Financial Derivatives and Risk

Management
• Term IV
• Finance Elective Course
• PGDM: 35 Students
• PGDM (FS): 19 Students
• PGDM (RM): 1 Student
Business Questions Those Can Be Answered After
the Successful Completion Of This Course
• How can a speculator formulate different kinds of speculative strategies
according to his or her risk appetite to exploit his or her conviction about the
future price movements?
• How can an arbitrageur assess mispricing (if any) in the market and how can
he or she earn riskless profit by exploiting those mispricing (or arbitrage
opportunities)?
• How can a manufacturer or a service provider hedge or mitigate price risk
against the unfavorable movement in the price of the underlying asset?
• How can one estimate the impact of change in different factors on the value
of the combined portfolio?
• How can one estimate the cost of hedging?
Business Questions Those Can Be Answered After
the Successful Completion Of This Course
• How can a speculator formulate different kinds of speculative
strategies according to his or her risk appetite to exploit his or her
conviction about the future price movements?
Business Questions Those Can Be Answered After
the Successful Completion Of This Course
• How can an arbitrageur assess mispricing (if any) in the market and
how can he or she earn riskless profit by exploiting those mispricing
(or arbitrage opportunities)?
Business Questions Those Can Be Answered After
the Successful Completion Of This Course
• How can a manufacturer or a service provider hedge or mitigate price
risk against the unfavorable movement in the price of the underlying
asset?
Business Questions Those Can Be Answered After
the Successful Completion Of This Course
• How can one estimate the impact of change in different factors on the
value of the combined portfolio?
Business Questions Those Can Be Answered After
the Successful Completion Of This Course
• How can one estimate the cost of hedging?
 Derivative Securities
• Derivative securities are securities whose prices are derived from
(determined by) the prices of other securities (underlying asset).
• Derivative securities are also called contingent claim because their
payoffs are contingent on the price on the underlying asset.
• Since value of derivatives depends on the value of underlying assets,
they can be powerful tools for hedging and speculation.
 Kinds of Derivative Securities
• Forwards/Futures
• Options
• Swap
Futures Markets
 Futures and Forwards
• Forward - an agreement calling for a future delivery of an asset
at an agreed-upon price
• Futures - similar to forward but feature formalized and
standardized characteristics
• Key difference in futures
• Secondary trading - liquidity
• Marked to market
• Standardized contract units
• Clearinghouse (Exchange)
 Key Terms for Futures Contracts
•  Futures price - agreed-upon price at maturity
• Long position - agree to purchase
• Short position - agree to sell
• Profits (Payoffs) on positions at maturity
Long = spot price on maturity minus original futures price ()
Short = original futures price minus spot price on maturity ()
 Long Futures

Payoff
on
Maturity

0  𝐹0
 
𝑆𝑇
 Short Futures

Payoff
on
Maturity

0  𝐹0
 
𝑆𝑇
 Contract Specification: Equity Futures
Parameter Index Futures Futures on Individual Securities
Underlying Two Indices (Nifty 50; Nifty Bank) 141 Securities
Trading Cycle 3 month trading cycle: the near 3 month trading cycle: the near
month (one); the next month (two); month (one); the next month (two);
and the far month (three) and the far month (three)
Expiry Day Last Thursday of the Month. If the Last Thursday of the Month. If the
last Thursday is a trading holiday, last Thursday is a trading holiday,
the expiry day is the previous the expiry day is the previous
trading day. trading day.
Permitted Lot Size Underlying Specific (Nifty 50: 75; Underlying Specific (Vodafone Idea:
Nifty Bank: 25) 1,40,0000; MRF: 10)
Price Step 0.05 0.05
 Contract Specification: Equity Options
Parameter Index Options Options on Individual Securities Long-Term Index Options
Underlying Two Indices (Nifty 50; Nifty Bank) 141 Securities Nifty 50
Trading Cycle 3 month trading cycle: the near 3 month trading cycle: the near Three quarterly expiries (Mar,
month (one); the next month month (one); the next month June, Sep and Dec) and next eight
(two); and the far month (three). (two); and the far month (three) half yearly expiries (June and
Nifty 50 Weekly Options Dec)
Expiry Day Last Thursday of the Month. If Last Thursday of the Month. If Last Thursday of the Month. If
the last Thursday is a trading the last Thursday is a trading the last Thursday is a trading
holiday, the expiry day is the holiday, the expiry day is the holiday, the expiry day is the
previous trading day. previous trading day. previous trading day.
For Nifty 50 weekly Option: Last
Thursday of the week; 7 weekly
expiry contract except expiry
week of monthly contract.
Permitted Lot Size Underlying Specific (Nifty 50: 75; Underlying Specific (Vodafone Underlying Specific
Nifty Bank: 25) Idea: 1,40,000 (8.40); MRF: 10
(63,000)]
Price Step 0.05 0.05 0.05
Sample of Future Contracts
Equity Futures Currency Futures Bullion Futures Commodity Futures Interest Rate
Futures
2 Indices US Dollar (1000) Gold Futures (1 Kg) Metal Futures Bond Futures.
(Aluminium;
Copper; Nickel; Zinc;
Lead)
141 Individual GBP (1000) Gold Mini Futures Energy (Crude Oil; Treasury Bill
Stocks (100 gm) Natural Gas) Futures.
Euro (1000) Silver Futures (30 Agricultural
Kg) Commodities (Black
Pepper; Cardamom;
Castor sees; Cotton;
Crude Palm Oil;
Kapas; Mentha Oil;
RBD Palmolein)
Yen (100,000)
 Trading Mechanics
• Clearinghouse - acts as a party to all buyers and sellers
• Obligated to deliver or supply delivery
• Closing out positions
• Reversing the trade
• Take or make delivery
• Most trades are reversed and do not involve actual delivery
• Open Interest
 Quoted Price: Nifty Futures (July): July
24, 2020 (12.00 Noon)
Buy Qty. Buy Price Sell Price Sell Qty.
3000 11,095.00 11,096.00 6150
450 11,094.70 11,096.15 75
225 11,094.10 11,096.90 300
75 11,094.05 11,096.95 75
75 11,094.00 11,097 300
7,41,450 Total Quantity 391,350
Nifty Futures: Historical Data (July Futures)
• Traded Volume (contracts): 1,81,513
• Traded Value * (lacs): 15,13,908.27
• Underlying value: 11,194.15
• Market Lot: 75
• Open Interest:96,83,475
• Change in Open Interest:-6,12,525
• % Change in Open Interest:-5.95
Quoted Price: Nifty Futures (July): July
24, 2020 (3.00 PM)
Buy Qty. Buy Price Sell Price Sell Qty.

3,525 11,170.00 11,170.70 300

375 11,167.80 11,170.80 150

75 11,167.35 11,171.20 150

75 11,167.10 11,171.55 75

75 11,167.00 11,171.95 225

4,18,875 Total Quantity 1,62,975

Figure 22.3 Panel A, Trading without a Clearinghouse.
Panel B, Trading with a Clearinghouse
 Margin and Trading Arrangements
Initial Margin - funds deposited to provide capital to absorb losses
Marking to Market - each day the profits or losses from the new futures
price are reflected in the account
Maintenance or variation margin - an established value below which a
trader’s margin may not fall
 Margin and Trading Arrangements
Continued
Margin call - when the maintenance margin is reached, broker will ask
for additional margin funds
Convergence of Price - as maturity approaches the spot and futures
price converge
Delivery - Actual commodity of a certain grade with a delivery location
or for some contracts cash settlement
Cash Settlement – some contracts are settled in cash rather than
delivery of the underlying assets
 Trading Strategies
• Speculation -
• short - believe price will fall
• long - believe price will rise
• Hedging -
• long hedge - protecting against a rise in price
• short hedge - protecting against a fall in price
 Basis and Basis Risk
• Basis - the difference between the futures price and the spot
price
• over time the basis will likely change and will eventually
converge
• Basis Risk - the variability in the basis that will affect profits
and/or hedging performance
Figure 22.4 Hedging Revenues Using Futures,
Example 22.5
(Futures Price = $97.15)
Option Terminology
• Buy - Long
• Sell - Short
• Call
• Put
• Key Elements
• Exercise or Strike Price
• Premium or Price
• Maturity or Expiration
American vs. European Options
American - the option can be exercised at any time before expiration or
maturity
European - the option can only be exercised on the expiration or
maturity date
Different Types of Options
• Stock Options
• Index Options
• Futures Options
• Foreign Currency Options
• Interest Rate Options
Payoffs and Profits at Expiration - Calls
Notation
Stock Price = ST Exercise Price = K
Payoff to Call Holder
(ST - K) if ST >K
0 if ST < K
Profit to Call Holder
Payoff - Purchase Price
Payoffs and Profits at Expiration - Calls
Payoff to Call Writer
- (ST - K) if ST >K
0 if ST < K
Profit to Call Writer
Payoff + Premium
Figure 20.2 Payoff and Profit to Call Option
at Expiration
Figure 20.3 Payoff and Profit to Call Writers
at Expiration
Payoffs and Profits at Expiration - Puts
Payoffs to Put Holder
0 if S > K
T

(K - S )
T if S < K
T

Profit to Put Holder

Payoff - Premium
Payoffs and Profits at Expiration – Puts
Continued
Payoffs to Put Writer
0 if S > K
T

-(K - S ) if S < K
T T

Profits to Put Writer

Payoff + Premium
Figure 20.4 Payoff and Profit to Put Option at
Expiration
Swaps
• Interest rate swap
• Foreign exchange swap
• Credit risk on swaps
The Swap Dealer
• Dealer enters a swap with Company A
• Pays fixed rate and receives LIBOR
• Dealer enters another swap with Company B
• Pays LIBOR and receives a fixed rate
• When two swaps are combined, dealer’s position is effectively
neutral on interest rates
Basis
•  b = S – F
Consider the hedger who knows that the asset will be sold at time
(future) and takes a short future position at time (current time). The
effective price that is received with hedging is:
Optimal Hedge Ratio
• Assume
  you are expected to sell one unit of the underlying asset after
three month.
• Further assume that for every one unit of exposure in the spot market,
you require h units (short or long) of position in the futures market for
the asset you use for hedging.
• Change in the value of portfolio is:

The objective of hedging is to minimize with respect to h (decision

variable)
•  For to be minimum,
Hedging Equity Portfolio
• 
Case Let
•  An Airline expects to purchase 2 million gallons of jet fuel in one
month.
• Decides to use heating oil futures for hedging.

• Each Heating oil future contract traded on MCX = 42,000 gallons of

heating oil.
Case let 2
• A company has a portfolio of Rs. 30 million.
• Beta of Portfolio = 1.2
• Company uses NSE Nifty futures to hedge risk
• Current futures price of NSE Nifty = 12,000
Case let 3
• Suppose that Nifty futures contract with four months to maturity is
used to hedge the value of a portfolio over the next three months.
• Current Value of Nifty index = 10,000
• Current Nifty futures price = 10,100
• Current Value of portfolio = 10,100,000 (Rs.)
• Risk-free rate = 4% per annum
• Dividend Yield = 1% per annum
• Beta of portfolio = 1.5
• What is the performance of Nifty hedge for the following spot and
futures price in three months.

S 9000 9500 10,000 10,500 11,000

F 9020 9520 10,030 10,530 11,030
•  Spot Market =
• Futures Market =
• Total Payoff =
Conditions of perfect hedge
1. The asset of the spot market is the same as asset of futures market
2. The date on which you are expected to buy from or sell in the spot
market matches with maturity of futures contract.
Arbitrage
Consider the following portfolio:
• Investment at time 0 (current time) in a underlying asset in spot
market
• Short futures position in the underlying asset with maturity date at
time T.
•Payoff
  of the portfolio at time T:
• Spot
• Short Futures
• Total
Question: Is payoff of the portfolio at time T deterministic or stochastic.

If the payoff is deterministic, one can expect to earn more than risk-free
rate.
•  Cost of the portfolio at time 0 =
• Thus, by investing at time 0, one gets at time T
• Since both and are determininstic
• , where is the rate per annum with m times compounding in a year.
Or
, where is the rate per annum with continuous compounding
• 

• Where is the present value of known income at time 0

•With
  annual compounding:

With compounding m times in a year:

Index futures
Currency Futures
• 
How to Exploit Arbitrage Opportunities
Case 1: If actual futures price is greater than theoretical futures price:
• Buy the underlying asset from the spot market at time 0 and sell at
time T.
• Short futures on the underlying asset with maturity time T.

Case 2: If actual futures price is less than theoretical futures price:

• Sell the underlying asset in the spot market at time 0 and buy at time
T.
• Long futures on the underlying asset with maturity time T.
• Suppose that the risk-free interest rate is 6% per annum with
continuous compounding for all maturities and the dividend of Rs. 10
per share on a stock is expected is expected after two months. The
current spot price of the stock is Rs. 5000.
• What is the three-month theoretical futures price of the stock?
• Explain the arbitrage opportunities if the actual three-month futures price of
the stock in the market is Rs. 5075. Show full working
• The current 6-month risk-free interest rate in US is 3% per annum
with continuous compounding and the current six-month risk-free
rate in India is 7% per annum with continuous compounding. The
current spot price of the US dollar is 1$ = Rs. 70.
• What is current arbitrage-free futures price of US dollar with time to maturity
of six months?
• The actual current market futures price for a contract on US dollars
deliverable in six months is 1$ = Rs. 74. What arbitrage opportunities does
this create? Show full working.
Options Recap
•  Payoff of Long call =
• Payoff of short call =
• Payoff of Long put =
• Payoff of short put =
•  Profit from Long call =
• Profit from short call =
• Profit from Long put =
• Profit from short put =
Naked Options: Speculation
• Bullish: Long call, Short Put
• Bearish: Long Put, Short Call
Options: Speculation (Spread)
• In spread either only call options or only put options with more than one
exercises prices are used. The combination of calls and puts are not used.
• Bull Spread (Bullish): one call (put) option is written with a higher
exercise price and one call (put) is purchased with a lower exercise price.
The maturity is same.
• Bear Spread (Bearish): one call (put) option is purchased with a higher
exercise price and one call (put) is written with a lower exercise price.
• Butterfly Spread: One call (put) each is purchased with extreme exercise
Price and two calls (puts) are written with a middle exercise price.
Relationship between exercise price and
option premium
• Inverse relationship between exercise price and call premium.
• Direct relationship between exercise price and put premium.
• Direct relationship between spot price and call premium.
• Inverse relationship between spot price and put premium.
•  As exercise price increases, call premium decreases at decreasing
rate. and

Exercise price Call Premium

1000 100
1100 75
1200 60
•  As exercise price increases, put premium increases at increasing rate.
and

Exercise Price Put Premium

1000 100
1100 125
1200 155
•  Absolute change in exercise price is always greater than absolute
change in premium
Bull Spread Using Call
• 

Buy Call () 0
Sell Call () 0 0
Total Payoff 0
Total Profit