 Definition of Risk

 Certainty , Uncertainty and Risk

 Types of Risk or Sources of Risk:
d) Interest rate risk
e) Exchange risk
f) Liquidity risk
g) Internal business risk
h) External business risk
i) Financial risk
j) Events of God
k) Market risk
l) Marketing risk
m) Credit risk
n) Other risks i.e. personnel/environmental/production risks
Risk avoidance

Loss control

Diversification

Separation

Risk transfer

Risk retention

Risk sharing
Mere survival
Peace of mind
Lower risk management costs and thus higher profits
Fairly stable earnings
Little or no interruption of operations
Continued growth
Satisfaction of the firm’s sense for a good image
Fulfillment of social responsibility
Determining objectives
Identifying risks
Risk evaluation
Development of policy
Development of strategy
Implementation
Review
 INSURANCE

DERIVATIVES:

 Forwards
 Futures
 Options
 Swaps
PROPERTY RISK

LEGAL LIABILITY RISK

OTHER RISKS
HUGE POTENTIAL LOSSES

PURE RISKS ARE CONTROLLABLE

INSURABILITY

LOWER PROBABILITY

NOT ASSOCIATED WITH OFFSETTING GAINS

EXPECTED COST OF LOSSES

COST OF LOSS CONTROL

COST OF LOSS FINANCING

COST OF INTERNAL RISK REDUCTION METHODS

COST OF RESIDUAL UNCERTAINTY

LOSS CONTROL

RISK FINANCING

INTERNAL RISK REDUCTION

 ( A ) IDENTIFICATION OF EXPECTED LOSSES:
 PROPERTY LOSSES
 LIABILITY LOSSES
 LOSSES TO HUMAN RESOURCES
 LOSSES FROM EXTERNAL FORCES

( B ) MEASUREMENT OF EXPECTED LOSSES:

 PROBABILITY DISTRIBUTION
 EXPECTED VALUE
 STANDARD DEVIATION
 FREQUENCY OF LOSSES
 SEVERITY OF LOSS
FIRE ACCIDENT TO PROPERTY PROBABILITY ESTIMATED LOSS

MAJOR .04 RS. 25 LACS

MINOR .06 RS. 5 LACS
NO ACCIDENT .90 RS. 0 LACS
TOTAL : 1
EXPECTED LOSS = 25 ( .04 ) + 5 ( .06 ) + 0 (0.9 )
= 1.3 LACS
VARIANCES = (25 – 1.3) (0.04 ) + ( 5 – 1.3 ) ( 0.06 ) + ( 0 – 1.3 ) ( 0. 9 )
= 22. 47 + 0. 82 + 0
= 23.29

STANDARD DEVIATION = RS. 4.83 LACS

INSURER’S SERVICES

AVOIDS RAISING COSTLY EXTERNAL FUNDS

AVOIDS FINANCIAL DISTRESS

REDUCES TAX PAYMENTS

 LIFE INSURANCE
GENERAL INSURANCE
SOCIAL INSURANCE
PROPERTY INSURANCE :

 Marine Insurance
 Fire insurance
 Miscellaneous insurance
Insurable interest
Utmost good faith
Indemnity
Subrogation
Warranties
Proximate cause
Assignment and
nomination
Transformation of insurance industry in India
Insurance sector reforms
Insurance regulatory and development authority ( IRDA )
Players in the insurance markets
Insurance market : new dimensions
( I ) Re-insurance
( ii ) Banc assurance
( iii ) Alternative risk transfer (ART )
WHOLE LIFE POLICY
ENDOWMENT ASURANCE POLICY
MONEY BACK POLICY
TERM POLICY
JOINT LIFE INSURANCE POLICY
CHILDREN’S POLICY
GROUP INSURANCE PLAN
Derivatives are contracts whose pay-offs depend upon the value of an
‘underlying’. The underlying can be a commodity , a stock , a stock
index , a currency , or interest rate , or literally anything – not
necessarily an asset.
When the values of underlying assets change, so do the values of
derivatives based on them.
The transactions in the derivatives are settled by the
offsetting/squaring transactions in the same derivatives. The
difference in value of the derivatives is cash settled.
It is easier to take short position in derivatives than in other assets.
Exchange traded derivatives are liquid and have low transaction cost.
It is possible to construct the portfolio which is exactly needed ,
without having the underlying assets.
Some derivatives are traded on organized exchanges while others are
traded only in OTC markets.
Exchange traded derivatives have standardized features and are not
tailored to the needs of buyers and sellers .
COMMODITY DERIVATIVES AND FINANCIAL
DERIVATIVES

BASIC DERIVATIVES AND COMPLEX DERIVATIVES

EXCHANGE TRADED AND OTC DERIVATIVES

RISK MANAGEMENT

PRICE DISCOVERY

TRANSACTIONAL EFFICIENCY

FINANCIAL ENGINEERING
Hedgers

Speculators

Arbitrageurs
FORWARDS

FUTUTERS

OPTIONS

FINANCIAL SWAPS
A forward contract is an agreement between two parties to buy
or sell an asset at a future date at a price agreed today.
In India, the forward contract have been quite common in
agriculture produce. With globalization effect, the forward
market for foreign currencies has also come up fast.
Forward contracts are generally tailor- made and non-
transferable.
FCs can be used to hedge or lock-in-the price of purchase or
sale of the asset at a future date.
In case of FCs, no initial margin or premium is payable, so
these can used without any cash outflow.
FCs have a counter party risk and in case of default by other
party, the aggrieved party may have to suffer a loss.
Generally, squaring off of a FC is not possible and it
compulsorily ends in delivery.
A futures contract, or simply called futures, is a contract to buy
or sell a stated quantity of a commodity or a financial claim at
a specified price at a future specified date.
Futures are traded in organized exchange and the terms of the
futures are standardized by the exchange with reference to
quantity, date, units of price quotations etc.
Both the parties to the futures have a right to transfer the
contract by entering into an offsetting futures contract. If not
transferred until the settlement / specified date, then they have
obligations to fulfill the terms and conditions of the contract.
The exchange provides the counter party guarantee through its
clearing house and different types of margin system.
Futures are marked to market at the end of each trading day.
 DIFFERNCE BETWEEN FUTURES AND
FORWARD
TYPES OF FUTURES :
 A foreign currency say Euro, Yen ,Swiss
franc etc.
 An interest-earning asset say a debenture
 An index ( usually a stock index )
 A physical commodity ( say, wheat , corn
etc )
 Futures on individual stock
The asset
The price
The contract size
Delivery arrangements
Delivery months
Limits on daily price movements
Trading units
 price price
CLEARING SELLER
BUYER HOUSE

Underlying Underlying
assets assets
Ensuring adherence to system and procedures for
smooth trading.
Minimizing credit risk by being a counterparty to all
trades.
Accounting for all the gains/losses on daily basis
Monitoring the speculation margins
Ensuring delivery or payment for the assets on the
maturity date for all the outstanding contracts.
MARGINING MECHANISM

SETTLEMENT MECHANISM

HOW TO READ FUTURE PRICES

Symbol : SBIN
Expiry date: 29-Dec-05
No. of contracts traded: 16420
Contract Value(Rs. lakh) : 76155.96
Last traded price(Rs) : 931.45
% change from previous close: 1.59
Open interest: 5806500
Value of underlying: 925.8
THIS REPRESENTS THE NUMBER OF OUTSTANDING FUTURES
CONTRACT :
PERIOD TRADER-A TRADER-B TRADER-C OPEN INTEREST
0 - - - 0
1 SELLS BUYS - 1
2 BUYS - SELLS 1
3 - SELLS BUYS 0
Suppose A,B,C,D,E and F are different investors. ‘+’
refers
To buying a futures contract and a ‘-’ refers to selling of
a
futures contract on the same underlying asset.
Different
Cases of transactions and calculations of open interest
(OI)
Have shown below:
Case-1 case-2 case-3 case-4 case-5
case-6
+A, -B +A, -B +A, -B +A, -B +A, -B +A,
-B
 Market order
Market if touched ( MIT )
Limit order
Market on close ( MOC )
Stop loss order
Time orders :
 Day orders
 Good till cancelled ( GTC )
 Good this week ( GTW ) / this month ( GTM )
 Good through date ( GTD )
Gold futures contract : size = 100 grams

Investor buys one December gold futures contract on

1st November at Rs. 400/ per gram.

Value of contract : Rs. 400 x 100 gm = Rs. 40,000/-

Initial margin ( say ) ; 10% = Rs.4000/-

Maintenance margin (say): 75% of initial margin =

Rs.3000/-
DAY Closing price of Daily Cumulative Margin Variation
gold/ gram gain ( loss) gain (loss) balance margin
Nov 1 400 --- ----- 4000 -------
Nov 2 403 300 300 4300
Nov 3 398 (500) (200) 3800
Nov 4 390 ( 800 ) (1000) 3000
Nov 5 392 200 (800) 3200
Nov 6 387 ( 500 ) ( 1300 ) 2700 1300
Nov 7 394 700 (600) 4700
Nov 8 401 700 100 5400
Nov 9 405 400 500 5800
Nov 10 410 500 1000 6300

On Nov.10 the margin balance is Rs.6300/- which represents a profit of Rs.1000(

Rs.6300 –Rs.5300 deposited as initial and variation margin) as the price of gold
is higher by Rs. 10/- compared to buying price.
DELIVERY OR CASH SETTLEMENT

OFFSETTING

EXCHANGE OF FUTURES FOR PHYSICAL(EFP)

Basis = Current cash price – futures price , normally
should be negative.
Basis risk
spreads
The cost of carry model of determining futures prices
Contango
Backwardation
COST OF CARRY MEANS STORAGE, INSURANCE,
TRANSPORTATION & FINANCING COST.
Ft, T = Ct + Ct x St, T x T-t / 365 + Gt, T
Where,
Ft, T = The future price at time t, which is to be
delivered at
time period T.
Ct = Cash price at time t
St, T = Annualized interest rate on borrowings
T-t = Time period
Gt, T = Storage costs
The price of silver was $ 7.511 per ounce in the New York market
on
April 27, 2008. At the close of trading on the same day, the
settlement
Price of December 2008 silver futures contracts was $ 8.456. The
Annualized borrowing rate on April 27, 2008 was 11%. 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.
A. Ft, T = Ct + Ct x St, T x T-t / 12 + Gt, T
= 7.511 + 7.511 x 0.11 x 8/12 + 0
= $ 8.061 per ounce
B. Futures are now priced at $ 8.456 per ounce. But the fair price
is only $ 8.061 per ounce, so the futures is overpriced.
So, the strategy should be : sell futures and buy spot.
And in the process the net arbitrage profit will be 8.456 – 8.061
= $ 0.395/ ounce
For Long investor: profit = Spot Price at Maturity – Futures price
Loss = Futures price – Spot price at maturity

Profit (Rs) Pay off

0 K = Strike price
Spot price
At maturity

Loss (Rs)
For Short investor : Profit = Futures price – spot price at maturity
Loss = spot price at maturity – futures price

Profit

0 Spot price
k At maturity

Loss Pay off

 A stock index is an indicator of the general level of stock prices.
It is calculated by taking into consideration the prices of a
representative
group of stocks traded in the stock market. Such a stock
market index can be used as an underlying asset to create a
future contract known as index futures.
 Future contracts are available on many stock indices across the
globe for example S & P 100 in USA , Nikkei 225 in Japan , DAX
in Germany and Nifty in India.
 The value of a particular stock index futures contract depends
upon the sum of money allotted per index point . The sum of
money allotted per index point in the case of Nifty is Rs. 1/- ,
when Nifty stands at 1990 , the value of a future contracts on
Nifty would be Rs.1990/-.
The index futures contracts are cash settled.
When an investor goes long in the index future contract, he will
receive a cash settlement on the expiration date, if the closing
price exceeds the contract price, otherwise he will have to pay.
Since index futures contracts are listed and traded on future
exchanges, the investor can offset his position on any day prior
to the expiration day.
The performance of all index futures contacts are guaranteed
by the exchange clearinghouse as its become the counterparty
to both the buyer and the seller.
The index future carries the margin requirements that are
applicable to both buyer and the seller.
The settlement price of sensex futures contract on a particular day was Rs.4600.
The
Initial margin is set at Rs. 10.000 , while the maintenance margin is fixed at
Rs.8000 .
The multiple of each contract is 50 . The settlement prices on the following five
days are
As follows :
DAY SETTLEMENT PRICE
RS.
1 4700
2 4500
3 4650
4 4750
5 4700
Calculate the mark-to-market cash flows and the daily closing balances in the
accounts of
m) An investor who has gone long , and
n) An investor who has gone short at Rs. 4,600.
DAY SETTLEMENT PRICE OPENING MARK-TO MARGIN CLOSING
BALANCE MARKET CALL BALANCE
1 4700 10000 5000 --
15000
2 4500 15000 (-)10000 5000
10000
3 4650 10000 7500 --
17500
4 4750 17500 5000 ---
22500
5 4700 22500 (-) 2500 ----
20000

Net profit ( loss) on the contract :

5000 – 10000 + 7500 + 5000 – 2500
= Rs. 5000

Answer for ( b ) loss is Rs. 5000 . Margin call for day 1 is 5000 and day 4 is 2500.
Let us consider an investor who wants to hold a portfolio which
is identical to the composition of a stock market index for a
period of one year. During the course of the year, he will
receive dividends and at the end of the year, the principal
value would have changed in line with the change in the index.
If we denote the current index value as, I0 , the expiration day
index value as It , and the dividends received as Dt , the rupee
return earned by the investor is given by the equation : (It - I0 )
+ Dt …….. EQ.1
If the investor decided to invest in an index futures contract as
an alternative to investing in the underlying portfolio, he will
buy the index futures contract and invest all his money in risk
free treasury bills or fixed deposits. If we denote the current
price of the index futures contract as F0 , the expiration day
price as Ft , and the interest earned as Rf , the rupee return
earned by investor is :
 (Ft - F0 ) + Rf …………. EQ.2
If the investor has to be indifferent between the two alternatives
then
(It – I0 ) + Dt = ( Ft – F0) + Rf …………. EQ.3
Since Ft = It i.e the final settlement price of the index futures
contract is
Set equal to the spot index value, EQ.3 can be simplified as
F0 = I0 + (Rf – Dt ) ………….. EQ.4
EQ.4 states that the current index futures price must be equal to
the
Index value plus the difference between the risk free interest and
Dividends obtainable over the life of the contract. The difference
Between Rf and Dt is referred to as the cost – of – carry and we
can
STOCK INDEX ARBRITAGE : If the price of the index futures
contract is out of line with the theoretical price suggested by
EQ.4, then an arbitrageur can earn abnormal risk less profits by
trading simultaneously in the spot (cash) and futures markets.
This process is called the stock index arbitrage or basis trading
or program trading. The following example illustrates the
mechanics involved.
EXAMPLE: The current value of sensex is 4500 and the
annualized dividend yield on the index is 4%. A three month
futures contract on the sensex can be purchased for a price of
Rs.4,600, the risk free rate of interest is 10%. Futures contracts
are trading on the sensex at multiples of 50. Can an investor
earn an abnormal ( risk free) rate of return by resorting to stock
index arbitrage? Assume that 50% of the stocks included in the
index will pay dividends during the next three months. Ignore
margin requirements, transaction costs and taxes.
The fair price of the index futures contract is given by the
equation:
F0 = 4500 + ( 4500 X 0.10 X 0.25 ) – ( 4500 X 0.04 X 0.50 )
= 4500 + 112.5 – 90
= 4522.5
The index futures is obviously overpriced. The arbitrageurs can
exploit
This opportunity by :
A. Buying a portfolio which is identical to the index.
B. Going short on the index futures contract.
The following calculations will show that the arbitrageurs can earn
an
abnormal rate of return irrespective of the outcome on the
expiration
Date.
If the sensex closed at 4200 on the expiration date, the
arbitrageurs
Profit will be as under:
C. Profit from short sale of futures ( 4600-4200)x50 =
20,000
D. Cash dividend received on the portfolio
( 4500 x 0.04 x 0.5 x 50 ) =
4500
C. Loss on sale of underlying portfolio(4500-4200)x50 = (-)
15000
D. Interest foregone ( 4500 x 0.10 x 0.25 x 50 ) = (-)
5625

NET ARBRITAGE PROFIT = 3875

On the other hand if the sensex closed at 4800 on the expiration
date
The arbitrageurs profit can be calculated as follows:
A. Profit on sale of the underlying portfolio(4800-4500)x50 =
15000
B. Cash dividend received on the portfolio(4500x0.04x0.5x50)=
4500
C. Loss on short sale of futures ( 4800 – 4500) x 50 = (-)
10000
D. Interest foregone ( 4500 x 0.10 x 0.25 x 50 ) = (-)
5625
NET ARBITRAGE PROFIT =
3875
As more and more arbitrageurs start buying the portfolio of stocks
and
An option is a contract in which the seller of the contract grants the
buyer, the right to purchase from the seller a designated instrument or
an asset at a specific price which is agreed upon at the time of
entering into the contract.
It is important to note that the option buyer has the right but not an
obligation to buy or sell.
But if the buyer decides to exercise his right the seller of the option
has an obligation to deliver or take delivery of the underlying assets at
the price agreed upon.
The seller of the option is also called the writer of the option.
CALL OPTION: An option contract is called a “call option “, if the writer
gives the buyer of the option the right to purchase from him the
underlying asset.
PUT OPTION: An option contract is said to be a “ put option “,if the
writer gives the buyer the right to sell the underlying asset.
EXERCISE DATE : The date at which the contract matures.
STRIKE PRICE : At the time of entering into the contract , the
parties agree upon a price at which the underlying asset may
be bought or sold. This price is referred to as the exercise price
or striking price. This is regardless of the market price of the
asset at the time of exercising.
EXPIRATION PERIOD : At the time of introducing an option
contract the exchange specifies the period ( not more than 9
months from the date of introduction of the contract in the
exchange ) during which the option can be exercised or traded.
This period is referred to as the Expiration period. An option
can be exercised even on the last day of the expiration period.
Beyond this date the option contract expires.
Such options , which can be exercised on any day during the
expiration period are called American options.
Such options , which can be exercised only on the last day of
the expiration period are called European options.
Depending on the expiration period an option can be short
term or long term in nature.
Warrants and convertibles belong to the latter category.
In India Reliance petroleum ltd had converted it’s warrants
issued as a part of triple optional convertibles debentures into
fully paid equity shares.
This is the amount which the buyer of the option ( call or put ) has to pay
to the
option writer to induce him to accept the risk associated with the
contract. It
Can also be viewed as the price paid to buy the option.
Now look the following terms of stock options of Sat yam computer
traded at
NSE.
Instrument type : OPTSTIK
Underlying : SATYAMCOMP
Expiry date : 30 OCT 2008
Option type : CA / PA
Strike price : 300
High price : 13
Low price : 10.9
Pre. Close : 11.35
Last price : 11.95
Number of contracts traded : 146
Turnover in Rs. Lakh : 546.83
Underlying value : 293.50
AT THE MONEY : An option whose exercise price is equal to the current
spot price is said to be at - the – money .
IN – THE – MONEY : A call option is in – the – money when the strike
price is below the current spot price of the underlying asset ; a put
option is in- the – money when the strike is above the current spot
price of the underlying asset .
OUT – OF – THE MONEY : A call option is said to be out – of – the –
money when the strike price is above the spot price of the underlying
asset or a put option is said to be out – of – the – money when the
strike price is below the current spot price of the underlying asset .
The buyer makes a loss if he exercises the option out – of – the –
money .
NEAR – THE – MONEY : An option is near the money if the current price
of the underlying asset price is close to the strike price .
 INTRINSIC VALUE of an option is the value of the profits that
are likely from the option. It consists of the profit that will
accrue, if the option is exercised today ( in the case of
American ) or the present value of the profit ( in the case of an
European option ).
The Intrinsic value is also the value of an option takes when it
is in the money. For a call it is max.( 0 , S – K ) and for a put it is
max ( 0 , K – S ) where S and K are spot price and strike price
of the underlying asset respectively .
 TIME VALUE is the difference between the option premium and
intrinsic value.
 PAY- OFF OF AN OPTION is the profit / loss that arise by way of
exercise / non –exercise of the option.
 COVERED CALL WRITING : An option contract is said to be a covered
call option , when the option is covered or protected by the writer by
depositing the shares of the company on which the option is written in
an escrow account with the brokerage firm. Therefore , the writer of a
call option does not have to deposit any cash as such and whenever
an exercise notice is received from the clearing house , the shares are
delivered .
In case , the option expires or if the writer enters into an offsetting
transaction he can withdraw the stocks deposited .
 NAKED CALL WRITING : If a trader writes a call option without owning
the underlying stock , it is called as Naked call writing .
When the writer does not own the underlying stock , he has to deposit
the necessary amount of margin with the brokerage firm who in turn
deposits it with the exchange . Sometimes , the deposit required by
the broker may be higher than the deposit required by the exchange.
A call option is a contract that gives the owner the right , but
not the obligation , to buy something at a specified price on or
before a specified date .
Let us , therefore , see when the owner of a call option on
shares would prefer to exercise his option and what benefit he
get out of it.
Let us specify certain notations :
Exercise price or strike price =K
Spot price of underlying asset =S
Expiry date of an option =T
Call option premium or price =C
Current time( i.e. today ) = O
Any time between today and expiration date = t
Let us consider an investor who has purchased a call option on
satyam with exercise price at Rs. 280 for a premium of Rs. 10.
If the price of the sat yam rises above 290 at any time before
the expiry date , the investor will exercise his option and will
make a profit by selling the share in spot market.
Let us assume that the current market price is 350 then the
investor will make a gross profit of 70 ( 350 – 280 ) and a net
profit of 60 ( 70 – 10 ) .
Hence , it would be profitable for the investor of the call option
to exercise his option if S > ( K + C ) . As there is no limit to
the increase in share price , the profit potential of the investor
is limitless.
The owner of option will not exercise his option if K > S . But his
loss will be restricted up to call premium amount .
The maximum profit available to a call writer is limited to the
option premium , while loss may be limitless .
The gross loss of the writer would be equal to ( S – K ) and net
loss would be equal to ( S – K – C )
Option trading is a zero sum game . The gain of the call owner
or buyer is the loss of the call writer ; the loss of the call owner
is the gain of the call writer.
The ultimate economic function of financial
derivatives ( forwards , futures , swaps and options )
is to provide means of risk reduction . Someone who
is at risk from a price change can use options to
offset that risk . That means options can be used as
hedging instruments .
Speculators are attracted to the options due to it’s
leverage feature and they used it to make
speculative gains .
Options can be used to hedging the anticipated
purchase by portfolio managers of Investment
companies .
A put option can be used to hedge the value of an existing
stockholding
An investor holding a particular stock faces the risk of reduction in
the
value of his stockholding due to a decline in the price of the stock
. The
Risk can be effectively hedged with a put option .
Let us consider an investor who has 500 shares of a company
whose
Current market price is Rs. 356. The value of his stockholding is
Rs. 1,78,000.
If there is any fall in share prices the value of his stock holding will
Decline .
Let us assume that put option on the stock with exercise price of
Rs.350 is available for a premium of Rs. 14.
ACTION : The investor can buy 500 put options on the stock by
paying
The premium Rs. 7000 ( 14 x 500 ) .
EFFECT : Let us assume that share price has declined to Rs 296 .
The intrinsic value of the put option purchased by the investor
would
now be Rs. 54 ( 350 – 296 ) i.e. K – S .
If there is more time to the expiration date , the put option would
have
A time value also . Let us assume that there are 10 days to
expiration
And the time value of the put option is Rs. 10 ; then the premium
on the
Put option purchased by the investor would be Rs. 64 ( 54 + 10 ) ,
the
There are two choices before the investor who has a put option on
the
Stock with Rs. 350 exercise price. He may either exercise his put
Option or close out his long position by selling the put option .
If he exercises his right under the put option to sell the shares at
Rs. 350 per share, he would receive Rs 1,75,000 ( 500 x 350 ) .
The
Reduction in value is only 3000. As he has already paid a
premium of
Rs 7000 to buy the put option , his total loss is Rs. 10000. If he
had not
Hedged risk his loss would have been 30000.
The second alternative before the investor with the put option is
to sell
The option at it’s current premium of Rs. 64. He would receive a
The investor can choose the course of action which
is more advantageous to him.
If on the contrary , the share price has increased
instead of declining , the value of his stockholding
would increase accordingly . The put option will not
be exercised .
However , the premium paid represents a loss to the
investor which may be compensated by the increase
in the value of the stockholding .
Suppose you contemplate to buy a call option with
strike
Price Rs. 42 / $ as you expect the following spot rates
with
Their probabilities :

Rs./ $ 40.00 41.50 43.00 44.50

46.00
Probability 0.15 0.25 0.30 0.20
0.10

What should be the option premium to enable you to

Let the option premium be ‘ C’ . Then the pay-off table for the
option
Would be as follows ;
Probability spot rate option exercised/not profit
0.15 40 NO -C
0.25 41.5 NO -C
0.30 43 YES -C + ( 43 – 42)=
-C+1
0.20 44.5 YES - C + 2.5
0.10 46 YES -C+4
To break even , expected profit should be zero:
-C( 0.15 ) – C( 0.25) + ( -C +1) 0.3 + ( - C + 2.5 ) 0.2 + ( -C + 4 )
0.1= 0
OR C = 1.2
Ms. Geeta established the following spread on the Delta
Corporation’s
Stock :
iii. Purchased one 3 – month call option with a premium of Rs 30
and an exercise price of Rs 550.
iv. Purchased one 3 – month put option 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
Ms.Geeta’s profit or loss if the lot is 100 :
g) The price of D. C. stays at Rs. 500 after 3 months
h) The price of D. C. falls to Rs. 350 after 3 months
i) The price of D.C. rises to Rs. 600.
( a ) Total premium paid on purchasing a call and put option
= ( 30 x 100 ) + ( 5 x 100 ) = 3500
In this case Ms. Geeta will not exercise any option because both
will
result in loss . So, the net loss will be 3500.
( b ) Since the price of the stock is below the exercise price of call,
the call will not be exercised. Only call option is valuable and is
exercised.
Ending value = - 3500 + ( 450 – 350 ) x 100
= 6500 i.e. NET GAIN
( c ) In this case put is worthless only call is valuable.
Ending value = - 3500 + ( 600 – 500 ) x 100 = 1,500 ( NET GAIN )
 FORWARD RATE AGREEMENT ( FRAs )

The FRA is an agreement between two parties which

determines the interest rate that will apply to a notional future
loan / deposit of an agreed amount for a specified period .
It is an OTC product .
It is predominantly used as an inter-bank tool for hedging of
short term interest rate risk .
There is no up-front premium payable .
Simpler to administer than futures since there is no margining
requirement .
The underlying principal amount is purely notional and no
actual exchange take place . The notional principal amount
( NPA ) is used for calculation of settlement amount to be
exchanged between parties.
Most liquid and frequently traded FRAs are for 3 to 6 months .
FRAs are available for periods extending to 2 years .
FRAs are available in currencies where there are no futures .
Quotes for various periods can be given in a number of ways
such as : 3 x 6 , 3 – 6 , 3 vs. 6 .
Such quotes signify that the FRA rate is being quoted for a
period starting 3 months from now and ending 6 months from
now . The first figure is known as the settlement / starting date
. The second figure is known as the maturity / expiry date.
The prices for various periods are quoted two- way ( bid – offer
quotes ). For instances , if a 3 – 6 FRA is being quoted as 4.35 –
4.40 percent . It signify that the quoting bank is willing to
accept a notional deposit , for a period starting 3 months from
now and ending 6 months from now at 4.35 percent .
And is wiling to lend a notional deposit at 4.40 % for the same period.
In other words , the quoting bank is a notional borrower ( for 3 to 6
month period ) at 4.35 % .
It is , therefore , essential to appreciate that a FRA quotation is an
interest rate , and not a price as in the case of futures contracts .
The n – year zero rate is the rate of interest earned on an investment
that starts today and lasts for n years . All the interest and principal is
realized at the end of n years . There are no intermediate payments .
The n – year zero rate is also referred as the n – year spot rate .
A forward interest rate is the interest rate implied by current zero
rates for a specified future time period . It is basically a compound
rate. Suppose , on a principal amount of 100 the zero –rate is 10%, on
the end of the 1st year it will become 110 , now at the end of 2nd year ,
the interest portion will be 11 , that means forward rate on original
sum is 11%.
FRAs can be used by any institution when it is exposed to a single
period interest rate risk
For example ING bank which has funded a one year US $ 5 million
floating rate loan on 6 – month loan ‘ LIBOR + ‘ basis is exposed to
interest rate risk from the 6th to the 12th month .
As the LIBOR for the first 6 month is already fixed at the time of
sanction of the loan , the bank would have already locked itself into a
spread . Its main cause of concern would be that at the end of the first
6 months period , its spread would be adversely affected , if the LIBOR
were to go down .
If, 6 – 12 FRA is being quoted say , 5.25 – 5.35 percent , the bank has
to sell FRA at 5.25 % , since it is seeking protection against a fall of
interest .
If the actual LIBOR settles at 5.15 % on the settlement date ( i.e. 6
months from now ) then the notional buyer / borrower ( that is quoting
bank ) has to compensate the ING bank for the difference in interest
rate on the notional principal amount of US $ 5 million .
EXAMPLE : There are two parties X and Y who are interested in
raising funds . Other details are as follows :
FIRM OBJECTIVE FIXED RATE FLOATING INT. RATE
X fixed rate 10.75 % LIBOR + 0.50
%
Y Floating rate 10.00 % LIBOR + 0.25
%
In the above table , we can see that the cost of borrowing for Y is
lower
Than that of X in both the markets. This difference is called
quality
Spread , which can be quantified for both fixed and floating rate
markets as follows :
Fixed market 10.75 % - 10.00 % = 0.75 %
Floating market LIBOR + 0.50% - LIBOR + 0.25 % = 0.25 %
From the above table it is clear that Y has an absolute
advantages in both fixed and floating rate market .
But it is also clear that X has a comparative advantage in
floating rate market i.e.( higher by only 25 bp ) than 75 bp in
fixed market.
Now , there objectives are X should borrow in fixed rate and Y
should borrow in floating rate market .
Considering , the comparative advantage enjoyed by X it is
possible to reduce the cost of funds to both X and Y if they
borrow in the markets where they enjoy comparative
advantages and then swap the borrowing .
The reduction in the cost depends on the quality spreads which
is 50 bp ( 0.75 % - 0. 25 % ) .
 Assume that both the firms want to share the benefit equally
between them – under the swap arrangement :
Y – borrows funds in fixed rate market and lends to X .
X – borrows funds in floating rate market and lends to Y .
Let us assume that X lends to Y at LIBOR and Y lends to X at 10 %
.
EFFECT : That means funds are available to Y at LIBOR as against
LIBOR + 0.25 and X at 10.50 instead of 10.75% . Thus , swap
enables
Reduction in cost for both parties .
DIFNITION : Financial swaps are private contractual agreements
between two parties to exchange cash flows in the future
according
To specified terms and conditions .
 Financial swaps are broadly classified into interest rate swaps
and currency swaps .
SWAP BROKER : He is an economic agent who helps in
identifying the potential counterparties to a swap transaction .
He charge a fee for the services provided and he is not a party
to the swap contract he is also called a market maker .
SWAP DEALER : Swap dealers bear the financial risk associated
with the deal he is arranging in addition to the functions of a
swap broker and becomes an actual party to the transaction .
He serves as a financial intermediary , earning profits by
helping complete , the swap transactions . The swap dealer
faces two main problems :
 Pricing of swaps
 Managing of default risk of the counterparty .
It is difficult to identify a counterparty to take the opposite side
of the transaction once a party has approached the swap
dealer with his /her requirements .
The swap deal cannot be terminated without the agreement of
the parties involved in the transaction.
Existence of inherent default risk .
Underdeveloped secondary markets for swaps, mainly as a
result of very slow development of standardized
documentation. This clearly shows that swaps are not easily
tradable.