Forward/ Futures

This is an agreement between two parties in which the seller contracts to sell an asset to the buyer at
a specified amount (K), called the delivery price, on a specified future date ‘T’.

Futures Vs Forwards
Futures are different from the forwards in following respect:
• Futures are exchange traded
• Futures are standardized
• In futures Counter-party risk is minimal (the counterparty is an exchange)
• Futures are marked-to-market everyday

Pricing of Forwards/Futures
Pricing of forward contract is done by replication and using the principle of ‘Riskless Arbitrage’.

Riskless arbitrage exists if:

• A deal that costs zero today generates a positive payoff sometime in the future.
• A deal generates positive initial cash flow, and non-negative future payoff.
For example to replicate a long position in oil forward one can borrow cash, buy oil spot and store it.
Since this portfolio will have value exactly equal to the long position in forward on maturity, both will
be priced equally even today. If this is not the case one can make riskless profit by selling the
expensive asset and buying the cheaper one (Riskless Arbitrage)
At a broad level using the above principle leads to a forward price which has the following form:

Forward Price = Spot Price + Cost of Carry

Here cost of carry, depending on the type of asset takes into account factors like cost of storage,
dividend payments, interest payments, insurance, transportation cost etc.
For most commodities the future prices are usually higher than the current spot price. This is because
there are generally costs associated with storage, freight and insurance. When the futures price is
higher than the spot price the situation is known as Contango and if the futures price is lower than the
spot price the situation is known as Backwardation. Backwardation occurs in situation where it is
beneficial to consume assets, like during strikes, shortages etc.

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Forward Rate Agreement (FRA)
It is an agreement where the seller contracts to lend to the buyer a specified amount for a specified
rate for a specified period starting at a specified future date. Typically, a FRA is cash settled by paying
/ receiving the difference between the specified interest rate and a benchmark interest rate. A typical
FRA quote looks like:
INR 6X9: 9:00-9:20 p.a.

This has to be interpreted as, that bank will accept 3 month INR deposit starting six months from now
and maturing 9 months from now, at an interest rate of 9.00% (bid rate). Whereas it will lend INR for a
period of 3 months starting six months from now, maturing 9 months from now, at an interest rate of
9.20% (offer rate).

Pricing of FRA

Pricing of FRA also follows the general principle of riskless arbitrage. Consider a INR 6x9 FRA:
In this FRA forward period is 6 months and the loan is for 3 months. Suppose a bank wants to sell this
FRA to a client given that
1. The Offer rate for 9 months is say x%.
2. The Bid rate for 6 months is say y %
To price this FRA bank will use the following strategy:
The Forward rate would be calculated for 3 month period assuming bank has offered 9 month loan
today itself at its offer rate i.e. x % and taken it back from the client for 6 month at its bid rate i.e. y%.
In other words the replicating portfolio for a short position in the given FRA is
• A long position in 9-month bond
• A short position in 6-month bond.
Thus FRA like any other forward contracts is also valued using the principle of replicating portfolio
and riskless arbitrage.

Sale & Purchase of FRA:

• The purchase of a FRA protects against a rise in the interest rates, where any party is to
borrow in the cash markets.
• The sale of a FRA protects against a fall in the interest rates, where any party is to lend in the
cash markets.
In dian Scenario
A FRA is settled by exchanging the difference between the pre-specified rate and a benchmark rate.
The characteristics of a good benchmark are:
1. Transparency
2. Liquidity and depth
3. Availability for the life time of the FRA
Presently, in India there is no acceptable benchmark especially for the long tenor floating leg. The
inter-bank market is quoting its benchmark only against the 91-Day T-bill cut-off yield.
The probable benchmarks that could emerge in the future could be:
• Crisil Government of India Securities benchmark
• Reuters Commercial Paper Rates for different tenors
• Treasury bills primary auction cut-off or secondary market rates
• Inter-bank term money rates
• Prime Lending Rates

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 • Interest Rate Swap Reference Rates
• Repo Reference Rates
Polling of brokers is another mechanism that is being used for arriving at the benchmark in the Indian
market. Here generally the parties involved appoint the Calculation Agent. At the time of entering into
a contract, the parties identify the mutually acceptable brokers/primary dealers/banks for polling. The
collection agent carries out polling on the settlement date. The average of the rates so polled is then
used as the benchmark. The polling might be done just on the effective date or may be for few days
around the effective date.

Risks in a FRA

Market Liquidity Risk

Market Liquidity Risk is the risk that a position will be difficult to reverse by either liquidating the
instrument or by contracting an offsetting position. A FRA tends to have substantial liquidity risk as
these contracts are customised to the requirement of the counterparties.

Funding / Interest Rate Risk

Funding risk arises if the FRA contract results in cash outflow on account of adverse interest rate
movement, at maturity. There is negligible Funding risk in an FRA as against Cash transaction as only
the net interest settlement amount is to be paid or received. An FRA, being a hedge transaction, the
client would gain on the underlying transaction, if the position in the FRA is reverse that of the
underlying transaction. At the time of initiating the FRA, the net cash exchange is expected to be zero.
With passage of time, this expectation may change if the benchmark rates move substantially.
Participants need to recognise any expected cash outflows in their liquidity planning. If the net
settlement amount is expected to result in inflow of funds, it may be ignored for the purposes of
liquidity planning. This is in line with the principal of conservatism.

Credit Risk
Credit risk estimates the potential loss that might arise due to the inability of a counter-party to meet
its obligations. For each counter-party, the institution may choose to set a sub-limit based on some
internal credit risk model for the FRA product, although some advanced credit-risk management
systems, which consolidate credit risks across products, may also be employed.

Currency Forwards
They are the most widely traded forms of forward contract. In currency forward as the name
suggests the underlying security is the currency.

Pricing of Currency Forwards

Forward Price = Spot Price + Cost of Carry (Forward Premium)
If there are no restrictions on capital flows then forward Premium should be equal to the Interest rate
differential between two currencies. This is known as Covered Interest Rate parity. So if the domestic
interest rates are higher than the foreign currency interest rate than the currency will depreciate over
time, as is the case with dollar-rupee exchange rate.
A related concept to covered interest rate parity is that of uncovered interest rate parity. This states
that forward rates are the best predictor of expected future spot rates.

Index Futures
Index Futures are futures contracts with a stock index as the underlying. Index Futures stand as a
cost-effective and efficient instrument to take exposure to the broad market.

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Index Futures in India
Index Futures trading started on The Stock Exchange, Mumbai (BSE) and National Stock Exchange
(NSE) in June, 2000. The contracts being traded are 3 month maturity futures on Sensex and Nifty.
Hence at any point of time, 3 separate maturity contracts are outstanding e.g. if the current month is
October then there will be futures contracts outstanding for October, November and December.
• The daily trading volume in futures was around 50 crores till February 2001. Then volumes
plummeted in the wake of the short-sell ban by SEBI. After the introduction of structural
reforms by SEBI from July 2, 2001 onwards, futures volume has shown a rising trend and the
current daily trading volume stands at around 150 crores or roughly 10 percent of the
underlying stock market volume.
• However, the liquidity is concentrated in only near month contracts. This makes rollover a
difficult and expensive process.
• The Bid - Ask spread in the Index Futures has narrowed down to around 0.1 percent from the
initial spread of more than 0.5%.
• Institutional players are not allowed to short shares. This may lead to index future contracts
being undervalued. (Main reason behind 'correct' valuation of index futures is the presence of
arbitrageurs. If Index futures are under-priced, arbitrageurs sell the underlying basket of
shares and buy index futures. The lack of an efficient lending-borrowing mechanism makes
shorting a difficult process. Hence, the futures has recently traded at a discount to its ‘correct’
value.)

Swaps
A swap agreement or transaction is an Over the Counter (OTC) contract under which the counter
parties agree to exchange a set of cash flows on pre specified dates. The cash flows to be exchanged
could be fixed or are determined according to a pre-determined formula. E.g. the cash flow payable
for one of the counterparties in a swap agreement could be a floating interest rate or it could be
linked to the price of a commodity.
Classification of swaps is done on the basis of what the payments are based on. The different types of
swaps are as follows.
• Interest Rate Swaps
• Currency Swaps
• Commodity Swaps
• Equity Swaps

Interest Rate Swaps

In an interest rate swap, the counter parties agree to exchange the interest on a notional principal on
pre specified dates according to pre determined formulae. For example:
Party A may agree to pay to party B LIBOR + 1% semi annually for 3 years in exchange for a fixed
rate of 8% on a notional principal of 1 million USD. The fixed rate which the party B pays is known as
the swap rate. Note that in interest rate swaps the principal amounts are not exchanged.

Reduction in Borrowing Cost

The rationale for entering into interest rate swaps is often cited as Ricardo’s Principle of Comparative
Advantage. According to this principle, if a country A has an absolute advantage over country B in
producing both cloth and wine (say), it does not mean that they should not trade. The principle is
demonstrated with an interest rate swap as an example. Party A can borrow at a fixed rate at 9.5% or
at a floating rate at LIBOR+2%. Party B, on the other hand, can borrow at a fixed rate of 11% or at a

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floating rate of LIBOR+2.5%. A has an absolute advantage over B in both markets. But the question is
that if A needs a floating rate loan and B needs a fixed rate loan, should they just access the fixed rate
and floating rate market respectively? It can be shown that if A borrows fixed and B borrows floating
and they enter into a swap, they can reduce their borrowing cost by 0.5% each.

By the above arrangement, Party A has managed to borrow at LIBOR+1.5% and party B has
borrowed at 10.5%. Market makers in swaps play an important role in bringing together such parties
with complimentary requirements and charge part of the savings in the form of a spread.
In the above example, an interest rate swap has helped two parties in reducing their costs of
borrowing.

Risk Management
Another very important use of interest rate swaps is in the area of risk management. Interest rate
swaps can be used to change the nature of assets and liabilities very effectively. E.g. if a company
has a fixed rate loan and its revenues are linked to the interest rates; it can shift from a fixed rate loan
to a floating rate loan using a swap. This would link both its assets and liabilities to the same factors
and reduce the risk being carried. In the context of financial institutions, this can be used for asset
liability management. A financial institution with long term liabilities and short-term assets can swap
the liabilities into a floating rate and hence reduce the tenor of the liabilities.

Pricing of Interest Rate Swaps

Swaps can be viewed as a combination of a long and a short position in bonds. E.g. the party A in the
above example is paying LIBOR and receiving 8% on a notional principal. This is the same as short
position in a floating rate bond (on which it has to pay LIBOR) and a long position in a bond that pays
a fixed rate of 8%. On a coupon paying date, a floating rate bond is valued at par. This is the principle
behind pricing the fixed leg of the swap. The fixed rate is such that the fixed leg also values to par at
the inception of the swap.

Interest Rate Swaps in India

The Reserve Bank of India (RBI) has allowed interest rate swaps for hedging purposes as long as the
benchmark being used for determining the floating rate is a money market or a debt market
instrument. However, for providing liquidity and depth to the market, banks are allowed to be market
makers for swaps. Banks and Primary Dealers can also be market makers after setting limits internally
and getting them approved by RBI.
One very important requirement for the existence of a liquid swap market as for the FRA market is the
existence of an acceptable transparent and liquid benchmark that can be used for determining the
floating leg of the swap. For many currencies, the LIBOR acts as the most liquid benchmark. In our
case, we lack a good benchmark. The most widely used benchmark is the overnight Mumbai Inter
Bank Offer Rate (MIBOR), which is a reference rate for the call money market. Since, this is an
overnight rate, the floating leg is calculated everyday and the swaps are called overnight interest rate
swaps (OIS). The maximum tenor for which such swaps are undertaken is 1 year. A new benchmark

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that has been introduced recently by Reuters is fast becoming popular. It is the Mumbai Forward
Offered Rate (MIFOR) and is calculated based on the forward premia for Rupee/Dollar exchange rate.
For undertaking longer tenor swaps, reference rates for longer tenors are required. Benchmarks
discussed in for the FRA can also be used for interest rate swaps.

Another kind of swap which is gaining in popularity in the Indian market is Constant Maturity
Treasury (CMT) swap.
A Constant Maturity Swap can be regarded as an Interest Rate Swap where the interest rate on one
leg is reset periodically but with reference to a market swap rate referred to as constant maturity rate.
The other leg of the swap could be any of the three: MIBOR or any other floating rate benchmark, a
fixed rate or another constant maturity rate. Constant Maturity Swaps can either be single currency or
cross currency Swaps. Consider as an example, a CMS agreement to exchange 6-month MIBOR with
a 5-year swap rate every six months for the next three years. Thus, every 6 months the floating rate
would be set to the prevailing 5-year swap rate. In order to keep the maturity constant, the reference
swap rate is reset at each reset date. The swap payments are made with a lag. The payment being
made at time (t+i) corresponds to the reference swap rate at time t. A Constant Maturity Treasury
(CMT) swap is a type of CMS where the reference swap rate is set equal to the yield on some treasury
bond. For example, an agreement to swap the 6-month MIBOR for the yield on a 5-ye government
bond is an example of a CMT swap.

Target Market

The Constant Maturity Swap is an ideal product for two types of users:
A. Corporates or Investors seeking to maintain a constant asset or liability duration.
B. Corporates or Investors seeking to take a view in the shape of a yield curve who seek the
flexibility that the Constant Maturity Swap provides.

Benefits over a plain vanilla IRS

1. It enables the investor to indulge in curve play- taking advantage of expectations of movements
in the spreads between the swap rate and the floating benchmark rate. Since the value of the
CMS is extremely sensitive to the slope of the yield curve, it provides a more precise tool with
which to take a position on the future shape of yield curves. If an investor believes that the spread
between the 10-year swap rate and the 6-month LIBOR rate is going to decrease in the future, he
can enter into a CMS in which he will receive the 6-month LIBOR and will pay the 10-year swap
rate. It is also possible for the investor to execute his view on the shape of the yield curve by
receiving one constant maturity rate and paying another constant maturity swap rate.
This can be illustrated through an example:
The interest rate yield curve is currently positively sloped with the current 6mth MIBOR at 5.00%
and the 3yr Swap rate at 6.00%, the 5yr swap at 8.00% and the 7yr swap at 8.50%. The current
differential between the 3yr swap and 6mth MIBOR is therefore +100bp. An investor believes that
this spread will narrow substantially at some time over the next 2 years. The investor is unsure as
to when the expected flattening will occur, but believes that the differential between 3yr swap and
MIBOR (now 100bp) will average 30bp over the next 2 years. In order to take advantage of this
view, the investor can use the Constant Maturity Swap. The investor can enter into the following
transaction for 2 years:

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 Investor Receives: 6 month MIBOR
Investor Pays: 3 year Swap mid rate less 55 bp (semi annually)

As the current spread is 100bp, the investor will be required to pay 45bp for the first 6 months. It
is clear that if the investor is correct and the differential does average 30bp over the two years,
this will result in a net flow of 25bp to the investor. The advantage is that the timing of the
narrowing within the 2 years is immaterial. As long as the differential averages less than 55 basis
points, the investor wins.
2. The constant-maturity treasury swap provides a mechanism similar to a normal swap for bridging
an asset-liability mismatch on the balance sheet. Its advantage in some cases arises because a
widely accepted short-term benchmark is often unavailable. Even if it is available, one may not be
willing to use that benchmark because of shallow illiquid markets in the benchmark making it
subject to abnormal swings. In such cases, this concern can often be overcome using a CMT
swap.
3. Investors can use CMS/CMT swap to target specific instrument maturities. The structure of the
swaps is such that they are effectively locked into the rate on a constantly rolled over instrument
of specific term. This is in contrast to the investor who holds say a fixed asset instrument. For e.g.
the investor wants to hold a bond of 10 years maturity. If he buys the bond, after one year, its
maturity becomes 9 years and so the investor’s purpose is not served. But by entering into a
CMS, the investor can maintain constant asset duration.

Currency Swaps
Currency swaps are similar to interest rate swaps in principle but they differ in two respects. Firstly
the interest payments for the two counter parties are in different currencies and secondly an
exchange of principal is also involved.
The rationale for currency swaps is also similar to interest rate swaps. One party may have a relative
advantage in borrowing in one currency whereas it may need funds in some other currency. A
currency swap can be used in such cases to reduce the cost of borrowing. The first currency swap
was arranged between World Bank and IBM. The World Bank needed funds in Swiss Francs but it
was getting very high rates in Francs. At the same time, it had access to very low rates in US Dollars.
On the other hand, IBM needed dollar funds and access to cheap Franc funds. The deal was arranged
so that IBM borrowed in Francs and World Bank in Dollars and they swapped the loans, thus fulfilling
their requirements at cheaper rates.
In the Indian context, currency swaps could be used to access overseas markets for funds in an
indirect way. A corporate may want to take a dollar denominated loan but may not be able to do so
because it is unknown in the foreign markets. It may then take up a rupee loan and convert it to a
dollar loan by entering into a dollar rupee swap. Sometimes, it may turn out to be cheaper for parties
to obtain very cheap loans denominated in foreign currencies. If the party needs rupee funds and has
all its revenues in rupees, it can swap the foreign currency loan into a rupee loan.
Currency swaps are also used for hedging. E.g. if a company has revenues in dollars and a rupee
liability, it can swap the liability to dollars and thus reduce the foreign exchange risk that the company
is running.

Pricing of Currency Swaps

The principle for pricing of currency swaps is similar to the pricing of interest rate swaps. At the time
of inception of the swap, the present value of one of the legs should be equal to the present value of
the second leg when converted at the spot rate. The cash flows are known for both the legs and they

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are discounted at the respective yield curves. The present value of one of the legs is converted to the
other currency at the spot rate and compared to the present value of the other leg. The rates are
adjusted so that the two legs become equal.

Commodity Swaps
In commodity swaps, the cash flows to be exchanged are linked to commodity prices. Commodities
are physical assets such as metals, energy stores and food including cattle. E.g. in a commodity
swap, a party may agree to exchange cash flows linked to prices of oil for a fixed cash flow.
Commodity swaps are used for hedging against
• Fluctuations in commodity prices or
• Fluctuations in spreads between final product and raw material prices (E.g. Cracking
spread which indicates the spread between crude prices and refined product prices
significantly affect the margins of oil refineries)
A Company that uses commodities as input may find its profits becoming very volatile if the
commodity prices become volatile. This is particularly so when the output prices may not change as
frequently as the commodity prices change. In such cases, the company would enter into a swap
whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. A
producer of a commodity may want to reduce the variability of his revenues by being a receiver of a
fixed rate in exchange for a rate linked to the commodity prices.

Options
Options are contracts that confer on the buyer of the contract certain rights (rights to buy or sell an
asset) for a predetermined price on or before a pre-specified date. The buyer of the option has the
right but not the obligation to exercise the option.
Options come in a variety of forms. Some option contracts, which have been standardized, are traded
on recognized exchanges. Other option contracts exist that are traded "over-the-counter". i.e., a
market where financial institutions and corporates trade directly with each other over the phone.
Besides these, options also exist in an embedded form in several instruments.
They popular basic instruments/variables underlying options are :
• Equity – index options, options on individual stocks, Employee Stock Options
• Interest rates – Bond options, Interest rate futures options, Options embedded in
bonds, Caps & Floors etc
• Foreign Exchange – Plain vanilla calls and puts, barrier options, various kinds of exotic
options
• Others – including commodities, weather, electricity etc.

Classification
Nature of the Right
• A call option gives the holder of the option the right to buy the underlying asset by a
certain date for a certain price.
• A put option gives the holder of the option the right to sell the underlying asset by a
certain date for a certain price
• A digital option gives the holder a certain payoff contingent on a certain event.

Time to Exercise
Options can be either "European" or "American". European options allow the holder to exercise his
right only on the final maturity date. American options on the other hand allow the holder to exercise

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the option on any date before the maturity date. "Bermudan" options that allow exercise on a fixed
number of dates during the tenor of the option are also available.

Mark to Market Position

An additional basis of classification could be the "moneyness" of the option. In-the-money options are
those that would lead to a cash inflow if exercised immediately. Similarly, Out-of-the-money options
are those that would lead to a cash outflow while at-the-money options would be cash neutral on
immediate exercise.
Payoff profiles

Purpose
Like any other derivatives options can be used for
• Speculation: implementing a view on the price of the underlying or on the volatility of
the underlying. Typically, options are used to take positions based on volatility views.
• Hedging: Reducing exposure to movements in the underlying
Using combinations of the various simple options, various kinds of complicated trading strategies can
be implemented.

Put-C all Parity

The prices of European puts and calls exhibit one very important relationship called the put-call
parity. This relationship makes no distributional assumptions and according to the put-call parity, the
prices and puts and calls are related by the following equation

It shows that the value of a European call with a certain exercise date and a certain exercise price can
be deduced from the value of a European put with the same exercise price and date and vice versa.
Option Pricing
The Black Scholes (B-S) option-pricing model is the first and most popular model for pricing options.
The model assumes that the underlying asset follows:
• Continuous time Wiener process,
• Asset prices are lognormally distributed.
• No transaction costs,
• Short selling is permitted
• Asset price volatility is constant
• There are no riskless arbitrage opportunities,

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 • The risk free interest rate is constant.

Under the above assumptions, the price of a European call is given by

where, s =volatility, S = Stock price, X = Exercise price, r = risk free rate of interest
T= time to maturity and t = time now
For American style options there are no closed form option pricing formula. Binomial trees are used
to price them.

Violations of assumptions
Most of the above assumptions are not valid in the real world. The market handles this problem in
different ways.
• Constant volatility assumption: The volatility does not remain constant with time. If
the estimate of average future volatility is correct, it will lead to a correct price.
However, determination of hedge ratio requires accurate estimation of volatility over
rest of the maturity of the option.
• Constant interest rates: This assumption, though not very significant in pricing of
options on equities, assumes a great deal of significance when dealing with interest
rate options. To overcome these problems, several interest rate option pricing models
have come into existence (e.g. – Vasicek, Cox-Ingersoll-Ross, Hull-White, Black-
Karasinsky, Heath-Jarrow-Morton etc.)
• Log normal asset prices: The assumption that prices are lognormally distributed is
violated systematically. The prices follow a distribution with excess kurtosis (fat tails)
than that implied by a log-normal distribution. The market recognizes this fact and
hence, there are differences in the volatilities of deep in-the-money, deep out-of-the-
money options and at-the money options. This is manifested in terms of implied
volatility smiles and smirks. Volatility smile (or smirk) is referred to a phenomenon
where the market uses different implied volatilities for options of different strike
prices. Volatility smiles are typically observed in currency options and currency
smirks are observed in Equity options.

Hedging of options
Implied Volatility

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Unlike other derivative instruments like forwards and swaps, a static hedge cannot be devised for
options. If an institution that has written an option wants to hedge it, it has to resort to dynamic
hedging, i.e., adjusting the hedge continuously.

The Indian Scenario

The Securities Contract Regulation Act (as amended) defines derivatives to include, inter alia, a
security derived from a debt instrument, share, and loan whether secured or unsecured, risk
instrument or contract for differences or any other form of security. The provisions of the SCRA say
that no contract for sale or purchase of such securities may be entered into other than between
members of a recognized stock exchange. Currently, options are not traded on any recognized
exchange in the country. But options do exist in various forms primarily because options are allowed
to be embedded in other securities. Some examples of options in Indian markets are
• Embedded puts/calls in corporate bonds: Options have existed in this form for long. Bonds with
embedded call allow the issuer to call back the option at any one of the coupon payment dates
(Bermudan style). In case of embedded puts, the investor has the right to put the bond back to
the issuer.
• Cross-currency options:
Trading in options on the Rupee-Dollar exchange rate are not allowed in India, though corporates
canuse them to hedge exposures with the maturity of the option matching the maturity of the
exposure. However, options on crosses (USD/JPY, USD/EUR, etc) are allowed. There are no
restrictions on authorised dealers (e.g. banks) on entering into any option positions, as long as they
are buyers of the option structures. In case 2 or more options are being traded as a part of a
structured deal, the net premium paid by the Indian counter-party has to be positive. However,
corporates and restricted dealers can use options and option structures only for hedging purposes.
This requires that the exposure being hedged be identified while booking positions and the
corporate/RAD in turn be a net premium payer for the option structure.

There is a small active market in cross-currency options with corporates using these structures both
or hedging as well as speculative purposes. Structures include plain vanilla European options, path
dependent options such as barriers and double barriers (knock-outs and knock-ins), as well as
structures such as bull and bear spreads, risk reversals1, range-forwards2, etc. Most of the currency
option structures are provided by foreign banks in India, who cover these positions back-to-back with
their overseas offices which manage the risk. The market is expected to develop further with
corporates becoming more knowledgeable about as well as increasing their risk appetite to these
exotic products. RBI approval for trading options on the rupee, when it comes, is expected to provide
a fillip to this market.

Bull Spread Bear Spread

1
Risk reversal refers to the implied volatility difference between a call and a put option of a given maturity at a given delta..
Typically risk reversals are quoted for 25 delta position for a given maturity. (eg. 1 month risk reversal is C 0.25) The prefix
indicates the type of option, call or put, that is trading at a premium to the other.
2
Range Forward refers to buying a call on a currency as well as selling a put on the same currency at a lower strike. The payoff
is similar to that of a forward with a flat between the two strikes

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 Strike 2 Strike 2

Current Current
Spot Spot

Range Forward

Strike 1

Put Strike Call Strike

Equity/Index Options

Index options trading started on The Stock Exchange, Mumbai (BSE) and National Stock Exchange
(NSE) in June, 2001. Options on both Sensex and Nifty are European options and are cash settled.
The daily trading volumes in index options has been in the range of 15-20 crs. The liquidity is mainly
concentrated in near month at-the-money options. The bid-ask spread in index options is very high as
there are few institutional players in the index options market.

Options on individual stocks were introduced in July 2001. The options were introduced on 31 stocks
which were selected on the basis of some SEBI stipulated criteria viz. Liquidity, free float, market cap
and volatility. Unlike index options, options on individual stocks are American in nature. These
options are also cash settled currently but will move to physical delivery based exercise shortly. The
liquidity in stock options is restricted to only 6-7 stocks. The daily trading volume in stock options is
currently in the range of 100 crores.

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