Crack Grade B 1

DERIVATIVES

Derivative is a product whose value is derived from the value of one or more basic
variables, called bases (underlying asset, index or reference rate), in a contractual
manner. The underlying asset can be equity, forex, commodity or any other asset. For
example, wheat farmers may wish to sell their harvest at a future date to eliminate the
risk of a change in prices by that date. Such a transaction is an example of a derivative.
The price of this derivative is driven by the spot price of wheat which is the ‘underlying’.

The International Monetary Fund defines derivatives as “financial instruments that are
linked to a specific financial instrument or indicator or commodity and through which
specific financial risks can be traded in financial markets in their own right. The value of
a financial derivative derives from the price of an underlying item, such as an asset or
index. Unlike debt securities, no principal is advanced to be repaid and no investment
income accrues”.

What kind of underlying assets are derivatives generally available on?

Common underlying assets for derivatives are:
• Equity Shares
• Equity Indices
• Debt Market Securities
• Interest Rates
• Foreign Exchange
• Commodities

Products, participants and functions:

Derivative contracts have several variants. The most common variants are forwards,
futures, options and swaps. The following three broad categories of participants hedgers,
speculators, and arbitrageurs trade in the derivatives market.

• Hedgers face risk associated with the price of an asset. They use futures or options
markets to reduce or eliminate this risk. Hedging is a position taken in futures for the
purpose of reducing exposure to one or more types of risk. • The hedging strategy can be
undertaken in all the markets like futures, forwards, options, SWAP etc.

Hedging means reducing or controlling risk. This is done by taking a position in the
futures market that is opposite to the one in the physical/cash market with the objective
of reducing or limiting risks associated with price changes.

Hedging is a two-step process. A gain or loss in the spot position due to changes in price
levels will be countered by changes in the value of a futures position. For instance, a wheat
farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a
fall in price, the loss in the cash market position will be countered by a gain in futures
position.

•Speculators use derivatives to bet on the future direction of the markets. Their objective
is to gain when the prices move as per their expectation.

• 3 types based on duration:

i. SCALPERS – hold for very short time (in minutes).

ii. DAY TRADERS- one trading day.
iii. POSITION TRADERS- long period (week, month, a year).

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• Arbitrageurs are in business to take advantage of a discrepancy between prices in two
different markets. If, for example, they see the futures price of an asset getting out of line
with the cash price, they will take offsetting positions in the two markets to lock in a profit.
Arbitrageurs try to make risk-less profit by simultaneously entering in to transactions in
two or more market.

Types of derivatives:

Exchange-traded derivatives:
 Exchange-traded derivatives are contracts that trade on an organized exchange.
Contracts can be bought and sold any time the exchange is open.
 The contracts have standardized terms set by the exchange or the clearing house.
 Prices are publicly available.

Over-the-counter derivatives:
 Over-the-counter derivatives result from agreements between two parties.
 The parties can negotiate contract terms that are mutually acceptable.
 Contracts can be terminated only with the agreement of the other party.
 Prices are not publicly available.

Standardized derivative: Standardized derivatives are as specified by exchanges and

have simple standard features like simple expiration date and strike price. These are also
called vanilla derivatives or plain vanilla derivatives. These are exchange-traded
derivatives. Eg. Futures, Options, Swaps.

Exotic derivatives are the derivatives which are more complex than commonly traded
"vanilla" products. This complexity usually relates to determination of payoff. The category
may have many non-standard features, developed for special classes of investors, for a
particular client or a particular market. These are generally not exchange traded and are
structured between parties on their own. Such contracts are \custom-built" for a client
by a large financial house in what is known as the \over the counter" derivatives market.
These contracts are not exchange-traded. This area is also called the \OTC Derivatives
Industry". Eg. Forwards (RBI PHASE 1 2017)

The most commonly used derivatives contracts are forwards, futures and options
which we shall discuss in detail later. Here we take a brief look at various derivatives
contracts that have come to be used.
Forwards: A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today’s pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. Futures contracts are special types of
forward contracts in the sense that the former are standardized exchange-traded
contracts.
Options: Options are of two types – calls and puts. Calls give the buyer the right but not
the obligation to buy a given quantity of the underlying asset, at a given price on or before
a given future date. Puts give the buyer the right, but not the obligation to sell a given
quantity of the underlying asset at a given price on or before a given date.

Warrants: Options generally have lives of upto one year, the majority of options traded

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on options exchanges having maximum maturity of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long Term Equity Anticipation Securities. These are
options having a maturity of up to three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a form of
basket options.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts. The two commonly used swaps are:
• Interest rate swaps: These entail swapping only the interest related cash flows between
the parties in the same currency.
• Currency Swaps: These entail swapping both principal and interest between the parties,
with the cash flows in one direction being in a different currency than those
in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the
expiry of the options. Thus, swaptions is an option on a forward swap. Rather than have
calls and puts, the swaptions market has receiver swaptions and payer swaptions A
receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed and receive floating.

Derivatives Market in India: SEBI set up a 24-member committee under the

Chairmanship of Dr. L. C. Gupta on November 18, 1996 to develop appropriate regulatory
framework for derivatives trading in India. The committee submitted its report on March
17, 1998 prescribing necessary pre-conditions for introduction of derivatives trading in
India. The committee recommended that derivatives should be declared as ‘securities’ so
that regulatory framework applicable to trading of ‘securities’ could also govern trading of
securities.
SEBI also set up a group in June 1998 under the chairmanship of Prof. J. R. Varma, to
recommend measures for risk containment in derivatives market in India. The report,
which was submitted in October 1998, worked out the operational details of margining
system, methodology for charging initial margins, broker net worth, deposit requirement
and real-time monitoring requirements.

The SCRA was amended in December 1999 to include derivatives within the ambit of
‘Securities’ and the regulatory framework was developed for governing derivatives trading.
The act also made it clear that derivatives shall be legal and valid only if such contracts
are traded on a recognised stock exchange, thus precluding OTC derivatives. Derivatives
trading commenced in India in June 2000 after SEBI granted the final approval to this
effect in May 2000. SEBI permitted the derivatives segments of two stock exchanges NSE
and BSE, and their clearing house/ corporation to commence trading and settlement in
approved derivatives contracts. To begin with, SEBI approved trading in index futures
contracts based on S&P CNX Nifty and BSE-30 (Sensex) index. This was followed by
approval for trading in options which commenced in June 2001 Options on individual
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securities commenced in July 2001. Futures contracts on individual stocks were launched
in November 2001.

“SCRA: The Securities Contracts (Regulation) Act, 1956 also known as SCRA is
an Act of the Parliament of India enacted to prevent undesirable exchanges in
securities and to control the working of stock exchange in India. It came into force
on February 20, 1957.”

Forwards: In a forward contract, two parties agree to do a trade at some future date, at a
stated price and quantity. No money changes hands at the time the deal is signed. One of
the parties to the contract assumes a long position and agrees to buy the underlying asset
on a certain specified future date for a certain specified price. The other party assumes a
short position and agrees to sell the asset on the same date for the same price. Other
contract details like delivery date, price and quantity are negotiated bilaterally by the
parties to the contract. The forward contracts are normally traded over the counter (OTC).

The salient features of forward contracts are:

 They are bilateral contracts (without any exchange between them) and hence
exposed to counter–party risk.
 Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
 The contract price is generally not available in public domain.
 On the expiration date, the contract has to be settled by delivery of the asset.
 If the party wishes to reverse the contract, it has to compulsorily go to the same
counterparty, which often results in high prices being charged.
 Settlement will take place sometime in future (can be based on convenience of the
parties)
 No margins are generally payable by any of the parties to the other.

Example: Assume that you buy a commodity from a seller for delivery in approximately 1
month. You commit to pay the Rs.100 when the commodity is delivered. You are buying
forward and taking delivery in a month from today. The seller is selling you a forward since
he promises to deliver in a month at Rs.100.

Where the buyer makes a gain, the gain is the mirror image of the seller's loss. If the price
of the commodity starts moving up to Rs. 110, the buyer makes a gain of Rs.10 and the
seller makes a loss of Rs.10. If the price of the commodity starts decreasing up to Rs. 80,
the buyer makes a loss of Rs.20 and the seller makes a gain of Rs.20.

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The commodity is the "deliverable instrument." This forward position entails a risk.
Whichever way the price of the commodity moves, one party has an interest to default
because it suffers a loss. If the price of the commodity drops to Rs. 60 in the open market,
the buyer might prefer to buy at Rs. 60 from open market, and not at original price of
Rs.100 from the seller with which forward contract was made. If the price of the commodity
rises to Rs. 150, the seller has an incentive not to deliver and so default on its commitment
to sell to the buyer at Rs. 100.

In an organized market, the seller//buyer would have to post the loss in the
dedicated margin account. The loss is cashed out and cannot be avoided by the
seller.

Futures: Futures markets were designed to solve the problems that exist in forward
markets. A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future at a certain price. But unlike forward contracts, the futures
contracts are standardized and exchange traded. To facilitate liquidity in the futures
contracts, the exchange specifies certain standard features of the contract. It is a
standardized contract with standard underlying instrument, a standard quantity and
quality of the underlying instrument that can be delivered, (or which can be used for
reference purposes in settlement) and a standard timing of such settlement. In futures
markets, unlike in forward markets, increasing the time to expiration does not increase
the counterparty risk.

A futures contract may be offset prior to maturity by entering into an equal and opposite
transaction. More than 99% of futures transactions are offset this way. The standardized
items in a futures contract are:
• Quantity of the underlying
• Quality of the underlying
• The date and the month of delivery
• The units of price quotation and minimum price change
• Settlement is done on daily basis

All future contracts are marked to market to the daily settlement price at the end of each
day. The daily settlement price or MTM (marked to market) settlement price is calculated
as the last half an hour weighted average price of the contract.

Final settlement price is the closing price of relevant underlying index/security in cash
market, on the last trading day of the contract. The closing price of the underlying
index/security is the last half an hour weighted average value.

Futures terminology:
 Spot price: The price at which an asset trades in the spot market.

 Futures price: The price at which the futures contract trades in the futures market.
Contract cycle: The period over which a contract trades. The index futures
contracts on the NSE have one month, two-month and three-month expiry cycles
which expire on the last Thursday of the month. If the last Thursday is a holiday,
Futures and Options will expire on the previous working day. Thus a January
expiration contract expires on the last Thursday of January and a February
expiration contract ceases trading on the last Thursday of February. On the next
working day following the last Thursday, a new contract having a three-month
expiry is introduced for trading.

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 Expiry date: It is the date specified in the futures contract. This is the last day on
which the contract will be traded, at the end of which it will cease to exist.

 Contract size: The amount of asset that has to be delivered under one contract.
Also called as lot size.

 Basis: In the context of financial futures, basis can be defined as the futures price
minus the spot price. There will be a different basis for each delivery month for each
contract.

 Cost of carry: The relationship between futures prices and spot prices can be
summarized in terms of what is known as the cost of carry. This measures the
storage cost plus the interest that is paid to finance the asset less the income earned
on the asset.

 Initial margin: The amount that must be deposited in the margin account at the
time a futures contract is first entered into is known as initial margin.

 Marked-to-market (MTM): In the futures market, at the end of each trading day,
the margin account is adjusted to reflect the investor’s gain or loss depending upon
the futures closing price. This is called marked–to–market.

 Available margin: Available margin is calculated by deducting MTM loss from

margin blocked at position level.

 Maintenance margin /Minimum Margin: This is somewhat lower than the initial
margin. This is set to ensure that the balance in the margin account never becomes
negative. If the balance in the margin account falls below the maintenance margin,
the investor receives a margin call and is expected to top up the margin account to
the initial margin level before trading commences on the next day.

 Tick size: the minimum amount is decided by the Exchange ( currently 0.05 rs ).

 Striking price: the price of the underlying asset specified in the contract (delivery
price).
 Future Payoffs: A payoff is the likely profit/loss that would accrue to a market
participant with change in the price of the underlying asset. This is generally
depicted in the form of payoff diagrams which show the price of the underlying asset
on the X-axis and the profits/losses on the Y-axis. Futures contracts have linear
payoffs. In simple words, it means that the losses as well as profits for the buyer
and the seller of a futures contract are unlimited.
 Long Position: One of the parties to the contract assumes a long position and
agrees to buy the underlying asset on a certain specified future date for a certain
specified price.
 Short Position: The other party assumes a short position and agrees to sell the
asset on the same date for the same price.

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Pricing of Stock Futures: The theoretical price of a future contract is sum of the current
spot price and cost of carry. However, the actual price of futures contract very much
depends upon the demand and supply of the underlying stock. Generally, the futures
prices are higher than the spot prices of the underlying stocks.

Futures Price = Spot Price + Cost of Carry : F= S + C

Cost of carry is the interest cost of a similar position in cash market and carried to
maturity of the futures contract less any dividend expected till the expiry of the contract.

Example Spot Price of Infosys = 1600, Interest Rate = 7% p.a. Futures Price of 1 month
contract=1600 + 1600*0.07*30/ 365 = 1600 + 11.51 = 1611.51.
This can also be expressed as: F = S (1 + r)T

In case of concept of continuous compounding, the cost of carry model used for pricing
futures is also given below: F = SerT
Where:
r =Cost of financing (using continuously compounded interest rate) (MIBOR)
MIBOR - Mumbai Inter-Bank Offer Rate
T Time till expiration in years
e = 2.71828
F = Future Price
S = Spot price

Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested
at 11% per annum. The fair value of a one-month futures contract on XYZ is calculated
as follows:
F = SerT
F = 1150 e0.11x1/12
F = 1160
Note: To take the buy/sell position on index/stock futures, you have to place certain
% of order value as margin, no need to pay full amount.

For example, you have to buy position in Fut-ACC- 26-Oct-2017 for 400 shares ( 1
lot) @ 1650 and Initial Margin % for ACC is 25%. In that case, margin requited to
buy would be 660000 * 25% = 165000/-.

If price of future on expiry or at the time of squaring off of an order rises to 1680 then
profit earned is: 1680-1650 = 30* 400= Rs 12000.

If price of future on expiry or at the time of squaring off of an order decreases to 1630 then
loss is: 1650-1630 = 20* 400= Rs 8000.

Question asked in RBI 2017 PHASE 2

If a person buys a stock in equity cash/spot market at Rs. 400 and sells the stock
at Rs. 440.

He/she buys the future of the stock at Rs. 400 by paying 20% margin money and
sells the future at Rs. 440.
Then returns on investments in both the cases are:

a. 50% and 50%

b. 10 % and 10%
c. 10% and 50%
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d. 50% and 10 %
e. 10 % and 20%

In 1st case Profit/return on investment is : 440-400 = 40

Investment made is Rs. 400
% Profit/return on investment is = 40/400X100= 10 %

In 2nd case Profit/return on investment is : 440-400 = 40

Investment made is 20% of 400 = 80
% Profit/return on investment is = 40/80X100= 50 %

Hence correct option is c.

Index Futures: Stock index future is an index derivative that draws its value from an
underlying stock index like Nifty or Sensex and helps a trader to take a view on the market
as a whole. Index futures permits speculation and if a trader anticipates a major rally in
the market he can simply buy a futures contract and hope for a price rise on the futures
contract when the rally occurs.

In India we have index futures contracts based on CNX Nifty and the BSE Sensex and
near 3 months duration contracts are available at all times. Each contract expires on the
last Thursday of the expiry month and simultaneously a new contract is introduced for
trading after expiry of a contract.NSE is the largest derivative exchange in India. The first
exchange traded financial derivative in India was commenced with the trading of Index
futures on NSE.

Index futures contracts of BSE Sensex 30 has a lot size of 15 and CNX Nifty 50 has a lot
size of 75.

Currency Futures: A Currency Futures contract is a standardized version of a Forward

contract that is traded on a regulated Exchange. It is an agreement to buy or sell a
specified quantity of an underlying Currency on a specified date in the future at a specified
rate. In India, currently only USD/INR, EUR/INR, GBP/INR and JPY/INR are available for
trading on various Exchanges. Currency Futures allow investors to take a view on the
movement of the Indian Rupee against other Currencies. This can be used to protect one's
business from Currency risks due to fluctuation of the exchange rates.
Features of currency trading in India:
Last trading day: Two working days prior to the last business day of the expiry month at
12:30 pm.

Contract Months: 12 near calendar months.

Tick size: 0.25 paise or INR 0.0025

Trading hours: Monday to Friday 9:00 a.m. to 5:00 p.m.

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Final settlement day: Last working day (excluding Saturdays) of the expiry month.
The last working day will be the same as that for Interbank Settlements in Mumbai.

Settlement: Daily settlement: T+1 , Final settlement : T + 2

Daily settlement price (DSP): Calculated on the basis of the last half an hour weighted
average price.

Final settlement price (FSP): All currency futures & options contracts on exchange are
net settled in cash in Indian Rupee. The final settlement price is the RBI Reference rate
for each currency pair published on the last trading day (Excluding Saturdays and FEDAI
holidays) for the expiry month.
FEDAI: Foreign Exchange Dealers Association of India. Headquarter at Mumbai.

The size of each contract for different currency pairs on the exchange are as follows:
Currency Pair Contract Size

USDINR USD 1000

EURINR EUR 1000

GBPINR GBP 1000

JPYINR JPY 100,000

Terminology:

Base currency and quote currency: The first currency in the currency pair is referred to
as the base currency and second currency is called the quote currency. For example, in
the USDINR currency pair, USD is the base currency and INR is the quote currency.

Bid price and ask price: Bid refers to the price at which the market is willing to buy a
specific currency. Ask refers to the price at which the market is willing to sell a specific
currency. The difference between the bid and ask price is referred to as the bid-ask spread.

Currency appreciation and depreciation mean: Let's assume that the current exchange
rate of the USD to the INR is INR 55. When the value of the Rupee moves up to INR
54/USD, we would say that the Rupee has appreciated in value against the USD. It means
we can buy USD100 for INR 5,400 instead of INR 5,500.

Similarly, when the value of the Rupee moves down to INR 56/USD, we would say that
the Rupee has depreciated in value against the USD. It means we can buy USD100 for
INR5,600 instead of INR 5,500.

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Calendar Spread : A calendar spread is a position in an underlying with one maturity
which is hedged by an offsetting position in the same underlying with a different maturity:
for example, a short position in a July futures contract on USD-INR and a long position
in the August futures contract on USD-INR is a calendar spread. Calendar spreads attract
lower margins because they are not exposed to market risk of the underlying. If the
underlying rises, the July contract would make a profit while the August contract would
make a loss.

Options: Options are fundamentally different from forward and futures contracts. An
option gives the holder of the option the right to do something. The holder does not have
to exercise this right. In contrast, in a forward or futures contract, the two parties have
committed themselves to doing something. Whereas it costs nothing (except margin
requirements) to enter into a futures contract, the purchase of an option requires an
upfront payment.

Types of options:
• Call option: A call option gives the holder the right but not the obligation to buy an
asset on or before a predetermined date for a certain price.

• Put option: A put option gives the holder the right but not the obligation to sell an
asset on or before a predetermined date for a certain price.

American options: American options are options that can be sold and exercised at any
time upto the expiration date. Options in stocks that have been recently launched in the
Indian market are "American Options".

European options: European options are options that can be sold any time but can be
exercised only on the expiration date itself. European options are easier to analyze than
American options, and properties of an American option are frequently deduced from those
of its European counterpart. Currently, in India index options are European in nature.

Note: Don’t be confused between selling and exercising. Selling means selling the option
at the option premium whatever it may be. Exercising means, force the contract seller to
give you the price difference (Spot price - strike price).

Options terminology:
Index options: These options have the index as the underlying. Like index futures
contracts, index options contracts are also cash settled.

Stock options: Stock options are options on individual stocks.

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Buyer of an option: The buyer of an option is the one who by paying the option premium
buys the right but not the obligation to exercise his option on the seller/ writer.

Writer of an option: The writer of a call/put option is the one who receives the option
premium and is thereby obliged to sell/buy the asset if the buyer wishes to exercise his
option.

Option price: Option price is the price which the option buyer pays to the option seller.
It is also referred to as the option premium.

Expiration date: The date specified in the options contract is known as the expiration
date, the exercise date, the strike date or the maturity.

Strike price: The price specified in the options contract is known as the strike price or
the exercise price.

In-the-money option: An in-the-money (ITM) option is an option that would lead to a

positive cash flow to the holder if it were exercised immediately. (i.e. for call option spot
price > strike price) and vice versa for put option.

At-the-money option: An at-the-money (ATM) option is an option that would lead to zero
cash flow if it were exercised immediately. (i.e. for call and put option spot price = strike
price)

Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead

to a negative cash flow it was exercised immediately. (i.e. for call option spot price < strike
price) and vice versa for put option.

Intrinsic value of an option: The option premium can be broken down into two
components–intrinsic value and time value. Intrinsic value of an option is the difference
between the market value of the underlying security/index in a traded option and the
strike price. The intrinsic value of a call is the amount when the option is ITM, if it is ITM.
If the call is OTM, its intrinsic value is zero. (i.e. for call option Spot Price - Strike Price)
and vice versa for put option.

Time value of an option: The time value of an option is the difference between its
premium and its intrinsic value. Both calls and puts have time value. An option that is
OTM or ATM has only time value. Usually, the maximum time value exists when the option
is ATM. The longer the time to expiration, the greater is an option’s time value, all else
equal. At expiration, an option should have no time value. i.e. (Option Premium – intrinsic
value).

Volatility: Volatility is the tendency of the underlying security’s market price to fluctuate
either up or down. It reflects a price change’s magnitude; it does not imply a bias toward
price movement in one direction or the other. Thus, it is a major factor in determining an
option’s premium. Generally, as the volatility of an under-lying stock increases, the
premiums of both calls and puts overlying that stock increase, and vice versa.

Open Interest (OI): Open interest is the total number of options and/or futures contracts
that are not closed out on a particular day, that is contracts that have been purchased
and are still outstanding and not been sold and vice versa.

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Contract cycle: The period over which a contract trades. The option contracts on the NSE
have one month, two-month and three-month expiry cycles which expire on the last
Thursday of the month. If the last Thursday is a holiday, Futures and Options will expire
on the previous working day. Thus a January expiration contract expires on the last
Thursday of January and a February expiration contract ceases trading on the last
Thursday of February. On the next working day following the last Thursday, a new
contract having a three-month expiry is introduced for trading. Cash settlement on T+1
basis. Daily settlement price is net premium value and final settlement price is
closing price of underlying.

Greeks: The options premium is determined by the three factors mentioned earlier –
intrinsic value, time value and volatility. But there are more sophisticated tools used to
measure the potential variations of options premiums. They are as follows:

Delta, Gamma, Theta, Vega, Rho

Delta: Delta is the measure of an option’s sensitivity to changes in the price of the
underlying asset. Therefore, it is the degree to which an option price will move given a
change in the underlying stock or index price, all else being equal.

Change in option premium

Delta= --------------------------------
Change in underlying price

Gamma: This is the rate at which the delta value of an option increases or decreases as
a result of a move in the price of the underlying instrument.
Change in an option delta
Gamma = -------------------------------------
Change in underlying price

Theta: It is a measure of an option’s sensitivity to time decay. Theta is the change in

option price given a one-day decrease in time to expiration. It is a measure of time decay
(or time shrunk). Theta is generally used to gain an idea of how time decay is affecting
your portfolio.

Change in an option premium

Theta= --------------------------------------
Change in time to expiry
Theta is usually negative for an option as with a decrease in time, the option value
decreases. This is due to the fact that the uncertainty element in the price decreases.

Vega: This is a measure of the sensitivity of an option price to changes in market volatility.
It is the change of an option premium for a given change – typically 1% – in the underlying
volatility.
Change in an option premium
Vega= -----------------------------------------
Change in volatility

Rho: The change in option price given a one percentage point change in the risk-free
interest rate. Rho measures the change in an option’s price per unit increase typically 1%
– in the cost of funding the underlying.
Change in an option premium
Rho= ---------------------------------------------------

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Change in cost of funding underlying

Options Pricing Models: Options have existed—at least in concept—since antiquity. It

wasn’t until publication of the Black-scholes (1973) option pricing formula that a
theoretically consistent framework for pricing options became available. That framework
was a direct result of work by Robert Merton as well as Fisher Black and Myron Scholes.
In 1997, Scholes and Merton won the Nobel Prize in economics for this work. Black had
died in 1995, but otherwise would have shared the prize.

The factors affecting the option price are: (i) The spot price of the underlying, (ii) exercise
price, (iii) risk-free interest rate, (iv) volatility of the underlying, (v) time to expiration and
(vi) dividends on the underlying (stock or index).

Example of Option contracts:

Reliance Industries Call options:

Premium or
Price at
Underlying Expiry Date Strike Price Lot Size which
contract
was made
RELIND 26-Oct-2017 760.00 1000 35.00

RELIND 26-Oct-2017 770.00 1000 30.00

RELIND 26-Oct-2017 780.00 1000 25.00

RELIND 26-Oct-2017 790.00 1000 19.00

RELIND 26-Oct-2017 800.00 1000 15.00

Spot Price = 780.00

1st case suppose spot price/settlement Price at the expiry increases to Rs. 830.00

Then Call Option pay off:

Call Option pay off Profit / loss =

Premium or on Expiry shall be (Option pay off –
Strike Price/unit at as= Premium per unit x
Lot Size
Price which contract 1000)
was made (Spot Price-Strike
Price) x lot size
760.00 1000 35.00 70x1000= 70000 70000-35000=35000

770.00 1000 30.00 60x1000=60000 60000-30000=30000

780.00 1000 25.00 50x1000=50000 50000-25000=25000

790.00 1000 19.00 40x1000=40000 40000-19000=31000

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800.00 1000 15.00 30x1000=30000 30000-15000=15000

2nd case suppose spot price/settlement Price at the expiry decreases to Rs. 770.00.

In a call option if spot or settlement price on expiry is below strike price then all
such options which have strike price equal to or greater than the spot/settlement
price, shall have zero payoff or zero intrinsic/premium value.

At the expiry Premium is equal to intrinsic value as time value is zero on expiry.
Call Option pay off Profit / Loss =
Premium or on Expiry shall be (Option pay off-
Strike Price/unit at as= Premium per unit x
Lot Size
Price which contract 1000)
was made (Spot Price-Strike
Price) x lot size
10000 – 35000 = -
760.00 1000 35.00 10x1000=15000
25000

770.00 1000 30.00 0 0- 30000 = -30000

780.00 1000 25.00 0 0- 25000= -250000

790.00 1000 19.00 0 0-19000 = -19000

800.00 1000 15.00 0 0-15000= -15000

Reliance Industries Put options:

Premium or
Price at
Underlying Expiry Date Strike Price Lot Size which
contract
was made

RELIND 26-Oct-2017 760.00 1000 10

RELIND 26-Oct-2017 770.00 1000 15

RELIND 26-Oct-2017 780.00 1000 20

RELIND 26-Oct-2017 790.00 1000 25

RELIND 26-Oct-2017 800.00 1000 30

Spot Price = 780.00

1st case suppose spot price/settlement Price at the expiry decreases to Rs. 740.00

Then Put Option pay off:

Put Option pay off Profit / loss =

Strike Premium or
Lot Size on Expiry shall be (Option pay off –
Price Price/unit at as=

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which contract (Strike Price - Spot Premium per unit x
was made Price) x lot size 1000)

760.00 1000 10 20x1000= 20000 20000-10000=10000

770.00 1000 15 30x1000=30000 30000-15000=15000
780.00 1000 20 40x1000=40000 40000-20000=20000

790.00 1000 25 50x1000=50000 50000-25000=25000

800.00 1000 30 60x1000=60000 60000-30000=30000

2nd case suppose spot price/settlement Price at the expiry increases to Rs. 785.00.

In a put option if spot or settlement price on expiry is above strike price then all
such options which have strike price equal to or lesser than the spot/settlement
price, shall have zero payoff or zero intrinsic/premium value.

At the expiry Premium is equal to intrinsic value as time value is zero on expiry.

Put Option pay off Profit / Loss =

Premium or on Expiry shall be (Option pay off-
Strike Price/unit at as= Premium per unit x
Lot Size
Price which contract 1000)
was made (Spot Price-Strike
Price) x lot size

760.00 1000 10 0 0-10000= -10000

770.00 1000 15 0 0-15000= -15000

780.00 1000 20 0 0-20000 = -20000

790.00 1000 25 5x1000=5000 5000-25000= -20000

15000-30000= -
800.00 1000 30 15x1000=15000
15000

Interest Rate Derivatives: Deregulation of interest rate exposed market participants to

a wide variety of risks. To manage and control these risks and to deepen money market,
scheduled commercial banks, primary dealers and all India financial institutions have
been permitted to undertake forward rate agreements (FRAs) and interest rate swaps
(IRSs).

A forward rate agreement (FRA) is a financial contract between two parties to exchange
interest payments for a ‘notional principal’ amount on settlement date, for a specified
period from start date to maturity date. Accordingly, on the settlement date, based on
contract (fixed) and the settlement rate, cash payments are made by the parties to one
another. The settlement rate is the agreed benchmark/ reference rate prevailing on the
settlement date.

An interest rate swap (IRS) is a financial contract between two parties exchanging or
swapping a stream of interest payments for a ‘notional principal’ amount on multiple

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occasions during a specified period. Such contracts generally involve exchange of a ‘fixed
to floating’ rates of interest. Accordingly, on each payment date–that occurs during the
swap period–cash payments based on fixed/ floating and floating rates, are made by the
parties to one another.

FRAs/IRSs provide means for hedging the interest rate risk arising on account of lendings
or borrowings made at fixed/variable interest rates.

Scheduled commercial banks (excluding Regional Rural Banks), primary dealers (PDs) and
all-India financial institutions (FIs) undertake FRAs/ IRSs as a product for their own
balance sheet management or for market making. Banks/FIs/PDS offer these products to
corporate for hedging their (corporates) own balance sheet exposures.

In view of the robust methodology of computation of these rates and their extensive use
by market participants, these have been co-branded with Fixed Income and Money
Market Derivatives Association (FIMMDA) from March 4, 2002. These are now known
as FIMMDA-NSE MIBID/MIBOR from March 4, 2002.

These rates are used as benchmarks for majority of deals struck for interest rate swaps,
forward rate agreements, floating rate debentures and term deposits.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward
contracts.

Types of Swap: Swaps are generally of the following types:

1. Interest Rate Swap:

Where cash flows at a fixed rate of interest are exchanged for those referenced to a floating
rate. An interest rate swap is a contractual agreement to exchange a series of cash flows.
One leg of cash flow is based on a fixed interest rate and the other leg is based on a floating
interest rate over a period of time.

Example of such swaps in the Indian market are:

Overnight Index Swaps (OIS) – Fixed v/s NSE Overnight MIBOR Index
Mumbai Inter-bank Forward Offer Rate (MIFOR) Swap – Fixed V/s Implied INR yield
derived from the USD/INR premium and the relevant USD Libor for that tenor, usually 6
months.
INBMK Swap – Fixed v/s 1 year INBMK rate. The 1 year INBMK rate is derived from the
rate on the benchmark Indian Government of India securities

A fixed rate of interest is one where the interest on the loan does not change until the loan
is settled. But in the case of floating interest rate, the interest rate fluctuates according to
the market forces of supply and demand. As a result, the interest rate may go down or it
may rise also. But, when the interest rate comes down, the borrower can take advantage
of it by swapping it with the help of the lender.
Types of Interest Rate Swaps:
1. A Plain Vanilla Swap: This is the simplest form of Interest rate swaps where a fixed
rate is exchanged for a floating rate or vice versa on a given notional principal at pre-
agreed intervals during the life of the contract.

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2. A Basis Swap: In a floating to floating swap, it is possible to exchange the floating rates
based on different benchmark rates. For example, we may agree to exchange 3m Mibor for
91 days T Bills rate. Such a swap is called a Basis Swap.
3. An Amortizing swap: As the name suggests, swaps that provide for reduction in
notional principal amount corresponding to the amortization of a loan, are called
amortizing swaps.
4. Step-up Swap: This is the opposite of an amortizing swap. In this variety the notional
principal increases as per a pre- agreed schedule.

5. Extendable Swap: When one of the counter parties has the right to extend the maturity
of the swap beyond its original life, the swap is said to be an extendable swap.
6. Delayed Start Swaps/Deferred Swaps/ Forward Swaps:When it is agreed between the
counter parties that the swap will come into effect on a future date, it is termed as a
delayed start swap or deferred swap or a forward swap.
7. Differential Swaps: Interest rate swaps which are structured in such a way that one
leg of the swap provides for payment of interest at a rate pertaining to a currency other
than the currency of the underlying principal amount. The other leg provides for payment
of interest at the rate and currency of the underlying principal.

For example, a corporate can choose to enter into a differential swap by which it could
bind itself to pay 3m USD Libor on a principal of Rs. 100 crores and receive 12% fixed in
the Indian currency. The interest on both the legs will be computed on the notional
principal of Rs. 100 crores. The swap is thus a combination of currency and plain interest
rate swaps. There is no currency risk in this arrangement.

2. Currency Swap: Where cash flows in one currency are exchanged for cash flows in
another currency. A currency swap is contractually similar to an interest rate swap. The
main differences are:
i. Each interest rate is in a different currency,
ii. The notional amount is now replaced by two principal amounts – one in each
currency, and
iii. These principal amounts are typically exchanged at the start of the swap and then re-
exchanged at maturity.
The major difference between a generic interest rate swap (IRS) and a generic currency
swap is that the latter includes not only the exchange of interest rate payments but also
the exchange of principal amounts both initially and on termination. Since the payments
made by both parties are in different currencies, the payments need not be netted.
Types: Currency Swaps can categorized based on how interest rates are structured:
(a) Fixed for Fixed Currency Swap: The interest payments exchanged are payable under
Fixed Rate Basis for both the contracting parties.
(b) Fixed for Floating Currency Swap or Plain Vanilla Currency Swap: Interest
payments exchanged are payable under Fixed Rate Basis for one party and Floating Rate
basis the other party.
(c) Floating for Floating Currency Swap or basis swap: Interest payments exchanged
are payable under Floating Rate Basis for both the parties. However, the base for fixing
the floating rates is the same for both the parties, i.e. LIBOR or MIBOR etc.

CREDIT DEFAULT SWAP (CDS) : CDS is in operation in India since October 2011 —
launched in only corporate bonds. The eligible participants are commercial banks, primary
dealers, NBFCs, insurance companies and mutual funds.

CDS is a credit derivative transaction in which two parties enter into an agreement,
whereby one party (called as the ‘protection buyer’) pays the other party (called as the

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‘protection seller’) periodic payments for the specified life of the agreement. The protection
seller makes no payment unless a credit event relating to a pre¬ determined reference
asset occurs. If such an event occurs, it triggers the Protection Seller’s settlement
obligation, which can be either cash or physical (India follows physical settlement). It
means, CDS is a credit derivative that can he used to transfer credit risk from the investor
exposed to the risk (called protection buyer,) to an investor willing to take risk (called
protection seller). It operates like an insurance policy. In an insurance policy, the
insurance firm pays the loss amount to the insured party. Similarly, the buyer of the
CDS— the bank or institution that has invested in a corporate bond issue— seeks to
mitigate the losses it may suffer on account of a default by the bond issuer.

Credit default swaps allow one party to ‘buy’ protection from another party for losses that
might be incurred as a result of default by a specified reference instrument (a bond issue
in India). The ‘buyer’ of protection pays a premium to the seller, and the ‘seller’ of
protection agrees to compensate the buyer for losses incurred upon the occurrence of any
one of the several specified ‘credit events’. Thus CDS offers the buyer a chance to transfer
the credit risk of financial assets to the seller without actually transferring ownership of
the assets themselves.

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