Derivatives - Betting: Chapter Break Up

CA FINAL – FINANCIAL REPORTING TAYAL INSTITUTE
Derivatives - Betting
Chapter Break up
1. Introduction
2. OTC Derivatives
3. Futures
4. Options
Part – I Introduction
Definition
Book : It’s a financial contract which derives its value from some underlying Asset.
Our Mentality : It’s a betting instrument. You want to bet on stock, labor, stock index (Nifty),
commodity, currency, temperature, rainfall and what not – the instrument is derivative.
Participants in the derivative market.
Hedgers : They have an existing exposure ( Say $ payable) and they take a position in
derivatives market, to kill that exposure. (Fattu)
Speculators: They have no existing exposure, however they have a price belief ( bullish / bearish ).
They enter into the derivative contract to profit from there price belief knowing fully
well that they may lose if the price belief goes wrong.
Arbitrageurs: These are generally sophisticated financial institutions backed by solid infrastructure
And money power. They use the expertise to find the mispricing in the derivative
Market. Accordingly they take long and the short positions to make riskless profit.
Part II OTC Derivatives
Forward rate agreement - Libor per betting
Definition
Book : Forward rate is the contract to borrow or invest a specified amount of money @ specified
rate of interest at a specified point of time in future for a specified period.
Actual : No Borrowing or investment takes place. It is simply a betting on labor.
Difference between OTC and Exchange Traded
No. OTC Exchange Traded

1. Forward Futures
2. No Margin Margin Requirements
3. Customized (Taylor made) Not Customized – its standardized (Shopping Mall)
4. More Suitable for hedging More Demand for Betting – i.e speculation
Compiled By Rahul Malkan(RM) Page 1

TAYAL INSTITUTE CA FINAL – FINANCIAL REPORTING
5. Forward Rate Fixed Mtm – Reprising

6. Not regulated Highly Regulated
7. Forward settled on maturity by Squared off prior maturity – or no maturity – no
physical delivery physical delivery
Quotations
FRA (Forward Rate Agreement) is an OTC derivative in which the bank acts as authorized dealers and
provide Bid / Ask Rates.
For instance Citibank Quotes at 6 x 9 FRA at 10% / 11%. This means this is the betting on 3 month
LIBOR after 6 months. The bullish client buy FRA at 11% waiting for upside gain. The bearish
customer will sells FRA at 10% waiting for downside gain
Difference
6 9
PV of Difference
The winner of the bet will get from the loser PV of Difference on the maturity of FRA.
FRA Pricing
FRA is priced such a manner that there is no arbitrage.
Practical Questions
1. RM buys 500 Cr 6 x 9 FRA at 10% / 11%. The rate turns out to be 12.5%. Calculate the
amount of pay off.
2. RM buys 500 Cr 6 x 9 FRA at 10% / 11%. The rate turns out to be 10%. Calculate the amount
of pay off.
3. A 5 x 12 FRA is presently quoted at 13% / 14%. A trader sells this FRA on notional principle of
₹ 6, 00, 00,000. What would be the payoff if after 5 months the 7 month LIBOR happens to
be 6%.
4. 9 month LIBOR ---- 10%

6 month LIBOR ---- 11%
What should be the price of 6 x 9 FRA?
5. Consider the following data

3 x 9 FRA --- 15 % / 16 %
i) What should be the price of 3 x 9 FRA ?
ii) Show the process of arbitrage using $ 1000 ?
6. The following market data is available : Spot USD/JPY 116.00
Page 2 Compiled by Rahul Malkan(RM)

Deposit rates p.a. USD JPY

3 months 4.50% 0.25%
6 months 5.00% 0.25%
Forward Rate Agreement (FRA) to Yen is Nil.

a. What should be 3 months FRA rate at 3 months forward?
b. The 6 and 12 months LIBORS are 5% & 6.5% respectively. A bank is quoting 6/12 USD
FRA at 6.50% - 6.75%. Is any arbitrage opportunity available? Calculate profit in such
case.
7. Given 2 month LIBOR = 8%

7 month LIBOR =10%
Find out the price of 2*7 FRA.
What if the 2*7 FRA is quoted at 15% / 16%.
What if the 2*7 FRA is quoted at 6% / 7%
8. Suppose today is 1st April 2007. A Ltd. is to invest Rs. 10,00,000 on 1st July, 2007 for a
period of 1 year. A Ltd. apprehends that the interest rates may decline by the time it will
invest. At present the interest applicable to the investment for I year is 9.75% p.a. A Ltd.
approaches a bank for an FRA. T he bank quotes the rate of 9.50 to p. a The parties enter
into an FRA on the basis of (i) the facts given in this question and (ii) the rate quoted
by the bank. On reference date, the interest rate prevailing in the market is 9.00.
 Explain the execution of the FRA.

 What amount will be invested by A Ltd. on 1st July, 2007?
 What amount will be received by A Ltd. on 1st July. 2008?
9. company is to borrow Euro 1m for a period of three months after 24 months from today.
It enters into a '24 27' FRA with agreed interest rate of 5%. After 24 months, the 3-months
interest is 5.50%. Explain the cash flow account of the FRA.
 What amount will be borrowed by the company for a period of three months after
24 months from today?
 What amount will be paid by company after 27 months from today?
Financial Swaps
1. A financial swap is an over the counter derivative which involves an exchange of stream of
cash flows. Effectively, a financial swap is a portfolio of forward contracts. It is a case of
multiple times betting. Being OTC, financial swap comes in various flavors.
2. A Plain vanilla interest rate swap is a fixed to floating swap with notional principle and
netting feature
3. Overnight Index Swap : This is extremely short term plain vanilla swap in which the floating
leg i.e. MIBOR is compounded daily. In case of holiday, MIBOR for previous day is applicable
for the holiday without compounding.

4. Currency Swap : In the currency swap, there are 2 principle amounts, one in each currency
based on exchange rate prevailing at the inception of the swap.
These principle amounts are not notional. There is an exchange of principle at the beginning
and re-exchange at the end of the swap.
Interest payments are not subject to netting.
5. Day Count Convention : If the problem focuses on days we use the 30 / 360 day convention
for the fixed leg and actual day convention for the floating leg
6. Pricing and Valuation of a SWAP
1. Meaning of Price and Value
A customer X approaches a bank for a 5 yr swap. In which X will receive LIBOR and pay
fixed.
LIBOR
X BANK
Fixed =?
What fixed rate will the bank quote?

This is known as PRICE of the SWAP ---- say 10%
2 yrs passes by and new swap pp is in the market for a 3 year swap happens to be 8%.
Obviously if x wants to cancel the swap today or sell it to some 3 rd party has to pay a
certain amount --- Known as the VALUE of the Swap
Note: Price – Rate for the fixed leg determined at the beginning
Value – Amount determined in between
2. Pricing
The price of the swap should be such that
Value of the = Value of the

Fixed Leg Floating Leg. No one should be in gain or loss at start
This gives rise to the following FORMULA
Price = 1 – DL x 100
∑d
Where DL = Last discounting factor
∑d = Sum of all discounting factors
3. Valuation: As discussed earlier, value of the swap is the difference between fixed and
floating bond. Since floating bond will always be valued at par, we just need to value
fixed bond.

Practical Questions
7. On 1st Jan 2010, A and B enter into financial swaps

Notional Principle - $ 500 mn
Term of the swap – 1 year
Payment frequency – quarterly.
Fixed Leg = 10%
Floating Leg = 3 month LIBOR.
B is the Fixed rate payer.
Calculate net cash flows at the end of each quarter if the 3 month LIBOR at the beginning of
each quarter happens to be
Date LIBOR
1/1/10 11%
1/4/10 8%
1/7/10 7%
1/10/10 13%
8. Suppose on 1st Jan 2010 A and B enter into a 1 year quarterly pay swap as shown below
10% on $ 500m
Suppose 3 month LIBOR on various reset dates turn out to be :
Date 3 Month LIBOR
1/1/10 10%
1/4/10 11.2%
1/7/10 7%
1/9/10 12.5%
9. A corporation enters into a $10 million notional principal interest rate swap. The swap calls
for a corporation to pay fixed rate and receive floating rate on LIBOR. The payment will be
made every 90 days for one year and will be based on the adjustment factor 90/360. The
term structure of LIBOR when the swap is initiated is as follows :
Days 90 180 270 360
Rate (%) 7.00 7.25 7.45 7.55
Note that at the initiation of the swap, the fixed rate is set at such a rate that the value of
the swap is zero.
You are required to :
(a) Determine the fixed rate on the swap,
(b) Calculate the first net payment on the swap.
10. Derivative Bank entered into a plain vanilla swap through on OIS (Overnight index
Swap) on a principal of Rs. 10 crores and agreed to receive MIBOR overnight floating
rate for a fixed payment on the principal. The swap was entered into on Monday, 2nd
August, 2010 and was to commence on 3rd August, 2010 and run for a period of 7 days.
Respective MIBOR rates for Tuesday to Monday were –
Tuesday 8%, Wednesday 9%, Thursday 10%, Friday 7%, Saturday 9%, Monday 10%.
If Derivative Bank received? 317 net on settlement, calculate. Fixed rate and interest
under both legs.
Notes :

Sunday is Holiday. Work in rounded rupees and avoid decimal working. (8 Marks)
11. On 20th July, Thursday, X ltd entered into a 6 day OIS with a bank for a notional
principal of Rs. 800 lakhs. The fixed rate of the swap was 11 %. The following table
shows the Mibor for each day :
Date Mibor
20/7 12%
11/7 11.5%
22/7 10%
23/7 (sun) N.A.
24/7 13%
25/7 12.5%
Compute the net payment at the end of the swap. (X ltd is the fixed rate receiver)
12. Consider 2 firms R and M who wish to borrow funds from the market.
Firm Fixed Rate Floating Rate Preference
R 8% L+3 Floating
M 11% L+1 Fixed
Design the swap to enable each firm achieve its preferred from of funding at a cheaper cost.
Also
a. What if, in the swap M pays to R 7%, while R will pay to M L + 0.5%, show the swap
and find out the effective cost of each party.
b. Design the swap such that the effective cost to R comes to L.
c. Design the swap such that the overall gain is equally shared between R and M
d. Design the swap with bank acting as the intermediary, such that the overall swap
gain is shared between R, M and Bank in the ratio of 1 : 1 : 2.
13. White Ltd. and Black Ltd. both wish to borrow $100 million for five years and have been offered the
following rates :
Firm Lending term available Maturity
Fixed interest Floating interest
White Ltd. 5% 6m LIBOR + 0.25% 5 years
Black Ltd. 4% 6m LIBOR + 0.75% 5 years
White Ltd. requires a fixed rate loan while Black Ltd. requires a floating rate loan.
You are required to
i. Design a swap that will net a bank, acting as an intermediary 0.20 percent per annum and
that will appear equally attractive to both companies.
ii. Explain the risks various parties face in this swap
14. Consider 2 firms R and M who wish to borrow funds from the market.
Firm Fixed Rate Floating Rate Preference
R 10% L + 0.25 Floating
M 13% L + 1.5 Fixed
Design the swap to enable each firm achieve its preferred from of funding at a cheaper cost.
15. The borrowing requirements of two companies APCO Ltd. and PATCO Ltd. as well as the
lending terms available to them in different markets are given as under:
Firm Objective Lending term Floating interest Maturity
available
Fixed interest
APCO US$ 100 mln. affixed rate 9% 6m LIBOR + 0.75% 5 years

PATCO US$ 100 mln. at floating 8% 6m LIBOR + 0.25% 5 years

rate
You are required to
i. Explain how to go about a swap in order to reduce their borrowing cost. Show the same
with a diagram.
ii. What are the risks involved in this swap?
16. A Inc. and B Inc. intend to borrow $200,000 and $200,000 in ¥ respectively for a time
horizon of one year. The prevalent interest rates are as follows :
Company ¥ Loan $ Loan
A Inc 5% 9%
B Inc 8% 10%
The prevalent exchange rate is $1 = ¥ 120.
They entered in a currency swap under which it is agreed that B Inc will pay A Inc @ 1 % over
the ¥ Loan interest rate which the later will have to pay as a result of the agreed currency
swap whereas A Inc will reimburse interest to B Inc only to the extent of 9%. Keeping the
exchange rate invariant, quantify the opportunity gain or loss component of the ultimate
outcome, resulting from the designed currency swap.
17. A and B enter into a 5 yr currency SWAP – Principle amount = £ 100 mn and $ 200 mn.
Payment frequency is annual. Interest rate is 5% on £ and 7% on $.
18. (a) X Ltd. wants to borrow fixed rate funds for 5 years. It can do so at an interest rate of
13% p.a. Also floating rate funds are available at a spread of 150 basis points over LIBOR. It
approaches a swap bank which quotes 5-year fixed to floating swap at 20/30 basis points
over 5-year treasuries vs. LIBOR. How should the firm reduce the cost of its fixed rate
funding given that 5- year treasuries are yielding 10%.
(b) Another firm Y Ltd. had borrowed 7-year fixed rate funds 2 years ago at 14%. It is now
expecting interest rates to fall and therefore wants to convert its fixed rate liability into
floating rate liability. Explain how Y Ltd. can achieve this objective .
19. X Ltd. has already borrowed 7 yr. fixed rate funds at 14% 2 years ago. It is now expecting int.
rates to fall. To capitalize on the same, it decides to convert its fixed rate liability into
floating rate liabilities through a swap. Banks are quoting fixed to floating interest rate swap
at 40/70 basis points over 5 year treasuries v/s LIBOR.
(a) Explain how X Ltd. can accomplish its objective. Compute its annual interest rate if libor
in the 5 yr. period happens to be 95%, 10.5%, 11 %, 12% & 10%.
(b) On a post-facto basis, do you think it was prudent for X Ltd. to have converted the nature
of funding? Treasuries are yielding 9%.
20. 3 years ago X Ltd had borrowed 7 year floating rate funds at L+1. However it now expects
interest rates to rise and would therefore like to convert into fixed rate funding. 4 year fixed
floating swaps are quoted at a spread of 50/70 basis pts over 4yr treasury v/s libor.
1. Explain how X ltd can achieve its objective.
2. If labor at the beginning of each year in the subsequent 4yr period happens to be 7%,
6%, 9% and 10%, was it prudent for X ltd to convert its nature of funding.

21. Asterix Inc. had raised floating rate funds two years ago at 6-month Prime + 1.25%. Now
it wants to convert this liability into fixed rate funding for 3 years. It approaches Bank of
New York for a swap. Bank of New York is quoting 6-month Prime/Fixed rate swap at
80/100 basis points over 5 year US treasuries which are yielding 4.55%. The Bank
agrees to do the swap with Asterix.
Bank of London is launching a Eurobond issue at a fixed dollar cost of 5.25%. The bank
prefers a 6-month LIBOR based funding. Bank of New York is quoting 6-month
LIBOR/Fixed rate swap at 100/125 basis points over 5 year US treasuries. The Bank of
London entered into a fixed-to-floating rate swap with Bank of New York.
Bank of Riverside has Prime based assets funded with LIBOR based deposits. It wants to
remove the mismatch of its assets and liabilities. It is willing to pay 6 month Prime +
0.25% in return for 6 month LIBOR.
a) Calculate the fixed rate achieved by Asterix by entering into the swap.
b) Mention what are the risks taken up by the Bank of New York by entering into swap
with Asterix?
c) Calculate the floating rate cost achieved by the Bank of London.
d) Show the assets and liabilities position of Bank of New York after entering into swap
with Asterix and Bank of London. Does the swap with Bank of Riverside helps the Bank
of New York?
e) Find out the net gain of Bank of New York after all the three swaps. Show all the swaps
entered by the Bank of New York through a diagram
22. Madhav Ltd., Keshav Ltd. and Damodar Ltd. are planning to raise a loan of Rs. 10 m
each. Madhav is interested on fixed rate basis, Keshav on MIBOR based floating rate and
Damodar on Treasury based floating rate. They have been offered the loans on the
following basis:
Madhav Keshav Damodar
FIXED RATE 6% 7% 8%
MIBOR BASED RATE M+1 M+3 M +4
T.BILL BASED RATE T+ 3 T+5 T +5
An intermediary brings them to the able and an interest swap is arranged. The
intermediary takes 0.10 of total saving commission and balance i. c. 0.90 is shared equally
by Madhav. Keshav and Damodar.
23. A Ltd. is considering a Rs. 50 crores 3 year interest rate swap. The company is interested in
borrowing at floating rate however, due to its good credit rating, it has a comparative over
lower rated companies in fixed rate market. It can borrow at fixed rate of 6.25% or floating
rate MIBOR+O.75%.
Presently, MIBOR is 5.25% but is expected to change in 6 months due to political situation in
the country. X Ltd. an intermediary bank agreed to arrange a swap. The bank will offset the
swap risk with a counter party (B. Ltd.) a comparative lower credit rated company, which
could borrow at a fixed rate of 7.25% and floating rate of MIBOR + 1.25%. X Ltd. would
charge Rs.12,00,000 per year as its fee from each party. Mr. Fin the CFO, of A Ltd. desires
that A Ltd. should receive 60% of any arbitrage saving (before payment of fees) from the
swap as A Ltd. enjoying high credit rating. Any fees paid to the bank are tax allowable. The
applicable tax rate is 30%. You are required to :
a. Evaluate whether the proposal is beneficial for both parties or not.
b. Assuming that MIBOR was to increase to 5.75% immediately after political crisis over
and shall remain constant for the period of swap. Evaluate the present value of

savings from the swap for A Ltd., assuming that interest payment are made semi-
annually in arrears
24. ABC Bank is seeking fixed rate funding. It is able to finance at a cost of six months
LIBOR+1/4% for Rs.200 million for 5 years. The bank is able to swap into a fixed rate at 7.5%
versus six month LIBOR treating six months as exactly half a year:
a. What will be the "all in cost" funds to ABC Bank?
b. Another possibility being considered is the issue of a hybrid instrument which pays 7.5%
for first three years and LIBOR -1/4% for remaining two year.
Given a three-year swap rate of 8% suggest the method by which the bank should achieve
fixed rate funding.
25. Suppose a dealer quotes All-in-cost' for a generic swap at 8% against six month LIBOR flat. If
the notional principal amount of swap is Rs.5,00,000.
I. Calculate semi-annual fixed payment.
II. Find the first floating rate payment for (i) above if the six month period from the effective
date of swap to the settlement date comprises 181 days and that the corresponding LIBOR
was 6% on the effective date of swap.
III. In (ii) above, if the settlement is on 'Net' basis, how much the fixed rate payer would pay
to the floating rate payer?
Generic swap is based on 30/360 days basis
26. Suppose a dealer quotes 'All-in-cost' for a generic swap at 8% against six-month libor
flat. If the notional principal amount of swap is Rs.5,00,000,
(i) Calculate semi-annual fixed payment.
(ii) Find the first floating rate payment for (i) above if the six-month period from the
effective date of swap to the settlement date comprises 181 days and that the
corresponding labor was 6% on the effective date of swap.
In (ii) above, if the settlement is on 'Net' basis, how much the fixed rate payer would
pay to the floating rate payer? (Generic swap is based on 30/360 days basis.)
27. Drilldip Inc. a US based company has a won a contract in India for drilling oil field. The
project will require an initial investment of ? 500 crore. The oil field along with equipments
will be sold to Indian Government for Rs. 740 crore in one year time. Since the Indian
Government will pay for the amount in Indian Rupee (Rs.) the company is worried about
exposure due exchange rate volatility. You are required to :
a. Construct a swap that will help the Drilldip to reduce the exchange rate risk.
b. Assuming that Indian Government offers a swap at spot rate which is 1 US$ = Rs. 50 in one
year, then should the company should opt for this option or should it just do nothing. The
spot rate after one year is expected to be 1US$ = Rs. 54. Further you may also assume that
the Drilldip can also take a US$ loan at 8% p.a.
28. TMC Corporation entered into €3.5 million notional principal interest rate swap agreement.
As per the agreement TMC is to pay a fixed rate and to receive a floating rate of LIBOR.
The Payment will be made at the interval of 90 days for one year and it will be based on the
adjustment factor 90/360. The term structure of LIBOR on the date of agreement is as
follows
Days Rate (%)

90 7.00
180 7.25
270 7.45
36 7.55
You are required to calculate fixed rate on the swap and first net payment on the swap.
Part III Futures
1. Future is forward contract to buy/sell an asset at the rate decided today.
2. Actually no buying or selling takes. It betting on prices and squared off at the pre-
determined prices.
3. Future may be defined as a standardized forward contract traded on an exchange with

immense liquidity, stringent margin requirement, daily mark to market feature and heavy
regulations.
4. The student should have mentally of betting for futures contract to solve the problem. For
eg. If a company buys $ 10,000 3m forward @ Rs. 55 / $. i.e irrespective of whatever the
spot rate may prevail after 3 months the company will buy $ 10,000 after 3 months.
Basically its an upside betting, the company is betting heavily on the rate to be > Rs. 55.
5. MARGIN REQUIREMENT (Accounting Discussion)
Initial margin Maintenance margin variation margin
µ + 3σ 75% of initial If the margin balance goes

where below maintenance, there
µ&σ refer to the will be a margin call on the
mean and SD of the trader & he has to bring an
daily amount known as variation
absolute(modular)cha margin to make the margin
nge in the value of a balance = INITIAL
future contract.
6. Relationship between Spot Price and Futures Price.
As per the cost of carry model(COC) –

Futures price = spot price + net cost of carry
i.e. F = S + NCC
where : NCC = interest saved + storage cost
saved – monetary benefit(eg.dividend)
foregone – convenience yield forgone
Note: convenience yield refers to the non monetary benefit that a commodity can provide &
futures on that commodity cannot provide.
Case 1: NCC is positive  implies f > s – we call it CONTANGO (sidha badla)
Case 2: NCC is negative  implies S > F or F < S – we call it BACKWARDATION (ulta Badla)
We also define a term called basis = S – F

So, basis is –ve /+ve under CONTANGO / BACKWARDATION

As we approach maturity of a futures contract , S & F converge towards each other such that
on maturity F=S i.e. basis = 0 . This is known as the rule of convergence.
7. Quantification of the COC Model
The spot price of commodity is known and standing today. Futures price is known today but
from a TVM perspective it is standing on maturity. The link between the two is R f i.e. either
compound or discount F. the other factors i.e. storage cost(SC), monetary benefit (MB) and
convenience yield(CY) may dispersed in the sum. Hence, we can have 2 types of COC model-
Type1: future value type : F = S + interest + FV of SC – FV of MB – FV of CY.
Type2: present value type : PV of F = S +PV of SC – PV of MB – PV of CY.
8. Stock - future arbitrage

If actual futures price is not equal to theoretical futures price there is an arbitrage
opportunity.
Situation 1: CASH AND CARRY ARBITRAGE

Long stock, short futures& borrow funds i.e. S +, f - & borrow funds when futures are over
priced i.e. actual f > theoretical f.It will involve interest expense & dividend income.
Situation 2: REVERSE CASH AND CARRY ARBITRAGE

i.e.short stock, Long futures & invest funds S-, f+ & invest
It will involve interest expense & dividend income.
Whatever be the type of arbitrage, profit will be equal to the amount of mispricing i.e.
difference between actual f &theoretical f multiplied by lot size.
Note: if lot size is not given , take it to be 100. However , if lot size of NIFTY FUTURES is not
given, take it to be 50
9. STOCK INDEX FUTURES
1) Stock index arbitrage:

This is the usual cash & carry or reverse cash & carry arbitrage. However it is more
difficult to execute as it will involve either buying the index or short selling the index.
2) BETA MANAGEMENT USING STOCK INDEX FUTURES
What is β MGMT?
β MGMT is basically market timing
if market is expected if market is expected

to rise, we should increase βp to fall we should decrease β p
There are 2 methods to change β of the portfolio -

Method 1: Stock trading
Want to decrease βp Want to increase β p

↓ ↓
Sell stock with high β buy stock with high β
buy stock with low β Sell stock with low β
However stock generally lack liquidity. Hence this process will take time & involve significant
transaction cost.
Method 2: Use Stock index futures
Want to decrease βp Want to increase β p

↓ ↓
Sell stock index futures Buy stock index futures
No. of futures:
Contract to be bought: X = Vp [βp - βp ]
Or sold is given F x M x βp
Vp = Value of portfolio
Bt = Target Beta → if not given: 0
Bp = Beta of Portfolio
Bf = Beta of Futures
F = Future PP
M = Multiple
10. HEDGING CURRENCY RISK THROUGH FUTURES

We had earlier learnt how to hedge transaction exposure using forward cover & money
market cover. Both forward & money market cover were examples of perfect hedge – they
eliminate uncertainty.
Transaction exposure can also be hedged using futures. However on a/c of standardization &
basis risk, futures cover is an imperfect hedge- it reduces but does not eliminate uncertainty.
1) WHETHER TO BUY OR SELL FUTURES?

UK Co. → $ receivable
Case1:$futures Case2: £ futures

available available
↓ ↓
Sell $ futures buy £ futures
US firm → ¥payable
Case1: ¥ futures Case2: $ futures

available available

↓ ↓
buy ¥ futures Sell $ futures
2) HOW DO YOU CHOOSE MATURITY OF THE FUTURES CONTRACT?

Preferably , we wish that maturity of the future contract matches with the exposure
maturity. However , if maturity does not match, we choose futures maturity to lie just after
exposure maturity.
3) CALCULATE THE NO. OF FUTURES CONTRACT

Case1: futures of exposure currency exist
No. of contracts = Exposure
Lot size
Case2: futures of some other currency is given
No. of contracts = Exposure equivalent
Lot size
4) WHAT IS THE METHOD OF PRESENTING THE OVERALL ANSWER
Step 1: buy or sell futures stating the reason why
Step 2: No. of contracts
Step 3: final sahib on the maturity date of the exposure

a. Square off futures & calculate profit or loss in the appropriate currency
– change in futures Price x lot size x no. of contracts
b. Settle the receivable or payable at the spot rate on maturity
c. Calculate opportunity cost on margin requirement, if any
Final :- In case of receivable – Home currency inflow.

In case of payable – Home currency Outflow
11. HEDGE RATIO:

While talking about basis risk earlier, we acknowledge that spot price (S)& futures price (F)
Do not move at the same rate. Hence , we now introduce a term called Hedge Ratio (HR). itis
the rate of change of spot price. W.r.t. futures price i.e. Hedge Ratio = ∆S
∆F
So, if hedge ratio = 0.8, it means that when futures price changes by 1, spot price is expected
to change by 0.8
Hence, no of futures
Contract = exposure x hedge x ratio
Lot size

How to calculate Hedge Ratio?

Hedge Ratio calculated by the least squares method i.e. HR = r x y
x
Where ystandard deviation of the change in spot price.
ystandard deviation of the change in futures price.
r correlation co-efficient between the futures price &spot price
Practical Question
29. On 15th July pound futures for maturity August end are traded on the International Monetary
Market (IMM) at $1.2450 (lot size pound 62,500). A trader bullish on $ against pound takes a
position in 14 futures contract. Initial margin is $1000 per lot & maintenance $ 750 per lot.
Future price for subsequent days happen to be -
Days Future Price
16th 1.2420
th
17 1.2490
18th 1.2520
th
19 1.2430
He squares off his position on 19th. Show the margin balance each day and compute the
overall profit/loss.
30. A trader has gone long on 5 Brent crude futures for December settlement at $26.32 per barrel.
The minimum contract size for Brent futures contract is 100,000 barrel. The initial margin is
$50,000 and the maintenance margin is $30,000. The futures close at the following prices on
the next ten trading days:
Day 1 2 3 4 5 6 7 8 9 10
$26.19 $ 26.30 $ 26.45 $ 26.48 $ 26.34 $ 26.21 $ 25.98 $ 25.87 $ 25.90 $ 25.95
The trader will take out the profit out of the margin account whenever he gets the opportunity
to do so.
You are required to
a. Prepare the margin account showing all the cash flows.
b. Find the profit/loss for the trader after 10 trading days.
31. Spot price of a commodity = 800

6 month futures price = 780
Rf = 9% p.a. compounded monthly
Storage cost = Rs. 10 at the end of each month
Monetary benefit= Rs. 15 at the end of each quarter
Calculate PV of convenience yield
32. The following information is available about standard gold.

Spot Price (SP) Rs. 15,600 per 10 gms.
Future Price (FP) Rs. 17,100 for one year future contract
f
Risk free interest Rate (R) 8.5%
Present Value of Storage Cost Rs. 900 per year

From the above information you are requested to calculate the Present Value of
Convenience yield (PVC) of the standard gold.
33. Solve the following

a. 9 months futures price on a cdty = 635
Rf = 8% p.a. compounded quarterly
Find spot price.
b. Spot price of the commodity = 430
Find 6 moths futures pric
c. 9 months futures price on a cdty = 165
Spot price = 160
Storage cost = ₹ 8 at the end of every month
Find PV Of CY.
34. Consider 9 month futures on a commodity –

Spot price = 240
Storage cost = Rs. 10 at the end of every month
Find 9 month futures price.
35. Consider 9 month futures on a stock :

Spot price = Rs.600
Rf = 10% p.a. compounded annually
The stock is expected to provide a dividend of Rs. 25 after 6 months and 12 months. Find out
the future price
36. 1) Stock pp' = Rs.500

Rf = 10%
Dividend yield = 3%
Find 6 mts future price.
2) Stock price = Rs.600
Rf = 10%
Annually dividend yield = 4%
Find the pp' of 3 m futures.
3) Stock pp' = Rs.800
Rf = 10%
Div. rate = 90%
Find the 6mts futures pp'.
37. Find out the future price depending upon the information given :
Case 1 : Stock price - Rs.1200
Futures maturity - 6 months
Interest rate -10%
Dividend yield - 3%


Rf- 12%
Annualized Dividend yield - 5%
Rf- 9%
Dividend rate - 80% (face value-10)
Rf- 14%p.a. compounded continuously
Dividend yield - 8%p.a. compounded continuously
38. Stock price of RM = 640

Rf = 10%
Dividend yield = 1 %
3mf pp’ = 780
Show the process of arbitrage (lot size 500)
39. Stock price of RM = 640

3 month futures price = 685
Risk free interest rate = 9%
Dividend yield = 2%
Show the process of arbitrage, (lot size = 500 shares)
40. The price of Silver was $7.511 per ounce in the New York market on April 27, 2001. At the
close of trading on the same day, the settlement price of December 2001, Silver futures
contracts was $8,456. The annualized borrowing rate on April 27, 2001 was about 11 % on
the Euro dollar rates. The cost of storing silver is negligible, as the quantity stored is very
small.
You are required to calculate the following:
a. The cost-of-carry price relationship between the cash price of silver and the futures price
of silver?
b. Show how an arbitrage gain can be made with the conclusion derived by you in (a) above?
41. Calculate the price of 3 months PQR futures, if PGR (FV Rs. 10) quotes Rs. 220 on NSE and
the three months future price quotes at Rs. 230 and the one month borrowing rate is given
as 15 percent and the expected annual dividend yield is 25 percent per annum payable
before expiry. Also examine arbitrage opportunities.
42. The share of X Ltd. is currently selling for Rs. 300. Risk-free interest rate is 0.8% per month. A
three months futures contract is selling for Rs. 312. Develop an arbitrage strategy and show
what your riskless profit will be 3-month hence assuming that X Ltd. will not pay any
dividend in the next three months.
43. Price of index = 5920

3 months NIFTY futures = 6035

Rf = 10%. It is expected that 40% of the companies comprising NIFTY will provide a
dividend yield of 2%
Show the process of arbitrage
44. 1) How many futures contract need to bought or sold to achieve a target β of 0.83
Take futures pp’ to be 4000 & lot size 50.
2) How many futures contract should be bought or sold for complete hedge?
3) The fund manager expects market to rise and wants to achieve a β of 4.43. How many
futures should be bought or sold?
45. A mutual Fund is holding the following assets in Rs.Crore :

Investments in diversified equity shares 90.00
Cash and Bank Balances 10.00
100.00
The Beta of the portfolio is 1.1. The index future is selling at 4300 level. The Fund Manager
apprehends that the index will fall at the most by 10%. How many index futures he should
short for perfect hedging so that the portfolio beta is reduced to 1.00? One index future
consists of 50 units.
Substantiate your answer assuming the Fund Manager's apprehension will materialize.
46. Consider a fund manager having a corpus of 500 lakhs as shown below :
Rs. (in Lakhs) Beta

Bond 150 0.8
Equity 300 4
Cash 50 0
500
Nifty futures trade at 5750 (lot size 50)
Futures of reliance industries trade at 1140 (lot size 250)
The fund manager is expecting a market crash
a. find out the beta of the portfolio and interpret the same
b. how many nifty futures should be bought or sold to achieve a beta of 0.5
c. how many nifty futures should be bought or sold foe complete hedging.
d. how many reliance industries should be bought or sold to achieve a beta of 0.7 (Assume
that beta of reliance futures is 1.6)
47. You have the following five stocks in your portfolio :

Security No of Shares Price / Share Beta
A 10000 50 1.2
B 5000 20 2.0
C 8000 25 0.7
D 10000 100 1.0
E 500 200 1.3
i. Compute portfolio beta
ii. How much additional investment is required in Risk free investment to have beta to 0.8 ?

iii. How much additional investment is required in Security B to increase beta to 1.4 ?
iv. Iv If the Nifty future is 2700 points and future have a contract multiplier of 50, how many
future contracts to be hedged to obtain the position as in (iii) above ?
48. Which position on the index future gives a speculator, a complete hedge against the
following transactions:
1. The share of Right Limited is going to rise. He has a long position on the cash market of Rs.
50 lakh on the Right limited. The beta of the Right Limited is 1.25.
2. The share of Wrong Limited is going to depreciate. He has a short position on the cash
market of Rs. 20 lakh of the Wrong Limited. The beta of the Wrong Limited is 0.90.
3. The share of Fair Limited is going to stagnant. He has a short position on the cash market of
Rs. 20 lakh of the Fair Limited.
The beta of the Fair Limited is 0.75.
49. On 17/01, a U.S. firm knows that it has a £8,90,000 receivable on 17/03. The spot rate is
£.6452/ $ and the 2 month forward rate is £.6495/$. Pound futures for maturity ending
March are quoted at $1.5367/£. Standard size of one contract is £62,500. On 17/03, the spot
rate happens to be £.6508/$ and Pound futures quote at 1,5329/£. Compare no cover,
forward cover and futures cover in terms of $ inflows on the 17/03?
50. XYZ Ltd. is an export oriented business house based in Mumbai. The Company invoices in US
currency. Its receipt of US $ 1,00,000 is due on September 1, 2005.
Market information as at June 1, 2005.
Exchange Rates Currency Futures
US $/Rs. US $/Rs. Contract size Rs.4,72,000
Spot0.02140 June0.02126
1 Month Forward 0.02136 September0.02118
3 Months Forward0.02127
Initial Margin Interest Rates in India
June Rs. 10,000 7.50%
September Rs. 15,000 8.00%
On September 1, 2005 the spot rate US $/Re. is 0.02133 and currency future rate is
0.02134. Comment which of the following methods would be most advantageous for XYZ
Ltd.
i. Using for word contract.
ii. Using currency futures.
iii. Not hedging currency risks.
It may be assumed that variation in margin would be settled on the maturity of the futures
contract.
51. Nitrogen Ltd, a UK company is in the process of negotiating an order amounting to €4

million with a large German retailer on 6 months credit. If successful, this will be the first
time that Nitrogen Ltd. has exported goods into the highly competitive German market. The

following three alternatives are being considered for managing the transaction risk before
the order finalized.
i. Invoice the German firm in Sterling using the current exchange rate to calculate the
invoice amount.
ii. Alternative of invoicing the German firm in € and using a forward exchange contract to
hedge the transaction risk.
iii. Invoice the German first in € anduse sufficient 6 months sterling future contracts (to the
nearly whole number) to hedge the transaction risk.
Following date is available :
Spot Rate €1.1750 - 1.1770/£
6 months forward premium 0.60 - 0.55 Euro Cents
6 months further contract is currently trading at €1.1760/£
6 months future contract size is £62,500
Spot rate and 6 months future rate €11785/£
Required :
Calculate to the nearest € the receipt for Nitrogen Ltd, under each of the three proposals.
In your opinion, which alternative would you consider to be the most appropriate and the
reason therefore.
52. ABC Technologic is expecting to receive a sum of US$400000 after 3 months. The company
decided to go for future contract to hedge against the risk. The standard size of future
contract available in the market is $1000. As on date spot and futures $ contract are quoting
at Rs. 44.00 & Rs.45.00 respectively. Suppose after 3 months the company closes out its
position futures are quoting at Rs.44.50 and spot rate is also quoting at Rs. 44.50. You are
required to calculate effective realization for the company while selling the receivable. Also
calculate how company has been benefitted by using the future option.
53. Zaz pic, a UK Company is in the process of negotiating an order amounting € 2.8 million
with a large German retailer on 6 month's credit. If successful, this will be first time for
Zaz has exported goods into the highly competitive German Market. The Zaz is
considering following 3 alternatives for managing the transaction risk before the order
is finalized.
(a) Mr. Peter the Marketing head has suggested that in order to remove transaction risk
completely Zaz should invoice the German firm in Sterling using the current €/£ spot
rate to calculate the invoice amount.
(b) Mr. Wilson, CE is doubtful about Mr. Peter's proposal and suggested an alternative of
invoicing the German firm in € and using a forward exchange contract to hedge the
transaction risk.
(c) Ms. Karen, CFO is agreed with the proposal of Mr. Wilson to invoice the German first in
€, but she is of opinion that Zaz should use sufficient 6 month sterling further
contracts (to the nearest whole number) to hedge the transaction risk.
Following data is available
Sport Rate € 1.1960-€ 1.1970/£
6 months forward premium 0.60- 0.55 Euro Cents.
6 month further contract is currently trading at € 1.1943/£
6 month future contract size is £62,500
Spot rate and 6 month future rate € 1.1873/£
You are required to

(i) Calculate (to the nearest £) the £ receipt for Zaz pic, under each of 3 above
proposals.
(ii) In your opinion which alternative you consider to be most appropriate
54. A firm in Denmark exports dairy products. On June 15 2004, an order worth $ 5 million to a
US super store chain was shipped. The payment was due after 3 months from the day of
shipment. The spot DKr/$ was 6.1569 and the 3 month forward rate was 6.1625 at that time.
The firm considered hedging the exposure through futures contract. Since futures contract
for Danish Kroner was not available, it considered either futures on Swiss Franc or Swedish
Kroner on IMM as both the currencies are closely related to Danish Kroner.
The spot SFr/$ rate was 1.2743 and September SFr futures were trading at $0.7875. The
spot SKr/ $ rate was 7.5833 and September SKr futures were trading at $0.13126 at that
time.
On September 15, 2004, dollar was priced in the spot market as at SFr 1.2678, SKr 7.6166
and DKr 6.1602. In the futures market September SFr future was priced $ 0.7891 and
September SKr futures was priced at $ 0.13133.
1. Find out which hedging strategy would have been better for the Danish firm. (Standard
size of SFr and SKr futures are 1,25,000 each).
55. XYZ Inc. an American company has a receivable of C$5 million maturing 4 months from
now. The company is trying to evaluate whether the exposure should be hedged
through futures market or a money market cover. Six month futures on Canadian dollar
are currently trading at US $0.7443 and the current C$/$ exchange rate is 1.3283. The 4-
month interest rate for dollar is 2.00%/2.50% p.a. The size of Canadian dollar futures is
C$100,000.
You are required to
a. Calculate the inflow to the company, if after four months futures contract trades
at 0.7449 and the spot C$/$ rate is 1.3346.
b. Calculate the borrowing interest rate on Canadian dollar, so that the company
should be indifferent between the futures hedge and money market cover.
56. An oil company has an exposure on 50,000 barrels of crude i.e.it is afraid of falling. It
decided to hedge the same using crude futures
Given: SD of the change in
Future price of crude = 8%
SD of the change in
spot price of crude = 10%
correlation coefficient
between the two (r) = 0.95
Q.1. Calculate & interpret the hedge ratio.
Q.2. Ignoring lot size, how many crude futures need to be bought or sold.
Q.3. What is the value of the crude futures bought or sold if futures price is presently $
102 /barrel

57. A company is long on 10 MT of copper @ Rs.474 per kg (spot) and intends to remain so for
the ensuing quarter. The standard deviation of changes of its spot and future prices are 4%
and 6% respectively, having correlation coefficient of 0.75.
What is its hedge ratio? What is the amount of the copperfuture it should short to achieve a
perfect hedge?
58. On 10/07, an Indian firm knows that it has a $ 590000 payable on the 10/09. The spot rate is
Rs.47.64/$ and the 2 month forward rate is Rs.47.85/$. Dollar futures of maturity Sept. ends
are trading at Rs.47.89/$ (contract size is $ 1,00,000). On the 10/09, the spot rate happens
to be Rs.47.95/$ and the futures quote at Rs.48.07/$. Compare no cover, forward cover and
futures cover with respect to Rupee outflow on the 10/09?
Part – 5 options
We divided our discussion on options into the following parts:

1) Introduction
2) Speculation
3) Hedging
4) Valuation
5) Option Greeks
INTRODUCTION
1) Option
Buyer (holder) Seller (writter)
 Enjoys a right  Suffers an obligation

 Pays initial premium  Receives initial premium
 Cannot have a negative  Cannot have a positive
payoff payoff
 Loves volatility  Hates volatility
 Suffers time decay  Enjoys time decay
Explanation:
1. Pay off refers to cash flow on maturity. It doesn’t refer to the premium amount.
2. Options are wasting assets. As time passes, other factors remaining constant, option value
falls. This is known as time decay. It hurts the buyer & benefits the seller.
2) Option
CALL PUT
upside betting  downside betting

pay off = max [S-E; 0]  pay off = max [E- S; 0]
right to buy  right to sell
 
right to enjoy
Compiled By Rahul Malkan(RM)
the upside Page 21 right to enjoy the downside
3) MONEYNESS OF AN OPTION
6 m Put = E = 500
Aaj share purchase 482

Put aaj fayde mein hai (500 – 482 = 18) - Thus put is in the Money
Agar, we have call S = 482

Call aaj ghate mein hai - Thus call is out of money
If S = 500 --- At the money

In the Money At the Money Out of Money
Call S>E S=E S<E
Put S<E S=E S>E
5) VALUE OF AN OPTION
OPTION PREMIUM
INTRINSIC VALUE TIME VALUE /

VOLATILITY PREMIUM/
EXTRINSIC VALUE
INTRINSIC VALUE is the minimum value that the potion should command based on current stock
price (no role of expectation)
If an option is presently in the money, intrinsic value is the amount by which it is in the money.
If the option is currently at the money or out of the money, intrinsic value is nil.
S>E S=E S<E

Call S–E 0 0
Put 0 0 E–S
The excise of option premium over and above intrinsic value is known as extrinsic value (depends
on expectation)
Greater the time left to maturity, greater the extrinsic value it is also known as time value.
Moreover, greater the expected volatility in the minds of the people, greater the extrinsic value. It is
also called VOLATILITY PREMIUM.
Note: we will derive option value exactly in Part 4
EXPIRY DAY ANALYSIS OF OPTION

Presentation techniques
PARAGRAPH WISE TABLE OR PROFILE DIAGRAM WISE
Practical Questions
Question.63
Consider the following option chain on NIFTY as on 9 th march. SPOT NIFTY INDEX  5870
CALL PUT

E March April May March April May
5200 705 742 769 0.15 0.20 0.25

5400 503 538 565 2 3.5 4
5600 299 315 352 9 12 18
5800 112 137 159 18 32 51
6000 15 32 51 150 180 200
1) Analyse the April 5600 call
2) Analyse the May 6000 call option
3) Analyse the March 6000 PUT option
Question 64
Consider the following six cases of call options
Case 1 Case 2 Case 3 Case 4 Case 5 Case 6
Spot Price at expiration 80 90 100 110 120 130
Strike Price 100 100 100 100 100 100
Find in each case (i) Whether the option is in the money, at the money or out of the money. (ii)
Value the option at expiration (iii) What will be your answers if the options referred in example
are put options?
Question 65
Mr. Tony has purchased a 3-month call option of King Ltd.' s equity share with an exercise price of
Euro 51. Determine the value of Call option at expiration if the share price at expiration turns out to
be either 47 or 54 Draw a diagram to illustrate your answer. Premium Paid = Euro 1
Question 66
Mr. X purchased a 3-month call option on equity share of Prerna Ltd. from Mr. Y at a strike price of
Rs. 160. Call Premium Rs. 5. Current price Rs. 155. Explain profit/loss (also called 'pay off) to X as
well to Y, if prices at expiration are Rs. 140, Rs. 150, Rs. 160, Rs. 170 or Rs. 180.
Question 67
LONG PUT - P+ at E = 750, Maturity 3months & Premium paid = Rs. 60. Explain the Profit or Loss if
after 3 months stock price(Rs.) happens to be -
a)1000
b)700
c) 500
Question 68
SHORT PUT(P+) at E - 850, Maturity 3m & Premium Received. = Rs. 105
a) 1000
b) 700
SPECULATION USING OPTIONS
COMBINATION SPREAD SYNTHETIC

STRATEGIES STRATEGIES STRATEGIES
CATEGORY 1: COMBINATION STRATEGIES

COMBINE, PUT & CALL
Volatile price Non Volatile price

Belief price belief
 
Buy both Put & Call (Long) sell both Put & Call (short)
 
V shaped inverted v shaped
Diagram Diagram
Depending upon whether we choose one strike price or 2 strike price, we have the following types of
strategies:
1. STRADDLE  1 strike price  1Put & 1 Call
2. STRIP  1 strike price  2Put & 1 Call
3. STRAP  1 strike price  1Put & 2Call
4. STRANGLE  2 strike price  put at a lower E & call at a higher E
CATEGORY 2 : SPREAD STRATEGY
SIMULTANEOUS BUYING & SELLING OPTIONS (ONLY CALLS OR ONLY PUTS)

 Will result is limited profit & Limited loss.
 First poetry:
If there is initial outflow – MAXIMUM LOSS = INITIAL OUTFLOW
MAXIMUM PROFIT = Diff. of E - INITIAL OUTFLOW
 Second poetry:
if there is initial inflow – maximum profit = INITIAL INFLOW
MAXIMUM LOSS = Diff. of E - INITIAL OUTFLOW
CATEGORISATION
Based on bullish/bearish belief Based on volatile / nonvolatile

Price belief
 
2 strike price butterfly spread

3 strike price
BULL & BEAR SPREAD
Case 1 : BULL SPREAD
E1 E2
Lower strike pp’ Higher strike pp’
Option buy Option sell
+ -

 
Buy Option at a Lower E sell Option at a Higher E
Case 2 – Bear Spread
E1 E2
- +
 
Sell Option at a Lower E Buy Option at a Higher E
SUMMARY
BULL SPREAD - - - - - - +/-
BEAR SPREAD - - - - - - -/+
Practical Questions
Question 69
Consider 3 month option on the stock of SBI
Strike Price Put Premium Call Premium
2500 220 200
Question 70
Consider 1 month options on NIFTY
E Put Premium Call Premium
P+ 5500 130 320
C+ 5800 305 140
Design a long strangle and show the profit diagram. Also show the profit profile for NIFTY lying
in the range of 5000 – 6500 in intervals of 250 each.
Question 71
Equity share of PGR Ltd. is presently quoted at Rs 320. The Market Price of the share after 6 months has the
following probability distribution.
Market Price 180 260 280 320 400
Probability 0.1 0.2 0.5 0.1 0.1
A put option with a strike price of ? 300 can be written. You are required to find out expected
value of option at maturity (i.e. 6 months)
Question 72
A call and put exist on the same stock each of which is exercisable at Rs.60. They now trade for:
Market price of stock or stock index Rs.55
Market price of call Rs.9
Market price of put Rs.1
Calculate the expiration date cash flow, investment value, and net profit from:
i. Buy 1.0 call
ii. Write 1.0 call
iii. Buy 1.0 put
iv. Write 1.0 put
For expiration date stock prices of Rs.50, Rs.55, Rs.60, Rs.65, Rs.70.

Question 73
The equity share of VCC Ltd. is quoted at Rs. 210. A 3-month call option is available at a premium of
Rs.6 per share and a 3-month put option is available at a premium of Rs. 5 per share. Ascertain the net
payoffs to the option holder of a call option and a put option.
i) The strike price in both cases in Rs. 220; and
ii) The share price on the exercise day is Rs. 200,210,220,230,240.
Also indicate the price range at which the call and the put options may be gainfully exercised.
Question 74
XYZ established the following spread on the Delta Corporation's stock :
1) Purchased one 3-month call option for 100 Nos. with a premium of Rs. 30 and an exercise
price of Rs. 550.
2) Purchased one 3-month put option for 100 Nos. with a premium of Rs. 5 and an exercise price
of Rs. 450.
The current price of Delta Corporation's stock is Rs, 500. Determine XYZ profit or loss if the price of
Delta Corporation :
a) Stays at Rs. 500 after 3 months.
b) Falls to Rs. 350 after 3 months.
c) Rises to Rs. 600.
Question 75
Consider 3 month options on NIFTY
Strike Put Call
Price Premium Premium
5400 80 240
5700 210 100
1. Design & explain bullish put spread
2. Design & explain bearish call spread
Question 76
Consider 1 month options on the stock of Reliance Industries .
Strike Put Call
Price Premium Premium
900 45 125
1100 135 40
1. Design bullish call spread
2. Design bearish put spread
BUTTERFLY SPREAD
There are 3 strike prices – E1, E2, and E3.

E2 represents the body
E1 and E3 represents the wings
Case 1 : Volatile Butterfly Spread
Buy 2 options at body i.e E2 and sell 1 option each at the wings
E1 E2 E3
- 2C+ -

Since the wings are costlier than the body it will result in a net initial inflow.
Accordingly, Max profit = Initial Inflow.
Max Loss = Difference of E – Initial Inflows
Case 2 : Non Volatile Butterfly Spread
Sell 2 options at the body i.e E2 and Buy 1 option each at the wings
E1 E2 E3
+ 2- +
Since the wings are costlier than the body it will result in a net initial outflow.
Accordingly, Max Loss = Initial outflow
Maximum Profit = Diff of E – Initial Outflow.
CONDOUR SPREAD
A strategy exactly similar to the butterfly spread is known as condour spread.
There are 4 strike prices i.e E1, E2, E3 and E4.
E2 and E3 are the body, while
E1 and E4 are the wings.
SUMMARY
VOLATILE BUTTERFLY ----- BODY BUY
NON VOLATILE BUTTERFLY ----- BODY SELL
Practical Questions
Question 77
Consider the following one month option on Nifty
Strike Price Call Premium Put Premium
5400 350 160
5600 252 237
5800 180 340
(i) Volatile butterfly put spread
(ii) Non Volatile butterfly call spread
(iii) Show the profit diagram, break even points, max profits and max loss. Also show the profit
profile at important prices.
Question 78
Consider the following information
E Call Premium
5500 390
5700 240
6000 125
Design a spread strategy to profit from massive movements in Nifty ?

Question 79
Consider the following information
Ex pp Put Premium
300 11
320 18
345 33
Design a non volatile butterfly put spread
Question 80
Consider 3 month option on ICICI Bank
Exercise Price Call Premium
800 80
850 42
900 20
Design a short Butterfly Spread.
Question 81
You are given three call options on a stock at exercise price of ₹ 30, ₹ 35 and ₹ 40 with the expiration
date in three months and the premium of Rs. 4, 2, and 1 respectively. Show how the option can be
used to create a butterfly spread. Construct a table with different market prices and show how profit
changes with stock prices ranging from Rs. 20 to 50 for the butterfly spread.
Question 82
Current Spot Price Rs 61 call option quotation in the market:
Strike Price Premium
Rs. 55 Rs. 10
Rs. 60 Rs. 7
Rs. 65 Rs. 5
Mr. X buys one call at strike price 55 and one call at strike price 65. He sell 2 calls with strike price
60. Give pay-offs if spot price on expiry on 51,52….70
HEDGING THROUGH OPTIONS
All the hedging techniques that we have done so far i.e forward cover, MMC and futures cover have
one thing in common – they protect the firm against adverse movement but they do not allow the
firm to enjoy the favorable movement.
If you hedge by buying options it is theoretically the best strategy in the world – you will be
protected against adverse movement and at the same time you will continue to enjoy the favorable
movement.
However, it will cost option premium. So we recommend option buying only if the firm expects high
volatility.

Some firms who are risk aggressive may even hedge their FC receivable or payable via option selling.
This is theoretically the worst strategy. The firm will not be protected against adverse movement
and at the same time the firm will not be able to enjoy the favorable movement. However, the only
advantage of this strategy is the premium received initially. Hence, we recommend this strategy only
for those firms which are risk aggressive and expect low volatility.
Presentation Style
Step 1 : Future value of the option premium
Step 2 : Expected spot rate on maturity
Step 3 : Expected payoff from options
Case 1 FC Payable Afraid of FC rising
C+ P-
Case 2 FC Receivable Afraid of FC falling
C- P+
Practical Questions
Question 83
An Indian firm has Dollar 2 lacs payable after 3 Months
Exchange Rate Forecasts
Spot Rate Prob
42 0.2
46 0.3
50 0.4
58 0.1
Call option on $ at a Strike Price of 45 is available for a premium of 1.3 (Rs./$) Put Option on $ at a
Strike Price of 44 is trading at a premium of Rs 0.8 /$ Evaluate the Call Cover and Put Cover.
Question 84
A Japanese firm has £30,000 receivable 6 months from now.
Exchange Rate forecasts are :-
Spot Rate Prob
105 0.3
120 0.2
135 0.1
150 0.4
Put Option on £ at a strike price of Rs.125 trade at a premium of Rs.12 Call Option on £ at a strike
price of 130 trade at a premium of Rs.14. 6 month Interest Rate : ¥ 0.8% /0.9% £ 4%/ 5%
Evaluate PUT cover & CALL cover
Question 85
XYZ Ltd. a US firm will need 3,00,000 in 180 days. In this connection, the following information is
available:

Sport rate 1 £ = $ 2.00

180 days forward rate of £ as of today = $ 1.96 Interest rates are as follows :
UK US
180 days deposit rate 4.5% 5%
180 days borrowing rate 5% 5.5%
A call option of £ that expires in 180 days has an exercise price of $1.97 and a premium of $0.04.
XYZ Ltd. has forecast the spot rates 180 days hence as below :
Future Rate Probability
$ 1.91 25%
$ 1.95 60%
$2.05 15%
Which of the following strategies would be most preferable to XYZ Ltd.?
(I.a.i.a) a forward contract
(I.a.i.b) a money market hedge
(I.a.i.c) an option contract
(I.a.i.d) no hedging
Show calculations in each case.
VALUATION OF OPTIONS
Given the complexity of the discussion, we will approach option valuation in stages
Stage 1 : Introduction
Option Value i.e Option premium comprises of 2 parts

1. Intrinsic Value – It is the minimum value that the option should command based on current
stock price.
IV of call = Max (S – E, O)
IV of put = Max (E – S, O)
2. Extrinsic Value – It is the excess of option premium cover and above IV. It depends upon the
time left to maturity and expected volatility of the stock in the minds of the people. Infact,
let us acknowledge that there are 6 determinants of the option value.
a) Stock Price (S)
b) Strike Price (E)
c) Time till Maturity
d) Volatility of the stock
e) Interest rate
f) Dividend
Stage 2 : Principle behind Option Valuation
Options are priced on the basis of the prevention of arbitrage principle.
Cost of protective Put = Cost of Fiduciary Call

Po + So = Co + PV of E
Stage 3 : Binomial Model of option Pricing
As the name suggests, Binomial model is based on the simple yet, unrealistic assumptions that if the
stock price is presently S, there can be 2 possible stock price on maturity i.e US and dS. Accordingly
we can find out the payoff of an option.
US ---- Cu / Pu
dS ----- Cu / Pu
Let the risk free interest rate be denoted by ‘r’ such that risk free interest rate factor be ‘R’
Let ‘p’ be the probability of the upmove and therefore ‘I-p’ is the probability of the downmove. Let
us further assume that the world is risk neutral i.e investors do not care about risk. Hence expected
return on all risky assets is Rf. The stock under consideration also belongs to that world and
therefore, expected stock price on maturity should rise at the rate of Rf to become SR (eg 100 x
1.05). Hence the risk neutral probability can be calculated as follows.
P=R–d
U–d
Hence the value of the option today = Present value of the expected payoff discounted at Rf.
Practical Questions
Question 86
The following table provides the prices of options on equity shares of X Ltd. and Y Ltd. The risk free
interest is 9%. You as a financial planner are required to spot any mispricing in the quotations of
option premium and stock prices? Suppose, if you find any such mispricing then how you can take
advantage of this pricing position.
Share Time to Exercise Share Call Put
exercise price price price Price
X Ltd. 6 months 100 160 56 4
Y Ltd. 3 months 80 100 26 2
Question 87
Consider 6 month put and call option on a stock at a strike price of 520. The stock price is presently
500. In 6 months time, the share price can go up by 30% and come down by 10%. Rf = 8% p.a
compounded annually. Find out the value of call and put option using binomial model.
Question 88

Current price Rs 100 Strike price of a 3- month call option Rs 95. After three months, the price may
be Ra 150or Rs 70. Risk free rate : 12% p. a (not compounded continuously).option writer uses
borrowed funds. Option Premium by Binomial Model?
Question 89
Find out the value of a 3 month call and put option on a stock at strike price = 980. The stock
presently trades at 1000. In 3 months time it can go up to 1150 or come down to 920. R f = 7% p.a.
effective.
Question 90
Current share price Rs. 1,000. Risk tree rate of return 20 % p. a (not compounded
continuously ). Find the value of a 3 months call option with strike price of Rs. 1000 using
Binomial Model assuming that at expiration date the spot price will be either Rs. 1150 or Rs. 900.
Question 91
Madhav holds 1200 shares of Murli Ltd. Current price is Rs. 100 per share. He estimates that after 1
year the price will be either Rs. 165 or Rs. 85. He writes a call with the exercise price of Rs. 105. The
risk free rate of return is 8%. What should be the call premium so that he earns a return equal to
risk-free rate?
Question 92
Current Price $1020. European Call Option of 6 months. Risk free rate of return = 18% p.a. (not
comp. Cont.). One possible spot price on expiration: $ 1320. Exercise Price $ 1000. Find the other
possible spot price assuming that the value of Call on the basis of Binomial model is $ 148.05.
Question 93
The stock of a company is currently quoted in the market at Rs.150. The price of the stock is
expected to go up or down by 10% in next one year and by 15% in the second year. The risk-
free interest rate in the economy is 6%.
Required :
Using two-step Binomial Model, find out the price of a 2-year American put option on the
company's stock with strike price of Rs. 175.
Question 94
X Ltd.'s share is currently trading at Rs. 220. It is expected that in six months some if could
double or halved (equivalent to a 6=98%). One year call option on X Ltd.'s share has an exercise
price of Rs. 165. Assuming risk free rate of interest to be 20%, calculate.
a) Value of call option on X Ltd's share.
b) Option Delta for the second six month, in case stock price rises to Rs. 440 or falls to Rs. 110.
Now suppose in 6 months the share price is Rs. 110. How at this point we can replicate portfolio
of call options and risk-free lending.
BLACK AND SCHOLES MODEL (ALSO REFERRED TO AS BLACK-SCHOLES-MERTON MODEL)
Black and Scholes have given a model for valuation of European all option. The model uses advanced
mathematics techniques and hence, its derivation is beyond the scope of this note. The model is as
Follows:
Value of European Call Option
= [spot Price . N(d1)] – [Present value of Exercise price . N (d2)]

Value of N(d1) and (d2) are calculate with the help of ‘ Normal Distribution Tables” using d 1 and d2
d1 = In(SP / EP) + (r +.50. SD2) t

SD.t
D2 = In(SP / EP) - (r -.50. SD2) t
SD.t
Alternatively : d2 = d1 – SD.t
Practical Questions
Question 95 –(a)
D1 = 0.76, d2 = 0.55, find N (d1) and (d2). Use Cumulative Distribution table.
Question 95 - (b)
D1 = 0.49, d2 = - 0.42, find N (d1) and (d2). Use Cumulative Distribution table.
Question 96
D1 = 0.4539 and d2 = 0.4744
Find N (d1) and N(d2). Use Cumulative Distribution table.
Question 97
Spot Price 15, Exercise price = 14:L r = 8% p.a. cc
T = 3 months, d1 = 0.38,d2 = 0.19. Find the value of Eco.
Question 98
Spot price $1000,Exercise P = $ 950, r = 0.10 p.a. c.c.,
S.D = 0.50 annual, t = 3 months. Find the value of ECO.
Question 99
Using the BS model, find the value of ECO, assuming r= 6% p.a. cc maturity period 2 months :
spot price Rs 110, Exercise Price Rs 100, Annual volatility (SD) 6% The Company is going to pay
dividend of Rs 5 per share after one month.
Question 100
From the following data for a certain stock, find the value of a call option:
Price of stock now Rs. 80
Exercise price Rs. 75
Annual SD 0.40
Maturity period 6 months
Annual interest rate 12%
Given:
e012x8 = 1.0060 In case of 1.0667 = 0.0645
Number of SD from Mean (Z) Area of the left or right of one tail
025 0.4013
0.30 0,3821
0.55 0.2912
0.60 0.2578

“Gratias agimus tibi”

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CA FINAL – FINANCIAL REPORTING TAYAL INSTITUTE

Participants in the derivative market.

Part II OTC Derivatives

Forward rate agreement - Libor per betting

Actual : No Borrowing or investment takes place. It is simply a betting on labor.

Difference between OTC and Exchange Traded

No. OTC Exchange Traded

Compiled By Rahul Malkan(RM) Page 1

5. Forward Rate Fixed Mtm – Reprising

FRA is priced such a manner that there is no arbitrage.

4. 9 month LIBOR ---- 10%

5. Consider the following data

6. The following market data is available : Spot USD/JPY 116.00

Page 2 Compiled by Rahul Malkan(RM)

Deposit rates p.a. USD JPY

Forward Rate Agreement (FRA) to Yen is Nil.

7. Given 2 month LIBOR = 8%

 Explain the execution of the FRA.

Compiled By Rahul Malkan(RM) Page 3

Interest payments are not subject to netting.

6. Pricing and Valuation of a SWAP

1. Meaning of Price and Value

What fixed rate will the bank quote?

The price of the swap should be such that

Value of the = Value of the

This gives rise to the following FORMULA

Page 4 Compiled by Rahul Malkan(RM)

7. On 1st Jan 2010, A and B enter into financial swaps

Compiled By Rahul Malkan(RM) Page 5

Page 6 Compiled by Rahul Malkan(RM)

PATCO US$ 100 mln. at floating 8% 6m LIBOR + 0.25% 5 years

ii. What are the risks involved in this swap?

Compiled By Rahul Malkan(RM) Page 7

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Compiled By Rahul Malkan(RM) Page 9

Part III Futures

1. Future is forward contract to buy/sell an asset at the rate decided today.

3. Future may be defined as a standardized forward contract traded on an exchange with

5. MARGIN REQUIREMENT (Accounting Discussion)

Initial margin Maintenance margin variation margin

µ + 3σ 75% of initial If the margin balance goes

As per the cost of carry model(COC) –

Page 10 Compiled by Rahul Malkan(RM)

So, basis is –ve /+ve under CONTANGO / BACKWARDATION

7. Quantification of the COC Model

8. Stock - future arbitrage

Situation 1: CASH AND CARRY ARBITRAGE

Situation 2: REVERSE CASH AND CARRY ARBITRAGE

9. STOCK INDEX FUTURES

1) Stock index arbitrage:

2) BETA MANAGEMENT USING STOCK INDEX FUTURES

if market is expected if market is expected

There are 2 methods to change β of the portfolio -

Compiled By Rahul Malkan(RM) Page 11

Method 1: Stock trading

Want to decrease βp Want to increase β p

Method 2: Use Stock index futures

Want to decrease βp Want to increase β p

10. HEDGING CURRENCY RISK THROUGH FUTURES