FINANCIAL DERIVATIVES &

RISK MANAGEMENT
BBA-VIII
 UNIT -1
INTRODUCTION
Concept of Financial Derivatives
• Derivatives are financial instruments whose returns are derived from other assets. That
is, their performance depends on how the underlying assets perform.
• Derivatives are the financial instruments or products whose value is derived from the
underlying assets such as security, index, currency, commodities, interest rate etc.
• A derivative is a financial contract, between two or more parties, which is derived from
the future value of an underlying asset. Derivatives are financial assets and can be used
as an item of investment portfolio.
• Derivatives assets are contracts between parties to purchase or sell some asset in future
date. All terms and conditions of transaction such as price of the assets, quality,
quantity, method of delivery of asset, date of delivery etc. are fixed at present and actual
transaction takes place in future.
Features of Financial Derivatives
• Contract: Financial derivatives are the agreement between two parties to buy or sell certain
asset on certain future date at price agreed today.
• Value depends on underlying asset: The value of the contract is the gain or loss of the
investor. The loss or gain the contract is depends on the price of underlying assets.
• Oppositely related payoffs: The payoff from a derivative is the gain or loss from a contract
at expiration. If there is gain to buyer then there is loss to seller of contract.
• Right and obligation: By contract, derivatives are obligatory for two parties. They must
meet their promises in time.
• Future transaction: Derivatives are agreement for future transaction. The life of a
derivative contract is determined at the time of contract.
• Provide a means of managing risk: Derivative securities are used by business
organizations, individuals and government to manage the different types of risk
exposure.
Types of derivatives
1. Option contract
• An option is a contract that gives its buyer (owner) the right but not obligation to buy or
sell an asset at a fixed price on or before a given date. Options are of two types- call option
and put option.
• A call option is the right to buy the underlying asset at a fixed price on or before a given
date.
• A put option is the right to sell the underlying asset at a fixed price on or before a given
date.
2. Forward contract
• A forward contract is a transaction in which the buyer and the seller agree upon the
delivery of a specified quality and quantity of asset (usually a commodity) at a specified
future date.
• A price may be agreed in advance or at the time of delivery.

• Two parties in a forward contract incur obligation to ultimately buy or sell the goods.

• There is no formal corporate body organized as the market for forward contract.

• They are traded strictly in over-the-counter market.

3. Future contracts
• A future contract is a commitment to buy or sell a specified commodity of
designated quality at a specific price and date in future.
• A future contract also gives the right and obligation of buying and selling to the
contracting parties like the forward contract.
• It is a standardized agreement that calls for delivery of a specified asset.
4. Option on Futures
• An option on future contract gives the buyer the right to buy or sell
futures contract at a later date at a price agreed upon today.
• Options on futures trade on futures exchange.
5. Swap
• A swap is a contract in which two parties agree to exchange cash flows.
• It is the simultaneous buying and selling of the same underlying asset
or obligation of equivalent capital amount where the exchange of
financial arrangements provides both parties to the transaction with
more favorable conditions than they would otherwise expect.
6. Warrant
• warrant is a feature attached with a debt security or preferred stock. A warrant is an
option to buy a stated numbers of shares of common stock at a specified exercise
price.
7. Contract for Difference (CFD)
• Contracts for difference are one of the world’s fastest-growing trading instruments.
• A CFD is an agreement to exchange the difference in value of a particular share or
index between the time at which a contract is opened and the time at which it is
closed.
• There is no restriction on the entry or exit price of a CFD, no time limit is placed on
when this exchange happens and no restriction is placed on buying first or selling
first.
8. Exchanged Traded Fund (ETF)
• A security that tracks an index, a commodity or a basket of assets
like an index fund, but trades like a stock on an exchange is called
exchange traded fund (ETF).
• ETFs experience price changes throughout the day as they are
bought and sold.
USES (IMPORTANCE) OF FINANCIAL DERIVATIVES
• To explore new investment opportunity
• To use the means of increasing profit or reducing risk
• To be aware of effects of derivatives on the primary securities
• To be aware of the risks and benefits associated with the
derivatives
• To gain from financial engineering
• To make a riskless profit from market inefficiencies
• To minimize risk
• To increase return
PARTICIPANTS IN DERIVATIVE MARKETS
1. Hedgers
• Hedgers are the traders trading in the derivative market with an objective of eliminating the losses arising
from price fluctuations to which they are already exposed.
• If someone bears an economic risk and uses financial derivatives to reduce that risk, the person is hedger.
Thus hedger takes position to reduce risk exposure.
2. SPECULATOR
• The traders who want to make profit out of price movements are known as speculators.
• Speculators are defined as investors who take positions that increase their exposure to certain risks in the
hope of increasing their wealth. Hedgers are the traders who wish to avoid the risk; speculators those who
are willing to take such risk.
3. ARBITRAGER
• An arbitrageur is one who makes riskless profits out of price differential in two different markets. Persons
actively engaged in seeking out minor pricing discrepancies are called arbitragers. They attempt to make
FUNCTIONS OF DERIVATIVE MARKETS
• The functions or the role of derivative markets can be
explained as follows:
1. Risk Management
• The main function of the market is to manage the risk of
future uncertainty. The derivative markets enable those
wishing to reduce their risk to transfer it to those wishing to
increase risk and return. Buying the spot items and selling a
futures contract or call option reduces the investor’s risk.
2. Price Discovery
• Forward and futures markets are an important source of
information about prices. Futures markets, in particular, are
considered a primary means for determining the spot price
of an asset.
3. Market Completion:
• A market is said to be complete only when the financial
instruments which hedge the possible loss exposures are
created.
• A complete market refers to the existence of various
financial instruments (i.e. derivatives instruments)
equalizing with the alternative future states of the economy.
4. Financial Function
• The derivative market provides the finance function in the
sense that the transactions in derivative market are based
on margin system wherein the buyers and sellers are
required to deposit only small portion of the contract value
ranging from 5-10% of the contract value but not total
traded volume.
5. Liquidity Function
• Since the derivatives market involves margin system, the traders can
execute the orders in large quantity than in a spot market which in turn
increases market liquidity.
6. Price Stabilization
• The derivative market controls both the height and depth of the market
and thus stabilizes the prices. The major factors causing price
stabilization are price discovery, speculation, tendency to panic etc.
DANGER OF DERIVATIVES
• Derivatives have occasionally been criticized for having been the source
of losses by some corporations, investment funds, state and local
government, non-profit investors and individuals. This happens when
 UNIT-2
MECHANICS OF FUTURES MARKETS
Forward vs Futures
Forward contract
• A forward contract is an agreement between two parties, a buyer, a seller
that calls for the delivery of an asset at a future point in time with a price
agreed upon today.
• Forward contracts are custom-tailored agreements. That is, the terms and
conditions on the contracts are set according to the needs of contracting
parties.
• There is no any organized body to manage the forward contract. They are
traded over-the-counter market.
• Forward contract also differ from futures contracts in that they are not
subjected to daily settlement procedure.
Future Contracts
• A Future contract is an agreement between buyer and seller that has
standardized terms, traded in organized exchange and follow daily
settlement.
• Futures contracts are created and traded through futures exchanges-
a physical location buying and selling futures contracts.
• Futures exchanges set the terms and conditions regarding delivery
time, procedures and the assets on which futures can be made.
• Parties who want to enter into a futures contract must accept the
standards fixed by futures exchanges.
An example;
• A juice seller needs 1,000 kg mangoes on June. However, the futures
exchange has set its terms of futures on mango as it can be delivered
only on April. At this situation, the juice seller cannot negotiate its
delivery terms with futures exchange. He searches for another party
who is ready to deliver 1000 kg mangoes on June. Both the parties
agree on price and other terms as per their needs. This contract is
now a forward contract.
 Difference between forward and future contracts
Futures Forward
Futures are traded through organized Forward contracts are traded in OTC market.
exchange. The terms and conditions of the The terms and condition of contract are
contract are standardized only price is customized. Traders can start from blank sheet
negotiated. of paper.

Futures contracts are guaranteed by clearing There is no third party guarantee in forward
house. There is no default risk. contract. Thus there is default risk,

Futures market provides more liquidity. Forward contract can be closed unless there is
Futures contract can be off settled any time consent of both parties. Thus, it provides less
before maturity without concert of liquidity.
counterparty.

Futures market is regulated by government Forward market is unregulated market.

agency.
Future contracts require margin deposit No margins are required in forward contract.
initially and maintenance margin of certain
level.

Most of the futures contracts almost 95 Most of the forward contract involve
percent are closed before maturity. underlying delivery.

Futures exchange keeps record of all futures Forward contracts are private contracts. There
contracts traded through exchange. The is more privacy.
transactions are transparent.

Cost of futures contract is brokerage Cost of forward contract is bid-ask spread

commission because they are traded through because they are traded through OTC dealer.
broker.

Gain or loss on futures contract is settled daily. There is no daily settlement. Gain or loss is
realized at expiration.
Specification of Futures
• Futures contracts are standard contracts. The terms and conditions
of each futures contracts offered are determined by future exchange
and are subject to the country’s regulation. Exchange traded futures
contracts must specify following things:
1. The Asset
• Futures contract can be made only on listed assets. Futures
contracts are made on both commodity and financial assets.
• Exchanges stipulate the grade/grades of commodities that are
acceptable.
2. The contract size
• The contract size specifies the amount or the number of unites of
the underlying asset that has to be delivered under one contract.
• This might be a designated number of bushels of grain, gallons of oil,
rupees of face value of financial assets, kilograms of metals etc.
3. Price Quotes
• The futures price is quoted in a way that is convenient and easy to
understand. The exchange specifies the quotation unit.
• The quotation unit is simply the unit in which the price is specified.
4. Trading Hours
• The exchange also specifies the trading hours during which the contracts trades.
• Most agricultural futures trade for four to five hours during the day.
• Most financial futures trade for about six hours.
5. Delivery Terms
• The exchange has a certain delivery dates, terms, arrangements and places.
• A futures contract is referred to by its delivery month such as December Gold
Futures, Magh corn futures etc.
• The exchange must specify the precise period during the month when delivery can
be made.
• Exchange specifies the place where delivery of the underlying asset will be made at
the end of the contract period. The delivery of the underlying is made from certain
warehouse or certain stores specified by futures exchange.
5. Daily Price Limit and Trading Halts
• The futures exchange has certain restrictions regarding the number of the
positions an investor can hold, the maximum range that the price can fluctuate
etc.
Daily Price Limit
• For most contracts, daily price limits are specified by the exchange.
• Price Limit is the maximum limit that price of a futures contract can fluctuate
during a trading day. It may be in percentage term or in an amount.
• If the price moves down or up by an amount equal to the daily price limit, it is
said to be Limit down or Limit up.
• Exchange may stop trading for certain period (for example, for half an hour) if
price changes very rapidly even if they are within the limit. Such types of halts
are known as circuit breakers.
• Position limits are the maximum number of contracts that a speculator may
DAILY SETTLEMENT AND MARGIN OPERATION
• Before entering into a futures contract, the perspective trader must
deposit some funds with his/her broker which serves as a good faith
deposit. This fund is called margin or performance bonds.
• The basic objective of margin is to provide a financial safeguard and
survival of clearing house ensuring that investors will perform their
contract obligations.
• There are three types of margins: initial margin, maintenance
margin and margin call.
• Initial Margin is the amount that must be deposited on the day the
transaction is opened. For most of the futures contracts, the initial
margin may be 5 percent or less of the value of underlying assets.
Maintenance Margin is the amount that must be maintained all the
time in a margin account for an open contract.
• This is normally 75 percent of initial margin.
Daily settlement
• Once the contract is opened, they are bought to the market every
day and gain or loss on that day due to change in futures price is
settled daily.
• If the futures prices moves against the investor resulting in loss, the
amount equal to the loss is deducted from investor’s margin account.
This process is called daily settlement or marking to market the
contract.
Margin Call
• If the investor continuously bears loss and balance on margin
account falls below the maintenance margin, the broker will make a
call to the investor asking him/her to deposit the extra amount. this
call is called margin call.
• When a margin call is made, the investor must deposit the amount
that is sufficient to bring the margin account balance back to the
initial margin level before starting of trade in next day.
• If the investor fails to deposit the variation margin, his/her position
will be liquidated (closed) by the clearinghouse. The amount
remained in the account can be withdrawn by the investor.
Example:
• An investor enters into a short futures contract to sell January cotton for Rs 150 per
kg on the Mercantile Exchange. The size of contract is 500 kg. initial margin is Rs
40000 and maintenance margin is Rs 30,000. What price change will lead to margin
call to investor? If investor does not deposit margin call, what will happen?
solution,
future prices (F) =Rs 150
contract size = 500 kg
initial margin = Rs 40,000
maintenance margin = Rs 30,000
Minimum Price change = (IM-MM)/contract size
= (40,000- 30000)/500 =Rs 20
Since this is short futures, there will be loss when the price of commodity increases.
Thus, when cotton price increases above (150 +20) Rs170, the investor will have
margin call.
Example:2
On December 15 ABC Ltd. Establish a long position in 200 shares of
TISCO at a futures price Rs 600 per share. Initial margin for contract is
Rs 30,000 and maintenance margin is Rs 20,000. draw a table
showing margin and making-to-market for ABC on 1st January with
the following information:
Date Dec.15 Dec.16 Dec.17 Dec.18 Dec.19 Dec.21 Dec.22 Dec.23 Dec.24 Dec.25 Dec.27 Dec.31 Jan 1
F Price 600 550 650 600 605 590 580 600 620 630 640 660 690
 Date Dec.15 Dec.16 Dec.17 Dec.18 Dec.19 Dec.21 Dec.22 Dec.23 Dec.24 Dec.25 Dec.27 Dec.31 Jan 1
F Price 600 550 650 600 605 590 580 600 620 630 640 660 690

Table for daily settlement

Date Settlement price Mark-to-market (Rs) Cummulative Margin account bal. Margin call (Rs)
(Rs) gain/loss (Rs) (Rs)
Dec. 15 600 - - 30,000 -
Dec. 16 550 (10000) (10000) 20,000 -
Dec. 17 650 20,000 10,000 40000
Dec.18 600 (10,000) - 30,000 -
Dec.19 605 1000 1000 31000 -
Dec.21 590 (3000) (2000) 28,000 -
Dec. 22 580 (2000) (4000) 26,000 -
Dec.23 600 4000 - 30,000 -
Dec.24 620 4000 4000 34,000 -
Dec.25 630 2000 6000 36,000 -
Dec.27 640 2000 8,000 38,000 -
Dec.31 660 4,000 12,000 42,000 -
Jan.1 690 6,000 18,000 48,000
Exp 3. An investor enters into two long futures contracts on orange. Each contract has contract size
of 15,000 pounds. The current price is Rs 160 per pound. The initial margin is Rs 600,000 per
contract, and the maintenance margin is Rs 450,000 per contract. What price change would lead
to a margin call? Under what circumstances could Rs 200,000 be withdrawn from the margin
account.
Solution:
Future price (Fo) = Rs 160; Contract size (n) = 15000 pounds
Initial margin (IM) = Rs 600,000 per contract;
Maintenance margin (MM) = Rs 450,000 per contract
Minimum price change = (IM – MM)/n = (600,000 – 450,000)/15000 = Rs 10
Since this is long futures, when price decreases, there will be loss and broker will make margin call.
When price decrease to Rs 160 – 10 = Rs 150 or below, there will be a margin call.
To withdraw Rs 200,000 from margin account, there must be profit of Rs 200,000 from two futures.
Minimum gain per pound required to withdraw Rs 200,000 = 200,000/(15000x2) = Rs 6.67
When price increase to Rs 160 + 6.67 = Rs 166.67 or above the investor can withdraw Rs 200,000
from margin account.
Exp. 4. At the end of one day a clearinghouse member is long in 100 contracts,
and the settlement price is Rs 50,000 per contract. The original margin is Rs
2,000 per contract. On the following day, the member becomes responsible
for clearing an additional 20 long contracts, entered into at a price of Rs
51,000 per contract. The settlement price at the end of this day is Rs 50,200.
How much does the member have to add to its margin account with the
exchange clearing house?
Solution:
The clearing member is required to provide 20 x Rs 2000 = Rs 40,000 as
initial margin for new contract.
There is a gain of (Rs 50200 – 50000) x 100 = Rs 20,000 on the existing
contracts.
There is a loss of (Rs 51000 – Rs 50200) x 20 = Rs 16000 on new contract
The net cash requirement = Rs 40,000 – Rs 20,000 + Rs 16000 = Rs 36000.
WAY OF CLOSING FUTURES
• The majority of futures contract that are initiated do not lead to
delivery. The reason is that most investors choose to close out their
positions prior to delivery period specified in the contract.
• Making and taking delivery under the terms of a futures contract is
often inconvenient and, in some instance, it is quite expensive. This
is true for a hedger to close out the futures position and then buy or
sell the asset in the usual way.
• Closing out futures position involves entering into an opposite trade
to the original one.
Method of settlement
1. Delivery: When seller wants the physical delivery or buyer wants to take
delivery, they have go through certain procedure. Delivery usually is a three-
day procedure.
• Position Day: Seller or buyer informs to clearing house (through broker) for
delivery.
• Notice of Intention Day: The exchange selects the holder of long position to
receive delivery.
• Delivery Day: The delivery takes place and the long pays the short.
2. Cash settlement: Some financial futures, such as those on stock indices, are
settled in cash because it is inconvenient or impossible to deliver the
underlying assets.
3. Offsetting: The most common and popular method of liquidating the open
futures position is to effect an offsetting future contracts via a reversing trade.
• For e.g., an investor who buys two Kartik gold futures contracts on
Bhadra 5 can close out position on Ashwin 25 by selling (shorting)
two Kartik gold futures contracts.
• Similarly, an investor who sells (short) Kartik gold futures on Bhadra
5 can close out position on Ashwin 25 by buying Kartik gold futures.
In each case, the investor’s total gain or loss is determined by the
change in the futures price between Bhadra 5 and Ashwin 25.
TYPES OF FUTURES
• Many types of future contracts trade on future exchanges around the world.
Some of them are:
1. Agricultural commodities
• This category is oldest group of future contracts. It includes widely used
grains such as wheat, corn, oats, soybean, rice etc and livestock.
2. Natural Resources
3. Miscellaneous commodities
4. Foreign currencies
5. Treasury bills and Eurocurrencies
6. Treasury notes and bonds
7. Equities
8. Managed Funds
9. Hedge Funds 10. Options on Futures
2. Natural Resources
• Future contracts are actively traded on two types of natural resources:
metals and energy products.
• The primary metals on which futures are traded are gold, silver, and
copper, with lighter trading on platinum and palladium.
3. Miscellaneous Commodities
• This category includes contracts that have mostly traded very lightly
and many are no longer listed.
• They include futures on fertilizer, shrimp, electricity, rubber, glass,
cement, potatoes, peanuts, sunflower seeds, inflation, peas, flax
kerosene, yarn, and shipping freight rates.
• These have also been futures on various measures of weather
including weather-related insurance claims.
4. Foreign Currencies
• There is a very large forward market in foreign currencies. Futures contracts
on foreign currencies are also traded, but these are not as active as are
forward contracts.
5. Treasury Bills and Eurodollars
• Treasury bill and Eurodollar contracts trade on the international monetary
market of the Chicago Mercantile Exchange.
• In the United States, the Eurodollar contract is the most actively traded
futures contract.
6. Treasury Notes and Bonds
• Treasury notes and bond contracts are virtually identical except that there
are three T-note contracts that are based on 2-year, 5-year, and 10-year
maturities while the T-bond contract is based on Treasury bonds with
maturities of at least 15 years that are not callable for at least 15 years.
7. Equities
• Stock index futures have been one of the spectacular success stories
of the financial markets in recent years. These cash-settled contracts
are indices of combinations of stocks.
8. Managed Funds
• Managed fund is simply a term that refers to the arrangement by
which an investor hires a professional futures trader to conduct
transactions on his or her behalf.
• The futures manager is a commodity trading advisor (CTA), which we
have discussed earlier.
• Managed funds can exist in one of four forms: futures funds, private
pools, a specialized contract with one or more CTAs, or hedge fund.
9. Hedge Funds
• A hedge fund is a privately organized pool of money that is investment of
literally any financial instruments on any markets of the world.
• Although hedge funds actively use futures contracts, they also use options,
spot instruments such as stock and bonds, and over-the-counter
instrument such as swaps, structured notes, and forward contracts.
10. Options on Futures
• Options on futures trade on many futures exchanges.
• In most cases throughout the world, the most actively traded futures
contracts also have options available on the futures contracts.
• Of course, many also have options trading on the underlying asset itself.
 Unit-3
FUTURES HEDGING STRATEGIES
Hedging Concept
• Hedging is a transaction in which an investor seeks to protect a
position or anticipated position in the spot market by using an
opposite position in derivatives.
• The main aim of hedging is to use futures market to reduce a
particular risk, such as the risk related to the change in price, change
in exchange rate, the level of stock market, and other variables.
• When an individual or company chooses to uses futures market to
hedge a risk, the objective is usually to take a position that
neutralizes the risk as far as possible.
• Consider, for example, a company that knows it will gain Rs 10000
for each Re1 increase in the price of a commodity over the next
three months and lose Rs 10000 for each Re 1 decrease on the price
of the commodity during the same period. The company does not
know whether the price will increase or decrease or remain same.
The company does not want to take risk of price of uncertainty and
wants to hedge.
• Soln,
To hedge, the company should take short futures position that is
designed to offset risk.
Forward/Futures Terminologies
• Basis: the difference between current cash price and the futures price
of the same commodity for a given contract month.
• Call option on futures: An option that gives the buyer right, but not
the obligation, to purchase (go “long”) the underlying futures contract
at the strike price on or before the expiration date of the option.
• Put option on futures: An option that gives the buyer right, but not the
obligation, to sell (go short) the underlying futures contract at the
strike price on or before the expiration date of the option.
• Cash (spot) market: A place where people buy and sell the actual
commodities, that is , a grain elevator, livestock market, or the like.
• Convergence: A term referring to cash and futures prices tending to
come together as the futures contract nears expiration.
• Delivery: The transfer of the cash commodity from the seller to the
buyer of a futures contract.
• Liquidate: Selling (or purchasing) futures contracts of the same
delivery month purchased or sold during an earlier transaction or
making (or taking) delivery of the cash commodity represented by the
futures contract.
• Long position: One who has bought futures contracts or plans to own
a cash commodity.
• Short position: One who has sold future contracts or plans to sell a
cash commodity.
• Nearby month: The futures contract month closest to expiration.
• Spread: The price difference between two related markets or
commodities.
Concept of Price and Value
Spot price, Risk Premium and the cost of carry for generic assets
• For any storable assets, the spot price is related to the expected future spot price, by
the cost of carry and the expected risk premium. Let us assume that:
So = current spot price Fo = futures price
s = storage cost iSo = amount of interest forgone on So
ST = future spot price at expiration of future contract
Eɸ = Expected risk premium
Today’s stock price is:
So =E(ST) – s - iSo – Eɸ
The cost of carry (C) = iSo + s – Y
Future price Fo = So + C
Where, Y = the convenience yield
The profit of investor (∏) = Fo - So - s – iSo
FORWARD PRICE FOR AN INVESTMENT ASSET
• The forward price of an asset is the sum of spot price and cost of carry. The
forward price of investment assets is calculated as:
Fo = (So – I).ert ( if interest is compounded continuously)
Fo = (So – I)( 1+ r)t (if simple compounding is used)
Where, I = income on investment
r = risk-free rate of return
t = time until delivery date
When Underlying Asset Provides Known Yield
Fo = So.e(r – q).t
Yield rate = cash income/market price
q = continuously compounded yield = m ln ( 1 + rm/m)
m= number of compounding in a year
Non-compounded rate rm = m (eq/m - 1)
5. Consider a long forward contract to purchase a non-dividend-paying stock in three
months. Assume the current stock price is Rs 40 and the risk-free interest rate with 3-
month maturity is 5 percent per annum. What is the forward price of stock? How can an
arbitrageur earn risk-less profit if market price of forward is Rs 43 or 39?
Solution,
Current price of stock, So = Rs 40
Time to expiration, t = 3 month or 0.25 year
Risk-free rate of interest, r = 5% p.a.
Forward price, Fo = ?
We have, Fo = So ert a
= 40 e0.05x0.25 = Rs 40.50
Thus, fair forward price is Rs 40.50
Alternatively, Fo = So(1+r)t = 40 (1.05)0.25 = Rs 40.50
If the market price of forward is Rs 43, the forward is overpriced. An overpriced forward
gives arbitrage opportunity. Since the forward is overpriced, the arbitrageur shout sell it.
The arbitrageur should follow the following strategies:
Today’s transactions:
• Borrow Rs 40 at 5% per annum for three months. The amount is
sufficient to purchase one underlying asset (stock).
• Purchase the stock at Rs 40 and hold it for three months.
• Enter into a short forward contract to sell the stock at Rs 43 after 3
months.
At maturity:
• The loan amount will increase to 40 (1+0.05)0.25 = Rs 40.50
• Receive Rs 43 by making delivery of stock under the term of forward
contract.
• Pay loan and earn profit = 43 – 40.50 = Rs 2.50
If the market price of forward in Rs 39, the forward is underpriced. An
underpriced forward also creates arbitrage opportunity. The
arbitrageur should follow following procedure to grab risk-less profit:
Today’s transactions:
• Sell or short a stock at current price Rs 40.
• Invest the proceeds at 5% for 3 months. The fund will be 40
(1+0.05)0.25 = Rs 40.50
At maturity:
• Sell the investment for Rs 40.50.
• Take delivery of stock by paying Rs 39 under the term of contract.
• Net gain to the arbitrageur = 40.50 – 39 = Rs 1.50
• This is the profit before taxes and transaction cost.
6. Consider a 10-month forward contract on a stock. Assume the current stock
price is Rs 50 and the risk-free interest rate is 8 percent per annum. The
expected quarterly dividend of Rs 0.75 per share. What is the forward price
of stock? How can an arbitrageur earn risk-less profit if market price of
forward is Rs 55 or 45?
Solution,
Current price of stock, So = Rs 50
Time to expiration, t = 10 month or 10/12 yearW.N.= 0.83
I = PV of dividend
Risk-free rate of interest, r = 8% p.a.
I = 0.75 e-0.08x 3/8 + 0.75 e-0.08x6/12
Forward price, Fo = ? + 0.75 e-0.08 x 9/12 = Rs 2.162
We have, Fo = (So – I) ert
= (50 -2.16 ) e0.08x0.83 = Rs 51.14
Thus, fair forward price is Rs 51.14
VALUATING FORWARD CONTRACTS ON INVESTMENT ASSETS
• The value of forward/ futures contract when written is zero. At a later stage, it may prove to have a
positive or negative value.
a. A general rule that is applicable to all forward contract is;
 Value of Long Forward (f) = (Fo – K).e-rt
 Value of Short Forward (f) = (K – Fo ). e-rt
b. Value on an investment asset that does not provide any intervening income;
For Long Forward (f) = So – K.e-rt
For short Forward (f) = K.e-rt – St
Where, So = spot price at the time of valuation of forward
K = delivery price
c. Value on an investment asset that provide known income (I);
 Value of long forward (f) = So – I – K.e-rt
 Value of short forward (f) = K. e-rt – So + I
d. Value on an investment asset that provides known yield (q);
 Value of long forward (f) = So e-qt – K e-rt
 Value of short forward (f) = K e-rt - S e-qt
Example 7 (Forward contract on non income assets)
A long forward contract on non-dividend-paying stock was entered into some
time ago. It currently has 6 months to maturity. The risk-free rate of interest
(continuous compounding) is 10 percent per annum, the stock price is Rs 25
and the delivery price is Rs 24. find the value of forward.
solution:
Risk free rate of interest (rf) = 10% p.a. maturity period (t) = 6/12= 0.5 year
Current stock price (So) = Rs 25
Delivery price (K) = Rs 24
WN.
Value of forward (f) = ? Fo = So e
rt

= 25 e
0.1x0.5
= 26.28
We know,
f = So – K .e-rt = 25 – 24 e-0.1x0.5 = Rs 2.17
Or, f = (Fo – K) e-rt
= (26.28 – 24) -0.1x0.5 = Rs 2.17
Example 8 (Forward contract on income paying assets)
A long forward contract on dividend-paying stock was entered into some time ago. It currently
has 6 months to maturity. The risk-free rate of interest (continuous compounding) is 10
percent per annum, the stock price is Rs 1000 and it is expected that the stock will pay Rs 20
dividend per share in 2nd month and 5th month of contracts life.
a. What are the forward price and initial value of forward contract?
b. Assume it is 3 months after the contract was entered into. The stock price now is Rs 1100
and risk-free rate is still 10 percent per annum. What are the forward price and value of
forward contract now?
solution: a.
Risk free rate of interest (rf) = 10% p.a. maturity period (t) = 6/12= 0.5 year
Current stock price (So) = Rs 1000 dividend on 2nd and 5th month = Rs 20
Forward price (Fo) = ? WN.
Value of forward (f) = ? I = 20 e-0.1x2/12 + 20e-0.1x5/12
= Rs 38.85
We know,
Fo = (So – I)ert = (1000 – 38.85)e0.1x0.5 = Rs 1010.42
Initial value of forward contract (f) = (Fo – K)e-rt = (1010.42 – 1010.42)e-0.1x0.5 = Rs 0
Example
A long forward contract on dividend-paying stock was entered into some time ago. It currently
has 6 months to maturity. The risk-free rate of interest (continuous compounding) is 10
percent per annum, the stock price is Rs 1000 and it is expected that the stock will pay Rs 20
dividend per share in 2nd month and 5th month of contracts life.
a. What are the forward price and initial value of forward contract?
b. Assume it is 3 months after the contract was entered into. The stock price now is Rs 1100
and risk-free rate is still 10 percent per annum. What are the forward price and value of
forward contract now?
solution: b.
Risk free rate of interest (rf) = 10% p.a. maturity period (t) = 6/12= 0.5 year
Current stock price (So) = Rs 1100 dividend on 2nd and 5th month = Rs 20
Forward price (Fo) = ? WN.
Value of forward (f) = ? I = 20e-0.1x2/12
= Rs 19.67
We know,
Fo = (So – I)ert = (1100 – 19.67)e0.1x0.25 = Rs 1107.67
Initial value of forward contract (f) = (Fo – K)e-rt = (1107.67 – 1010.42)e-0.1x0.25 = Rs 94.86
Example 9. (Forward contract on income yield paying assets)
A long forward contract on an asset was was entered into 6 month ago. It
currently has 6 months to maturity. The initial forward price was Rs 487.55. The
continuously compounded yield on asset is 5 percent per annum and the risk-free
rate of interest (continuous compounding) is 10 percent per annum, the stock
price is Rs 500.
a. What is value of forward contract?
solution:
Risk free rate of interest (rf) = 10% p.a. maturity period (t) = 6/12= 0.5 year
Current stock price (So) = Rs 500 dividend yield (q) = 5%
Forward price or delivery price (K) = Rs 487.55
Value of forward (f) = ?
We know,
Fo = So e(r – q)t = 500 e(0.1 - .05)x0.5 = Rs 512.66
-rt -0.1x0.5
FUTURES ON STOCK INDICES
A stock index can be usually regarded as the price of an investment asset that pays
dividend.
Future price Fo = So e(r-q)t
Where, So = spot index value or index value today
e.g Consider a 3-month future contract on the NEPSE index. Suppose that the stocks
underlying the index provide a dividend yield of 2 percent per annum that the current
value of index is 1000, and that is the continuously compounded risk-free interest rate
is 6 percent per annum. Calculate the future price.
Solution,
Spot index value (So) = 1000; interest rate(r)=6%
Dividend yield (q) =2%; expiration time(t) =3mths
Future Price (Fo) =?
We have, Fo = So e(r-q)t
= 1000. e(.06-0.02)x3/12 =
FORWARD / FUTURES CONTRACTS ON CURRENCIES
The price of future currency contract (f) = So e(r-rf).t
Where,
So = current spot price or current exchange rate
r = risk free rate on home currency
rf = risk free rate on foreign currencies
e.g., a forward contract on US $. The one-year interest rate in US is 5 percent
p.a. and that in Nepal is 10 percent p.a. the correct exchange rate is Rs
110/$. Find one year forward exchange rate.
Solution,
So = 110/$ ; r = 10%; rf = 5%; Fo = ?; t = 1
We have,
Fo = So e(r-rf)t = 110 x e(0.10-0.05)x1 = Rs 115.64/$
FUTURES/FORWARD ON COMMODITIES
1. The forward price on commodity
Fo = (So + U).ert
where, U = present value of storage cost
2. futures price when storage cost is given as a percentage of market
price
Fo = So e(r+u-y)t
where, u = storage cost per annum
y = convenience yield
example:
Example: Currently, the exchange rate between US dollar and British pound is
$1.50/£ and the three-month forward exchange rate is $1.52/£. The three-
month dollar interest rate is 8 percent p.a. and that is 5 % of pound.
Assume that you can borrow as much as $ 15,00,000 of £ 100000.
determine whether IRP is currently holding? If IRP is not holding, how
would you carryout covered interest opportunity? Your home currency is
dollar.
Solution:
Dollar interest (rd) = 8%
pound interest rate (rp) = 5%
Spot exchange rate (S) = $1.50/£
Forward exchange rate (F) = $1.52/£
Time to expiration (t) = 3/12 years
Amount can be borrowed = $1500,000 or £1000,000
Solution:
Dollar interest (rd) = 8%; pound interest rate (rp) = 5%
Spot exchange rate (S) = $1.50/£; Forward exchange rate (F) = $1.52/£
Time to expiration (t) = 3/12 =0.25 years
Amount can be borrowed = $1500,000 or £1000,000
If IRP is holding, following condition must hold,
(1 + rd)t = F/S (1 + rp)t
Or, 1.080.25 = 1.52/1.5 x 1.050.25
1.019427 < 1.02577
Since, both sides are not equal, there is profitable covered interest
opportunity. The arbitrageur should carry out the following transactions to
get arbitrage profit. Since left side is less, the arbitrageur should borrow in
home currency or in dollar and lend in foreign currency that is pound.
Solution:
Today
• Borrow $1500000 at 8% for three months and convert into pound at spot rate.
The pound proceeds will be £1000,000.
• Lend £1000,000 at 5% for three months. The maturity value will be £1000,000
(1+0.05)0.25 = £1012272.23
• Sell the maturity value forward. That is, enter into short forward contract to sell
£1012272.23 at $1.52/ £ at the end of three months from now.
At maturity
• The proceeds from selling maturity value of pound investment forward will be
1012272.23 x 1.52 = 1538653.8
• The dollar loan will be 1500,000 (1 + 0.08)0.25 = $1529139.82
• Repay the loan and the net profit will be = 1538653.8 – 1529139.82
= £9513.98
FUNDAMENTALS PRINCIPLES
• Hedging is the process of reducing the financial risks that either arise
in the course of normal business operations or are associated with
investments.
• When one chooses to uses futures to hedge a risk, the objective is
usually to take a position that neutralizes the risk as far as possible.
There are two types of hedges: Long Hedge and Short Hedge.
a. Long Hedge
• A long hedge means to hedge by going long in the futures market.
• Long hedge situation is faced when a party plans to purchase an
asset at a later date, such as a bread maker. There is a worry that the
price of wheat can increase in the future, the bread maker would
buy futures contract.
b. Short Hedge
• Short hedge means to hedge by going short in the futures market.
• A person who holds an asset and is concerned about a decrease in
its price might consider to hedge the risk of loss by taking short
position in futures.
• A farmer, for example by agreeing through a future contract to
deliver a certain amount of wheat at a specified future date and
price, avoids exposure to unfavorable price movements. Thus, the
farmer is a hedger who hedges the down side price risk of wheat.
ARGUMENTS FOR AND AGAINST HEDGING
• There is an issue about hedging: (i) Why do corporations hedge? (ii)
Should they hedge?
• Obvious thing is that hedging is done to reduce risk.
• Hedging avoids from getting unpleasant surprise due to change in
these variables like: interest rates, exchange rates, and price of
different assets.
• It is also true that some risks are left unhedged. Here we discuss in
favor and against hedging.
1. Hedging and Shareholders
• It is known that the objective of the firm is to increase the price of
the share i.e. increase wealth of shareholders. However, the
shareholders can, if they wish, do the hedging themselves.
• The shareholders don’t need the firm to do hedging for them.
• Hedging for shareholders tend to be difficult due to commission and
other costs would be more to shareholders as volume of
transactions.
• it may be difficult to shareholders to determine the correct number
of futures contracts necessary to hedge risks.
• Due to these reasons, hedging is not something that shareholders
can always do as effectively.
• Therefore, corporations acting in favor of shareholders should hedge
risk to avoid unexpected result.
2. Hedging and Competitors
• Competitive forces within the industry may be such that price of
goods and services produced by firm fluctuate to reflect change in
price, interest rates exchange rates, and so on.
• In a competitive environment firm without hedging can get almost
constant profit margin than firm with hedge! We discuss here:
• Assume, firm A and firm B are manufactures of gold jewelry and
competitor to each other as well. Firm A purchases futures contract
to purchase gold and firm B with no hedge.
• If gold price increases firm A earns more profit than firm B, but firm
B earns more profit if price of gold decreases. The profit of B is
constant but not of A.
3. Hedging Eliminates the Advantages
• Futures hedging leads to worst outcome if market goes in favor and
reduces gains potential.
• For example, oil producer firm can hedge down side price risk of oil.
If price decreases, firm will be better off. However, if price increases,
firm can not be in position to sell at high price and regret for being
hedge position!.
With all of this talk of hedging, hedger should understand the point
that hedging is the tool to reduce the risk but not eliminating.
Hedging is a bet that bad things will happen in the market. Hedging
may or may not be in favor.
BASIS RISK
• Basis refers to the difference between the spot price and futures price.
Basis = Spot price – Futures price
Initial Basis = So – Fo
Basis at time t = St – Ft
Basis at expiry = ST – FT
• For a hedger, basis is important. So, we should understand how basis
affects the performance of a hedge and what factors influence the basis.
• Basis Risk in finance is the risk associated with imperfect hedging using
futures. It could arise because of the difference between the asset whose
price is to be hedged and the asset underlying the derivative or because of
a mismatch between the expiration date of the futures and the actual
selling date of the asset.
• Basis risk is created by changing the basis.
• If the spot price at expiry increases by more than the futures price,
the basis increases. This situation is said to be a strengthening basis.
• If the futures price increases by more than the spot price, the basis
will decrease and it is referred to as a weakening of the basis.
• Basis risk can lead to an improvement or a deterioration of the
hedger’s position.
• Strengthening basis improves the performance of short hedge and
vice versa.
• Similarly, if the basis weakens, it improve long hedge position and vice
versa.
• This proves that the risk in futures hedge comes from change in basis.
CROSS HEDGING
• Sometime the asset which we are willing to hedge may not be listed
in the futures exchange. At that time, we need to take short position
on that asset whose price behaves in similar manner to the asset
being hedged. At this situation, the price changes of hedged asset
may not be exactly equal. Therefore, the hedge may not be perfect.
This type of risk is known as cross hedging risk.
• Cross hedge is one in which the asset whose price is to be hedged
and the asset underlying futures contract are not identical.
 UNIT – 4
MECHANICS OF OPTION MARKETS
Defining Option
• Option is a contract that gives its buyer the right but not obligation
to buy or sell an asset at a fixed price on or before a given date.
• Buyer of option is also called holder or owner of option and seller is
also called the writer of option.
• The seller of option grants the buyer of option the right, but not
obligation to purchase from or sell to the seller an asset (underlying
asset).
• This option is sold with a certain price is called option price.
TYPES OF OPTION
• Options come in two basic types: Call Option and Put Option.
Call Option
• A call option is a contract that gives its owner the right but not
obligation to buy the specified asset at a pre-specified price before
or given date.
• A call option holder has the right to exercise the option.
• If the market price of the underlying asset is more than the exercise
price, option holder exercises the option, otherwise purchases from
market.
 Value of call option C = max [(ST – E), 0]
Put Option
• A Put option is a contract that gives its owner the right but not
obligation to sell the specified asset at a fixed price on or before the
pre-specified date.
• Option holder pays a certain amount to buy the option is called price
of put.
• Put option holder has the right whether to exercise the option or
not.
• If market price of the underlying asset decreases below the exercise
price, the option holder exercises the option, otherwise sells in the
market.
 The value of put option P = max [ (E – ST), 0]
Styles of Options
• Call and put option further divided based on the styles of exercising
as:
1. American option: The option that can be exercised at any time on
or before expiration is called American option.
2. European Option: The option that can be exercised only on the
expiration date is called European option.
Options Terminologies
1. Option Price:
• The initial entry fee of the option is the option price which is known
value of option.
• Buyer of option pays the price to the seller of option to take long
position in the option.
2. Exercise/ Strike Price:
• The fixed price of the underlying asset at which the option buyer
buy or sell the asset on or before given date is called exercise price.
3. Expiration Date:
• The last date of exercising the option is expiration date.
4. Underlying Asset:
• The asset which is mention on the option contract and which is
bought or sold while exercising the option is called underlying asset.
5. Exercising the Options:
• When option buyer purchases or sells the underlying asset from/to
the option seller at a pre-fixed price on or before the expiration date
is called exercising the option.
6. In-the-Money Option:
• Option is said to be in-the-money option if it is worth exercising.
• Call option is in-the-money, when ST > E;
• Put option is in-the-money, when E > ST
7. Out-of-the-Money:
• Option is said to be out-of money option if it is not worth exercising.
• Call option is out-of-the-money, when ST < E;
• Put option is out-of-the-money, when E < ST
8. At-the-Money:
• Option is at-the-money when market price of an underlying asset is
equal to exercise price.
9. Option Position:
• The buyer of option is called long position and seller of option is
called short position.
OPTION QUOTATION
• Option trading prices are published in newspapers what is known as
options price quotations.
• Option price information are available daily in the Wall Street
Journal in USA.
• Option price quotations always are of the last day transaction along
with the current bid-ask price.
• Option price quotations demonstrate both the price of the last trade
and volume for that day, exercise price, expiration date, and open
interest for each option (call and put) and current Bid and Ask price.
An example of option price quotation:
Calls Last Sale Bid Ask Net Vol. Open Int.
16 Apr 60 10 12 13 2 150 15400

Let us understand the quotations:

1. Call option expires on 2016 April (generally, Friday of third week).
(col. 1)
2. Exercise price is Rs 60. (col. 1)
3. Call option price was Rs 10 on quotation day i.e. yesterday. (col. 2)
4. Price of call option has gone up by Rs 2 on that day. (col. 5)
5. The price of call option the day before yesterday was Rs 8. (col. 2 &
5)
6. Market maker or dealer is willing to pay Rs 12 for the call option.
(col. 3)
7. Dealer is ready to sell call option at Rs 13 if you want. (col. 4)
8. On that day 150 call options had been traded.(col.6)
9. Total number call options traded up to that day were 15400. They
are outstanding call options as they have not yet exercised. (col. 7)
10. Bid-ask spread is Ask price – Bid price = Rs 1.
 UNIT – 5
OPTION STRATEGIES AND PROFIT DIAGRAMS
Pricing Option at Expiration
• Since, option is a derivative security; its value is affected by its
underlying asset and other market variables.
• We use the following notations for explaining relationship and value
of options.
S0 = Stock price today; E = Exercise price
T = Time to expiration; r = risk free rate of interest
ST = Stock price at options expiration
C (S0 , T, E) = Price of a call option
P (S T, E) = Price of a put option
a. The values of call at expiration:
• at expiration value of a call equals to its intrinsic value because
there is no life and call price contains no time value.
 Value of Call C = max.[(ST – E, 0)]
e.g.,
What must be the price of call that expires today if the call has an
exercise price of Rs 1000 and market price of underlying stock is Rs
1400. what would happen if the market price of call were Rs 600 or
Rs 200?
Solution,
Given, E = Rs 1000; ST = Rs1400
We know,
C = Max [(ST – E), 0] = Max [ (1400 – 1000), 0]
C = Rs 400.
• If option is priced at Rs 600, arbitrageur sells the option and buys
stock at Rs 1400. his net cost is (1400 – 600) Rs 800. If he would
exercise it his cost is Rs 1000. Thus, His net gain = 1000– 800 =Rs
200.
• If option price is Rs 200, buys the option and exercises it at Rs 1000.
He sells the stock at Rs 1400 and his net gain is (1400 – 200 –
1000)Rs 200.
2. The Value of Put at Expiration
• The value of put at the expiration is equal to its intrinsic value.
 The Value of Put (P) = Max [(E – ST ),0]
e.g.,
Suppose a put option on Unilever stock is expiring today. The
exercise price of put is Rs 2,000 and it is selling for Rs 1800. what is
the value of put? How will an arbitrageur react if the market price of
put is (i) Rs 250 (ii) Rs 150?
Solution, given,
ST = Rs 1800 E = Rs 2000 C=?
The value of Put (P) = Max[(E – ST ), 0]
= Max [ (2000 – 1800), 0] = Rs 200
• If the market price is Rs 250, an arbitrager sells the option and buy
the stock in the market. His net cost is Rs 2000 – 250 = Rs 1750. if he
would exercise his cost is Rs 1800. thus, his net gain is Rs 50.
• If the market price is Rs 150, he buys the option and exercises it. His
total cost is Rs 150 + 1800 = Rs1950.
If he would the stock from market his cost is Rs 2000.
His net gain is Rs 50 (i.e. 2000 – 1950).
STRATEGIES INVOLVING A SINGLE OPTION AND A STOCK
Long position in Stock:
• An investor can buy stock today for S0 , and sell it at a future at
unknown price ST . Once it is purchased, the investor is said to be in
long position.
 The profit in long stock = Ns (ST – S0 )

tock
g S
lon
Profit and loss

S0
Stock Price (ST )
Short position in Stock:
• An investor borrows stock and sells today. It is called sale short. Later
he purchases the stock and pays to lender. Once it is sell short, the
investor is said to be in short position.
 The profit in short position = Ns (S0 – ST )
Where, Ns = Number of stocks in the transaction.
Sh o
rt S
toc
k
Profit and loss

S0
Stock Price (ST )
Call Option Transaction
Buy a Call
• The purchase of a call is said to be long call. It gives right to buy the underlying
stock in future at price E. the buyer pays call price is C. the return to the option
holder at expiry is:
π = Nc [Max(ST – E, 0) – C]
= Nc [C1 – C] (=+=C1 = value of option at expiry)

ro fit
x. p
Ma
Profit and loss

Max. loss

S0
Stock Price (ST )
• E.g, Ms Asha buys a call option at Rs 5 to buy the stock at Rs 95 in
one year from Mr. Ashik. Current price of stock is Rs 100. Now,
calculate the value of call option to Ms. Asha if possible stock prices
are Rs 80, 90, 100, 105 and 110. prepare the payoff table, profit
table and profit diagram for the possible stock prices. Also calculate
the stock price at which Ms Asha makes no gain and no loss.
Solution,
Payoff table for long call position
Possible stock price at Exercise price Value of long call at expiration
expiration (ST ) (E) (CT ) = Max [(ST – E), 0]
80 95 0
85 95 0
90 95 0
95 95 0
100 95 5
105 95 10
110 95 15

Payoff diagram for long position in call option

15 payoff
Value of call

10
5

0
80 85 90 95 100 105 110
Stock price at expiration (ST)
The table for profit and loss for long position
Possible stock price Value of Long Call Price of call at Profit and Loss
(ST) CT = Max[(ST – E), 0] beginning (C) = ( CT – C)
80 0 5 -5
85 0 5 -5
90 0 5 -5
95 0 5 -5
100 5 5 0
105 10 5 5
110 15 5 10

Profit and loss diagram for long position

15 profit
profit

10
5 BEP

0
80 85 90 95 100 105 110
-5
Loss Stock price at expiration (ST )
-10
Write a Call
• Writing a call is the sell of a call or the short call position.
• Investor can sell call option in two ways:
1. One way is to sell call without concurrently owning the underlying
stock is known as writing an uncovered or naked call.
2. Another way is to sell call concurrently owning underlying stock is
said to be writing covered call.
The value of a short call position at expiration is,
Cw = - Max [(ST – E), 0]
The profit or loss on the sale(write) of a call is,
Profit or Loss = C = - Max[{(ST – E), 0} + C] if ST < E
Profit or Loss = -ST + E + C; if ST > E
• Short call payoff diagram

Value of call

Stock Price

• Short call Profits and losses diagram

Profit & Loss

Profit

Loss

Stock Price
• Example;
• Suppose Mr Mahesh sells the call option at Rs 10 on the stock with the
exercise price of Rs 100. the current price is Rs 100. now possible price at
expiration are Rs 80, 90, 100, 110, 130. prepare payoff table and diagram.
• We prepare a payoff table for the short position in call.

Stock price at Exercise Price (E) Value of short call

expiration(ST) (Cs)
80 100 0
90 100 0
100 100 0
110 100 - 10
120 100 - 20
130 100 - 30
Profit and loss table for short position
Stock Price (ST) Value of Short call (Cs) Price Received (C) Profit and Loss
80 0 10 10
90 0 10 10
100 0 10 10
110 -10 10 0
120 - 20 10 - 10
130 - 30 10 - 20

30
20
Profit & loss

10 BEP
profit
0
80 90 100 110 120 130
-10
-20 Loss Stock price at expiration

BEPcaii = E + C = 100 + 10 = 110

Covered Call Strategy
• Covered call involves buying shares as soon as the call option has
been sold in equal number to hedge the loss from the increase price
of the stock.
• The profit equation in covered call is
Profit = (ST – S0)– Max[(ST – E), 0] + C
 UNIT – 6
OPTION PRICING MODELS
1. The Binomial Option Pricing Model (BOPM)
2. Black Scholes Model (BSM)
The Binomial Model
• BOPM is one of the popular models of option pricing.
• BOPM was developed by Cox, Ross and Rubinstein in 1979.
• It can be used to estimate the fair value of a call option or put
option.
• It is based on two possible price of a stock in future, so it is known
as Binomial Model.
a. One Period Binomial Model
• One period model assumes single period between the initiation of
option contract and expiration of option contract.
• There are two possible prices of stock (i.e. upper price ‘Su’ and down
price ‘Sd’) at expiration.
• There are two possible price of option (i.e. upper call price ‘C u’ and
down call price ‘Cd’) at expiration.
• Stock Price tree:
Su
Cu
S0
C0 Sd
Cd
• The present value of call is calculated as below:
 Upper Call Price Cu = Max [ (Su – E), 0]
 Down Call Price Cd = Max [(Sd – E), 0]
 Expected Value of Call at Expiry (C1) = p. Cu + (1 – p) . Cd
 Present Value of Call (C0) = C1/(1+r)t
• Similarly value of put is calculated.
 Expected Value of Put at Expiry (P1) = p. Pu + (1 – p) . Pd
 present Value of Put (P0) =[p.Pu + (1 –p).Pd ]/(1 + r)t
• When the continuous compounding is given
 Present Value of Call (C0) = C1 . e-rT
 Present Value of Put (P0) = P1 . e-rT
• Estimation of Probability
 Probability that the stock price will rise (p) = (1 + r – d)/(u – d)
• If rate is continuously compound
p = (erT – d)/(u – d)
Where, r = risk free rate of interest
d = down move factor =Su/S0
u = up move factor =Sd/S0
Hedge Ratio:
A hedge ratio shows the risk-free combination of long stock – short call
or long stock – long put. It is called option delta.
 hedge Ratio (h) = (Cu – Cd)/(Su – Sd)
The Multi- Period Binomial Model
• The Multi-period model assumes that there will be more than one
sub-periods between now and expiration.
• The price of underlying stock moves up and down in each sub-period
until expiration.
• BOPM adjusts the two or more than two time intervals for stock
price changes.
• The periodic up price movement and down price movement rate will
be equal in each sub-period.
• The prices of stock form of decision tree as given in next page.
• Some formula for multi-period BOPM
 up move factor (u) = Suu /Su
 Down move factor (d) = Sud / Su
• Probability that the price Su goes up to Suu is
 p = (1 + r –d)/(u-d)
• If continuous compounding;
P = (ert – d) /(u-d)
Value of option end of one period
 Cu = [p. Cuu + (1 – p) . Cud] /(1 + r)t
 Cd = [ p. Cud + (1 – p) Cdd]/ (1 + r)t
 Value of Call option (C0) = [p. Cu + (1 – p) Cd ]/(1+r)
 Value of Put option (P0) = [p. Pu + (1 – p) Pd ]/(1+r)
Alternative formula:
Value of call (C0 ) = [p2 Cuu + 2p (1-p)Cud + (1-p) Cdd]/(1+r)2
Hedge Ratio
 Initial hedge ratio h = (Cu– Cd)/(Su– Sd)
 upper hedge ratio h = (Cuu– Cud)/(Suu– Sud)
 down hedge ratio h = (Cud– Cdd) / (Sud– Sdd)

 Binomial Price Tree Suu

Su Cuu
S0 Cu Sud
C0 Sd Cud
Cd Sdd
Cdd
 Dividend adjustment:
• Dividend is deducted from the price of stock when it is paid.
• Ex-dividend price = Su- div. and = Sd – div
Valuation of American options
• The value of American option is always greater or equal to European
options because American options can be exercised before or at
expiration.
Black-Scholes Option Pricing model
• Black-Scholes Option Pricing Model was developed by Fisher Black
and Myron Scholes in 1973.
• It is the option pricing model which is used when there is volatility of
stock price and risk-free rate is given.
Assumptions:
• There are no transaction costs or taxes.
• Risk-free interest rate is known and constant.
• The short selling of stocks with the full use of proceeds is permitted.
And pays no dividend.
• European exercise terms are used.
• There are no arbitrage opportunities.
• Black-Scholes Option Pricing model for stock option is given as
below:
Value of call (Co) = S0 N(d1) – E. e-rt N (d2)
Where,
d1 = [ln(S0/E) + {r + σ2/2} T]/ σ√T
d2 = d 1 – σ √ T
• N(d1) and N(d2) are table values of d1 and d2 .