foreign Exchange Markets: Markets where different currencies are
exchanged.
Forwards: Contracts where parties agree to buy or sell an asset at a
future date at a predetermined price.
Fundamental Analysis: An approach to evaluating investments that
focuses on examining the underlying value and prospects of an asset,
h i
l
including factors such as earnings, cash flows, and industry conditions.
e
D
Future: A contract that provides a way to set a price of a commodity

of
or currency at a future date. This contract arises an obligation on part
of buyer and seller to execute it.

ty
Greeks: Statistical values based on past data to understand the behaviour
of the underlying.
s i
e r
Hedge Ratio: The futures position to cash market position ratio is known
as the Hedge Ratio.
i v
U n
Hedging: A strategy used to minimize or offset potential losses by taking

,
an opposite position in another asset.

L
Historical Default Experience: The past data and statistics on the

O
S
frequency and severity of credit defaults across different asset classes

/
and time periods.
L
O
Historical Simulation: This method of calculating VaR uses historical data

/ C
to estimate the potential loss. It involves analysing past price or return

E
data to create a distribution of possible outcomes and then determining

D C the VaR based on the desired confidence level.

©D
Identically Distributed: Implies that the distribution of price changes
remains consistent over time, assuming that the underlying market
conditions remain the same.
Independence: The characteristic of random walks where price changes
are not influenced by previous price movements. Each price change is
considered to be independent of the prior movement.
Index Options: An option whose underlying stock is an index itself.

310 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 GLOSSARY

Informed Investment Decisions: Decision-making based on careful Notes

analysis, evaluation of risks and returns, and understanding the role of
financial engineering concepts in options strategies.
Interest Rate Swap: A financial derivative contract where two parties
agree to exchange interest rate payments on a specified notional principal
amount. It allows one party to swap fixed interest rate payments for
floating interest rate payments, or vice versa.

i
Investment Objectives: The goals and targets set by investors, such as
capital preservation, income generation, or capital appreciation, which
l h
guide the design and implementation of options strategies.

D e
of
Liquidity Stress: A situation where a financial institution or market faces
difficulties in obtaining sufficient liquid assets to meet its obligations.

ty
Long Hedge: A long hedge involves buying futures contracts to protect

s i
against a potential increase in the price of an underlying asset that you
own.
e r
i v
Long Position: The party who give consent to buy the specific underlying

receive the underlying asset in the future.

U n
assets at a given date, and at a given price. The person is eligible to

L ,
Long: Taking a long position i.e., buying a call or put.

O
Market Efficiency: The degree to which prices in the market accurately

S
L /
reflect all available information. In an efficient market, it is difficult to
consistently gain an advantage by identifying undervalued or overvalued
assets.
C O
E /
Market Risks: The potential for losses due to changes in market conditions

C
or unexpected events.

D
Market Scenarios: Different situations or conditions in financial markets

©D
that impact the performance and outcomes of options strategies.
Money Markets: Markets for short-term borrowing and lending, typically
involving low-risk financial instruments.
Monte Carlo Simulation: Monte Carlo simulation is a computational
technique that uses random sampling to model and analyse the behaviour
of complex systems. In finance, it is often used to estimate VaR by
generating a large number of random scenarios and calculating the resulting
portfolio values or returns.

PAGE 311
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Multiple Asset Options: Options contracts that involve more than one
underlying asset, allowing investors to design strategies based on the
performance of several assets.
Non-Performing Loans (NPLs): Loans that have defaulted or are expected
to default on their scheduled payments.
Normal Linear VaR: It refers to the calculation of VaR using a normal
distribution assumption. This approach assumes that asset returns follow

i
a normal distribution and calculates VaR based on the mean and standard

h
deviation of the returns.

e l
Option: A contract that gives buyer the right to either purchase or sell

D
an underlying stock at a certain price within specific time.

of
Option Pricing: The process of determining the fair price of an option

ty
contract.

i
Options: Contracts giving the buyer the right, but not the obligation, to

s
r
buy or sell an asset at a specific price within a certain period.

v e
Options Strategies: The combination of multiple options contracts to

n i
achieve specific investment objectives or exploit market opportunities.

, U
Participants: Individuals, corporations, financial institutions, and government
entities involved in financial markets.

O L
Payoff: The financial outcome or profit/loss resulting from an options

S
strategy or investment position.

L /
Predictability: Refers to the ability to forecast or anticipate future price

O
changes based on historical patterns or other indicators.

C
E /
Probability of Default (PD): The likelihood that a borrower or issuer
will default on its debt obligations within a specific timeframe.

D C Put Option: An option contract that grants the holder the right to sell

©D
the underlying asset at a specified price and time.
Quadratic Model: A quadratic model is a mathematical model that
represents a relationship between variables using quadratic equations.
In the context of risk management, a quadratic model may be used to
estimate the risk or potential loss of a portfolio based on the relationships
between different assets or factors.
Quantitative Methods: Mathematical and statistical techniques used to
analyze and model financial data, market behaviour, and the performance
of options strategies.

312 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 GLOSSARY

Random Shocks: Unexpected events or news that impact asset prices Notes
and can lead to sudden and significant price fluctuations.
Risk and Return: The trade-off between the potential for gains (return)
and the possibility of losses (risk) in options strategies. Evaluating and
managing this trade-off is crucial for making informed investment decisions.
Risk Free Rate: A rate of return without risk e.g., rate of return on
treasury bill.
Risk Management: The process of identifying, assessing, and mitigating
h i
potential risks associated with options strategies, considering factors such
e l
D
as market volatility, correlation, and liquidity.

of
Scenario Analysis: A risk management technique that examines the impact
of specific scenarios on a portfolio’s performance.

ty
Semi-Strong Form Efficient Market: A form of market efficiency that

s i
posits that asset prices reflect all publicly available information, including
news, announcements, and other market data.
e r
i v
Short Hedge: A short hedge involves selling futures contracts to hedge

plan to sell in the future.

U n
against a potential decrease in the price of an underlying asset that you

L ,
Short Position: The party who give consent to sell the specific underlying

O
assets at a given date, and at a given price. The person is entitled to

S
/
deliver underlying asset in the future.

L
O
Short: Taking a short position i.e., selling a call or put.

/ C
Sovereign Credit Risk: The risk associated with a government’s ability

E
to meet its debt obligations.

C
Speculating: A strategy used to profit from market movements by taking
D
©D
a position in an asset.
Spot Price: The current market price of the specific underlying asset is
known as spot price.
Stock Markets: Markets where shares of publicly traded companies are
bought and sold.
Stress Testing: Stress testing involves subjecting a portfolio or financial
system to extreme scenarios or adverse conditions to assess its resilience
and potential losses. It helps identify vulnerabilities and weaknesses in a
portfolio and evaluate its performance under different stress conditions.

PAGE 313
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
 MBAFT 7408 FINANCIAL DERIVATIVES

Notes Strike Price: The price at which the contract of option (call or put) may
be exercised.
Strong-form Efficient Market: The strongest version of the EMH,
suggesting that asset prices reflect both public and private information,
making it impossible for any market participant to consistently achieve
abnormal returns even with access to private information.
Structured Products: Complex investment products combining various

i
financial instruments to meet specific risk profiles or objectives.

l h
Supply and Demand: Factors influencing the availability and desire for
financial assets in the markets.
D e
of
Swap: A swap is a financial derivative contract in which two parties
agree to exchange cash flows or financial instruments over a specified

ty
period of time. Swaps are typically traded over the counter (OTC), as
they are customized agreements.
s i
e r
Swaptions: Options to enter into an interest rate swap or other types of
swaps.
i v
U n
Technical Analysis: An investment approach that relies on historical
price patterns, charts, and technical indicators to predict future price

L ,
movements and make investment decisions.

O
Total Return Swaps (TRS): Derivative contracts that allow parties to

S
ownership.
L /
exchange the total return of an underlying asset without transferring its

C O
Underlying Assets: An Assets from which an option derives its values.

E /
Value at Risk (VaR): VaR is a widely used risk management measure

D C that estimates the potential loss of an investment or portfolio over a

specified time horizon and at a given level of confidence. It quantifies

©D
the maximum expected loss under normal market conditions.
Weak-form Efficient Market: A form of market efficiency that suggests
all historical price and volume information is already reflected in asset
prices, making it impossible to use past data to gain an advantage in
predicting future price movements.

314 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi