MODULE –I

INTRODUCTION TO DERIVATIVES

UNIT- 1: DERIVATIVES: AN OVERVIEW

Structure :
1.1 Objectives
1.1 Introduction
1.2 Meaning and Definitions Of Derivatives
1.3 History of Derivatives
1.4 Need for Derivatives
1.5 Features of Financial Derivatives
1.6 Underlying Asset in A Derivatives Contract
1.7 Types of Financial Derivatives
1.8 Uses of Financial Derivatives
1.9 Summary
1.10 Self Assessment Questions
1.11 Case Study
1.12 Notes
1.13 References

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1.0 O BJECTIVES
After studying this unit, you should be able to;
• Define the terms Financial Derivatives.
• Highlight the features of Derivatives.
• Give an account of types of Financial Derivatives.
• Describe the uses of Derivatives.

1.1 INTRODUCTION
A Derivatives trading has become an important economic activity all over the
world. The derivatives originate in mathematics and refer to a variable which has been
derived from another variable. A derivative is a financial product which has been derived
from another financial product or commodity. The derivatives do not have independent
existence without underlying product and market. Derivatives are contracts which are
written between two parties for a easily marketable assets. Derivatives are also known
as deferred delivery or deferred payment instruments. A derivative is a complicated
financial contract that gets (derives) its value from an underlying asset. The buyer
and seller agree on how much the asset price will change over a specific period. The
underlying asset can be a commodity, such as oil, gasoline or gold. Many derivatives are
based on stocks or bonds. Others use currencies, especially the U.S. dollar, as their
underlying asset. Still others use interest rates, such as the yield on the 10-year Treasury
note, as their base. These assets can be, but do not have to be, owned by either party to
the agreement. This makes derivatives much easier to trade than the asset itself. Most
derivatives require that the agreement is fulfilled. That’s accomplished by either by an
exchange of the asset, a cash payment, or another agreement that offsets the value of the
first.
Today, the financial derivatives have become increasingly popular and most
commonly used in the world of finance. This has grown with so phenomenal speed all
over the world that now it is called as the derivatives revolution.
Financial derivatives like futures, forwards, options and swaps are important tools
to manage assets, portfolios and financial risks. Thus, it is essential to know the
terminology and conceptual framework of all these financial derivatives in order to
analyze and manage the financial risks. The prices of these financial derivatives contracts
depend upon the spot prices of the underlying assets, costs of carrying assets into the

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future and relationship with spot prices. For example, forward and futures contracts are
similar in nature, but their prices in future may differ. Therefore, before using any financial
derivative instruments for hedging, speculating, or arbitraging purpose, the trader or
investor must carefully examine all the important aspects relating to them.

1.2 MEANING AND DEFINITIONS OF DERIVATIVES

Let us start by understanding what derivatives really are. In order to understand
the nature of derivatives, we need to start from marketing of products or assets. In a
market, certain types of assets are exchanged for money between buyers and sellers. For
eg: in the stock market, shares of different corporates are being bought and sold. In the
commodities market, different types of commodities are traded such as gold, cotton,
rubber etc. in the foreign exchange market foreign currencies such as US Dollar, Euro,
Yen etc. are traded. In other words, Derivatives are derived values. A Derivative is a
financial instrument or contract whose value is delivered from some other asset or
economic variable which is called an underlying assets. In normal trading an asset is
acquired or sold. When we deal with derivatives the asset itself is not traded, but the
right to buy or sell the asset is traded.
Definitions
According to Webster Dictionary, Derivatives is “A substance that can be derived
from another substance.”
John C. Hull defined the derivatives as “A financial instrument whose value depends
on (or derived from) the value of other, more basic underlying variables.”
D.G. Gardener defined the derivatives as “A derivative is a financial product which
has been derived from market for another product.”
The securities contracts (Regulation) Act 1956 defines “derivative” as under
section 2(ac).As per this “Derivative” includes
(a) “A security derived from a debt instrument, share, loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security.”
(b) “A contract which derived its value from the price, or index of prices at underlying
securities.”
The above definition conveys that the derivatives are financial products. Derivative
is derived from another financial instrument/contract called the underlying. A derivative
derives its value from underlying assets.

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Points to Note that:
a. Derivatives may be commodity or financial derivatives.
b. Financial derivatives are financial instruments (or contracts).
c. The value of the derivative depends on the value of the original asset.
d. The original asset (security or commodity or economic variable) from which the
value of derivative instrument is derived is knows as Underlying Asset.
e. Derivatives are securities under the Securities Contracts (Regulation) Act and hence
trading the derivatives is governed by the regulatory framework under this Act.

1.3 HISTORY OF DERIVATIVES

The history of derivatives is surprisingly longer than what most people think.
Some texts even find the existence of the characteristics of derivative contracts in
incidents of Mahabharata. Traces of derivative contracts can even be found in incidents
that date back to the ages before Jesus Christ. However, the advent of modern day
derivative contracts is attributed to the need for farmers to protect themselves from any
decline in the price of their crops due to delayed monsoon, or over production. The first
‘futures’ contracts can be traced to the Yodoya rice market in Osaka, Japan around1650.
These were evidently standardized contracts, which made them much like today’s futures.
The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was
established in 1848 where forward contracts on various commodities were standardized
around 1865. From then on, futures contracts have remained more or less in the same
form, as we know them today. Derivatives have had a long presence in India. The
commodity derivative market has been functioning in India since the nineteenth century
with organized trading in cotton through the establishment of Cotton Trade Association
in 1875. Since then contracts on various other commodities have been introduced as
well. Exchange traded financial derivatives were introduced in India in June 2000 at the
two major stock exchanges, NSE and BSE. There are various contracts currently traded
on these exchanges. The National Stock Exchange of India Limited (NSE) commenced
trading in derivatives with the launch of index futures on June 12, 2000. The futures
contracts are based on the popular benchmark S&P CNX Nifty Index. The Exchange
introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSE also
became the first exchange to launch trading in options on individual securities from July
2, 2001. Futures on individual securities were introduced on November 9, 2001.

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 Futures and Options on individual securities are available on 227 securities
stipulated by SEBI. The Exchange provides trading in other indices i.e. CNX-IT, BANK
NIFTY, CNX NIFTYJUNIOR, CNX 100 and NIFTY MIDCAP 50 indices. The Exchange
is now introducing mini derivative (futures and options) contracts on S&P CNX Nifty
index. National Commodity & Derivatives Exchange Limited (NCDEX) started its
operations in December 2003, to provide a platform for commodities trading. The
derivatives market in India has grown exponentially, especially at NSE. Stock Futures
are the most highly traded contracts. The size of the derivatives market has become
important in the last 15 years or so. In 2007the total world derivatives market expanded
to $516 trillion. With the opening of the economy to multinationals and the adoption of
the liberalized economic policies, the economy is driven more towards the free market
economy. The complex nature of financial structuring itself involves the utilization of
multi-currency transactions. It exposes the clients, particularly corporate clients to
various risks such as exchange rate risk, interest rate risk, economic risk and political
risk.With the integration of the financial markets and free mobility of capital, risks alsomultiplied.
For instance, when countries adopt floating exchange rates, they have to face risks due
to fluctuations in the exchange rates. Deregulation of interest rate cause interest risks.
Again, securitization has brought with it the risk of default or counter party risk. Apart
from it, every asset, whether commodity or metal or share or currency - is subject to
depreciation in its value. It may be due to certain inherent factors and external factors
like the market condition, Government’s policy, economic and political condition
prevailing in the country and so on. In the present state of the economy, there is an
imperative need of the corporate clients to protect their operating profits by shifting
some of the uncontrollable financial risks to those who are able to bear and manage them.
Thus, risk management becomes a must for survival since there is a high volatility in the
present financial markets.
In this context, derivatives occupy an important place as risk reducing machinery.
Derivatives are useful to reduce many of the risks discussed above. In fact, the financial
service companies can play a very dynamic role in dealing with such risks. They can
ensure that the above risks are hedged by using derivatives like forwards, future, options,
swaps etc. Derivatives, thus, enable the clients to transfer their financial risks to the
financial service companies. This really protects the clients from unforeseen risks
and helps them to get there due operating profits or to keep the project well within the
budget costs. To hedge the various risks that on faces in the financial market today,
derivatives are absolutely essential

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1.4 NEED FOR DERIVATIVES
Since 1991, due to liberalization of economic policy, the Indian economy has
entered an era in which Indian companies cannot ignore global markets. Before the
nineties, prices of many commodities, metals and other assets were controlled. Others,
which were not controlled, were largely based on regulated prices of inputs. As such
there was limited uncertainty, and hence, limited volatility of prices. But after 1991,
starting the process of deregulation, prices of most commodities is decontrolled. It has
also resulted in partly deregulating the exchange rates, removing the trade controls,
reducing the interest rates, making major changes for the capital market entry of foreign
institutional investors, introducing market based pricing of government securities, etc.
All these measures have increased the volatility of prices of various goods and services
in India to producers and consumers alike. Further, market determined exchange rates
and interest rates also created volatility and instability in portfolio values and securities
prices. Hence, hedging activities through various derivatives emerged to different
risks.Futures’ trading offers a risk-reduction mechanism to the farmers, producers,
exporters, importers, investors, bankers, trader, etc. which are essential for any country.
In the words of Alan Greenspan, Chairman of the US Federal Reserve Board, “The
array of derivative products that has been developed in recent years has enhanced
economic efficiency. The economic function of these contracts is to allow risks that
formerly had been combined to be unbundled and transferred to those most willing to
assume and manage each risk components.” Development of futures markets in many
countries has contributed significantly in terms of invisible earnings in the balance of
payments, through the fees and other charges paid by the foreigners for using the markets.
Further, economic progress of any country, today, much depends upon the service sector
as on agriculture or industry.
Services are now backbone of the economy of the future. India has already crossed
the roads of revolution in industry and agriculture sector and has allowed the same now
in services like financial futures. India has all the infrastructure facilities and potential
exists for the whole spectrum of financial futures trading in various financial derivatives
like stock market indices, treasury bills, gilt-edged securities, foreign currencies, cost
of living index, stock market index, etc. For all these reasons, there is a major potential
for the growth of financial derivatives markets in India.

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1.5 FEATURES OF FINANCIAL DERIVATIVES
1. It is a contract:
Derivative is defined as the future contract between two parties. It means there
must be a contract binding on the underlying parties and the same to be fulfilled in future.
The future period may be short or long depending upon the nature of contract, for example,
short term interest rate futures and long term interest rate futures contract.
2. Derives value from underlying asset:
Normally, the derivative instruments have the value which is derived from the
values of other underlying assets, such as agricultural commodities, metals, financial
assets, intangible assets, etc. Value of derivatives depends upon the value of underlying
instrument and which changes as per the changes in the underlying assets, and sometimes,
it may be nil or zero. Hence, they are closely related.
3. Specified obligation:
In general, the counter parties have specified obligation under the derivative
contract. Obviously, the nature of the obligation would be different as per the type of the
instrument of a derivative. For example, the obligation of the counter parties, under the
different derivatives, such as forward contract, future contract, option contract and swap
contract would be different.
4. Direct or Exchange Traded:
The derivatives contracts can be undertaken directly between the two parties or
through the particular exchange like financial futures contracts. The exchange-traded
derivatives are quite liquid and have low transaction costs in comparison to tailor-made
contracts. Example of exchange traded derivatives are Dow Jons, S&P 500, Nikki 225,
NIFTY option, S&P Junior that are traded on New York Stock Exchange, Tokyo Stock
Exchange, National Stock Exchange, Bombay Stock Exchange and so on.
5. Related to Notional Amount:
In general, the financial derivatives are carried off-balance sheet. The size of the
derivative contract depends upon its notional amount. The notional amount is the amount
used to calculate the payoff. For instance, in the option contract, the potential loss and
potential payoff, both may be different from the value of underlying shares, because the
payoff of derivative products differs from the payoff that their notional amount might
suggest.

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6. Delivery of underlying asset not involved:
Usually, in derivatives trading, the taking or making of delivery of underlying
assets is not involved, rather underlying transactions are mostly settled by taking offsetting
positions in the derivatives themselves. There is, therefore, no effective limit on the
quantity of claims, which can be traded in respect of underlying assets.
7.May be used as deferred delivery:
Derivatives are also known as deferred delivery or deferred payment instrument.
It means that it is easier to take short or long position in derivatives in comparison to
other assets or securities. Further, it is possible to combine them to match specific, i.e.,
they are more easily amenable to financial engineering.
8. Secondary Market Instruments:
Derivatives are mostly secondary market instruments and have little usefulness
in mobilizing fresh capital by the corporate world, however, warrants and convertibles
are exception in this respect. Exposure to risk: Although in the market, the standardized,
general and exchange-traded derivatives are being increasingly evolved, however, still
there are so many privately negotiated customized, over-thecounter (OTC) traded
derivatives are in existence. They expose the trading parties to operational risk, counter-
party risk and legal risk. Further, there may also be uncertainty about the regulatory
status of such derivatives.
9. Off Balance Sheet Item:
Finally, the derivative instruments, sometimes, because of their off-balance sheet
nature, can be used to clear up the balance sheet. For example, a fund manager who is
restricted from taking particular currency can buy a structured note whose coupon is
tied to the performance of a particular currency pair.

1.6 UNDERLYING ASSET IN A DERIVATIVES CONTRACT

As defined above, its value is entirely derived from the value of the underlying
asset. The underlying asset can be securities, commodities, bullion, currency, livestock
or anything else. In other way the underlying asset may assume many forms:
(i) Commodities including grain, coffee beans, orange juice;
(ii) Precious metals like gold & silver;
(iii) Foreign exchange rates or currencies;

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(iv) Bonds of different types, including medium to long term negotiable debt, securities
issued by governments, companies etc;
(v) Shares and share warrants of companies traded on recognized stock exchanges and
stock index;
(vi) Short term securities such as T-bills; and
(vii) Over the counter (OTC) money market products such as loans or deposits.

1.7 TYPES OF FINANCIAL DERIVATIVES

The financial derivatives are those assets whose values are determined by the
value of some other assets, called as the underlying. Presently, there are complex varieties
of derivatives already in existence, and the markets are innovating newer and newer ones
continuously. For example, various types of financial derivatives based on their different
properties like, plain, simple or straightforward, composite, joint or hybrid, synthetic,
leveraged, mildly leveraged, customized or OTC traded, standardized or organized
exchange traded, etc. are available in the market.
Due to complexity in nature, it is very difficult to classify the financial derivatives,
so in the present context, the basic financial derivatives which are popular in the market
have been described in brief. In simple form, the derivatives can be classified into
different categories which are shown in the below Fig. 1.1.
Types of Derivatives

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 One form of classification of derivative instruments is between commodity
derivatives and financial derivatives. The basic difference between these is the nature of
the underlying instrument or asset. In a commodity derivatives, the underlying instrument
is a commodity which may be wheat, cotton, pepper, sugar, jute, turmeric, corn, soya
beans, crude oil, natural gas, gold, silver, copper and so on. In a financial derivative, the
underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index,
gilt-edged securities, cost of living index, etc. It is to be noted that financial derivative
is fairly standard and there are no quality issues, whereas in commodity derivative, the
quality may be the underlying matters. However, the distinction between these two from
structure and functioning point of view, both are almost similar in nature.
Another way of classifying the financial derivatives is into basic and complex
derivatives. In this, forward contracts, futures contracts and option contracts have been
included in the basic derivatives whereas swaps and other complex derivatives are taken
into complex category because they are built up from either forwards/futures or options
contracts, or both. In fact, such derivatives are effectively derivatives of derivatives.
I Basic Financial Derivatives
1. Forward Contracts
A forward contract is a simple customized contract between two parties to buy or
sell an asset at a certain time in the future for a certain price. Unlike future contracts,
they are not traded on an exchange, rather traded in the over-the-counter market, usually
between two financial institutions or between a financial institution and its client.
Example
An Indian company buys Automobile parts from USA with payment of one
milliondollar due in 90 days. The importer, thus, is short of dollar that is, it owes dollars
for future delivery. Suppose present price of dollar is ¹ 68. Over the next 90 days, however,
dollar might rise against ¹ 68. The importer can hedge this exchange risk by negotiating
a 90 days forward contract with a bank at a price ¹ 70. According to forward contract in
90 days the bank will give importer one million dollar and importer will give the bank 50
million rupees hedging a future payment with forward contract. On the due date importer
will make a payment of‘ 50 million to bank and the bank will pay one million dollar to
importer, whatever rate of the dollar is after 90 days. So this is a typical example of
forward contract on currency.
The basic features of a forward contract are given in brief here as under:

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1. Forward contracts are bilateral contracts, and hence, they are exposed to
counterparty risk. There is risk of non-performance of obligation either of the
parties, so these are riskier than to futures contracts.
2. Each contract is custom designed, and hence, is unique in terms of contract size,
expiration date, the asset type, quality, etc.
3. In forward contract, one of the parties takes a long position by agreeing to buy the
asset at a certain specified future date. The other party assumes a short position by
agreeing to sell the same asset at the same date for the same specified price. A
party with no obligation offsetting the forward contract is said to have an open
position. A party with a closed position is, sometimes, called a hedger.
4. The specified price in a forward contract is referred to as the delivery price. The
forward price for a particular forward contract at a particular time is the delivery
price that would apply if the contract were entered into at that time. It is important
to differentiate between the forward price and the delivery price. Both are equal at
the time the contract is entered into. However, as time passes, the forward price is
likely to change whereas the delivery price remains the same.
5. In the forward contract, derivative assets can often be contracted from the
combination of underlying assets, such assets are oftenly known as synthetic assets
in the forward market.
6. In the forward market, the contract has to be settled by delivery of the asset
onexpiration date. In case the party wishes to reverse the contract, it has to
compulsory go to the same counter party, which may dominate and command the
price it wants as being in a monopoly situation.
7. In the forward contract, covered parity or cost-of-carry relations are relation
between the prices of forward and underlying assets. Such relations further assist
in determining the arbitrage-based forward asset prices.
8. Forward contracts are very popular in foreign exchange market as well as interest
rate bearing instruments. Most of the large and international banks quote the
forward rate through their ‘forward desk’ lying within their foreign exchange trading
room. Forward foreign exchange quotes by these banks are displayed with the spot
rates.
9. As per the Indian Forward Contract Act- 1952, different kinds of forward contracts
can be done like hedge contracts, transferable specific delivery (TSD) contracts

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 and non-transferable specify delivery (NTSD) contracts. Hedge contracts are freely
transferable and do not specific, any particular lot, consignment or variety for
delivery. Transferable specific delivery contracts are though freely transferable
from one party to another, but are concerned with a specific and predetermined
consignment. Delivery is mandatory. Non-transferable specific delivery contracts,
as the name indicates, are not transferable at all, and as such, they are highly specific.
In brief, a forward contract is an agreement between the counter parties to buy or
sell a specified quantity of an asset at a specified price, with delivery at a specified time
(future) and place. These contracts are not standardized; each one is usually being
customized to its owner’s specifications.
2. Future Contracts
Like a forward contract, a futures contract is an agreement between two parties
to buy or sell a specified quantity of an asset at a specified price and at a specified time
and place. Futures contracts are normally traded on an exchange which sets the certain
standardized norms for trading in the futures contracts.
Example
A silver manufacturer is concerned about the price of silver, since he will not be
able to plan for profitability. Given the current level of production, he expects to have
about 20,000 ounces of silver ready in next two months. The current price of silver on
May 10 is ¹ 1052.5 per ounce, and July futures price at FMC is ¹ 1068 per ounce, which
he believes to be satisfied price. But he fears that prices in future may go down. So he
will enter into a futures contract. He will sell four contracts at MCX where each contract
is of 5000 ounces at ¹ 1068 for delivery in July.
Perfect Hedging Using Futures

Date Spot Market Futures Market

May 10 Anticipate the sale of 20,000 ounce in Sell four contracts, 5000 ounce each
two months and expect to receive July futures contracts at 1068 per
1068 per ounce or a total ` ounce.
21.36,00.00
July 5 The spot price of silver is ` 1071 per Buy four contracts at 1071. Total
ounce; Miner sells 20,000 ounces and cost of 20,000 ounce will be
receives 21.42,0000. 21,42,0000.
Profit / Loss Profit = 60,000 Future Loss= 60,000

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The following are the features of futures contracts.
1. Standardization
One of the most important features of futures contract is that the contract has
certain standardized specification, i.e., quantity of the asset, quality of the asset, the
date and month of delivery, the units of price quotation, location of settlement, etc. For
example, the largest exchanges on which futures contracts are traded are the Chicago
Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME). They specify about
each term of the futures contract.
2. Clearing House
In the futures contract, the exchange clearing house is an adjunct of the exchange
and acts as an intermediary or middleman in futures. It gives the guarantee for the
performance of the parties to each transaction. The clearing house has a number of
members all of which have offices near to the clearing house. Thus, the clearing house
is the counter party to every contract.
3. Settlement Price
Since the futures contracts are performed through a particular exchange, so at the
close of the day of trading, each contract is marked-to-market. For this the exchange
establishes a settlement price. This settlement price is used to compute the profit or
loss on each contract for that day. Accordingly, the member’s accounts are credited or
debited.
4. Daily Settlement and Margin
Another feature of a futures contract is that when a person enters into a contract,
he is required to deposit funds with the broker, which is called as margin. The exchange
usually sets the minimum margin required for different assets, but the broker can set
higher margin limits for his clients which depend upon the credit-worthiness of the clients.
The basic objective of the margin account is to act as collateral security in order to
minimize the risk of failure by either party in the futures contract.
5. Tick Size
The futures prices are expressed in currency units, with a minimum price
movement called a tick size. This means that the futures prices must be rounded to the
nearest tick. The difference between a futures price and the cash price of that asset is
known as the basis.

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6. Cash Settlement
Most of the futures contracts are settled in cash by having the short or long to
make cash payment on the difference between the futures price at which the contract
was entered or impossible to deliver sometimes, the underlying asset. This type of
settlement is very much popular in stock indices futures contracts.
7. Delivery
The futures contracts are executed on the expiry date. The counter parties with a
short position are obligated to make delivery to the exchange, whereas the exchange is
obligated to make delivery to the longs. The period during which the delivery will be
made is set by the exchange which varies from contract to contract.
8. Regulation
The important difference between futures and forward markets is that the futures
contracts are regulated through a exchange, but the forward contracts are self-regulated
by the counter-parties themselves. The various countries have established Commissions
in their country to regulate futures markets both in stocks and commodities. Any such
new futures contracts and changes to existing contracts must by approved by their
respective Commission.
3. Options Contracts
Options are the most important group of derivative securities. Option may be
defined as a contract, between two parties whereby one party obtains the right, but not
the obligation, to buy or sell a particular asset, at a specified price, on or before a specified
date. The person who acquires the right is known as the option buyer or option holder,
while the other person (who confers the right) is known as option seller or option writer.
The seller of the option for giving such option to the buyer charges an amount which is
known as the option premium.
Options can be divided into two types: calls and puts. A call option gives the holder
the right to buy an asset at a specified date for a specified price, whereas in put option,
the holder gets the right to sell an asset at the specified price and time. The specified
price in such contract is known as the exercise price or the strike price and the date in
the contract is known as the expiration date or the exercise date or the maturity date.
The asset or security instrument or commodity covered under the contract is
called as the underlying asset. They include shares, stocks, stock indices, foreign
currencies, bonds, commodities, futures contracts, etc. Further options can be American

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option or European option.A European option can be exercised on the expiration date
only, whereas an American option can be exercised at any time before the maturity date.
Example
Suppose the current price of CIPLA share is ¹ 750 per share. X owns 1000 shares
of CIPLA Ltd. and apprehends in the decline in price of share. The option (put) contract
available at BSE is of ¹ 800, in next two-month delivery. Premium cost is ¹ 10 per
share.X will buy a put option at 10 per share at a strike price of ¹ 800. In this way X has
hedged his risk of price fall of stock. X will exercise the put option if the price of stock
goes down below ¹ 790 and will not exercise the option if price is more than ¹ 800, on
the exercise date.In case of options, buyer has a limited loss and unlimited profit potential
unlike in case of forward and futures.
It should be emphasized that the option contract gives the holder the right to do
something. The holder may exercise his option or may not. The holder can make a
reassessment of the situation and seek either the execution of the contracts or its non-
execution as be profitable to him. He is not under obligation to exercise the option. So,
this fact distinguishes options from forward contracts and futures contracts, where the
holder is under obligation to buy or sell the underlying asset. Recently in India, the
banks are allowed to write cross-currency options after obtaining the permission from
the Reserve Bank of India.
4. Warrants and Convertibles
Warrants and convertibles are other important categories of financial derivatives,
which are frequently traded in the market. Warrant is just like an option contract where
the holder has the right to buy shares of a specified company at a certain price during the
given time period. In other words, the holder of a warrant instrument has the right to
purchase a specific number of shares at a fixed price in a fixed period from an issuing
company. If the holder exercised the right, it increases the number of shares of the issuing
company, and thus, dilutes the equities of its shareholders. Warrants are usually issued
as sweeteners attached to senior securities like bonds and debentures so that they are
successful in their equity issues in terms of volume and price. Warrants can be detached
and traded separately. Warrants are highly speculative and leverage instruments, so trading
in them must be donecautiously.
Convertibles are hybrid securities which combine the basic attributes of fixed
interest and variable return securities. Most popular among these are convertible bonds,
convertible debentures and convertible preference shares. These are also called equity

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derivative securities. They can be fully or partially converted into the equity shares of
the issuing company at the predetermined specified terms with regards to the conversion
period, conversion ratio and conversion price. These terms may be different from
company to company, as per nature of the instrument and particular equity issue of the
company.
II Complex
Swaps and other complex derivatives are taken into complex category because
they are built up from either forwards / futures or options contracts, or both.
1. SWAP Contracts:
Swaps have become popular derivative instruments in recent years all over the
world. A swap is an agreement between two counter parties to exchange cash flows in the
future. Under the swap agreement, various terms like the dates when the cash flows are
to be paid, the currency in which to be paid and the mode of payment are determined and
finalized by the parties. Usually the calculation of cash flows involves the future values
of one or more market variables.
There are two most popular forms of swap contracts, i.e., interest rate swaps and
currency swaps. In the interest rate swap one party agrees to pay the other party interest
at a fixed rate on a notional principal amount, and in return, it receives interest at a
floating rate on the same principal notional amount for a specified period. The currencies
of the two sets of cash flows are the same. In case of currency swap, it involves in
exchanging of interest flows, in one currency for interest flows in other currency. In
other words, it requires the exchange of cash flows in two currencies. There are various
forms of swaps based upon these two, but having different features in general.
2. Exotics Derivatives
As discussed earlier, forwards, futures, options, swaps, etc. are described usually
as standard or ‘plain vanilla’ derivatives. In the early 1980s, some banks and other financial
institutions have been very imaginative and designed some new derivatives to meet the
specific needs of their clients. These derivatives have been described as ‘non-standard’
derivatives. The basis of the structure of these derivatives was not unique, for example,
some non-standard derivatives were formed by combining two or more ‘plain vanilla’
call and put options whereas some others were far more complex.
In fact, there is no boundary for designing the non-standard financial derivatives,
and hence, they are sometimes termed as ‘exotic options’ or just ‘exotics’. There are

16
various examples of such non-standard derivatives such as packages, forward start option,
compound options, choose options, barrier options, binary options, look back options,
shout options, Asian options, basket options, Standard Oil’s Bond Issue, Index Currency
Option Notes (ICON), range forward contracts or flexible forwards and so on.

1.8 USES OF FINANCIAL DERIVATIVES

Derivatives are supposed to provide some services and these services are used by
investors. Some of the uses and applications of financial derivatives can be enumerated
as following:
1. Management of risk:
One of the most important services provided by the derivatives is to control, avoid,
shift and manage efficiently different types of risk through various strategies like hedging,
arbitraging, spreading etc. Derivative assist the holders to shift or modify suitable the
risk characteristics of the portfolios. These are specifically useful in highly volatile
financial conditions like erratic trading, highly flexible interest rates, volatile exchange
rates and monetary chaos.
2. Measurement of Market:
Derivatives serve as the barometers of the future trends in price which result in
the discovery of new prices both on the spot and future markets. They help in
disseminating different information regarding the future markets trading of various
commodities and securities to the society which enable to discover or form suitable or
correct or true equilibrium price in the markets.
3. Efficiency in trading:
Financial derivatives allow for free trading of risk components and that leads to
improving market efficiency. Traders can use a position in one or more financial
derivatives as a substitute for a position in underlying instruments. In many instances,
traders find financial derivatives to be a more attractive instrument than the underlying
security. This is mainly because of the greater amount of liquidity in the market offered
by derivatives as well as the lower transaction costs associated with trading a financial
derivative as compared to the costs of trading the underlying instruments in cash market.
4. Speculation and arbitrage:
Derivatives can be used to acquire risk, rather than to hedge against risk. Thus,
some individuals and institutions will enter into a derivative contract to speculate on the

17
value of the underlying asset, betting that the party seeking insurance will be wrong
about the future value of the underlying asset. Speculators look to buy an asset in the
future at a low price according to a derivative contract when the future market price is
high, or to sell an asset in the future at a high price according to derivative contract when
the future market price is low. Individual and institutions may also look for arbitrage
opportunities, as when the current buying price of an asset falls below the price specified
in a futures contract to sell the asset.
5. Price discovery:
The important application of financial derivatives is the price discovery which
means revealing information about future cash market prices through the future market.
Derivative markets provide a mechanism by which diverse and scattered opinions of
future are collected into one readily discernible number which provides a consensus of
knowledgeable thinking.
6. Hedging:
Hedge or mitigate risk in the underlying, by entering into a derivative contract
whose value moves in the opposite direction to their underlying position and cancels
part or all of it out. Hedging also occurs when an individual or institution buys an asset
and sells it using a future contract. They have access to the asset for a specified amount
of time, and can then sell it in the future at a specified price according to the futures
contract of course, this allows them the benefit of holding the asset.
7. Price stabilization function:
Derivative market helps to keep a stabilizing influences on spot prices by reducing
the short term fluctuations. In other words, derivatives reduces both peak and depths and
lends to price stabilization effect in the cash market for underlying asset.
8. Gearing of value:
Special care and attention about financial derivatives provide leverage (or gearing),
such that a small movement in the underlying value can cause a large difference in the
value of the derivative.
9. Develop the complete markets :
It is observed that derivative trading develop the market towards “complete
markets” complete market concept refers to that situation where no particular investors
be better of than others, or patterns of returns of all additional securities are spanned by
the already existing securities in it, or there is no further scope of additional security.

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10. Encourage competition :
The derivatives trading encourage the competitive trading in the market, different
risk taking preference at market operators like speculators, hedgers, traders, arbitrageurs
etc. resulting in increase in trading volume in the country. They also attract young
investors, professionals and other experts who will act as catalysts to the growth of
financial market.
11. Liquidity and reduce transaction cost :
As we see that in derivatives trading no immediate full amount of the transaction
is required since most of them are based on margin trading. As a result, large number of
traders, speculators, arbitrageurs operates in such markets. So, derivatives trading enhance
liquidity and reduce transaction cost in the markets of underlying assets.
12. Other uses :
The other uses of derivatives are observed from the derivatives trading in the
market that the derivatives have smoothen out price fluctuations, squeeze the price spread,
integrate price structure at different points of time and remove gluts and shortage in the
markets. The derivatives also assist the investors, traders and managers of large pools of
funds to device such strategies so that they may make proper asset allocation increase
their yields and achieve other investment goals.

1.9 SUMMARY
This unit discussed about the features of derivatives, definition of derivatives,
underlying asset in a derivatives contract are discussed in length. An account of types of
derivatives and uses of derivatives is also given in this unit. Derivatives are risk
management that help in effective management of risk by various stakeholders.
Derivatives provide an opportunity to transfer risk, from the one who wish to avoid it, to
one, who wishes to accept it.

1.10 SELF ASSESSMENT QUESTIONS

1. Define Financial Derivatives?
2. Describe the features of Financial Derivatives.
3. Briefly explain the types of Derivatives.
4. Mention the different uses of Financial Derivatives.

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1.11 CASE STUDY
1. A farmer in Karnataka expects to harvest 25000 bushels of Rice in late July. On 10th
June, the price of wheat is ¹ 170 per bushel. The farmer is worried as he suspects that
price will fall below ¹ 160 before his July delivery date he can hedge is position by
selling July Rice futures. The July Rice future price is ¹ 167 per bushel. The former
sold the July Rice futures. When July end approached, the price had fallen to ¹ 160 per
bushel.
Calculate
(a) What is the gain of the future contract?
(b) What is the revenue from the sale of Rice?
(c) What is the cash flow per bushel of Rice?
2. If more Tax concessions are offered to real investors that share market will move
forward. Do you agree? Give reasons.

1.12 NOTES
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1.13 REFERENCES
1. Gupta S.L., Financial Derivatives Theory, Concepts and Problems, Delhi.
2. Kevin S. Commodity and Financial Derivatives, PHI Learning Private Limited, New
Delhi.
3. Kumar S.S.S. Financial Derivatives, New Delhi, 2000.
4. Stulz M. Rene, Risk Management & Derivatives, Cengage Learning, New Delhi.
5. Prafulla Kumar Swain, Fundamentals of Financial Derivatives, Himalaya Publishing
House, New Delhi

22
UNIT -2 : FINANCIAL DERIVATIVES IN INDIA

Structure :
1.0 Objectives
2.1 Introduction
2.2 Evolution of Derivatives in India
2.3 Evolution of Derivatives Market in India
2.4 Functions of Derivatives Market
2.5 Derivatives Market in India – A Structural Look
2.6 Major Recommendations Of Dr. L.C. Gupta Committee
2.5.1 Derivatives Concept
2.5.2 Financial Derivatives – Types
2.5.3 Equity Derivatives
2.5.4 Basic Reasons for The Preference of Stock Index Futures
2.5.5 Strengthening of Cash Market
2.5.6 Mixing of Cash and Forward Transactions
2.5.7 Differences in Trading Cycles among Stock Exchanges
2.5.8 Weakness of Stock Exchange Administrative Machinery
2.5.9 Inadequate Depository System
2.7 Benefits of Derivatives in India
2.8 Factors Affecting Growth of Derivatives
2.9 Summary
2.10 Self Assessment Questions
2.11 Case Study
2.12 Notes
2.13 References

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2.0 OBJECTIVES
After studying this unit, you should be able to;
• Understand the Evolution of Derivatives in India
• Know about the Evolution of Derivatives Market in India
• Be aware about the Functions of Derivatives Market
• Understand the Recommendation of L.C.Gupta Committee

2.1 INTRODUCTION
The individuals and the corporate sector units are freely using derivatives, also
popularly known as future market instruments, in most of the developed countries of the
world to manage different risks by the individuals and the corporate sector units, emerged
in 1970s, the derivatives markets have seen exponential growth and trading volumes
have nearly doubled in every three years, making it a multi- trillion dollar business market.
The future markets in various segments have developed so much that now one cannot
think of the existence of financial markets without the derivatives instruments. In other
words, the derivatives markets whether belonging to commodities or financials have
become, today, an integral part of the financial system of a country.
The Indian financial markets indeed waited for too long for derivatives trading to
emerge. The phase of waiting is over. The statutory hurdles have been cleared. Regulatory
issues have been sorted out. Stock exchanges are gearing up for derivatives. Mutual funds,
foreign institutional investors, financial institutions, banks, insurance companies,
investment companies, pension funds and other investors who are deprived of hedging
opportunities now find the derivatives market to bank on. They would find very soon all
other important derivatives instruments in the Indian financial markets to manage their
portfolios and associated risks.

2.2 EVOLUTION OF DERIVATIVES IN INDIA

The origin of derivatives can be traced back to the need of farmers to protect
themselves against fluctuations in the price of their crop. From the time it was sown to
the time it was ready for harvest, farmers would face price uncertainty. Through the use
of simple derivative products, it was possible for the farmer to partially or fully transfer
price risks by locking-in asset prices. These were simple contracts developed to meet
the needs of farmers and were basically a means of reducing risk.

24
2.3 EVOLUTION OF DERIVATIVES MARKET IN INDIA
Derivative markets in India were originated in the last part of 19th century. In the
area of commodities, the Bombay Cotton Trade Association started future trading way
back in 1875. This was the first organized futures market. Then Bombay Cotton Exchange
Ltd. in 1893, Gujarat Vyapari Mandall in 1900, Calcutta Hesstan Exchange Ltd. in 1919
had started future market. After the country attained independence, derivative market
came through a full circle from prohibition of all sorts of derivative trades to their
recent reintroduction. Commodities futures’ trading in India was initiated long back in
1950s; however, the1960s marked a period of great decline in futures trading. Market
after market was closed usually because different commodities’ prices increases were
attributed to speculation on these markets. Accordingly, the Central Government imposed
the ban on trading in derivatives in 1969 under a notification issue. The late 1990s shows
this signs of opposite trends—a large scale revival of futures markets in India, and hence,
the Central Government revoked the ban on futures trading in October, 1995, The Civil
Supplies Ministry agreed in principle for starting of futures trading in Basmati rice,
further, in 1996 the Government granted permission to the Indian Pepper and Spice Trade
Association to convert its Pepper Futures Exchange into an International Pepper
Exchange. As such, on November 17, 1997, India’s first international futures exchange
at Kochi, known as the India Pepper and Spice Trade Association—International
Commodity Exchange (IPSTA-ICE) was established. Similarly, the Cochin Oil Millers
Association, in June 1996, demanded the introduction of futures trading in coconut oils.
The Central Minister for Agriculture announced in June 1996 that he was in favour of
introduction of futures trading both domestic and international. Further, a new coffee
futures exchange (The Coffee Futures Exchange of India) is being started at Bangalore.
In August, 1997, the Central Government proposed that Indian companies with commodity
price exposures should be allowed to use foreign futures and option markets. The trend
is not confined to the commodity markets alone, it has initiated in financial futures too.
The first steps towards introduction of Financial Derivatives trading in India, was
the promulgation at the securities laws (Amendment) Ordinance 1995. It provides for
withdrawal at prohibition on options in Securities.The Reserve Bank of India set up the
Sodhani Expert Group which recommended major liberalization of the forward exchange
market and had urged the setting up of rupeebased derivatives in financial instruments.
The RBI accepted several of its recommendations in August, 1996. A landmark step taken
in this regard when the Securities and Exchange Board of India (SEBI) appointed a
Committee the Dr. L.C. Gupta Committee by its resolution, dated November 18, 1996

25
in order to develop appropriate regulatory framework for derivatives trading in India.
While the Committee’s focus was on equity derivatives but it had maintained a broad
perspective of derivatives in general.
The Board of SEBI, on May 11, 1998, accepted the recommendations of the Dr.
L.C. Gupta Committee and approved introduction of derivatives trading in India in the
phased manner. The recommendation sequence is stock index futures, index options and
options on stocks. The Board also approved the ‘Suggestive Bye-Laws’ recommended
by the Committee for regulation and control of trading and settlement of derivatives
contracts in India. Subsequently, the SEBI appointed J.R. Verma Committee to look into
the operational aspects of derivatives markets. To remove the road-block of non-
recognition of derivatives as securities under Securities Contract Regulation Act, the
Securities Law (Amendment) Bill, 1999 was introduced to bring about the much needed
changes. Accordingly, in December, 1999, the new framework has been approved and
‘Derivatives’ have been accorded the status of ‘Securities’. However, due to certain
completion of formalities, the launch of the Index Futures was delayed by more than two
years. In June, 2000, the National Stock Exchange and the Bombay Stock Exchange started
stock index based futures trading in India. Further, the growth of this market did not take
off as anticipated. This is mainly attributed to the low awareness about the product and
mechanism among the market players and investors. The volumes, however, are gradually
picking up due to active interest of the institutional investors.The more detail about
evolution of derivatives are shown in table No.1 with the help of the chronology of the
events.

26
A Chronology of Events: Financial Derivatives of India
Sl.
Progress Date Progress of Financial Derivatives
No.
1. 1952. Enactment of the forward contracts (Regulation) Act
2. 1953 Setting up of the forward market commission.
3. 1956 Enactment of Securities Contract Regulation Act 1956
4. 1969 Prohibition of all forms of forward trading under section 16 of
SCRA
5. 1972 Informal carry forward trades between two settlement cycles began
on BSE
6. 1980 Khuso Committee recommends reintroduction of futures in most
commodities
7. 1983 Govt. amends bye-laws of exchange of Bombay, Calcutta and
Ahmedabad and introduced carry forward trading in specified
shares
8. 1992 Enactment of the SEBI Act
9. 1993 SEBI Prohibits carry forward transactions
10. 1994 Kabra Committee recommends futures trading in 9 commodities
11. 1995 G.S. Patel Committee recommends revised carry forward system
12. 14th Dec. 1995 NSE asked SEBI for permission to trade index futures
13. 1996 Revised system restarted on BSE
14. 18th Nov. 1996 SEBI setup LC Gupta committee to draft frame work for index
futures
15. 11th May 1998 LC Gupta committee submitted report
16. 1st June 1999 Interest rate swaps/forward rate agreements allowed at BSE
17. 7th July 1999 RBI gave permission to OTC for interest rate swaps/forward rate
agreements
18. 24th May 2000 SIMEX chose Nifty for trading futures and options on an Indian
index
19. 25th May 2000 SEBI gave permission to NSE & BSE to do index futures trading
20. 9th June 2000 Equity derivatives introduced at BSE
21. 12th June 2000 Commencement of derivatives trading (index futures) at NSE
22. 31st Aug. 2000 Commencement of trading futures & options on Nifty at SIMEX
23. 1st June 2001 Index option launched at BSE
24. June 2001 Trading on equity index options at NSE
25. July 2001 Trading at stock options at NSE

27
26. 9th July 2001 Stock options launched at BSE
27. July 2001 Commencement of trading in options on individual securities
28. 1st Nov. 2001 Stock futures launched at BSE
29. Nov. 2001 Commencement of trading in futures on individual security
30. 9th Nov. 2001 Trading of Single stock futures at BSE
31. June 2003 Trading of Interest rate futures at NSE
32. Aug. 2003 Launch of futures & options in CNX IT index
33. 13th Sep. 2004 Weekly options of BSE
34. June 2005 Launch of futures & options in Bank Nifty index
35. Dec. 2006 'Derivative Exchange of the Year by Asia risk magazine
36. June 2007 NSE launches derivatives on Nifty Junior & CNX 100
37. Oct. 2007 1st NSE launches derivatives on Nifty Midcap - 50
38. Jan. 2008 Trading of Chhota (Mini) Sensex at BSE
39. 1st Jan. 2008 Trading of mini index futures & options at NSE
40. 3rd March 2009 Long term options contracts on S&P CNX Nifty index
41. NA Futures & options on sectoral indices ( BSE TECK, BSE FMCG,
BSE Metal, BSE Bankex & BSE oil & gas)
42. 29th Aug. 2008 Trading of currency futures at NSE
43. Aug. 2008 Launch of interest rate futures
44. 1st Oct. 2008 Currency derivative introduced at BSE
45. 10th Dec. 2008 S&P CNX Defty futures & options at NSE
46. Aug. 2009 Launch of interest rate futures at NSE
47. 7th Aug. 2009 BSE-USE form alliance to develop currency & interest rate
derivative markets
48. 18th Dec. 2009 BSE's new derivatives rate to lower transaction costs for all
49. Feb. 2010 Launch of currency future on additional currency pairs at NSE
50. Apr. 2010 Financial derivatives exchange award of the year by Asian Banker
to NSE
51. July 2010 Commencement trading of S&P CNX Nifty futures on CME at
NSE
52. Oct. 2010 Introduction of European style stock option at NSE
53. Oct. 2010 Introduction of Currency options on USD INR by NSE

28
54. July 2011 Commencement of 91 day GOI trading Bill futures by NSE
55. Aug. 2011 Launch of derivative on Global Indices at NSE
56. Sep. 2011 Launch of derivative on CNX PSE & CNX infrastructure Indices at
NSE
57. 30th March 2012 BSE launched trading in BRICSMART indices derivatives
58. 29th November 2013 BSE launched currency derivative segment
59. 28th January 2014 BSE launch of Interest Rate Futures

Source: Compiled from NSE and BSE website.

2.4 FUNCTIONS OF DERIVATIVES MARKET
With the increase in Internalization of economic activity, the derivative market
performs a number of economic functions. Few important functions are as follows:
1. Management of Risks: This is the most important function of derivatives.
Financial derivatives provide a powerful tool for limiting risks that individuals and
organisations face in the ordinary conduct of their business. Different kinds of risks
faced by participants are (a) credit risk; (b) market risk; (iii) liquid risk; (d) legal risk;
and (e) operational risk. Thus,
Chart 2.1

29
 Derivatives offer protection from possible adverse market movements and can
be used to manage or offset exposures by hedging or shifting risks particularly during
period of volatility thereby reducing costs.
2. Efficiency in Trading:
Derivatives bring efficiency in the market and make the market a full complete
due to the following reasons:
a. Low transaction costs;
b. Minimization of risks;
c. Clear reflection of the market perception.
d. Protection to investors from financial risks;
e. Facilitating the trading activities under regulated form.
3. Price Discovery:
In an organized derivatives market price reflect the perception of market
participants about the future. This leads the prices of underlying to the perceived future
level. As a result, the prices of derivatives converge with the prices of the underlying at
the expiration of derivative contract. Thus, derivatives help in discovery of future as
well as current prices of underlyings.
4. Price Stabilization Function:
Derivatives provide a significant tool or mechanism through which all the investors
or the participants can judge the movement of prices and protects themselves from
financial risk. Indirectly derivatives stabilize the price movements through a participative
controlled mechanism.
5. Catalyst for New Entrepreneurial Activity:
Derivatives offer new business and employment opportunities across the globe.
At present, there are so many active people working in the stock markets as agents,
traders, advisors and many more with distinctive responsibilities. The attractive gains
through low investment instills a within educated people to earn more and start their
own business.

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2.5 DERIVATIVE MARKETS IN INDIA – A STRUCTURAL LOOK
Derivatives markets are successful institutions because they make financial
markets more efficient. This generally means that borrowing and lending can occur at
lower cost than would otherwise be the case because derivatives reduce transaction. A
derivative contract is an enforceable agreement. This agreement may be a standardized
contract or a customized contact.
The following diagrams exhibit the structural look of the above concept:
Chart 2.2
Derivative Contract
Derivative Contract

Customized or OTC Standardised or

Contracts Exchange Traded Contracts

Forward Contracts

Merchandising Options Swaps, FRAs

And Customised

NTSD TSD

The various derivative contracts as exhibited above are explained below:

1. Customised Contracts: All the OTC contracts are customized contracts. Forward
contracts (other than futures) are customized.
2. Standardised Contracts: Future contracts are standardized. In other words, the
parties to the contracts do not contracts do not decide the terms of future contracts,
but they merely accept terms of contracts standardized by the Exchange.
3. Forward Contract: A forward contract is a legally enforceable agreement for
delivery of the underlying assets on a specific date in future at a price agreed on
the date of contract. Under Forward Contracts (Regulation) Act, 1952, all the
contracts for delivery of goods, which are settled by payment of money difference

31
 or where delivery and payment is made after a period of 11 days are forward
contracts.
4. Future Contract: Futures contract is specific type of Forward contract. These are
exchange traded contracts to sell or buy standardized financial instruments or
physical commodities for delivery on a specified future date on agree price. As the
terms of the contracts are standardized, these are generally not used for
merchandising purposes. These contracts are generally for protecting against risk
of adverse price fluctuations.
5. Non-transferable Specific Delivery (NTSD) Contract: It is an enforceable
bilateral agreement under which the terms of contract are customized and the
performance of the contract is by giving specific delivery of goods. Cannot be
transferred by transferring delivery order, railway receipt, bill of lading, warehouse
receipts or any other documents of titles or underlyings or goods.
6. Transferable Specific Delivery (TSD) Contract: It is an enforceable customized
agreement where the rights and liabilities under the delivery order, railway receipt,
bill of lading, warehouse receipts or any other documents of title to the goods are
transferable. The contract is performed by delivery goods by first seller to the last
buyer.

32
Chart 2.3

Derivative Contract

Commodity Market (Futures) Financial Derivative Markets

Regulatory Authority
Regulatory Authority

Forward Market
Commission (FMC) SEBI RBI

Stock Exchange OTCs

Contracts Forwards

1. Stock Futures Currency Interest Rate

2. Index Futures Forward Forward
3. Stock Options
4. Index Options
5. Currency Futures Option Forwards
6. Interest Rate Futures Short- Long-
7. Currency Options term term

33
2.6 MAJOR RECOMMENDATIONS OF DR. L.C. GUPTA
COMMITTEE
SEBI appointed the L.C.Gupta Committee on 18th November 1996. The brief view
of the important recommendations made by the Dr. L.C. Gupta Committee, on the
introduction of derivatives markets in India. These are as under:
1. The Committee strongly of the view that there is urgent need of introducing of
financial derivatives to facilitate market development and hedging in a most cost
efficient way against market risk by the participants such as mutual funds and other
investment institutions.
2. There is need for equity derivatives, interest rate derivatives and currency derivatives.
3. Futures trading through derivatives should be introduced in phased manner starting
with stock index futures, which will be followed by options on index and later options
on stocks. It will enhance the efficiency and liquidity of cash markets in equities
through arbitrage process.
4. There should be two-level regulation (regulatory framework for derivatives trading),
i.e., exchange level and SEBI level. Further, there must be considerable emphasis
on self-regulatory competence of derivative exchanges under the overall supervision
and guidance of SEBI.
5. The derivative trading should be initiated on a separate segment of existing stock
exchanges having an independent governing council. The number of the trading
members will be limited to 40 percent of the total number. The Chairman of the
governing council will not be permitted to trade on any of the stock exchanges.
6. The settlement of derivatives will be through an independent clearing Corporation/
Clearing house, which will become counter-party for all trades or alternatively
guarantees the settlement of all trades. The clearing corporation will have adequate
risk containment measures and will collect margins through EFT.
7. The derivatives exchange will have on-line-trading and adequate surveillancesystems.
It will disseminate trade and price information on real time basis through two
information vending networks. It should inspect 100 percent of members every
year.
8. There will be complete segregation of client money at the level of trading/clearing
member and even at the level of clearing corporation.

34
9. The trading and clearing member will have stringent eligibility conditions. At least
two persons should have passed the certification programme approved by the SEBI.
10. The clearing members should deposit minimum ¹ 50 lakh with clearing corporation
and should have a net worth of ¹ 3 crores.
11. Removal of the regulatory prohibition on the use of derivatives by mutual funds
while making the trustees responsible to restrict the use of derivatives by mutual
funds only to hedging and portfolio balancing and not for specification.
12. The operations of the cash market on which the derivatives market will be based,
needed improvement in many respects.
13. Creation of a Derivation Cell, a Derivative Advisory Committee, and Economic
Research Wing by SEBI.
14. Declaration of derivatives as ‘securities’ under Section 2 (h) of the SCRA and
suitable amendments in the notification issued by the Central Government in June,
1969 under Section 16 of the SCRA.
The SEBI Board approved the suggested Bye-Laws recommended by the L.C. Gupta
Committee for regulation and control of trading and settlement of derivatives contracts.
Explanation of Some Important Terms Used in the Committee’s Recommendations
2.6.1 Derivatives Concept
A derivative product, or simply ‘derivative’, is to be sharply distinguished from
the underlying cash asset. Cash asset is the asset which is bought or sold in the cash
market on normal delivery terms. Thus, the term ‘derivative’ indicates that it has no
independent value. It means that its value is entirely ‘derived’ from the value of the cash
asset. The main point is that derivatives are forward or futures contracts, i.e., contracts
for delivery and payment on a specified future date. They are essentially to facilitate
hedging of price risk of the cash asset. In the market term, they are called as ‘Risk
Management Tools’.
2.6.2 Financial Derivatives – Types
Though the Committee was mainly concerned with equity based derivatives but it
has tried to examine the need for derivatives in a broad perspective for creating a better
understanding and showing inter-relationship.
Broadly, there are three kinds of price risk exposed to a financial transaction, viz.

35
 1. Exchange rate risk, a position arisen in a foreign currency transaction like
import, export, foreign loans, foreign investment, rendering foreign services, etc.
2. Interest rate risk, as in the case of fixed-income securities, like treasury
bond holdings whose market price could fall heavily if interest rates shot up
3. Equities’, ‘market risk’, also called ‘systematic risk’—a risk which cannot be
diversified away cause the stock market as a whole may go up or down from time to time
The above said classification indicates towards the emergence of three types of financial
derivatives namely currency futures, interest rate futures and equity futures. As both
forward contracts and futures contracts can be used for hedging, but the Committee
favours the introduction of futures wherever possible.
Forward contracts are presently being used in India to provide forward cover
against exchange rate risk. Currency and interest rate futures lie in the sphere of Reserve
Bank of India (RBI).
The Dr. L.C. Gupta Committee recognizes that the basic principles underlying
the organization, control and regulation of markets of all kinds of financial futures are
the more or less same and that the trading infrastructure may be common or separate,
partially or wholly. The Committee is of further opinion that there must be a formal
mechanism for coordination between SEBI and RBI in respect of financial derivatives
markets so that all kinds of overlapping of jurisdiction in respect of trading mechanismare
removed. Financial derivatives markets in India have been developed so far in three
important instruments like equity, interest and currency. First one is regulated by the
SEBI, whereas other two are controlled by the RBI. The markets of these instruments
are in their preliminary stage.
2.6.3 Equity Derivatives
Dr. L.C. Gupta Committee considered in its study both types of equity like stock
index derivatives and individual stocks derivatives. At the international level, stock index
derivative is more popular than the individual stock. The Committee found in its survey
that index futures are more preferable than individual stock from the respondents. The
orderof over-all preference in India as per the survey of the Committee was as follows:
(i) Stock index futures, (ii) Stock index options, (iii) Individual stock options and (iv)
Individual stock futures.

36
2.6.4 Basic Reasons for the Preference of Stock Index Futures
Not only in India, in other countries too, is stock index futures most popular
financial derivatives due to the following reasons:
1. Institutional investors and other large equity holders prefer the most this instrument
in terms of portfolio hedging purpose.
2. Stock index futures are the most cost-efficient hedging device whereas hedging
through individual stock futures is costlier as observed in other countries.
3. Stock index futures cannot be easily manipulated whereas individual stock price
can be exploited more easily in India it is rather easier to play this game as witnessed
in the past scams.
4. This is in fact that due to a limited supply of an individual stock, supply can easily
be cornered even in large companies in India like Reliance Industries, State Bank
of India, etc. The Management of these companies has complained many times
about their share prices being manipulated by some interested parties. On the other
hand, the supply of stock index futures is unlimited, and hence, the possibility of
cornering is ruled out. In fact, the manipulation of stock index futures can be
possible only of the cash prices of each component securities in the index be
influenced, which is rare and not so high.
5. It is observed from the experiences of other countries that stock index futures are
more liquid, more popular and favorable than individual stock futures. The same is
also witnessed by the L.C. Gupta Committee in its survey from the responses of
the respondents.
6. Since, stock index futures consists of many securities, so being an average stock,
is much less volatile than individual stock price. Further, it implies much lower
capital adequacy and margin requirements in comparison of individual stock futures.
7. In case of stock index futures trading, there is always clearing house guarantee, so
the chances of the clearing house going to be bankrupt is very rare, and hence, it is
less risky.
8. Another important reason is that in case of individual stocks, the outstanding
positions are settled normally against physical delivery of the shares. Hence, it is
necessary that futures and cash prices remained firmly tied to each other. However,
in case of stock index futures, the physical delivery is almost impractical, and
they are settled in cash all over the world on the premise that index value, as

37
 independentlyderived from the cash market, is safely accepted as the settlement
price.
9. Lastly, it is also seen that regulatory complexity is much less in the case of stock
index futures in comparison to other kinds of equity derivatives.
In brief, it is observed that the stock index futures are more safer, popular and
attractive derivative instrument than the individuals stock. Even in the US market, the
regulatory framework does not allow use of futures on the individual stocks. Further
only very few countries of world, say one or two, have futures trading on individual
stock.
2.6.5 Strengthening of Cash Market
The Dr. L.C. Gupta Committee observed that for successful introduction of futures
market in any country, there must be a strong cash market because derivatives extract
their value from the cash asset. The constant feedback between these two markets through
arbitrage will keep these markets in alignment with each other. The Committee noted
certain weaknesses of the Indian equities markets which should be taken care for success
of the futures trading in India. A few important weaknesses observed are as under:
2.6.6 Mixing of Cash and Forward Transactions
1. There is queer mixture of cash and future transactions in the Indian stock markets.
For example, cash transactions (involving delivery), in most active scripts,
deliveries are just around 5 per cent of the trading volume whereas in many others,
it is just, 20-30 percent. In fact, the dominant cash transactions are the non-delivery
which are the equivalent of futures/forward transactions.
2. It is further noted that the above said mixed system (cash-cum-carry forward) is
not very sound for futures trading because (i) no transparency in the carry forward
system, (ii) the influence of fundamental factors is not so strong due to dominance
of short term speculation and (iii) creating a future market on such basis may have
the effect of compounding the existing weaknesses.
3. The Committee is of the view that there must be separation between cash market
and futures market. It will promote the markets economic efficiency. This has led
to the adoption of the rolling settlement system because in this way, cash market
will function as genuine cash markets but no carry forward. Even futures market
does not permit carry forward from one settlement to another in the way practiced
inIndia.

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4. The trading in Indian stock market was shifted to rolling settlement recently where
always empha sized for settlement by delivery. But in India, ‘squaring up or closing’
business (i.e. offsetting of buying and selling transactions within the settlement)
is accounted for in bulk which is not appropriate for futures trading.
2.6.7 Differences in Trading Cycles among Stock Exchanges
1. Indian stock exchanges, now, most of them, have a weekly trading cycle but the
cycles are not uniform. For example, NSE has from Wednesday to Tuesday and
BSE has from Monday to Friday. Due to difference in trading cycles, the brokers
who have membership in both the exchanges can easily go on circulating their trades
from one exchange to the other without ever having to delivery. Such situation is a
complete travesty of the cash market and an abuse to the stock market system.
2. It seems that in Indian stock markets, the different trading cycles have been kept
with a vested interest in order to deliberately generate arbitrage opportunities, it is
seen that due to this, the prices for the same securities on two (NSE and BSE)
stock exchanges differ from 0.5 to 1.5 percent even it is larger on expiration days.
The Committee feels that the different cycles serving the interest of only speculators
and not of genuine investors. Even it is not good for market development and futures
trading.
3. It is also noted, that the prices of various securities on both exchanges (NSE and
BSE), sometimes are not the same. As a result, the value of the stock indices on
both the exchanges will not be same, if computed separately from the NSE and
BSE prices. This will create a problem in valuation of future market stock.
4. The Committee also noted that for a successful future trading, a coordinated but
pro-competitive nationwide market system be achieved. So it is suggested that
before implementing a uniform trading cycle system among all exchanges, till such
time the rolling settlement system can be adopted. This system will provide ‘a
sound and reliable basis for futures trading in India.
2.6.8 Weakness of Stock Exchange Administrative Machinery
The Dr. L.C. Gupta Committee members were of the strong opinion that for
successful derivatives trading on the stock exchanges, there must be stringent
monitoringnorms and match higher standard of discipline, than in the present, be
maintained. Though the SEBI has already made a good efforts but much more still is to
be done specifically in the controlling of trading members.

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2.6.9 Inadequate Depository System
The Committee is of the view that all such securities which are composing in
stock index and used for stock index futures, should necessarily be in depository mode.
As observed earlier, settlement problems of the cash market may weaken the arbitrage
process by making it risky and costly. Since, index based derivatives trading does not
itself involve deliveries, it will increase the arbitrage trading between cash and index
derivatives markets.
The arbitrage process keeps the two markets in alignment. Thus, due to this reason,
it is essential for successful futures trading that all the scripts of the particular stock
index futures must be in the depository mode. Hence, depository scripts in India should
be enhanced.
The Committee has no doubt that the creation of futures markets by introducing
the financial derivatives, including equity futures, currency futures and interest rate
futures would be a major step towards the further growth and development of the Indian
financial markets provided that the trading must be cost-efficient and risk hedging
facilities.

2.7 BENEFITS OF DERIVATIVES IN INDIA

Derivatives are innovative Financial Instrument that aims to increase return and
reduce risk. The Indian Derivatives market has achieved tremendous growth over the
years. During December, 1995, the NSE applied to the SEBI for permission to undertake
trading in stock index futures. Later SEBI appointed the Dr. L.C. Gupta Committee, which
conducted a survey amongst market participants and observed an overwhelming interest
in stock index futures, followed by other derivatives products. The LCGC recommended
derivatives trading in the stock exchanges in a phased manner. It is in this context SEBI
permitted both NSE and BSE in the year 2000 to commence trading in stock index futures.
The question, therefore, becomes relevant—what are the benefits of trading in Derivatives
for the country and in particular for choosing stock index futures as the first preferred
product?
Following are some benefits of derivatives:
1. India’s financial market system will strongly benefit from smoothly functioningindex
derivatives markets.

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2. Internationally, the launch of derivatives has been associated with substantial
improvements in market quality on the underlying equity market. Liquidity and market
efficiency on India’s equity market will improve once the derivatives commence
trading.
3. Many risks in the financial markets can be eliminated by diversification. Index
derivatives are special in so far as they can be used by the investors to protect
themselves from the one risk in the equity market that cannot be diversified away,
i.e., a fall in the market index. Once the investors use index derivatives, they will
stiffer less when fluctuations in the market index take place.
4. Foreign investors coming into India would be more comfortable if the hedging
vehicles routinely used by them worldwide are available to them.
5. The launch of derivatives is a logical next step in the development of human capital
in India. Skills in the financial sector have grown tremendously in the last few years.
Thanks to the structural changes in the market, the economy is now ripe for
derivatives as the next area for addition of skills.

2.8 FACTORS AFFECTING GROWTH OF DERIVATIVES

Growths of derivatives are affected by a number of factors. Some of the important
factors are as below:
a) Increased volatility in asset prices in financial markets.
b) Increased integration of national financial markets with the international markets.
c) Marked improvement in communication facilities and sharp decline in their costa.
d) Development of more sophisticated risk management tools, providing economic
agents, a wider choice of risk management strategies.
e) Innovation in the derivatives markets, which optimally combine the risk and returns,
reduced risks as well as transactions costs as compared to individual financial assets.

2.9 SUMMARY
Derivatives markets have shown tremendous growth in recent years. Derivatives
help the economy achieved an efficient allocation of risk. They assist in completing
markets, theory providing firms and individuals with new investment opportunities.
Derivatives provide information to financial market participants and may help reduce
overall market volatility.

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2.10 SELF ASSESSMENT QUESTIONS
1. Bring out the historical development of Derivatives market in India.
2. Discuss the functions of Derivatives market.
3. Describe the Derivative markets structure.
4. Interpret major recommendations of L. C. Gupta committee.
5. What are the benefits of Derivative in India?

2.11 NOTES
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2.12 REFERENCES
1. Prafulla Kumar Swain., Fundamentals of Financial Derivatives, Himalaya Publishing
House.
2. Gupta S.L., Financial Derivatives Theory, Concepts and Problems, Delhi.
3. Kevin S. Commodity and Financial Derivatives, PHI Learning Private Limited, New
Delhi.
4. Kumar S.S.S. Financial Derivatives, New Delhi, 2000.
5. Stulz M. Rene, Risk Management & Derivatives, Cengage Learning, New Delhi.

44
UNIT-3 : REGULATORY AUTHORITIES AND
DERIVATIVE EXCHANGES IN INDIA

Structure :
3.0 Objectives
3.1 Introduction
3.2 Regulation of Derivatives Trading In India
3.3 Regulatory Objectives of Derivatives Market
3.4 Derivative Exchanges in India
3.5 Categories of Derivatives Trading and Regulatory Authorities in India
3.6 Otc Derivatives Market in India
3.7 Regulatory Framework for Otc Derivatives
3.8 Exchange-Traded Derivatives (Etd) Market in India
3.9 Summary
3.10 Self Assessment Questions
3.11 Case Study
3.12 Notes
3.13 References

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3.0 OBJECTIVES
After studying this unit, you should be able to;
• Know about the Regulations of Derivatives Trading in India.
• Beware about the Regulatory objectives of Derivatives Market.
• Understand the Derivatives exchanges in India.
• Know about the categories of Derivatives Regulatory authorizes in India.

3.1 INTRODUCTION
India has started the innovation in financial markets very late. Some of the recent
developments initiated by the regulatory authorities are very important in this
respect.Futures trading have been permitted in certain commodity exchanges. Mumbai Stock Exchange
has started futures trading in cottonseed and cotton under the BOOE and under the East
India Cotton Association. Necessary infrastructure has been created by the National Stock
Exchange (NSE) and the Bombay Stock Exchange (BSE) for trading in stock index futures
and the commencement of operations in selected scripts.

3.2 REGULATION OF DERIVATIVES TRADING IN INDIA

The regulatory frame work in India is based on L.C. Gupta Committee report and
J.R. Varma Committee report. It is mostly consistent with the International Organization
of Securities Commission (IOSCO). The L.C. Gupta Committee report provides a
perspective on division of regulatory responsibility between the exchange and SEBI. It
recommends that SEBI’s role should be restricted to approving rules, bye laws and
regulations of a derivatives exchange as also to approving the proposed derivatives
contracts before commencement of their trading. It emphasizes the supervisory and
advisory role of SEBI. It also suggests establishment of a separate clearing corporation
maximum exposure limits, mark to market margins, margin collection from clients and
segregation of clients funds, regulation of sales practice and accounting and disclosure
requirements for derivatives trading. The J.R. Varma committee suggests a methodology
for risk containment measures for index-based futures and options and single stock
futures. The risk containment measures include calculation of margins, position limits,
exposure limits and reporting and disclosure.

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3.3 REGULATORY OBJECTIVES OF DERIVATIVES MARKET
In India the derivatives trading activities are governed by the Securities Contract
(Regulation) Act1956 and the Securities and Exchange Board of India Act, 1992. The
framework for derivatives trading in India is laid down by L C Gupta Committee which
was constituted by SEBI. SEBI has also framed suggestive Bye Laws for Derivative
Exchanges/Segments and their Clearing Corporation/House, which lays down the
provisions for trading and settlement of derivative contracts. The suggestive Bye-Laws
become the base for any further changes in the Rules, Bye Laws & Regulations for
derivatives segment through exchanges and their clearing corporation/house. SEBI has
also laid out regulatory frameworks of the following activities for derivative trading in
India - Eligibility conditions for Derivative Exchange/Segment and its Clearing
Corporation/House; Types of Membership in the derivatives market in India; Eligibility
of indices and stocks for futures and option Trading; Minimum size of derivatives contract
and Measures to protect the rights of investor in Derivatives Market.
When derivatives were first introduced in India by L C Gupta Committee, it was
strongly opposed by the brokers of Bombay Stock Exchange (BSE) and National Stock
Exchange (NSE). But later the MD of NSE convinced the brokers and introduced
derivatives in India for which it had prepared constantly and thoroughly.
Regulatory objectives
The Committee believes that regulation should be designed to achieve specific,
well-defined goals. It is inclined towards positive regulation designed to encourage
healthy activity and behavior. It has been guided by the following objectives:
a. Investor Protection: Attention needs to be given to the following four aspects:
i. Fairness and Transparency:
The trading rules should ensure that trading is conducted in a fair and transparent
manner. Experience in other countries shows that in many cases, derivatives brokers/
dealers failed to disclose potential risk to the clients. In this context, sales practices
adopted by dealers for derivatives would require specific regulation. In some of the
most widely reported mishaps in the derivatives market elsewhere, the underlying reason
was inadequate internal control system at the user-firm itself so that overall exposure
was not controlled and the use of derivatives was for speculation rather than for risk
hedging. These experiences provide useful lessons for us for designing regulations.

47
ii. Safeguard for clients’ moneys:
Moneys and securities deposited by clients with the trading members should not only
be kept in a separate clients’ account but should also not be attachable for meeting the
broker’s own debts. It should be ensured that trading by dealers on own account is totally
segregated from that for clients.
iii. Competent and honest service:
The eligibility criteria for trading members should be designed to encourage
competent and qualified personnel so that investors/clients are served well. This makes
it necessary to prescribe qualification for derivatives brokers/dealers and the sales
persons appointed by them in terms of a knowledge base.
iv. Market integrity:
The trading system should ensure that the market’s integrity is safeguarded by
minimizing the possibility of defaults. This requires framing appropriate rules about
capital adequacy, margins, clearing corporation, etc.

3.4 DERIVATIVE EXCHANGES IN INDIA

Indian Derivative Exchanges are of two types, they are;
(i) Over the Counter (OTC) markets;
(ii) Exchange Traded Markets.
SBI and RBI are regulatory authority to permit the following stock exchanges for
Equity, Debt and Forex related derivatives.
(i) National Stock Exchange;
(ii) Bombay Stock Exchange;
(iii) United Stock Exchange; and
(iv) MCX-SX
It may be noted that Forward Markets Commission (FMC) headquartered at
Mumbai, is the regulatory authority under the Ministry of Consumer Affairs, Food and
Public Distribution, Govt. of India. It is a statutory body set up in 1953, under the Forward
Contracts (Regulation) Act 1952. It grants recognition to an association for commodity
derivative trading.

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The following are recognized derivative (commodity) exchanges in India.

Sl.
Commodity Exchanges
No.
1. Bhatinda Om & Oil Exchange Ltd., Batinda.
2. The Bombay Commodity Exchange Ltd., Mumbai
3. The Rajkot Seeds oil & Bullion Merchants` Association Ltd
4. The Kanpur Commodity Exchange Ltd., Kanpur
5. The Meerut Agro Commodities Exchange Co. Ltd., Meerut
6. The Spices and Oilseeds Exchange Ltd.
7. Ahmedabad Commodity Exchange Ltd.
8. Vijay Beopar Chamber Ltd., Muzaffarnagar
9. India Pepper & Spice Trade Association, Kochi
10. Rajdhani Oils and Oilseeds Exchange Ltd., Delhi
11. National Board of Trade, Indore
12. The Chamber Of Commerce, Hapur
13. The East India Cotton Association, Mumbai
14. The Central India Commercial Exchange Ltd., Gwalior
15. The East India Jute & Hessian Exchange Ltd.
16. First Commodity Exchange of India Ltd, Kochi
17. Bikaner Commodity Exchange Ltd., Bikaner
18. The Coffee Futures Exchange India Ltd, Bangalore
19. Esugarindia Limited
20. National Multi Commodity Exchange of India Limited
21. Surendranagar Cotton oil & Oilseeds Association Ltd
22. Multi Commodity Exchange of India Ltd
23. National Commodity & Derivatives Exchange Ltd
24. Haryana Commodities Ltd., Hissar
25. e-Commodities Ltd.

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 Of these 25 commodities exchanges the MCX, NCDEX and NMCEIL are the
major Commodity Exchanges.
a. Multi commodity exchange of India Ltd.:
MCX is an independent and de-mutualized exchange based in Mumbai. Established
on 10 November, 2003, it is the third largest bullion exchange and fourth largest energy
exchange in the world. Recognized by the Government of India it deals in numerous
commodities and carries out online trading, clearing and settlement processes for
commodities future marketcountrywide.MCX COMDEX is India’s foremost and sole
composite commodity futures price index.
b. National Commodity & Derivatives Exchange of India Ltd (NCDEX):
It is located in Mumbai, is a public limited company incorporated on 23rd April
2003. Promoted by national level establishments it is run by professional management.
Regulated by the Forward Market Commission with reference to futures trading in
commodities, it trades in various commodities online. The NCDEX is covered by:
1. Companies Act
2. Stamp Act
3. Contracts Act
4. Forward Commission (Regulation) Act
c. National Multi-Commodity Exchange of India Limited (NMCEIL):
It is considered the first de-mutualized, online exchange dealing in numerous
commodities. Incorporated on 20th December 2001, it is promoted and run by:
1. Central Warehousing Corporation
2. National Agricultural Cooperative Marketing Federation of India Limited
3. Gujarat Agro Industries Corporation Limited
4. National Institute of Agricultural Marketing
5. Gujarat State Agricultural Marketing Board
6. Neptune Overseas Limited
The Commodity Exchanges with their extensive reach embrace new participants,
resulting in a powerful price discovery process.

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3.5 CATEGORIES OF DERIVATIVES TRADING AND
REGULATORY AUTHORITIES IN INDIA
There are six categories of derivatives traded in India. These are regulated by the
appropriated regulatory authorities in India. A brief outline of these derivatives are as
follows:

1. Commodity Futures:
Derivative Contract Underlying Asset Regulatory Authority
Commodity Futures Coffee, oil seeds oil, gold, Forward Market Commission
silver, pepper, cotton, jute
2. Index Futures: It is contract on a stock index or other index:
Single Index Futures Sensex Index, NIFTY Index SEBI
3. Forward Rate Agreement:
FRA / Interest Rate Swap Short-term security of RBI
(IRS) national principal
4. Stock Option:
Stock Options Individual Shares SEBI through NSE & BSE
5. Stock Futures on Individual Securities:
Futures on Individual Stocks SEBI through NSE and BSE
Security
6. Interest Rate Futures:
Interest Rate Futures 91-days T-Bills RBI
19 Years Bonds
10 Years Zero Coupon
Bonds

3.6 OTC DERIVATIVES MARKET IN INDIA

Over-the-counter (OTC) contracts are bilaterally negotiated between two parties.
There is no fixed expiry date of OTC contracts and are often customized to fit the specific
requirement of the user. In the recent year, the OTC derivatives market has witnessed a
tremendous growth across the world due to their flexibility, low operating cost and zero
regulatory cost. However the OTC contracts have substantial credit risk borne by the
counter party default.

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3.7 REGULATORY FRAMEWORK FOR OTC DERIVATIVES
In India, the regulations of all OTC derivatives are completely within the purview
of the RBI. Legally, the RBI received this power from the Reserve Bank of India Act,
1935, the Banking Regulation Act, 1949, the Foreign Exchange Management Act, 1999
and the Securitization and Reconstruction of Financial Assets and Enforcement of
Security Interest Act, 2002 (Gopinath 2010). The Reserve Bank of India (Amendment)
Act, 2006 was a key milestone for regulation of OTC interest rate, foreign currency and
credit derivatives. According to this Act, at least one of the parties in OTC derivatives
transaction should be a RBI regulated entity. To start with, RBI permitted Primary Dealers
(PDs)16, all scheduled commercial banks (SCBs) excluding regional rural banks and
the financial institutions17 to undertake transactions in interest rate swap (IRSs) and
forward rate agreements (FRAs) for their own balance sheet management and also for
the purpose of market making. The non-financial institutions have been allowed to use
IRS and FRA to hedge their exposure.

3.8 EXCHANGE-TRADED DERIVATIVES (ETD) MARKET IN INDIA

Two exchanges in India have been permitted to trade in derivatives contracts, the
National stock exchange (NSE) and the Bombay stock exchange (BSE). NSE’s
contribution to the total turnover in the market is nearly 99%. Hence, the market design
enumerated in the study is the derivative segment of NSE. The different aspects of market
design for Future and Option segment of the NSE can be summarized as follows:
Trading Mechanism :
The future and option trading system of NSE, called NEAT-F&O trading system,
provides a fully automated screen-based trading for Index futures and options and stock
futures and options on a nationwide basis as well as on line monitoring and surveillance
mechanism. It supports an order driven market and provides complete transparency of
trading operations.
There are four entities in the trading system as follows:
i) Trading members who can trade either on their own account or on behalf of their
clients including participants.
ii) Clearing members who are members of National Securities Clearing Corporation
Limited (NSCCL) and carry out risk management activities and confirmation /
inquiry of trades through the trading system. These clearing members are also
trading members and clear trades for themselves and/or others.

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iii) Professional clearing members (PCMs) are clearing members who are not trading
members. Typically, banks and custodians become PCMs and clear and settle for
their trading members.
iv) Participants who are client of trading members like financial institutions. These
clients may trade through multiple trading members, but settle their trades through
a single clearing member only.

3.9 SUMMARY
This unit explores about Derivatives trading in India, regulatory objectives of
Derivatives market, Derivatives exchanges in India, Derivatives trading and regulatory
authorities in India and OTC and ETD market in India.

3.10 SELF ASSESSMENT QUESTIONS

1. Discuss regulation of Derivatives Trading in India
2. What is meant by Derivatives Regulatory Authorities?
3. Describe Derivatives exchange in India
4. Difference between OTC market and ETD market

3.11 NOTES
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3.12 REFERENCES
1. Prafulla Kumar Swain., Fundamentals of Financial Derivatives, Himalaya
Publishing House.
2. Gupta S.L., Financial Derivatives Theory, Concepts and Problems, Delhi.
3. Kevin S. Commodity and Financial Derivatives, PHI Learning Private Limited,
New Delhi.
4. Kumar S.S.S. Financial Derivatives, New Delhi, 2000.
5. Stulz M. Rene, Risk Management & Derivatives, Cengage Learning, New Delhi.

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UNIT-4: PARTICIPANTS IN DERIVATIVES MARKET

Structure :
1.0 Objectives
4.1 Introduction
4.2 Derivatives Market Participants
4.3 Risks Faced by Participants
4.4 Participants in Future Market
4.5 Future Market Trading Mechanism
4.6 The Facilitators of Future Trading
4.6.1 Exchange
4.6.2 The Clearing House
4.6.3 The Floor Broker
4.6.4 The Regulators of Futures Contracts and Market
4.7 Summary
4.8 Self Assessment Questions
4.9 Case Study
4.10 Notes
4.11 References

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4.0 OBJECTIVES
After studying this unit, you should be able to;
• Understand the participants in Derivative Market.
• Analyse the Risks faced by the participants.
• Describe the participants in future market.
• Understand the structure of Future Market Trading Mechanism.

4.1 INTRODUCTION
Derivative contracts have several variants. The most common variants are forwards,
futures, options and swaps. The following three broad categories of 4— participants -
hedgers, speculators, and arbitrageurs trade in the derivatives market. Hedgers face risk
associated with the price of an asset. They use futures or options markets to reduce or
eliminate this risk. Speculators wish to bet on future movements in the price of an asset.
Futures and options contracts can give them an extra leverage; that is, they can increase
both the potential gains and potential losses in a speculative venture. Arbitrageurs are in
business to take advantage of a discrepancy between prices in two different markets. If,
for example, they see the futures price of an asset getting out of line with the cash price,
they will take offsetting positions in the two markets to lock in a profit.

4.2 DERIVATIVES MARKET PARTICIPANTS

Greater liquidity among the traders has increased the growth of derivatives market
worldwide. Finding a party to a contract has become an easier job. The different types of
traders in derivatives market are;
a) Hedgers
b) Speculators
c) Day Traders / Scalpers;
d) Floor Trader; and
e) Arbitrageurs.
a) Hedgers:
Hedger is a user of the market, who enters into futures contract to manage the
risk of adverse price fluctuation in respect of his existing or future asset. Hedgers are

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those who have an underlying interest in the commodity and are using futures market to
insure themselves against adverse price fluctuations. Examples could be stockists,
exporters, producers, etc. They require some people who are prepared to accept the
country-party position(speculators).
b.Speculators:
A trader, who trades or takes position without having exposure in the physical
market, with the sole intention of earning profit is a speculator. Speculators are those
who may not have an interest in the ready contracts, etc. but see an opportunity of price
movement favourable to them. They are prepared to assume the risks, which the hedgers
are trying to cover in the futures market. They provide depth and liquidity to the market.
They provide a useful economic function and are an integral part of the futures the market.
It would not be wrong to say that in absence of speculators the market will not be liquid
and may at times collapse.
c. Day Traders:
Day traders take positions in futures or options contracts and liquidate them prior
to the close of the same trading day. A floor trader is an Exchange member or employee
of a member, who executes trade by being personally present in the trading ring or pit.
The floor trader has no place in electronic trading systems.
d. Floor Traders:
A floor trader is an Exchange member or employee of a member, who executes
trade by being personally present in the trading ring or pit. The floor trader has no place
in electronic trading systems.
e. Arbitrager:
Arbitrage refers to the simultaneous purchase and sale in two markets so that the
selling price is higher than the buying price by more than the transaction cost, resulting
in risk-less profit.

4.3 RISKS FACED BY PARTICIPANTS

The different kinds of risks faced by participants in derivatives markets are:
a. Credit Risk;
b. Market Risk;
c. Liquidity Risk;

58
d. Legal Risk; and
e. Operational Risk.
a. Credit Risk:
Credit risk on account of default by counter party: This is very low or almost
zeros because the Exchange takes on the responsibility for the performance of contracts.
b. Market Risk:
Market risk is the risk of loss on account of adverse movement of price.
c. Liquidity Risk:
Liquidity risks is the risk that unwinding of transactions may be difficult, if the
market is illiquid
d. Legal Risk:
Legal risk is that legal objections might be raised, regulatory framework might
disallow some activities.
e. Operational Risk:
Operational risk is the risk arising out of some operational difficulties, like, failure
of electricity or connectivity, due to which it becomes difficult to operate in the market.

4.4 PARTICIPANTS IN THE FUTURES MARKET

There are two main participants within a futures market.
a. Hedgers; and
b. Speculators.
a. Hedger:
Hedging is done to manage price risk. Hedgers wish to protect themselves from
unfavorable price movement by foregoing a profit if the price moves in their favor. There
are different reasons why hedging might be undertaken. A wheat farmer can hedge against
a possible price decline in the future and on the other hand a cookie maker can hedge
against an increase in the price of wheat in the future. A lender can hedge against a possible
decline in the interest rate, whereas a borrower can hedge against a possible increase in
the interest rate. To hedge, you either have the underlying commodity (ie. Farmer) or
you require the underlying commodity at some point in the future (ie. Baker)

59
TYPES OF HEDGING
1. Short hedging:
Here the producer of a particular commodity wants to ensure that they get at least
a given price in the future. If the price of a bushel of wheat for a December contract is
currently $8.50 and the farmer feels that due to whatever reasons he might not be able to
get more than this price in the future, he can enter into a contract to sell wheat at $8.50/
bushel in December. Let us suppose that he has made a contract of 10,000 bushels. If the
price of wheat in December is $8.10/bushel he would still be getting $8.50/bushel as
per the contract. Hence the final amount he is able to get is $85,000($8.50*10000). If
he did not hedge he would have got $81,000 by selling the wheat in the open market.
Hence he is able to get a profit of $4,000 and is able to protect his income through
hedging. On the flip side if the open market price of wheat increases to $9.50/bushel he
would have made $95,000 by selling the wheat in the open market. But because of the
contract he is able to get only $85,000 giving him a loss of $10,000. Besides the profit
the major advantage is that he knows the amount he will get on his crop which allows
him to plan accordingly for the season.
2. Long Hedging:
A jeweler can hedge for Gold as a consumer of the commodity. If gold is trading
at $1200.00 per troy ounce in the 6 month future contract and the jeweler feels that the
price of gold will increase he can purchase a contract to buy gold at $1200.00 6 months
from now. This way if the price of gold increases he will be protected from the unfavorable
price movement as a consumer of the commodity. Let us say that the price of gold
increases to $1260.00 in 6 months and he has purchased a contract to buy 100 troy
ounces of gold. He will have to give $120,000 to purchase the gold instead of spending
$126,000 in the open market. Hence he has been able to reduce his cost by $6,000.
However if the price of gold decreases to $1,150 in 6 months he still has to spend
$1,200 per troy ounce to purchase gold. Here his net loss would be $5,000. Again here
the major benefit is that it will allow smoother functioning of his operations. Due to
sudden changes in the market he does not have to change his operations.
b. Speculators:
The other part of futures market is made of speculators. They provide liquidity to
the market. If a farmer wants to short sell a contract for 5,000 bushels of wheat expiring
in 3 months it is highly unlikely that he will immediately find another consumer who
wants to long buy a similar amount of wheat at the same time. The speculators, although

60
they do not have any interest in the underlying asset or commodity, still buy the contract
looking to profit through ideal market timings. This helps the entire system by bringing
in much needed liquidity.
TYPES OF SPECULATORS
1. Going Long:
If a speculator believes that the price of a commodity will increase in the future
he will buy or “go long” a futures contract. If the price does increase in the future he will
be able to get a profit by selling the contract at a higher price. For example a trader
believes that the value of crude oil will increase in the future. The current price for a
December contract of 1000 barrels is $90 per barrel. In 2 weeks the price of the contract
increases to $92 per barrel. Selling the contract in two weeks will give him a profit of
$2,000. However if the price of the contract decreases he stands to lose.
2. Going Short:
If a speculator believes that the price of a commodity will decrease in the future
he can sell a futures contract now. When the price has decreased he can buy back the
contract at a lower price to cover his position. For example a trader sells a December
contract of 1000 barrels for crude oil at $88 per barrel. In 1 week the price of oil
decreases to $85, he can now buy the contract and effectively cover or offset his position.
This will give him $3 per barrel profit or $3,000 profit on the entire contract. Generally
stop-loss and several other strategies are used to ensure that the losses are not magnified
and one can get good returns from the trade.

4.5 FUTURE MARKET TRADING MECHANISM

Futures contracts are traded on an organized exchange and the contract terms are
standardized by that exchange. The trading process of futures contracts are based on the
following elements:
1. Futures Contract Design
2. Futures Market Operational Guidelines
3. Derivatives Trading Regulations
4. Futures Contract Delivery cum Settlement Procedure

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FUTURES CONTRACT DESIGN
Futures are exchange traded contracts. The term of the contracts are standardized
by the exchanges. The most important principle for designing a future contract is to take
into account the systems and practices being followed in the cash market. A well-designed
futures contract is based on the following foundation:
(A) The Parties:
The traders and investors are the original parties to a future contract. They are the
buyers and sellers of futures contracts.

Classification of Traders in a Futures Exchange

Trade Member Clearing Member Self-clearing Member Professional

Clearing Member

1. Trading Member:
He trades on his own behalf and on behalf of his own clients. The exchange assigns
a trading member ID to each trading member. There may be more than one user of each
TM. The exchange notifies the number of users allowed for each TM. Each user of the
TM must be registered with the exchange. Accordingly, the Exchange assigns a unique
user ID to each user. The unique trading member ID functions as a reference for all
orders / trades of different users. This ID is common for all users of a particular TM.
2. Clearing Member:
Generally, a clearing member performs the settlement obligations of his own
trading claims as well as the trading claims of other non-clearing members.
3. Self-Clearing Members:
When a member trades, clears and settles his own trade only he is called a self-
clearing member.
4. Professional Clearing Member:
He performs only clearing functions only. He does not trade on his own account
or on behalf of his client.

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4.6 THE FACILITATORS OF FUTURES TRADING
The facilitators support the original traders for smooth functioning of futures
deal. These facilitators are:
1. The Exchange
2. The Clearing House
3. The Brokers
4. The Regulators
4.6.1 EXCHANGE
An exchange itself does not trade but acts like a facilitator. In India, there are two
categories of future exchanges, i.e. Commodity Future Exchanges and Financial Future
Exchanges. All the commodities are not suitable for future trading. For a commodity to
be suitable for future trading, it must possess the following characteristics.
a. The commodity should have s suitable demand and supply conditions, i.e., volume
and marketable surplus should be large.
b. Prices should be volatile to necessitate hedging through future trading. In this
commitment face a price risk. As a result, there should be a demand for hedging
facilities.
c. The commodity should be free from substantial control from Government
regulations imposing restrictions on supply, distribution and prices.
d. The commodity should be homogeneous or alternatively it must be possible to
specify a standard grade and to measure deviations from that grade. This
condition is essential for the futures exchange to deal in standardized contracts.
e. The commodity should be storable. In the absence of this condition, arbitrage
would not be possible and there would be no relationship between the spot and
futures market.
The Securities and Exchange Board of India has permitted the following stock
exchanges to facilitate the futures trading in India:
1. Bombay Stock Exchange
2. National Stock Exchange
3. United Stock Exchange

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4.6.2 THE CLEARING HOUSE
Every futures exchange has a clearing house associated with it which clears all
the transactions of that exchange. A cleaning house is a financial institution that provides
clearing and settlement services for financial and commodity derivatives and securities
transactions.
4.6.2.1 Constitution and Status of a Clearing House
A clearing house may be formed as a separate body corporate or it may be a part
of the future exchange. It carries the obligation to clear all the transactions of the
affiliating or constituent future exchange. For example, National Securities Clearing
Corporation Limited (NSCCL) acts as the clearing house of National Stock Exchange
(NSE).
A clearing house acts as an intermediary between two traders (Clearing Members)
with an obligation to reduce the risk of one of such clearing member when the
counterparty fails to honour the trade obligation. It has a number of members who are
only allowed to trade. Sometimes, brokers or commission merchants who are not clearing
house members, they may channel their trade transactions through the clearing member.
4.6.2.2 Functions of a Clearing House
An associated clearing house is an integral part of derivative exchange. It performs
the following important functions.
1. It Acts a Legal Counterparty to the Buyer as well as seller: First, the buyers and
sellers agree to price, quantity, quality, expiration month and the underlying asset
etc. as per the specification of the exchange. The moment the deal is concluded, the
clearing house act as a third parties to all future contracts – as a buyer to every
clearing member seller and a seller to every clearing member buyer. In other words,
the clearing house assumes the obligation to buy the seller’s contract and to sell it
the buyer. As a result, the original parties to the trade will have to deal only with the
clearing house. Because the clearing house is the trade to both parties, they don’t
have to worry about performance of the contract. Furthermore, the clearing house
allows each trader to close out his position independently of the other. It may be
notes that in case of cash market, the intermediary will never become the legal
counterparty to the transactions, but in case of futures derivative, the clearing house
plays a distinct role as a legal counterparty to both the buyer and seller.

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2. It Records and Settles the day-do-day Trading Results: At the beginning, a clearing
member enters his futures order. He should clearly specify whether the transaction
is his own or his client. Accordingly, the clearing house records all transactions and
works out the open positions of all the trading members. Thus:

3. It gives Guarantee to the Performance of Future Contracts: A clearing house acts as

a legal counterparty to both buyers and sellers of future contracts. It regulates,
monitors and protects the clearing members. It gives guarantee to the performance
of all future contracts. As netting is permissible, so a clearing house normally adopts
the facility of clearing on a net basis.
4.6.3 THE FLOOR BROKER
A floor broker is a person who executes transactions on the trading floor on
behalf of clients of a firm (member of an exchange). In contrast with the floor trade
who makes deals on his or her own behalf?
Floor brokers take the responsibility for executing the orders to trade futures
contracts that are accepted by the clients. These stock market professionals can work
for client firms of all sizes, and they may specialize in a particular type of commodity,
or work more generally in a stock exchange.
4.6.3.1 Functions of Floor Broker:
A floor broker is also known as pit broker. He receives order from his client firm
and executive the order on the floor. His objective is to get the best deal, whether he
involves in buying or selling for the clients. Once the order is completed, it is recorded
and the client is informed that the deal has been successfully completed. One of the

65
advantages of working as a floor broker is that one is not exposed directly to risks of
market volatility when a deal goes badly.
A floor broker should be capable to deal with a wide range of personalities, and to
deal with a past paced work environment. He should possess some more basic skills like
his ability to clearly project his voice in the floor so that he can be heard over the din of
the trading floor, and the aggressiveness to make a good trade and confirm it.
Every exchange has slightly different conventions and rules which floor brokers
must become familiar with. It conducts specialized training programmes for the floor
brokers to update their skills.
4.6.4 THE REGULATORS OF FUTURES CONTRACTS AND MARKET
To regulate the future derivatives each nation has set up the statutory regulators.
In India, the following regulatory system is in practice:
a. For Commodity Futures: Forward Contracts (Regulation) Act, 1952 was passed
in India. It is implemented by Forward Market Commission under Ministry of
Consumer Affairs, Food and Public Distribution, Government of India.
b. For Financial Futures: The Securities Contract and Regulation Act (1952) was
passed. It is implemented by SEBI since 1992 (the year of set-up).

4.7 SUMMARY
This unit discussed about the Derivatives Market Participants, Risks faced by the
participants, Future Market Trading Mechanism. The role of facilitators in future trading
isalso discussed in the length. An account of functions of floor brokers is given in this
unit.
4.8 SELF ASSESSMENT QUESTIONS
1. Who are the participants in forward / future markets? Discuss.
2. What kinds of risks do participants face in derivatives market?
3. Briefly discuss the functions of clearing house in a future market.
4. Discuss the role of various facilitators in futures market.

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4.9 CASE STUDY
Case Study 1
You are back in Mumbai after a grueling day in New Delhi. You were called by
themandarins in the North Block to explain the cause of the crash in the price of the
stock of your company- a leading Indian Software MNC. The investors were aghast at
the stock price crash. The main charge was simple. Your company used futures trading
for speculation Instead of normal hedging.
Before you can get out of our Shining Merc (which might get auctioned soon)
mediapersonsare already all over the place thrusting microphones in your face- waiting
for a sound bite. You barely mumble ‘no comments’ to the gathering but promise to get
back with detailed description of events, to be transmitted live on the television, in a
couple of hours.
As you sit down at your office table, and call for a RT (room-temperature) glass
of Narial paanee (coconut water)-Since your friends tell that it is god when you have
hyperacidity; you need a strong stomach lining to digest all the vitriol being offered to
you.
When you look at the documents spread in front of you, the following details
emerge:
(a) Since the exposure of your company is in USD, you chose to buy 6-month USD
futures at a price that was above spot price for a long time, and you sell GBP
futures for 9-months since pricing is very attractive, and you are expecting to
receive payments for services rendered in about 8-months’ time.
(b) As the maturity of USD futures approached, US of A attacked Iraq, leading to a
jump in oil prices.
(c) Sensing trouble you immediately bought 3-months interest rate futures which
weretrading below spot.
(d) Within a week of your purchase, markets started stabilizing and returned to normal
behavior.
(e) But your board was uncomfortable with your position, and margin calls. They ask
you to settle your position and face the jury, charging you for speculation in the
markets with company money.

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Questions
1. What additional information will you need?
2. How will you defend your case?

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4.11 REFERENCES
1. Prafulla Kumar Swain., Fundamentals of Financial Derivatives, Himalaya Publishing
House.
2. Gupta S.L., Financial Derivatives Theory, Concepts and Problems, Delhi.
3. Kevin S. Commodity and Financial Derivatives, PHI Learning Private Limited, New
Delhi.
4. Kumar S.S.S. Financial Derivatives, New Delhi, 2000.
5. Stulz M. Rene, Risk Management & Derivatives, Cengage Learning, New Delhi.

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 MODULE- II
FORWARDS AND FUTURES

UNIT - 5 : INTRODUCTION TO FORWARDS AND

FUTURES

Structure:

5.0 Objectives
5.1 Introduction
5.2 Forwards
5.3 Features of Forwards
5.4 Futures
5.5 Features of Futures
5.6 Socio-Economic Benefits of Futures
5.7 Futures V/s Forwards
5.8 Types of Futures
5.9 Notes
5.10 Case Study on Speculation / Hedging
5.11 Summary
5.12 Key Words
5.13 Self Assessment Question
5.14 References

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5.0 OBJECTIVES
After studying this units, you will be able to:
• Understand the basic meaning of forwards and futures,
• Clearly distinguish between forwards and futures,
• Grasp why futures are traded
• Make a list of different futures contracts traded

5.1 INTRODUCTION
The forward contract is the most basic derivative contract. It just represents a
commitment today to transact in the future. Forward markets for future delivery of
commodities have been in existence for many centuries. Organized futures markets, however,
are a relatively modern development dating only to the 19th century. Futures markets replace
informal and privately traded forward contracts with highly standardized exchange-traded
securities. Futures contract is simply the standard version of a forward contract. A
considerable terminology surrounds these contracts. This unit introduces basic terminology
and features of forward contracts vis-à-vis futures contracts and the mechanics of trading in
these markets, followed by a brief note about pricing of these contracts.

5.2 FORWARDS
A forward contract is an agreement to buy or sell something in the future. The
agreement is made today to exchange cash for a good or service at a later date. This differs
from a spot transaction, where one party pays for a good or service, and immediately receives
that good or service. In a forward contract there are two parties: the buyer and the seller. The
buyer is said to have a long position, and seller a short position. The terms of the contract are
agreed upon today, and delivery and payment take place in the future, at what is called either
the delivery date, the settlement date, or the maturity date of the contract.
Money rarely changes hands when a forward contract is originated. Payment from the
buyer of the forward contract to the seller is generally made only upon the delivery of the
good. On the day that forward contract is originated, both parties face potential default risk,
arising out of uncertainty concerning the other party’s ability and willingness to fulfill the
terms of the contract. For most of the forward transactions, there is no system to ensure
performance of the contract.

72
 A forward contract is to buy or sell a specific good on a specific future date; at a
specified price. This price is called the forward price. Thus, a jewellery firm may agree
today to buy 1000 grams of gold 3 months hence, at Rs.27550/10 gms. The forward price is
Rs.27550/10gms. The forward price is likely to differ from the spot price, which is today’s
price for delivery of gold today. There may be many forward prices, one for each possible
delivery date. For example, the forward price for delivery 6 months hence may be Rs.27890/
10 gms.
A fair forward price will result in a forward contract that has no value when it is
originated. Subsequently, the forward contract will likely become valuable for only one of
the two parties. For the party that has a long position, the contract will have a positive value,
or become an asset, when the forward price (for delivery on the settlement date of the original
contract) rises.
For example, suppose that today is March 1, and Mr. X has agreed to buy gold 3
months hence, on June 1, at a price of Rs.27550/10 gms. The next month (say April 1), Rs.
27590/10 gm is the fair price for delivery of gold on June 1, (note that this is no longer a 3-
month forward contract; it is a 2-month forward contract . Mr. X’s long position now valuable.
He has a contract that entitles him to buy gold at Rs.27550/10 gms. But new agreements,
being originated on April 2, have a forward price of Rs.27,590/10 gms. His contract to buy
gold at only Rs.27550/10 gms is a “bargain”. The contract is a valuable asset for Mr.X. It
then follows that the forward contract to sell gold at Rs.27550/10 gms has become a liability
for the counterparty to the forward contract. The seller of the forward contract is obliged to
deliver gold on June 1,at only Rs.27,550/10 gms, while new contracts are being created to
sell gold at a higher price. Forward contracts, like all derivatives, are zero-sum games.
Whatever one party gains, the other party must lose.

Table 1: Profit/Loss on a Forward Contract

Position Forward Price
Rise Fall
Long a forward contract profit loss
Short a forward contract loss profit
Table 1 summarises how the parties that are long and short a forward contract make
profit or incurr losses when forward prices change from the original forward price that was
agreed upon in the original contract.

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 The profits and losses associated with forward contracts are typically realised at
delivery. Before delivery, as forward prices for delivery on the settlement date of the original
contract fluctuate, each party could experience unrealised gains and losses. For either party,
the forward contract may change from being an asset on some dates to being a liability. But
the actual profit or loss is realised only on the delivery date. Payoff profile of forward contract
on gold is demonstrated in table 2 with the assumed gold price in the spot market on expiry
date of the contract.
Table 2 : payoffs to long and short positions
Spot price of gold in Payoff to forward contract (per gram)Rs
4month(per gram)Rs
(Forward Price = 2900/g)

Long Position Short Position

3400 500 -500

3200
300 -300
3000
100 -100
2800
-100 100
2600
-300 300
2400
-500 500

Many forward contracts are cash settled. This means that no delivery takes place on
the settlement date. The party with the profitable position receives a cash payment from the
party with the loss position.
Traders and firms around the world transact in forward markets. There are well
developed forward markets in many commodities such as coffee, rubber, etc., and precious
metals such as gold. Forward contracts do not trade on organised exchanges. Instead, firms
usually trade with financial institutions that make markets in forward contracts. This market
is often called the OTC market; or the over-the-counter market.
Before winding up the discussion on forwards, the following unique features may be
noted:

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5.3 FEATURES OF FORWARDS
a) Forwards are transactions involving delivery of an asset or a financial instrument at a
future date, and therefore, are over-the-counter (OTC) contracts. OTC products are
customized contracts which are written across the counter or struck on telephone,
fax or any other mode of communication by financial institutions to suit the needs of
their customers.
b) Both the buyer and seller are committed to the contracts. They have to take delivery
and deliver respectively, the underlying asset on which the forward contract was entered
into.
c) Forwards perform the function of ‘price – discovery’ for commodities and financial
assets. Both the buyer and seller of a forward contract are fixed to the price decided
upfront.
d) As there is no performance guarantee in a forward contract, there is always counterparty
risk.
e) In most cases, one of the counterparties of a forward contract is a banker or a trader
squaring up his positions by entering into reverse contracts. These transactions do
not take place simultaneously, so the banker or trader will normally keep a large bid-
ask spread to avoid any loss due to price fluctuations. This procedure increases the
cost of hedging.

5.4 FUTURES
A futures contract is an agreement to buy or sell an asset at a certain time in the future
for a certain price. It is an agreement to deliver (sell) or take delivery (buy) of a standardised
quantity of an underlying commodity/instrument, at a pre-established price agreed on a
regulated exchange at a specified future date.
Futures have evolved out of forwards and are exchange – traded versions of forward
contracts. They are one of the most popular and widely used derivative instruments.

5.5 FEATURES OF FUTURES

a) Futures are traded on organized exchanges with clearing associations that act as
intermediaries between the contracting parties.
b) Futures are standardised contracts that provide for the performance of the contract
either through deferred delivery of an asset or a final cash settlement.

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c) Both the parties pay a margin to the clearing association. This is used as a performance
bond by contracting parties. The margin paid is generally marked to the market price
every day.
d) Each futures contract has an association month which represents the month of contract
delivery or final settlement, for example – a September T-bill, a March Euro, A November
Nifty futures, etc.

a) Why Futures are traded?

Futures contracts are bought and sold by a large number of individuals and businesses,
and for a variety of purposes. Most individuals buy and sell futures because they wish to
speculate about future price levels of the commodity that underlies a futures contract, whether
it is silver, gold, corn, or crude oil. Businesses usually buy and sell futures for the opposite
reason: to eliminate (or hedge) their risk exposure due to changes in the price of a commodity.
Managers of a large pools of money, such as pension funds or mutual funds, may also use
futures as a less costly way of achieving their portfolio goals.
(a) Speculation
It is easier for traders to take bigger deals in futures market with small investment
than in the cash market as shown in box 1.
Box 1 Trading in Futures Vs Cash Market
Company X : Desired position: 1000 shares
_________________________________________________________________
Future Market Cash Market
_____________________________________________________________________

* Current stock price: Rs.200 * Current stock price : Rs.200

* Required Margin : 11% * Value of purchase : Rs.2,00,000
(200 x 1000)
* Margin Money available Rs.22,000
* Value of purchase : Rs.2,00,000
………………………………………………………………………………………
Total Money required to take position in 1000 shares

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 Rs.22,000 Rs. 2,00,000
…………………………………………………………………………………………
If the stock price goes up by 10%
* profit =Rs.20,000 * profit Rs.20,000
(2,00,000 x 10 )
100
* Gain on amount invested * Gain on amount invested
(20,000 x 100) = 92% ( 20,000 x 100 ) = 10%
22,000 2,00,00
…………………………………………………………………………………………
If the stock price falls…………..

* Loss is equal in both the markets

* Extra margin required to roll over F & O position
Speculators buy and sell futures contracts with the expectation of making windfall
gains from changes in the price of the underlying commodity. A speculator who believes that
gold prices will be higher in the future may buy gold now and hold it until a future time when
he can sell it at the higher price. This is something not everyone may be willing to do, since
it involves taking delivery of gold bullion and storing it. Another alternative is for speculators
to buy a futures contract that permits them to take delivery of gold at some time in the future,
presumably at a time when the price of gold is higher. Of course, for this strategy to be
profitable, the futures price that a speculator pays now will have to be les than the price he
will be able to sell the gold for after he takes delivery. Assuming that current futures prices
are below what our speculator thinks gold prices will be in the future, he will buy a futures
contract today, plan to take delivery (or otherwise offset his delivery obligation) of the gold
at some point in the future, and then sell the gold at the later time for a profit. If he is wrong,
and gold prices do not rise but in fact fall, the speculator will lose money. Thus trading
futures is an easy and low-cost way for speculators to make bets on the future prices of
various commodities.

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(b) Hedging
Hedgers seek to protect themselves against price changes in a commodity in which
they have an interest. They take a futures position with the objective of reducing their risk.
Speculators, in contrast, willingly take an additional risk with the objective of profiting from
price changes.
Take the simple case of a farmer, who has planted his cotton crop and is waiting to
harvest it. He does not know the price at which he will be able to sell the cotton once it is
harvested. Suppose that it is now April and that the farmer anticipates that he will be ready to
sell his cotton by next September, five months from today. Although the current price of
cotton is know, no one knows what the price of cotton will be in five months – it might be
higher or lower.
The farmer is exposed to price risk. The price of cotton will fall significantly before
he has a chance to bring the cotton to market and sell it. The futures markets enable the
farmer to hedge (or reduce) his price risk. He can accomplish this by selling his cotton now,
for future delivery: by simply selling (or shorting) September cotton futures contracts. For
example, he can agree now, in April, to sell (or deliver) his cotton in September when he
harvests it, at a price that he agrees to now (in April).
The price that the farmer will have agreed to sell cotton in September is the current
price that is quoted for the September cotton futures contract. This price reflects the market’s
best guess as to what the price of cotton will be next September. This guess, of course, could
turn out to be wrong: the price might be much higher or lower than everybody now thinks it
will be. Many things can happen between April and September . For example, the weather
maybe very dry, making crop yields low. This would cause a sharp rise in prices. Or the
opposite could occur. Whatever happens, our farmer, by shorting futures contracts, is
protected. He has locked in his selling price. He no longer has any price risk. If he had not
hedged, on the other hand, lower prices might have significantly reduced his income.

5.6 SOCIO-ECONOMIC BENEFITS OF FUTUREs

An interesting question would be: why do futures contracts exist? Do they serve any
useful purpose, or are they merely gambling instruments that have created speculation –
based price volatility? Futures markets exists for several reasons:
a) Futures prices contain information. This is called “price discovery” function of futures.
Commodity producers and consumers can get to know what the future spot price will
be, and what future supply and demand of a good will be, by observing the current futures
price. This would help them make better production and storage decisions.

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b) The economic benefits of having a more accurate price estimate in advance are well
known. More accurate price estimates result in a superior allocation of resources as
both producers and consumers make better decisions about which commodities to
produce, which to consume, how much to produce and consume in the present versus
the future.
c) Futures make transactions across time easier. They allow firms and individuals to quickly
create low cost agreements to exchange money for goods at future times. The transactions
costs of trading futures are minimal relative to the rupee amount of the commodity
underlying most contracts.
d) Futures allow businesses and individuals to hedge against undesirable price changes.
Genuine producers and uses of commodities need not bother about unexpected price
volatilities. They can transfer price risk to speculators and concentrate on doing what
they do best: produce and use.
So long as futures are used for genuine hedging purposes, there are no risks. The
potential risks arise mainly out of excessive use of futures for speculative gains. There are
living examples of financial debacles suffered by companies like Procter and Gamble ,
Kashima Oil co., Orange County and others mainly due to the use of futures markets for the
purposes other than genuine hedging.

5.7 FUTURES VS FORWARDS

A key distinction between futures and forward contracts is that the terms of a futures
contract are standardized. Buyers or sellers of a gold futures contract cannot individually
negotiate about how much gold must be delivered, the form and quality of the gold that will
have to be delivered, and where delivery must take place. Indeed, a NCDEX gold futures
contract requires the delivery of 1 Kg of gold bullion with a carat fitness of 0.999 at only
exchange-approved warehouses. The parties to an analogous forward contract would
customarily negotiate each of these terms.
Although highly standardized, a number of futures contracts with different delivery
dates are commonly traded on a particular commodity exchange at any moment in time.
There may, for example, be several gold futures contracts traded, each with a different delivery
date, starting from the current month and going out one year into the future. Thus, traders can
choose among several futures contracts which differ only by their delivery dates.

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 Table 3 Distinction between Forwards and Futures
Nature of Difference Forwards Futures
1. Size of Contracts Customised Standardized
2. Marked-to-market Not done Done
3. Margin Not required Required
4. No. of contracts There can be many Max. 12 a year
5. Hedging These are tailor-made Perfect hedging difficult
6. Market Liquidity Illiquid Liquid
7. Nature of market Over-the-counter Exchange traded
8. Mode of delivery Specifically decided. Most are cash settled

The purpose of standardizing futures contracts is to create an instrument that reduces

to a minimum the transaction costs associated with trading a deferred delivery instrument. If
all terms of a futures contract had to be individually negotiated by the parties to the contract,
as they are in a forward contract, the costs would be much higher. Table 3 lists differences
between forwards and futures. Further, by permitting trading in a contract with a limited
number of designated delivery dates, trading is concentrated in relatively few discrete time
intervals so that liquidity is enhanced.

5.8 TYPES OF FUTURES

Futures are broadly classified into commodity futures and financial futures.
Commodity futures fall into four commodity groupings: agricultural (cotton, Jute, coffee,
oilseeds, food grains, tea, sugar, wheat, yarn etc.) energy (oils), metals (both precious and
industrial, bullion, silver, iron and steel, etc.) and chemicals and plastics.
Financial futures consist of stock futures, interest rate futures, foreign currency futures
and stock index futures. Interest rate futures are futures contracts written on fixed-income
securities or instruments. A fixed–income security or instrument requires the payment of
interest in the form of fixed rupee amounts at predetermined points in time. Dealing in
interest rate securities entails interest rate. It is the risk that the price (or market value) of a
security will change. Two factors have contributed to the introduction and growth of interest
rate futures: The enormous growth of the debt market and increased volatility of interest
rates. Both factors have increased the need for an instrument to hedge or manage interest-
rate risk involved in holding and trading fixed income obligations.

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 Foreign currency futures provide a mechanism for managing currency risk. A major
impetus to their introduction was the end of a system of fixed exchange rates and the
widespread adoption of floating exchange rates, which resulted in a sharp increase in exchange
rate volatility (and therefore in exchange rate risk). The fixed exchange rate system that
existed prior to 1973 was formalised in 1944 when the International Monetary Fund was
created.
Stock index futures are contracts based on stock indexes such as sensex and nifty.
These indexes provide summary measures of changes in the value of particular segments of
the equity market – that covered by the specific index. Stock index futures are useful in
managing large stock portfolios.

5.9 NOTES

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5.10 A CASE STUDY ON SPECULATION / HEDGING

June 2016 sugar futures are traded today (i.e. 7th April) at MCX at a price of Rs.
2850 per quintal. The size of each futures contract on MCX is 10 tons. The margin money
required to be deposited is 8% of total value of futures contracts.
A dealer in sugar is anticipating decline in sugar prices in the coming months.
Accordingly he plans to take up June sugar futures contracts for a total of 38 tons.
Required:
1. What position will he be taking in the futures market?
2. How many contracts he needs to take?
3. How much margin money he has to deposit with the clearing house?
4. Suppose in the month of May 2016, June futures price fell by 10%. The dealer wants
to wind up his position in the futures market. How can he do that?
5. What is the percent of profit/loss on his investment?

5.11 SUMMARY
The forward contract is the most basic derivative contract. A forward contract is an
agreement to buy or sell something in the future. Both the buyer and seller of forward
contract are committed to take delivery and deliver, respectively, the underlying asset. There
is no performance guarantee in a forward contract.
Futures have evolved out of forwards and are exchange-traded. Trading in futures is
subject to margin requirements. Future are traded both for hedging and speculative purposes.
The principal advantages of futures markets are price discovery and hedging price
risk. The popularly traded futures contracts are interest rate futures, currency futures, stock
futures and

5.12 KEY WORDS

Forwards Futures Speculation Hedging

5.13 SELF ASSESSMENT QUESTIONS

1. Define a forward contract. Discuss its features with suitable examples.
2. Distinguish between a spot contract and a forward contract.

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3. Briefly explain the features of futures contracts.
4. Distinguish between a forward contract and a futures contract
5. Why futures are traded? Explain with suitable examples.
6. What are the different types of futures contracts?

5.14 REFERENCES
1. Financial Derivatives – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
2. Capital market Instruments – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
3. Risk Management – Insurance and Derivatives – By G.Kotreshwar (HPH)
4. Financial Derivatives – By Gupta (PHI)
5. Introduction to Futures and Options Markets – By John Hull (PHI)
6. Derivatives – By D.A.Dubofsky and T.W.Miller (Oxford)

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UNIT- 6 : TRADING IN FORWARDS AND FUTURES

Structure :
6.0 Objectives
6.1 Introduction
6.2 Clearing House
6.3 Open Interest
6.4 Margin Requirements
6.5 Marking to Market (M2M)
6.6 Settling a Futures Position
6.7 Pricing of Futures and Forwards
6.8 Continuous Compounding
6.9 Notes
6.10 Case Study
6.11 Summary
6.12 Key Words
6.13 Self Assessment Questions and Problems
6.14 References

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6.0 OBJECTIVES
After studying this units, you will be able to:
• Understand the basics of trading in forwards and futures,
• Clearly grasp the concept of M2M,
• Clearly understand the concept of continuous compounding,
• Calculate the prices of futures , and
• Understand the modes of closing out a futures contract.

6.1 INTRODUCTION
The mechanics of trading in futures contracts are more complex than for ordinary
stock transactions. In a stock purchase, a broker simply acts as an intermediary to enable the
investor to buy shares from or sell to another investor through the stock exchange. In futures
trading, however, the clearing house plays a more active role. A brief discussion of basic
terms and institutions involved in futures trading is presented below.

6.2 CLEARING HOUSE

A clearing house also known as clearing corporation, plays an important role in the
trading of futures contracts. It acts as an intermediary for the parties who trade in futures
contracts. It ensures the performance of contracts by the parties, and thus boosts confidence
in the system. The clearing house becomes the seller of the contract for the long position
and the buyer of the contract for the short position. This arrangement makes the clearing
house the trading partner of each trader, both long and short. The clearing house, bound to
perform on its side of each contract, is the only party that can be hurt by the failure of any
trader to observe the obligations of the futures contract. This arrangement is necessary
because a futures contract calls for future performance, which cannot be as easily guaranteed
as an immediate stock transaction.
The clearing house makes it possible for traders to liquidate positions easily. If one
is currently long in a contract and want to undo his position, he simply instructs his broker
to enter the short side of a contract to close out his positions. This is called a reversing
trade. The broker nets out his long and short positions, reducing his net position to zero.

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6.3 OPEN INTEREST
The open interest on the contract is the number of contracts outstanding. (Long and
short positions are not counted separately, meaning that open interest can be defined as the
number of either long or short contacts outstanding). The clearinghouse’s position nets out
to zero, and so is not counted in the computation of open interest. When contracts begin
trading, open interest is zero. As time passes, open interest increases as progressively more
contracts are entered. Almost all traders, however, liquidate their positions before the contract
maturity date.
Instead of actually taking or making delivery of the commodity, virtually all market
participants enter reversing trades to cancel their original positions, thereby realizing the
profits or losses on the contract. Actual deliveries and purchases of commodities are then
made via regular channels of supply, usually via warehouse receipts.

6.4 MARGIN REQUIREMENTS

When two parties trade a futures contract, the futures exchange requires some good
faith money from both, to act as a guarantee that each will abide by the terms of the contract.
This money is called margin. The margins are of three types: Initial margin, maintenance
margin and varibale margin.
Initial margin: The initial margin is required at the start of a new transaction. It can
be bought in the form of cash or Treasury bills. Usually the initial margin is a tiny fraction of
the underlying notional principal amount. For instance, in NSE, if the initial margin for
taking a position in the stock futures market for a given stock is 11%, a trader can take a
contract of value of Rs.2,00,000 with a sum of Rs.22,000 as initial margin. Thus, futures are
highly levered instruments which imply that with a very small amount, one can command
large resources. Computer algorithms such as SPAN (Standard Portfolio Analysis of risk)
are commonly used for establishing initial margin requirements. The algorithms analyse
historical price data to derive VaR (Value at Risk) which measures the potential loss in a
worst-case one-day price movement.
More specifically, exchanges commonly set initial minimum margin levels equal to
m + 3s, where m is the average of the daily absolute changes in the rupee value of a futures
contract and s is the standard deviation of these daily changes, measured over some time
period in the recent past.
Let us take coffee futures contracts as an example. Each coffee futures contract is,
say, for 100 bags of coffee. Let us assume that the current market price of coffee is Rs.12000

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per bag, and that the average daily absolute price change is Rs.550 per bag. Further, assume
that the standard deviation of the distribution of recent absolute daily price changes is Rs.230
per bag. Thus, m is equal to Rs.550 x 100 or Rs.55000; s is equal to 230 x 100, or 23000;
and m + 3s = Rs.55000 + Rs.69000, or Rs.124000. This would be the initial margin
requirement on a coffee futures contract. An exchange can change the required margin
anytime. If price volatility increases, or if the price of the underlying commodity rises
substantially, the initial margin will be increased.
Maintenance margin: The maintenance margin represents the minimum margin which
needs to be maintained in individual margin accounts. It is akin to the minimum balance
prescribed by banks in the case of savings deposit accounts.
Variable margin: The variable margin is calculated on a daily basis for the purpose
of marking-to-market all outstanding positions at the end of each day. This is to be deposited
most often in cash only. The day’s closing price is generally used as the basis for the purpose
of marking-to-market.

6.5 MARKING TO MARKET (M2M)

The process of marking profits or losses that accrue to traders on daily basis is called
marking to market. Futures prices may rise or may fall everyday. Instead of waiting until the
maturity date for traders to realize all gains and losses, the clearinghouse requires all positions
to recognize profits as they accrue daily. If the futures price of cotton rises from Rs.4000 to
Rs.4,100 per quintal , the clearinghouse credits the margin account of the long position for
500 quintals times Rs. 100 per quintal or Rs. 50,000 per contract. Conversely, for the short
position, the clearinghouse takes this amount from the margin account for each contract
held. This daily settling is called marking to market. It means the maturity date of the
contract does not govern realization of profit or loss. Marking to market ensures that, as
futures prices change, the proceeds accrue to the trader’s margin account immediately.
Illustration of M2M
M2M helps to maintain the financial stability of the market by enabling losses in
futures contracts to be collected in small increments as they are occurring rather than waiting
until a contract matures. Consider that the spot price of gold is Rs 3000 per gram and the one
year futures price is Rs 3150. Assume that each futures contract is for 1 Kg (i.e. 1000grams).
And hence each contract value is 31,50,000. Further assume that the initial margin for gold
futures contract traded at a recognized exchange is 4 pc, i.e., is Rs 1,26,000. Therefore, both
the buyer and seller of the futures contracts would be required to deposit Rs 1,26,000 with
their brokers.

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 Assume that an investor enters into a long position in a single gold futures contract at
a price of Rs 3150 per gram on day 0. Suppose the next day the settlement price rises by Rs
50 per gram from Rs 3150 to Rs 3200 per gram. Price changes over the remainder of the
year are shown in table 1.
Table 1 : Hypothetical settlement price in 1-year gold futures

Cumulative change
(Rs)
Change in Future
Day Futures price (Rs) Total for
price (Rs) Per
1
gram
contract
0 3150 Not - -
applicable
1 3200 +50 +50 +50000
15 3240 +40 +90 +90000
50 3210 -30 +60 +60000
240 3140 -70 -10 -10000
365 3100 -40 -50 -50000

Even though the investor entered into a contract to buy gold at Rs 3150 per gram, the
next day his contract is rewritten at a contract price of Rs 3200 per gram. To compensate
him for agreeing to buy gold at a price Rs 50 higher than his original contact price, the
clearing house of the exchange gives him Rs 50 per gram or Rs 50,000. This amount is
credited to his brokerage account at the end of day 1, so at that point he would have
Rs.1,26,000+Rs 50,000=Rs 1,76,000 in his account. Where does the Rs 50,000 come from?
It comes from an investor who held short position in gold futures contract. Like him, the
contract price of investor with short position is also reset to Rs 3200 per gram. But he has to
pay the exchange Rs 50 per gram or Rs 50,000 for having his selling price adjusted upward in
his favour. At the end of day 1, an investor who established a short position on day zero would
now have Rs 1,26,000-Rs 50,000=Rs 76,000 in his brokerage account.
This adjustment continues till the last day of the contract. Suppose on the last settlement
day the futures price is Rs 3100 per gram. By day 365 the gold futures price has gone up and
down at least once. At the end of day 365, both long and short investors will be contracting to
buy and sell gold at Rs 3100 per gram. Over the 365-day period, the long investor will have
paid his broker a net Rs 50 per gram, and the short investor would have received Rs 50 per
gram. Note that if the long investor will be required to buy gold at Rs 3100 per gram. After
adding the Rs 50 per gram he has paid his broker in daily settlement, the total amount paid for

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the gold is Rs 3100+Rs 50 =Rs 3150, the initial contract price, similarly, the investor who is
short will be required to sell for Rs 3100 per gram, but with Rs 50 he has received in daily
settlement, he effectively sells gold for Rs 3150 per gram.

6.6 SETTLING A FUTURES POSITION

Once having established a futures position, traders have an obligation under the terms
of the futures contract either to take delivery (a long position) or to make delivery (a short
position) of the underlying commodity. However, making or taking physical delivery is only
one of several ways that futures contracts can be settled. There are three common ways of
liquidating a futures position: physical delivery; by making an offsetting futures transaction
(called offsetting); and by cash delivery.
(1) Physical Delivery
Liquidating a futures position by making or taking physical delivery is usually the
most cumbersome way to fulfill contractual obligations. It requires actually purchasing or
selling a commodity, something traders would normally not want to do unless they had a
particular need for the commodity (and in the large amounts required). A commercial firm,
which deals in commodities, might very well wish to settle by physical delivery. In addition,
at certain times it might be financially desirable to settle by physical delivery, even if it is
inconvenient. To see how physical delivery works, let us take a particular futures contract:
coffee traded on National Commodities and Derivatives Exchange (NCDEX). A trader who
is short one coffee futures contract is required to make delivery of 50 bags of Coorg coffee
of arabica quality.
The operational procedure for making physical delivery on futures differ by the type
of futures contract. At the beginning of the delivery month on the exchange–designated notice
days, let us say for the February 05 contract, exchange rules require that all traders having
open positions in the February 05 contract notify their respective members that they intend
to make or take delivery during February, and when and in what quantities such deliveries are
desired. The exchange members in turn must notify the clearinghouse of their customers’
intentions. After this nomination process is complete, the clearinghouse matches longs and
shorts, usually by matching the oldest short position to the oldest long position until all
short quantities are matched with a long. Delivery notices are then sent, via the customer’s
exchange members, to all parties, indicating to whom their delivery obligation runs and when,
where, and in what quantities delivery is to be made. Exchange rules provide for substantial
default penalties in the event that a party fails to perform. When delivery is satisfactorily
made, the clearinghouse is notified and extinguishes on its books the obligations of the

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respective clearing exchange members. These exchange members in turn extinguish the
corresponding customer obligations to them.
Physical delivery imposes obvious costs on traders: warehouse expenses, insurance
costs, possibly shipping costs, and brokerage fees. In addition, if a long does not need the
commodity for commercial purposes, he or she will have to re-sell it at an additional cost.
Similarly, the short may have to purchase the commodity before he or she can make delivery.
However, there are alternative ways of liquidating futures obligations which would avoid
these costs.
An important aspect of physical delivery is its relationship to the deliverable stock
of a commodity. By deliverable stock of a commodity is commonly meant the amount of a
commodity that meets exchange -–specified quality standards and is available for delivery at
exchange –specified locations (such as warehouses). Deliverable stocks, of course, may
(and usually do) constitute far less of a commodity’s stock than actually exists, in India and
the rest of the world. Since it may sometimes be difficult to bring such stocks into deliverable
position, however, the concept of a deliverable stock is relevant.
(2) Offsetting
The most common way of liquidating an open futures position is to effect an offsetting
futures transaction – in effect, to reverse the initial transaction which established the futures
position (shown earlier in Figure 9.1). Figure 9.2 Shows the order flow that would accompany
such as offsetting transaction. The initial buyer (long) liquidates his position by selling (or
going short) an identical futures contract (same commodity and same delivery month).
Similarly, the initial seller (short) liquidates his position by buying (going long) an identical
contract. After these trades are executed and reported to the clearinghouse, both traders’
obligations are extinguished on the books of the clearinghouse and on the exchange members.
Let us suppose that on Jan 1, Mr. A takes up a long position (i.e., to buy) in the future
market for one Kg of gold for April month; for Rs 2700/gm of gold. On 25th Feb, he decides
to close out his position, and hence, enters into another future contract, now for short position,
at Rs 2800/gm of gold for the same delivery month, i.e., April.
Mr. A’s Account Quantity Cash flow on 30th April
(Rs)
To pay for long position +1000 grams - 27, 00,000.00
To receive for short position -1000 grams +28, 00,000.00
Gain nil Rs 1,00,000.00

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 Offsetting the futures contract is an important technique to get out of a futures position.
Movements in forward price generate paper gains and losses for those holding futures
positions. By taking the offsetting position, the holder of futures contract locks the difference
of price between the two period, i.e., t and . This gain or loss is not realized until the
expiration date T. In simple term, once the party has offset the position, there will be no
further gain or losses out of the forward position.
In comparison to making or taking physical delivery, settlement by offset is relatively
simple. It requires only a liquid futures market to facilitate offsetting trades, and entails only
the usual brokerage costs.
(3) Cash Delivery
This procedure is a substitute for physical delivery and completely eliminates having
to make or take physical delivery. It is available only for futures contracts that specifically
designate cash delivery as the settlement procedure. Physical delivery is not permitted on
these contracts. Contracts on stock index futures use cash delivery to settle contracts.
The mechanics of cash delivery are simple: the price of the relevant futures contract,
at the close of trading in that contract, is set equal to the cash price of the underlying
commodity at that time. Any money owing to either the short or the long at that time, because
of setting the futures price equal to the cash price, is transferred (via the clearing house)
from the party who owes the money to the party who is owed the money. This procedure is
obviously much simpler than making and taking physical delivery, since it avoids having to
handle the physical commodity at all. It also means, however, that a buyer can no longer use
a futures contract to acquire the physical commodity. He will have to buy the commodity
elsewhere, if that is what he wants.
Exchanges have adopted cash delivery as an alternative to physical delivery for two
reasons. First, the nature of the underlying commodity may not permit feasible physical
delivery. For example, stock index futures would require physical delivery of hundreds or
thousands of shares of stock in calculated proportions, requiring a cumbersome and costly
delivery procedure. Second, cash delivery avoids the problem that it may be difficult for
traders to acquire the physical commodity at the time of delivery because of a temporary
shortage of supply. Cash delivery also makes it difficult for traders to manipulate or influence
futures prices by causing an artificial shortage of the underlying commodity. T h e
popularity of cash delivery has grown substantially in recent years, and has enabled exchanges
to offer futures contracts that would not have been feasible without such a delivery mechanism.

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6.7 PRICING OF FUTURES AND FORWARDS
The forward price of an asset is the price that is quoted today for delivery of the asset
in the future, the price is contracted today but is paid when the asset is delivered in the future.
This section explains the theory of pricing and valuation of forwards contracts. In particular,
it describes the cost-of-carry price relationship and other key pricing concepts such as
contango, backwardation and basis.
(1) Newspaper Quotes
Table 2 : Futures on NSE
Price (Rs.)
October open High Low close Open No. of
Interest (000)contracts
ACC 1056 1078 1056 1064.6 1023.5 2074
Allahabad
Bank 92.45 94.02 90.00 90.95 4676 2001
Source: www.nseindia.com
Many newspapers carry future quotations. In The Economic Times, futures quotations
can currently be found in the NSE ‘Derivatives’ section. Table 2 shows the quotations for
stocks as they appeared on NSE website on Nov. 21, 2013. These refer to the trading that
took place on preceding day (NOV. 21, 2013).
a) Open: The price for the day’s first trade that occurs during the time period designated
as the opening of the market (or the opening call).
b) High: The highest price of a trade recorded during the day.
c) Low: The lowest price of a trade recorded during the day.
d) close: The closing price is usually determined by formula using the range of prices
recorded within the closing period (such as the last minute of trading). It is determined
by the exchange’s settlement committee and is intended to indicate the fair value of
the futures contract at the close of trading. As such, the settlement price is not usually
the last trading price of the day, and sometimes may not even be within the day’s price
range.

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e) Open Interest: This refers to the number of futures contracts that are open (or being
held) at the close of the previous day’s trading. In Table 6.2, the Nov. 2013 ACC futures
contract shows an open interest of 10,23,500 at the close of trading on Nov.20.
f) Trading Quantity: Quantity is the total value of futures contracts at the end of the day
for each stock.
g) Number of Contracts: This refers to the total number of futures contracts that are
traded during the day. There were, for example, 200 futures contracts for Andhra Bank
stock on Nov.20.
(2) Cost of Carry
Table. 3: NCDEX Barley Futures Prices
Spot price Rs.1381.4
Dec. 2013 Rs.1384.5
Jan.2014 Rs.1422.0
Source: www.ncdex.com 22.11.2013
The first obvious feature of the price relationship shown in Table 3 is that the Jan(2014)
futures price is always above the cash price. Second, the extent to which the Jan. futures
price exceeds the cash price is largely determined by the time to delivery. The longer the
time period before expiration, the more the futures price exceeds the cash price. Third, as
the delivery date approaches the futures price slowly but inevitably converges to the cash
price.
The extent to which the Jan.(2014) futures price exceeds the cash price at any moment is
determined by what is commonly known as the cost-of-carry. This term refers to the costs
associated with purchasing and carrying (or holding) a commodity for a specified period of
time. These costs would include the financing costs associated with purchasing cash gold,
storage costs, insurance, and any other costs involved in carrying the commodity forward in
time. A measure of financing costs is the amount of money that would have to be used to
purchase the cash commodity times the relevant interest rate for the period of time that the
commodity is carried (such as three months or a Year).
The following formula describes a general cost-of-carry price relationship between
the cash (or spot) price and the futures price of any commodity.

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Futures = cash + interest + storage
Price price costs per unit costs per unit
Symbolically,
FPt, T = CPt + CPt x R x T–t + CSt,T …………(1)
365
Where:
FPt,T = the futures price at time t for a futures contract requiring delivery at time T.
CPt = the cash price at time t.
R = the risk-free interest rate per annum
CSt,T = the costs of storing the physical commodity per unit for the time period T minus t.

The formula (3.1) does not allow for the continuous compounding of interest costs
but captures only the simple interest. In addition, the formula assumes that there are no
transactional costs, all borrowing and lending is done at the same risk-free interest rate and
commodities can be stored indefinitely without any change in their characteristics.
On the basis of these assumptions, let us use the above formula to see just how well it
describes the price relationships that we observe between cash and futures gold prices.
Suppose on Feb., 2014, the cash price of gold was Rs.2800 per gram. At the close of trading
on Feb.28, the settlement price of the April 2014 gold futures contract was Rs.3258 per
gram. The time duration of the contract is 2 months. The annualized borrowing rate was
about 10.50 per cent. Finally, the cost of storing gold is significantly high at Rs.409. Inserting
these numbers into equation (3.1) above, we have
2800 + [2800 x 0.105 x 2/12 + 409] = Rs.3258
Thus, the simple cost-of-carry formula works quite well in describing the relationship
between cash and futures gold prices. However, this may not be true for all commodities at
all times.

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6.8 CONTINUOUS COMPOUNDING
Consider an amount A invested for n years at an interest rate of r per annum. If the
rate is compounded once per annum, the terminal value of the investment is
A(1+r)n
If it is compounded m times per annum, the terminal value of the investment is
A 1+r mn

m
suppose that A = Rs.100, r = 10% per annum, and n = 1, so that we are considering one
year. When we compound once per annum (m = 2), this formula shows that the Rs.100
grows to
Rs.100 x 1.1 = Rs.110
When we compound twice a year (m = 1), we earn 5% interest per six months, with
the interest being reinvested, and the Rs.100 grows to
Rs.100 x 1.05 x 1.05 = Rs.110.25
When we compound four times a year (m=4), we earn 2.4% per 3 months, with the
interest being reinvested, and the Rs.100 grows to
Rs.100 x 1.02544 = Rs.110.38
When we compound 365 times a year (m = 365), we earn 0.0274% per day with the
interest being reinvested, and the Rs.100 grows to
Rs.100 (1.000274)365 = Rs.110.52
The limit as m tends to infinity is known as continuous compounding. With continuous
compounding, it can be shown that an amount A invested for n years at rate r grows to
Ae r n
Where e is the mathematical constant, 2.71828. Suppose A = 100, n = 1, and r = 10%
(or 0.1), so that the value to which A grows with continuous compounding is
100e(0.1) (1) = 110.52
This is (to two decimal places) the same as the value using daily compounding. For
most practical purposes, continuous compounding can be thought of as being equivalent to
daily compounding. Compounding a sum of money at a continuously compounded rate r for

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n years involves multiplying it by er n . Discounting it at a continuously compounded rate r
for n years involves multiplying by 1 / er n or e-r n .
(i) Price of an Asset That Pays No Dividends
In this section and subsequent sections it is assumed that there are some market
participants for whom the following are true:
a) the market participants are subject to no transactions costs when they trade.
b) the market participants are subject to the same tax rate on all net trading profits.
c) the market participants can borrow money at the same risk-free rate of interest as they
can lend money.
d) there are no arbitrage opportunities.
The following notations will be used to explain pricing of different types of assets:
T: time when the forward contract matures (years)
So: price of asset underlying the forward contract today
Fo: forward price today
I: Present value of dividends/income on assets
r: risk-free rate of interest per annum, with continuous compounding, for an investment
maturing at time T. (For derivation of continuous compounding formula, see Appendix 9A)

Subject to assumptions and notations mentioned above, the forward price of an asset
providing no income is given by

F0 = S0 erT ……………(2)
Example
Consider a forward contract to buy a zero-coupon bond that will mature in six months
from today. The current price of the bond is Rs.850. Aassume that the risk-free rate of interest
(continuously compounded) is 10 pc per annum. Using equation (3.2) with T = 6/12, r =
0.10, and So = Rs.850 to obtain the forward price,

Fo = 850e0.10x6/12 = Rs. 894

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This would be the delivery price in a contract negotiated today.
(ii) Price of a Fixed Income Generating Asset
The price of an asset that provides income with a present value of I during the life of
a forward contract is given by
F0 = (S0 – I)ert ………………(3)
Example
Consider a 10-month forward contract on a stock with a price of Rs.150. We assume
that the risk-free rate of interest (continuously compounded) is 8% per annum for all
maturities. We also assume that dividends of Re.0.75 per share are expected after three
months, six months, and nine months. The present value of the dividends, I, is given by
I = 0.75e-0.08x3/12 + 0.75e –0.08x6/12 + 0.75e-0.08x9/12 = 2.162
The variable T is 10 months or 10/12 years so that the forward price, F0 , from equation
(3.3) is given by
F0 = (150 – 2.162)e0.08x10/12 = Rs.158.04
(iii) The Effect of a Known Dividend Yield
Consider a situation where the asset underlying a forward contract provides a known
dividend yield. This means that the income, when expressed as a percentage of the asset
price, is known. We assume first that the dividend yield is paid continuously at a constant
annual rate of q. To illustrate what this means, suppose that q=0.05 so that the dividend yield
is 5% per annum. When the asset price is Rs.10, dividends in the next small interval of time
are paid at the rate of 5% of Rs.10(or 5 paise) per annum; when the asset price is Rs.100,
dividends in the next small interval of time are paid at the rate of Rs.5 per annum; and so on.
In practice, dividends are not paid continuously, but in some situations the continuous dividend
yield assumption is a good approximation of reality.
The forward price for an investment asset providing a continuous dividend yield at
rate q is given by
F0 = S0e(r-q)T ……………….(4)
Example
Consider a six-month forward contract on an investment asset that is expected to
provide a continuous dividend yield of 5% per annum. The risk-free rate of interest (with

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continuous compounding) is 9% per annum. The asset’s price is Rs.150. In this case S0 =
150, r = 0.09, T = 0.5 (6/12), q = 0.05. From equation, the forward price F0 is given by
F0 = 150e (0.09-0.05)x0.5 = Rs.160.07
When the dividend yield is continuous, but varies throughout the life of the forward
contract, q should be set equal to the average dividend yield during the life of the contract.
Equation (3) can also be used in situations where there is a known dividend yield, but it is
paid at discrete points in time. It is necessary to find the continuous dividend yield that is
equivalent to the discrete dividend yield.

6.9 NOTES
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6.10 CASE STUDY
Mr. Amith Raj after completing his master’s degree in commerce with finance
specialization joined JP tyres Ltd as finance executive. He observed that the company is
hardly using derivatives for controlling the price risk of inputs, particularly the rubber. Mr.
Gopalam who is in charge of purchasing is having his own reservations about the futures
market as they involve deposits of margin requirements and other rigidities. However, Mr.
Raj was able to convince Mr. Gopalam to use atleast the forward market for hedging the
rubber price exposure.
The company’s practice is to procure rubber on the basis of quarterly budget. At the
beginning of first quarter on 1st April. Mr. Gopalam took a long position in the June forward
market for June delivery of 500 tons of rubber at a price of Rs.16000/quintal. Starting from
1st week of May the downtrend in rubber price sustained throughout and at the end of June
reached the level of Rs.12000/quintal. This lead to the verbal exchange between Mr. Raj and
Mr. Gopalam who all along used to manage without recourse to derivatives.
Questions:
1. What is the extent of loss incurred or profit made on the forward contract?
2. If the forward contract resulted in a loss, who is to be blamed?
3. If Mr. Raj had to take futures contract, do you think the profit made or loss incurred
would have been different?
4. Under the given circumstance of the case, discuss the merits and limitations of using
forwards as hedging tools vis-à-vis futures contracts.
5. What are the other derivative products Mr. Raj would have tried to hedge rubber price
exposure?
6.11 SUMMARY
Trading in futures is subject to margin requirements. Future are traded both for hedging
and speculative purposes. The principal advantages of futures markets are price discovery
and hedging price risk. The popularly traded futures contracts are interest rate futures, currency
futures, stock futures and commodity futures.
Clearing house plays an important role in futures trading by creating a platform for
buyers and sellers and ensuring the performance of the contract through margin requirements
and M2M. Majority of futures contracts are settled at maturity either by off-setting trade or
by cash settlement. Settlement by physical delivery is common to forward contract but not
to futures contracts.

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 Cost-of-a carry is the basic relationship that describes the pricing of futures contracts
in commodities. In case of financial assets, theoretical futures price is based on time value
of money with the assumption of continuous compounding. The value of a forward contract
at initiation will be zero. Subsequently the forward contract becomes valuable to the parties
depending on whether the price of underlying moves upward or comes down.

6.12 KEY WORDS

Clearing House Margin Marking to Market Cost of Carry
6.13 SELF ASSESSMENT QUESTIONS AND PROBLEMS
1. Briefly discuss the functions of a clearing house in a futures market.
2. What is margin money? Why it is collected? What are the different forms of margin
money?
3. What is M2M? Illustrate the M2M procedure.
4. Briefly discuss the futures market trading mechanism in India.
5. How do you determine the price for the following investment assets
(a) Investment asset which generates no income
(b) Investment asset which generates a known cash income
(c) Investment asset which generates a known dividend.
6. Calculate forward price from the following data
Underlying = Coupon (interest) bearing bond
Face value = Rs. 20,000
Date of maturity = 31st March 2016
Coupon interest payments:
On 30th September 2013 = Rs. 1000
On 31st March 2014 = Rs. 1000
Risk-free interest rates (continuously compounded)
- 8% p.a. for six months
- 10% p.a. for one year
7. Determine the futures price from the following data:

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 Spot price of the commodity = Rs. 90,000
Storage cost = 6% p.a. of spot price
Insurance cost = 4% p.a. of spot price
Transportation cost = 3% (fixed)
Financing cost = 12% p.a.
Carry period = 6 months
Use cost-of-carry model.

6.14 REFERENCES
1. Financial Derivatives – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
2. Capital market Instruments – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
3. Risk Management – Insurance and Derivatives – By G.Kotreshwar (HPH)
4. Financial Derivatives – By Gupta (PHI)
5. Introduction to Futures and Options Markets – By John Hull (PHI)
6. Derivatives – By D.A.Dubofsky and T.W.Miller (Oxford)

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UNIT - 7 : USING FUTURES FOR HEDGING

Structure:
7.0 Objectives
7.1 Introduction
7.2 Hedging Principles
7.3 Short Hedge
7.4 Long Hedge
7.5 Cross Hedge
7.6 Basis Risk
7.7 The Hedge Ratio
7.8 Notes
7.9 Illustrative Problem
7.10 Case Study
7.11 Summary
7.12 Key Words
7.13 Self Assessment Questions and Problems
7.14 References

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7.0 OBJECTIVES
After studying this units, you will be able to:
• The basic principle of hedging,
• The distinction between long hedge and short hedge,
• The meaning of ‘basis risk’,
• The concept of hedge ratio, and
• The mathematical expression of hedge ratio.

7.1 INTRODUCTION
The basics of futures contracts were discussed in the previous units. One of the major
reasons for the existence of futures contracts is that they can be used for hedging the risk.
Hedging involves transfer of risk by one party to another .The party who undertakes a futures
contract with the objective of transferring risk is called the ‘hedger’. The basic idea in a
hedging strategy using futures market is to lock in a price today for a contract that expires on
some future date. The companies with sizeable exposure in currency, commodity and interest
rate markets use futures markets for bringing stability in their earnings.

7.2 HEDGING PRINCIPLES

The various factors that need to be considered while using futures to hedge are:
1) Size: The quantity of a commodity or asset that is subjected to price risk is to be
ascertained.
2) Type: The hedger has to chose an appropriate futures contract for hedging purpose.
For example, a dealer in edible oils may choose a representative commodity like ground
nut futures contract for hedging.
3) Time: The hedger should decide a futures contract of a particular month that is closer
to the required timing of purchase or sale of the underlying commodity or asset. For
example, a coffee curing firm which plans to buy raw coffee in the beginning of January
may trade in January coffee futures.
4) Number of contracts: The number of futures contracts that should be used to hedge is
to be determined. For example, a bullion dealer who needs to hedge for 1.8 kilo of
bullion may make use two futures contracts of 1 kilo each.

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5) Hedge ratio: In order to determine the optimum size of the exposure to the size of
the position taken in the futures market, appropriate hedge ratio needs to be determined.
The two special features of futures hedging strategies are described below:
1) Because futures contracts are standardised, the underlying asset, the delivery location,
the quantity, and the delivery date may all differ from the asset that is being hedged.
This risk is called basis risk.
2. If the underlying asset of the futures contract is sufficiently different from the asset
being hedged, it is important to determine the degree to which price changes of the two
assets are correlated. This is called hedge ratio.
One of the main reasons cited for the existence of futures markets is that they provide
an effective way to transfer price risk at a low cost. Futures contracts are used to manage risk
by taking a futures position that is opposite of the existing or anticipated cash position. In
other words, a hedger sells futures against a long position in the cash asset or buys futures
against a short position in the asset.

7.3 SHORT HEDGE

A short hedge is a hedge that involves a short position in futures contracts. A short is
basically used to guard against the possible fall in the price of an asset to be sold later. It is
appropriate when the hedger already owns an asset and expects to sell it at some time in
future. It can also be used when a hedger does not own an asset right now, but knows that the
asset will be owned at some time in the future. Consider for example, an exporter knows that
he will receive U.S. dollars in 2 months. The exporter will realise a gain if the U.S. dollar
increases in value relative to Rupee and incurs loss if dollar decreases in value relative to
Rupee. A short futures position leads to a loss if dollar appreciates and a gain if it depreciates
in value. It has the effect of offsetting the exporter’s risk.
Example
Suppose that a cotton merchant has negotiated a contract to sell 850 quintals of long
staple cotton on March 10. It has been agreed that the price that will apply in the contract is
the market price on June 20. The merchant is therefore, in a position where he will gain
Rs.8500 for each Rs.10 increase in the price of cotton per quintal over the next three months
and lose Rs.8500 for each Rs.10 decrease in the price during this period. Suppose that the
spot price on March 10 is Rs.4210 per quintal and the June cotton futures price is Rs.4190
per quintal. Suppose each futures contract is for the delivery of 50 bales of 170 kgs. each on
NCDEX , the merchant can hedge his exposure by shorting 10 June futures contracts. If the

106
merchant closes out his position on June 20, the effect of the strategy should be to lock in a
price close to Rs.4190 per quintal.
Suppose that the spot price on June 20 proves to be Rs.4050 per quintal. The merchant
realises Rs.34,42,000 for the cotton under its sales contract. Since June 20 is the delivery
date for the futures contract, the futures price on June 20 should be very close to Rs.4050 on
that date. The merchant, therefore, gains Rs.4190 – 4050 = Rs.140 per quintal or Rs.1,19,000
in total from the short futures position. The total amount realized from both the futures
position and the sales contract is, therefore, Rs.4190 per quintal or Rs.35,61,000 in total.
For an alternative outcome, suppose that the price of cotton on June 20 proves to be
Rs.4250 per quintal. The merchant realises Rs.4250 per quintal for the cotton and loses
Rs.60(4250-4190)per quintal on the short futures position or Rs.51,000 in total from the
short features position. The total amount realised from both the futures position and the
sales contract is, therefore, Rs.4190 per quintal or Rs.35,61,500.

7.4 LONG HEDGE

A long hedge is a hedge that involves a long position in futures contracts. It is used to
guard against the possible rise in the price of an asset to be acquired later. The hedger is
either currently short the cash good or has a future commitment to buy the good at the spot
price that will exist at a later date. In either case, the long hedger faces the risk that prices
will rise. Because the long hedger has a long futures position and a short cash position, any
subsequent price rise should lead to a profit in the futures market and a loss in the cash
market. The hedger must also be aware that prices may fall, in which case a profit will be
earned on the spot position, while a loss will be sustained in the futures market.
Example
Suppose that a tyre manufacturing company knows it will require 1000 quintals of
rubber on May 15. It is, say, Jan.15 today. The spot price of rubber is Rs.20,350 per quintal
and the May futures price is Rs.20,210 per quintal. The company can hedge its position by
taking a long position in 10 May futures contracts and closing its position on May 15. The
strategy has the effect of locking in the price of the rubber that is required at close to Rs.20,
210 per quintal.
Suppose that the price of rubber on May 15 proves to be Rs.20,260 per quintal. Since
May is the delivery month for the futures contract, this should be very close to the futures
price. The company gains on the futures contracts.

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1000 x (Rs.20,260 – 20,210) = Rs.50,000
It pays 1000 x Rs.20,260 = Rs.2,02,60,000 for the rubber. The total cost is therefore
Rs.2,02,60,000 – Rs.50,000 = 2,02,10,000 or Rs.20,210 per quintal. For an alternative
outcome, suppose that the futures price is Rs.20,050 per quintal on May 15. The company
looses approximately:
1000 (Rs.20,210 – Rs.20,050) = 1,60,000
on the futures contract and pays Rs.1000 x Rs.20,050 = Rs.2,00,50,000 for the rubber. Again
the total cost is Rs.2,02,10,000 or Rs.20,210 per quintal.
Note that it is better for the company to use futures contracts than to buy the rubber
on Jan 15 in the spot market. If it does the latter, it will pay Rs.20,350 per quintal instead of
Rs.20,210 per quintal and will incur both interest and storage costs. It may thus be observed
that any gains in the futures market offsets losses in the cash market so that futures hedging
does not necessarily make financial position better.

7.5 CROSS HEDGE

For various reasons, hedging through futures contracts does not work perfectly in
real life. For instance, the asset whose price is to be hedged may not exactly match with the
asset underlying the futures contract. Such a situation prompts the hedger to use a similar
asset underlying a futures contract for hedging purpose. This is called cross hedging. For
example, an airlines company may use a future contract where the underlying is Arabian Gulf
Jet fuel, though it needed aviation turbine fuel futures contract.

7.6 BASIS RISK

Basis refers to the difference between the futures price and spot price. Basis risk is
the risk attributable to uncertain movements in the spread between a futures price and on
spot price.
The basis risk arises in the following situations;
1) The asset being hedged is different from the asset underlying the futures contract
2) The date on which the hedge is to close out is different from the delivery date of the
futures contract
3) The amount of asset being hedged is not an integer multiple of the contract size of the
futures contract used to hedge.

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 If the asset being hedged exactly matches the asset underlying the futures contract,
the basis risk can be reduced significantly. However, if there are no futures contracts on the
asset being hedged, the hedger will have to carry out a careful analysis of all available futures
contracts in order to decide which of these contracts have futures prices that are highly
correlated with the price of the asset being hedged. Similarly, basis risk will be high if the
time gap between the expiry date of the hedge and the delivery date of the asset is large.
Generally, the rule is to chose a date later in the delivery month but as close to the expiry
date of the hedge. For example, if the delivery month is August, the delivery date according
to the contract is August 20 and the date the exposure ends is August 27, it would be better to
take up a September contract rather than August Contract, this is because, if one hedges
using a August Contract, the position is not covered for a period of seven days from August
20 to August 27, and the hedger faces the risk of unknown price movement in the spot
market for these 7 days.
The basis in a hedging situation is :
Basis = Spot price of asset _ Futures price of
to be hedged contract used
When the spot price increases by more than the futures price, the basis increases.
This is referred to as a strengthening of the basis. When the futures price increases by more
than the spot price, the basis declines. This is referred to as a weakening of the basis. To
examine the nature of basis risk, the following notation is used:
S1 : spot price at time t1
S2 : spot price at time t2
F1 : futures price at time t1
F2 : futures price at time t2
b1 : basis at time t1
b2 : basis at time t2
Let a hedge is put in place at time t1 and closed out at time t2 . As an example, consider
the case where the spot and futures prices at the time the hedge is initiated are Rs.1250 and
Rs.1220, respectively, and that at the time the hedge is closed out they are Rs.1200 and
Rs.1190 respectively. This means that
S1 = 1250, F1 = 1220, S2 = 1200, and F2 = 1190.
From the definition of the basis

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 b1 = S1 – F1
b2 = S2 – F2
and in our example, b1 = 30 and b2 = 10.
Consider first the situation of a hedger who knows that the asset will be sold at time
t2 and takes a short futures position at time t1. The price realized for the asset is S2 and the
profit on the futures position is (F1-F2). The effective price that is obtained for the asset with
hedging is, therefore,
S2 + F1 – F2 = F1 + b2
In our example, this is Rs.1230. The value of F1 is known at time t1. If b2 were also
known at this time, a perfect hedge would result. The hedging risk is the uncertainty associated
with b2. This is known as basis risk. Consider next a situation where a company knows it will
buy the asset at time t2 and initiates a long hedge at time t1. The price paid for the asset is S2
and the loss on the hedge is (F1 - F2 ). The effective price that is paid with hedging is, therefore,
S2 + F1 – F2 = F1 + b2
This is the same expression as before and is Rs.1230 in the example. The value of F1 is
known at time t1 and the term b2 represents basis risk.
Choice of Contract
One key factor affecting basis risk is the choice of the futures contract to be used for
hedging. This choice has two components:
i) The choice of the asset underlying the futures contract.
ii) The choice of the delivery month
If the asset being hedged exactly matches an asset underlying a futures contract, the
first choice is generally fairly easy. In other circumstances, it is necessary to carry out a
careful analysis to determine which of the available futures contracts has futures prices that
are most closely correlated with the price of the asset being hedged.
The choice of the delivery month is likely to be influenced by several factors. In the
examples earlier in this chapter, we assumed that when the expiration of the hedge corresponds
to a delivery month, the contract with that delivery month is chosen. In fact, a contract with
a later delivery month is usually chosen in these circumstances. This is because futures
prices are in some instances quite erratic during the delivery month. Also, a long hedger runs
the risk of having to take delivery of the physical asset if he holds the contract during the
delivery month. This can be expensive and inconvenient.

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 In general, basis risk increases as the time difference between the hedge expiration
and the delivery month increases. A good rule of thumb is, therefore, to choose a delivery
month that is as close as possible to, but later than, the expiration of hedge. This rule of
thumb assumes that there is sufficient liquidity in all contracts to meet the hedger’s
requirements. In practice, liquidity tends to be greatest in short maturity futures contracts.
The hedger may, therefore, in some situations be inclined to use short maturity contracts and
roll them forward.
Example
Suppose an Indian company has struck a sales contract with a Japanese firm on 2nd
May and expects to receive 40 million Japanese yen at the end of November. The company is
worried about the possible depreciation of Yen and, therefore, plans a short position in the
Yen currency. Futures contracts have delivery months of March, June, September and
December. The December futures price for the yen is currently Re.0.3900 (per Yen). Suppose
one contract is for delivery of 10 million yen.
Strategy
The company can
1. Short four December yen futures contract on May 2.
2. Close out the contract at the end of November.
Basis Risk
The basis risk arises from the hedger’s uncertainty as to the difference between the
spot price and December futures price of the Japanese yen at the end of November.
The Outcome
When the yen arrived at the end of November, it turned out that the spot price was
0.36 and the futures price was 0.3625. It follows that:
Basis = 0.3600 – 0.3625 = -0.0025
Gain on futures = 0.3900 – 0.3625 = 0.0275
The effective price in Rupees per yen received by the exporter is the end-of-November
spot price plus the gain on the futures:
0.3600 + 0.0275 = 0.3875
This can also be written as the initial December futures price plus the basis:
0.3900 – 0.0025 = 0.3875

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7.7 THE HEDGE RATIO
Hedge ratio is concerned with the determination of proper number of futures contracts
to buy or sell when one is hedging. The process of selecting which futures contract and the
number of futures contracts to trade is frequently described as an “art”. There is a need for
gathering as much information as possible and carefully analysing the data to establish an
‘estimate’ of relationship between the price of the cash good being hedged and a futures
price.
The hedge ratio is defined to be the ratio between the number of futures contracts
(each on one unit of an underlying asset) required to hedge one unit of a cash asset that must
be hedged. For example, if 0.90 rubber futures contracts (each on one quintal of rubber)
must be sold to hedge the future production of one quintal of rubber, then the hedge ratio is
0.90.
A critical factor for a hedger is to determine the optimal futures position to assume, or to
determine the optimal hedge ratio. If, for example, the hedger wishes to minimize risk, he
must take a futures position (i.e., the number of futures contracts times the quantity
represented by each contract) that will result in the maximum possible reduction in the
variability of the value of his total (hedged) position.
A general definition of a hedge ratio (HR) is :
HR = Qf
Qc ...………………(1)

Where Qf is the quantity (or units) of the commodity represented by the futures position, and
Qc is the quantity (or units) of the cash commodity that is being hedged. If, for example a
4000 bags coffee short futures position is taken to hedge a 5000 bags coffee cash position,
the HR equals 0.80. Though a hedge ratio of 1.0 was considered in the previous examples, a
ratio of less than 1 a reality. In the previous example, the hedger’s exposure was on 1000
bags of coffee beans and futures contracts were entered into for the delivery of exactly this
quantity of beans. As the objective of the hedger is to minimise risk, setting the hedge ratio
equal to 1 is not necessarily optimal. The hedge ratio that minimizes risk (HR*) is defined as
HR* = Q*f
Q*c …......…………(2)

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Where Q*f is the quantity (or units) of futures that minimizes risk. To understand how the
value of this ratio is determined, consider the following:
“VH = “ CP x Qc - “ FP x Q*f .......…..………(3)
Where “ VH is the change in value of the total hedged position, “ CP is the change in
the cash price, “ FP is the change in the futures price, Qc is the cash position, and Q*f is the
futures position that minimizes risk. Both Qc and Q*f are assumed to be constant for the life
of the hedge. If the change in the value of the hedged position is set equal to zero (making
variability equal to zero), then
“CP x Qc = “ FP x Q*f
and
“CP = Q*f
“FP Qc …...……….(4)

Since HR* = Q*f / Qc , the value of optimal hedge ratio is

HR* = “CP/”FP …………….(5)

or is equal to the ratio of the change in the cash price to the change in the futures price. For
example, if cash price changes by Re.1 for every Rs.1.2 change in the futures price, the
minimum–variance hedge ratio will be
HR* = Re. 1.00 = 0.83
Rs. 1.20
This ratio can be used to determine the number of futures contracts with which to
hedge. For this purpose, equation (4.4) can be restated as
Q*f = Qc x “CP
“FP ….....………(6)
or as
Q*f = Qc x HR* …......………(7)

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 As Q*f is equal to the product of number of futures contracts (N*fc ) that minimises
risk and the quantity (or units) of the commodity represented by each futures contract (Qfc) :
Q*f = N*fc x Qfc ……....………(8)
Therefore,
N*fc x Qfc = Qc x HR* ……...………(9)
And
Nfc = Qc x HR* .....…………..(10)
Qfc
The equation (4.10) is the general formula used to determine the number of futures
contracts with which to hedge in order to achieve the minimum–variance hedge.
To illustrate how this formula is used, consider the case of hedging a long cash position
of 5000 bales of long staple cotton by selling cotton futures on NCDEX. Assume that for
every Rs.50 change in the cotton futures price, there is a Rs.35 change in the cotton cash
prices. To establish the minimum–variance hedge, how many futures contracts should be
sold? Using equation (4.5), we know that

HR* = 0.35 = 0.70

0.50
and as each contract on NCDEX is for a delivery of 50 bales, using equation (10)
N *fc = 5000 bales x 0.70 = 70
50 bales
Thus, the minimum-variance hedge requires selling 70 contracts on NCDEX.
Estimating HR*
The hedge ratio is a key concept in hedging. Much of the discussion about hedging
strategy focuses on how best to estimate and calculate this ratio. The optimal hedge ratio,
HR*, is the slope of the regression equation when DCP is regressed against DFP:
DCP = a + b DFP
or
y = a + bx ……………..(11)

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where y is dependent variable, i.e., DCP and x is independent variable, i.e., DFP. The parameters
‘a’ and ‘b’ in equation (11) are usually estimated from historical data on DCP and DFP. A
number of equal non-overlapping time intervals are chosen and the values of DCP and DFP
for each of the intervals are observed. Ideally, the length of each time interval should be the
same as the length of the time interval for which the hedge is in effect.
Alternatively, the optimal hedge ratio is the product of coefficient of correlation
between DCP and DFP and the ratio of standard deviation of DCP to the standard deviation of
DFP.
HR* = r sDCP
sDFP ….....…..(12)

7.8 NOTES
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7.9 ILLUSTRATIVE PROBLEM
Company X has negotiated a contract on June 15 to sell 100 M.T (1 M.T = 1,000
kgs.) of sugar (standard grade). The price in the sales contract is the spot price on September
16. The spot price of sugar is Rs.2,550 /q and the September futures price is Rs.2,510 /q.
Devise a hedging strategy such that the company should receive a price close to Rs.2,510 /q.
Show the result if the price on September 16 happens to be (a) Rs.2,470 /q (b) Rs.2,565 /q.
Solution
Hedging Strategy

June 16 : Short 10 September futures contracts on sugar

(as minimum lot size is 10 MT on NCDEX)
September 16: Close out futures position
Result
(a) Price of sugar on September 16 is Rs.2470.00
The price received on sales contract 2470.00

Gain on futures contract 40.00

(2510 – 2470)
Total 2510.00
(b) Price of sugar on September 16 is 2565.00
The price received on sales contract 2565.00
Loss on futures contract -55.00
(2510 – 2565)
Total 2510.00

7.10 CASE STUDY 1 : GOLDEX LTD.

Mr. Amla, a post-graduate in finance, joined Goldex Ltd. as its CFO. Goldex is engaged
in the production and marketing of gold jewellery. On resuming duty as CFO, Mr. Amla
found that the company has not used futures market for hedging price risk. The purchasing
committee which met on Jan 5, decided to buy 100 kgs. of gold in June. The current spot

117
price is Rs.29,560 /10 gms. The one-year interest rate is 8% and the present value of storage
cost of each 10gms of gold for six months is determined to be Rs.285
Mr.Amla found that the actual June futures price equals the theoretical futures price.
Further, he has collected the data relating to weekly average percentage change in the spot
and future price of gold for 20 weeks (Table ). He is planning to trade futures on NCDEX.
Though the management was sceptical about the proposal to use futures market, Mr. Amla
succeeded in convincing the management about the utility of futures market.
Table : weekly average percentage change in spot and futures price of gold for the
last 20 weeks
Trading Spot Future Trading Spot Future
Week Price(%) Price(%) Week Price(%) Price(%)
1 2.1 2.8 11 -0.5 1.1
2 2.3 3.4 12 1.1 2.4
3 1.8 2.9 13 0.6 1.9
4 -0.2 1.3 14 0.9 2.8
5 0.7 1.5 15 1.3 2.5
6 1.3 3.6 16 1.8 3.3
7 0.9 1.8 17 0.6 2.1
8 1.2 2.7 18 0.7 2.2
9 0.5 1.3 19 1.4 3.1
10 1.5 3.6 20 0.6 1.8
Discussion Questions:
(1) In order to hedge the price risk due to possible rise in the price of gold in June, guess
what strategy Mr. Amla would have put to work?
(2) Determine the hedge ratio Mr. Amla would have used in his Strategy.
(3) How many contracts do you think Mr.Amla would have traded in the futures market,
given that each gold futures contract is for the delivery of I kg. of gold?
(4) Suppose on the settlement date (after 6 months from now) the spot price of gold
turned out to be Rs.30,290/10 gms., what will be the impact on the profitability of
the company ?
(5) What would have been the impact on company’s profitability if Mr. Amla did not
trade futures contracts?

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7.11 SUMMARY
This unit provided a brief discussion of hedging decisions using futures contracts.
By buying futures when a price risk leads to a loss, and selling futures when price declines
are undesired, one can avoid the adverse consequences of price changes. The hedger should
identify the net exposure to risk. He should determine what happens if price rise or fall. This
helps in deciding whether futures should be bought or sold. The hedge ratio is the ratio of the
size of the position taken in futures contracts to the size of the exposure. If the hedgers wish
to minimise the variance of their total positions, it may be optimal to use a hedge ratio
different from 1.0.

7.12 KEY WORDS

Hedging principles Long hedge Short hedge Cross hedge Hedge ratio

7.13 SELF ASSESSMENT QUESTIONS AND PROBLEMS

1. Define hedging. What principles need to be considered while using futures for hedging?
2. Define a short hedge and long hedge. Under what circumstances a short hedge and a
long hedge are appropriate?
3. Define ‘ Basis Risk’ . Illustrate with a suitable example.
3. Illustrate, with a suitable example, the procedure for estimating hedge ratio.
4. A trader enters into a short Long staple cotton futures contract when the futures price
is Rs.4,892 per quintal. The contract is for the delivery of 10 tons. How much does the
trader gain or lose if the cotton price at the end of the contract is (a) Rs.4810 per
quintal; (b) Rs.5,005 per quintal.
5. Suppose that the standard deviation of quarterly changes in the price of a commodity is
Rs.65, the standard deviation of quarterly changes in a futures price on the commodity
is Rs.81, and the coefficient of correlation between the two changes is 0.8. What is the
optimal hedge ratio for a three-month contract? What does it mean?
6. An investor has invested in 2000 shares of MTN Ltd. The spot market value of stock is
Rs.135. He wants to keep the investment for another one month but expects a fall in its
price. The investor chooses to hedge by buying futures contracts on NIFTY. The standard
deviation of the change in the price of MTN stock over a one-month period is 12. The
standard deviation of change in futures price of NIFTY Index over a one-month period
is Rs.21 and the co-efficient of correlation between the one-month change in price of

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 MTN stock and one-month change in the NIFTY futures price is 0.64. Determine the
minimum-variance hedge ratio (HR*) and the number of NIFTY contracts required.

7.14 REFERENCES
1. Financial Derivatives – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
2. Capital market Instruments – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
3. Risk Management – Insurance and Derivatives – By G.Kotreshwar (HPH)
4. Financial Derivatives – By Gupta (PHI)
5. Introduction to Futures and Options Markets – By John Hull (PHI)
6. Derivatives – By D.A.Dubofsky and T.W.Miller (Oxford)

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UNIT - 8 : STOCK INDEX FUTURES

Structure :
8.0 Objectives
8.1 Introduction
8.2 Meaning of Stock Index Futures
8.3 Major Indices Traded in the Indian Capital Market
8.4 Contract Specifications
8.5 Pricing of Index Futures
8.6 Portfolio Hedging
8.7 Notes
8.8 Illustrative Problems
8.9 Case Study
8.10 Summary
8.11 Key Words
8.12 Self Assessment Questions and Problems
8.13 References

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8.0 OBJECTIVES
After studying this units, you will be able to:
• understand the basic meaning of stock index and stock index futures,
• The basics of trading specifications stock index futures,
• Make a list of popularly traded stock indices in India,
• Find the price of a stock index future, and
• Illustrate the application of stock index futures for portfolio hedging.

8.1 INTRODUCTION
Stock index futures are the contracts written on a particular stock index like SENSEX.
These are one of the earliest financial futures introduced. The first index future contract was
traded at Kansas Board of Trade, USA, in 1982. Since then many leading derivative exchanges
throughout the world have started trading index futures. The basic objective behind creation
of index futures can be attributed to the need of portfolio managers to hedge their portfolio
risk. Index futures are ideal for hedging the risk of a portfolio of stocks. In recent times,
index futures are also increasingly used for speculative, arbitrage and portfolio insurance.
Therefore, index futures have turned out to be versatile instruments in derivatives market all
over the world. Trading of BSE Sensex futures commenced at BSE on 9th June, 2000. Trading
of Nifty futures commenced at NSE on 12th June 2000. This chapter provides an overview of
stock index futures and their specifications and illustrate the procedure for using index futures
for hedging purpose.

8.2 MEANING OF STOCK INDEX FUTURES

An ‘index’ is just a number that is computed to measure the price movements of
stocks, bonds and commodities. Stock market indexes are meant to capture the overall price
behavior of equity markets. A stock market index is created by selecting a group of stocks
that are representative of the whole market or segment of the market. For example, the BSE
sensex index is made up of 30 stocks that are traded on the BSE. The index value tracks the
movement of the market as a whole, which simply means that index measures the changes in
the value of a portfolio of stocks. An index is calculated with reference to a base period and
a base index value. Major stock indices actively traded in Indian stock exchanges are listed in
Appendix 6A.

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 Stock index futures are futures contracts in which the underlying asset is some stock
index. A stock index future is a distinctive financial derivative for the following reasons:
1) It is basically an exchange traded derivative
2) The price of index futures is always quoted in terms of index points and not in terms of
currency.
3) The contract size is specified as a multiplier. The multiplier for the BSE Sensex future
contract is 15. This means that contract size is 15 times the Sensex index points. If the
Sensex index is 20,100 points, the contract value is Rs.3,01,500.
4) The mode of settlement is compulsorily on cash basis. This is because indexes are not
physically deliverable.
5) The price of index futures is different from value of index futures. The price of index
futures is always quoted in terms of index points and not in term of currency. The value
of futures contract is calculated in terms of currency by multiplying index points by
the contract size (ie., multiplier).
6) The creation of stock index future contract is attributed to the need of stock market
investors, particularly portfolio managers who are concerned about possible decrease
in the value of portfolio. Managing the risk by dealing in individual stocks would be
very expensive. Instead stock index futures proved to be an ideal derivative for hedging
price risk of a portfolio of stocks.

8.3 MAJOR INDICES TRADED IN THE INDIAN CAPITAL MARKET

(1) Sensex
Sensex is the most widely used equity price index in the country. It is constructed
with the base year to be 1978-79, and comprises of 30 scrips of listed companies on the
Bombay Stock Exchange. The index has been serving the purpose of quantifying the price
movements and also the sensitivity of the market in an effective manner.
(2) BSE – 200 and the Dollex
Bombay Stock Exchange introduced a new index series in May 1994 with the title
BSE-200 along with the dollar-linked version of the BSE-200 called Dollex. For construction
of this index, equity shares of 200 companies selected on the basis of their market
capitalization and other factors from the specified and non-specified categories of listed
companies on The Stock Exchange, Mumbai, are included. The index is constructed taking
the year 1989-90 as the base. The index is constructed on the weighted aggregative basis,

123
with the number of equity shares outstanding as weights. On a given day, the index is calculated
as the percentage of the aggregate market value of the equity shares of all the companies (in
the sample) on that day to the average market value of those companies during the base
period.
(3) NIFTY
The NSE-50 index was launched by the National Stock Exchange of India Limited,
taking as base the closing prices of November 3, 1995 when one year of operations of its
Capital Market segment were completed. It was subsequently renamed S&PCNX Nifty –
with S&P indicating endorsement of the index by Standard and Poor’s and CNX standing for
CRISIL NSE Index. The index is based on the prices of the shares of 50 companies (chosen
from among the companies traded on the NSE). The base value of the index has been set at
1000.
(4) NIFTY Junior
While S&PCNX Nifty index includes highly liquid companies with a market
capitalization of more than Rs.5 billion, the S& P Nifty Junior includes companies which are
highly liquid, have a market capitalization of at least Rs.2 billion and which are other than
those included in the S& P CNX Nifty index set. It was introduced on January 1, 1997, with
a base date as November 4, 1996 and base value as 1000.
(5) BSE National Index
BSE started a new index in January 1989, called National Index comprising of 100
scrips from the specified and non-specified categories of listed companies on the country’s
five major stock Exchanges at Mumbai, Kolkata, Delhi, Ahmedabad and Chennai. In addition
to being a relatively broad-based index, this index enabled the assessment of stock price
movements on a national level. However, since October 1996, the prices of The Stock
Exchange, Mumbai, only are taken in to account for calculation of the index, which is now
designated as the BSE Index.
(6) BSE 500
The BSE 500 Index is a broad-based index comprising of 500scrips chosen from
among top 750 companies listed on The Stock Exchange, Mumbai, in terms of market
capitalization. The index is very broad-based covering all the 23 major industries and 102
sub-sectors of the economy. The index has the base date fixed at February 01, 1999 and has
the base value set at 1000.

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8.4 CONTRACT SPECIFICATIONS

A typical stock index contract specifies the underlying stock index, the contract size,
the tick size, and the margins to be maintained. It also contains the month in which the
contract is going to expire. Some samples contracts on stock indices are given in Box 1 and
Box 2. Box 6.1 contains contract specification in respect of the Sensex Futures, traded on
the BSE. Another example of contract specification of an S&P NIFTY futures contract are
given in Box 1
It may be noted that every index futures contract has a “multiplier” which for instance
is 15 for SENSEX. This is used for determining the value of a futures contract. For example,
the value of a futures contract on SENSEX, when SENSEX value is 20,000, would be equal
to 20,000 X 15 = 3,00,000. The minimum and maximum movements in prices of futures
contracts are provided by exchange. It is evident that the underlying in these contracts are,
respectively, SENSEX and S&P CNX Nifty indices. In each of these contracts the life time
of every series is 3 months at any point in time, 3 series are open for trading including those
expiring in the near month, next month and far month. In each case the contract matures on
the last Thursday of the designated month.
Nifty Futures
Underlying symbol denotes the underlying index which is S&P CNX Nifty.
S&P CNX futures contracts have a maximum of 3-month trading cycle – the near
month (one), the next month (two) and the far month (three). A new contract is introduced on
the trading day following the expiry of the near month contract. The new contract will be
introduced for a three month duration. This way, at any point in time, there will be 3 contracts
available for trading in the market i.e., one near month, one mid month and one far month
duration respectively. S&P CNX Nifty futures contracts expire on the last Thursday of the
expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous
trading day. The permitted lot size of S&P CNX Nifty futures contracts is 200 and multiples.

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Box 1 : Contract specifications for futures on Sensex

Source : The Stock Exchange, Mumbai – www.bse.india.com

The price step in respect of S&P CNX Nifty futures contracts is Re. 0.05. Base price
of S&P CNX Nifty futures contracts on the first day of trading would be theoretical futures
price. The base price of the contracts on subsequent trading days would be the daily settlement
price of the futures contracts.
There are no day minimum/maximum price ranges applicable for S&P CNX Nifty
futures contracts. However, in order to prevent erroneous order entry by trading members,
operating ranges are kept at + 10%. In respect of orders which have come under price
freeze, members would be required to confirm to the Exchanges that there is no inadvertent
error in the order entry and that the order is genuine. On such confirmation the Exchange
may approve such order. Quantity Freeze for S&P CNX Nifty futures contracts would be

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 20,000 units or greater. However, in exceptional cases, the Exchange may, at its discretion,
not allow the orders that have come under quantity freeze for execution for any reason
whatsoever including non-availability of turnover/exposure limits.
Sensex Futures
The underlying for the SENSEX futures is the BSE Sensitive index of 30 scrips,
popularly called the SENSEX. The contract multiplier is 15. This means that the Rupee
notional value of a futures contract would be 15 times the contracted value. The ticker symbol
is BSX. Regulations permit introduction of futures upto 12 months maturity initially. However,
futures for the three near months have been introduced. The expiry date has been fixed as the
last Thursday of the month for each month.
Box 2 :Contract specifications for Futures on S&P CNX Nifty

Item Specification
Security Description UDITX NIFTY
Underlying Unit S&P CNX Nifty Index
Contract Size 200 or multiples thereof
Price Steps Re. 0.05
Price Bands Not applicable
Trading Cycle A maximum of three month trading cycle the near
month (one), the next month (two) and the far
month (three). New contract is introduced on the
next trading day following the expiry of near
month contract.
Last Trading/Expiration day The last Thursday of the expiry month, or the
preceding trading day if the last Thursday is a
trading holiday
Settlement In cash on T+1 basis
Final Settlement Price Index closing price of the last trading day.1
Daily settlement price Closing price of futures contract
Settlement day Last trading day

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1. On the last day, the futures closing price for each Nifty futures contract is computed
by taking the weighted average price for the last half-an-hour’s trades.
Source: NSE Fact Book 2000
The day after the expiry, a new future would come into existence for next month
maturity. For example on 30th of June the September future would come into existence offer
expiry of August futures. The tick size is “0.1”. This means that the minimum price fluctuation
in the value of a future can be only 0.1. In Rupee terms, this translates to minimum price
fluctuation of Rs.1.5 (Tick size X contract Multiplier = 0.1 X Rs.15).
The futures closing price will be calculated based on a set of 120 price points of the
cash sensex values taken between the last half an hour of trading. The highest and lowest 20
price points will be ignored and closing price computed as an average of the remaining 80
price points. This process will ensure that manipulation of the closing price by moving it in
one direction for a short duration or for only a few contracts is eliminated.
The profits and losses would depend upon the difference between the price at which
the position is opened and the price at which it is closed. Consider the followings examples:
Position – Long –Buy June Sensex Futures @ 18,000
Payoff : Profit – If the futures price goes up
Loss – if the futures price goes down
Calculation – The profit or loss would be equal to fifteen times the difference in the
two rates. If June Sensex Futures is sold at 19,000 there would be a profit of 1000 points
which is equal to Rs.15,000 (1000X15)
However if the June Sensex Futures is sold at 17,500 there would be a loss of 500 points
which is equal to Rs.7,500 (500X15).

8.5 PRICING OF INDEX FUTURES

A Stock index traces the change in the value of a hypothetical portfolio of stocks. The
value of a futures contract on a stock index may be obtained by using the cost of carry model.
For such contracts, the spot price is the “spot index value”, the carry cost represents the
interest on the value of stocks underlying the index, while the “carry return” is the value of
the dividends receivable between the day of valuation and the delivery date. Accordingly,
indices are thought of as securities that pay dividends, and the futures contracts valued
accordingly. The valuation of stock index futures may be done as follows:

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Case 1 : When the securities included in the index are not expected to pay any dividends
during the life of the contract:
F=
Where F is the value of futures contract, is the spot value of index, r is the continuously
compounded risk-free rate of return, and t is the time to maturity (in years).
Example
Calculate the value of a futures contract using the following data:
Spot value of index = 16,550
Time to expiration =76 days
Contract multiplier = 100
Risk-free rate of return = 7.7% p.a.
From the given information, we have
Spot value, = 16,550
Time to expiration =76/365 year
Accordingly,
F = 0
76
= 16,550 (0.077
365
= 16,550 * 1.01615
= 16817.2825
Thus, the value of a contract = 16817.2825 *100 =16, 81,728.25
Case 2: : When the securities included in the index are expected to pay any dividends during
the life of the contract. Pricing of index futures contracts is based on the same principle as
applicable to any others financial asset, i.e,
F = (S0 – D) ert
Where, So = index value at present
F= Futures price
r = risk-free rate; and
T = time to maturity
D = present value of dividends on all stocks in the index.

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In case the estimated dividend yield (d) is provided, the above formula can be restated as;
F = So x e(r-d)T
Example
Consider a 3-month futures contract on the BSE 30 Sensex index. Assume that the
dividend yield is estimated to be 4%. The current value of the index is 19,600 points, and the
risk-free rate is 8%. What will be the price of the futures contract with expiry in three months?
Since F = S x e(r-d)T
=19,600 x e (0.08-0.04)(90/365)
=19,794.21
Thus, the value of the future contract will be 19,794.21 × 15 = Rs. 2,96,913.15

8.6 PORTFOLIO HEDGING

A portfolio of shares can be hedged by selling an appropriate number of index futures
contracts. This requires: (1) Selection of an appropriate index that matches with the
portfolio.(2) Estimating beta of the portfolio. If the portfolio to be hedged is typically
different from the portfolio of stocks underlying the index on which the futures are written,
hedging will not be optimal.
The beta (b) of the portfolio indicates the degree of correlation between the returns
in portfolio and market index. For instance, b value of 1 means that the return in the portfolio
tends to follow the return on the market. If b=0.5, given 1% increase in the return on market,
there shall be 0.5% increase in the return on portfolio. Therefore, b value is the determining
factor in deciding the number of future contracts to be taken up for hedging:
N=b x S/F
Where, S is the value of the portfolio and F s the price of the futures contract( i.e.,
futures price x size of each contract).
Example
A investor has a portfolio of five stocks of value of Rs.78,98,000 . On June 1st he is
expecting a possible fall in the prices of the shares in the near future. Accordingly, he decides
to use Nifty futures to hedge against the possible fall in the value of his portfolio.
i. The current Nifty value is 5850
ii. Nifty futures can be traded in units of 200 only

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iii. Risk-free rate of interest is 8%.
iv. Expected dividend yield on portfolio is 3%
v. Portfolio beta is 1.5
The current futures price should be:
F = So x e(r-d)T
= 5850 x e (0.08-0.03)0.25
= 5923.58
Then, the value of future contract will be
5923.58 x 200 =11,84,716
The number of futures contracts to be taken is given by
N=b x S/F
=1.5 x 78,98,000 /11,84,716
= 9.9
This means that a short position will be taken in 10 future contracts. Suppose, on
75 day from the origin of the futures contract, the investor wants to wind up his futures
th

contracts. Suppose that Nifty is trading at Rs 5,600 on 75th day (i.e., somewhere in the middle
of August). Then the futures price for maturity in august will be:
F = S x e (0.08-0.03)15/365
= 5600 x 1.00205
= 5611.49
Gain from the futures contract will be:
Gain = [opening price – closing price] x size x No. of contracts
= [ 5923.58 - 5611.49] x 200 x 10
= [312.09] x 200 x 10
= Rs. 6,24,200
This shows that the gain on future contract compensate for decline in the value of portfolio
investment due to fall in Nifty from 5850 to 5600 level as shown below:

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1) Fall in the value of market index
[ Index value on day 1 - index value on 75th day x 100 ]
Index value on day 1
= 5923.58 – 5611.49
5923.58
= 5.27 %
2) Fall in the value of portfolio will be equal to:
5.27 pc x 1.5 = 7.9 %
3) Therefore, the fall in the value of portfolio
= 7.9 % x 78,98,000
= 6,23,942
It can be observed that the gain in futures contract is not exactly equal to the fall in the value
of portfolio due to approximation of 9.9 as 10 futures contracts.

8.7 NOTES
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8.8 ILLUSTRATIVE PROBLEMS
Problem 1
The current value of Sensex is 21,100 points. Assume that the dividend yield is 2%
and the risk free rate of interest is 8%. What will be the value of futures contract with expiry
in 90 days and a lot size of 15?
Solution
Since F = S × e(r – d) T
= 21,100 × e (0.08 – 0.02) (90/365)
= 21,416.50
The value of futures contract will be
= 21,416.50 × 15
= Rs. 3,21,247.50
Problem 2
On March 31st 2014 an investor has a portfolio of 5 shares as given below:
Share Price No. of Shares Beta
A 60 5000 1.05
B 80 8000 0.35
C 100 10000 0.80
D 125 15000 0.85
E 140 1500 0.75
In view of volatile stock market gripped by bearish trend, the investor plans to hedge
his portfolio investment by trading June index futures with a strike price of 1500.
Required:
(1) What position would investor take in the futures market? Why?
(2) If the index futures has a minimum lot size of 250 units; find the number of contracts
the investor needs to trade in order to get full hedge until June for his portfolio.
(3) Calculate number of future contract the investor should trade if he desires to reduce
beta of his portfolio to 0.50.

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Solution
Share Price No. of Shares Total Weights Beta Beta of Portfolio
A 60 5000 3,00,000 0.075 1.05 0.07875
B 80 8000 6,40,000 0.159 0.35 0.05565
C 100 10000 10,00,000 0.248 0.80 0.1984
D 125 15000 18,75,000 0.466 0.85 0.3961
E 140 1500 2,10,000 0.052 0.75 0.039
40,25,000 0.7679
(1) The investor has to take a short position in futures market.
(2) The value of each futures contract:
1500 × 250 = 3,75,000
No. of futures contracts required :
= 40,25,000 × 0.7679
3,75,000
= 8.23 or 8 contracts
(3) Total value of the portfolio = Rs. 40,25,000
Target beta value = 0.5
No. of futures contracts required will be
= 40,25,000 × 0.5
3,75,000
= 5.36 contracts or 5 contracts

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8.9 CASE STUDY
Mr. Anmol is the manager of a large mutual fund. The stock portfolio which accounts
for more than 60% of total investment corpus of mutual fund with sector-wise composition
as follows:
Sector % investment
IT 28
BANK 22
FMCG 18
ENERGY 16
PHARMA 16
The values of the portfolio on June 1st is Rs200 millions. Mr. Anmol is expecting
down trend in the stock market over next 3 month. He is considering index futures to hedge
the portfolio. He has collected information on stock index futures on June 1st. Table below
provides details of the futures contracts on NSE and BSE on June 1.

Name of futures lots size current value (Rs) price of futures expiring 30th Aug
S&P CNX NIFTY 200 5,990 6,100
BANK NIFTY 200 9,950 10,140
CNX IT 200 5,140 5,230
SENSEX 200 20,130 21,180
Mr.Anmol has estimated the values of return on the portfolio with the indexes as well as beta
Name of futures correlation Beta
S&P CNX NIFTY 0.92 0.97
BANK NIFTY 0.90 0.85
CNX IT 0.85 0.89
SENSEX 0.98 1.01
Mr. Anmol is looking at various hedging options.
Discussion Question:

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1) Which index do you think is more appropriate for hedging the portfolio?
2) What position would Mr. Anmol take in the futures market?
3) Determine the No. of futures contracts that could be used for hedging in this case.
4) Calculate the value of the portfolio on Aug 30 if the chosen index futures fell by 10%
at the time of closing out the futures contract.
5) What is the gain in the value of hedged portfolio compared to the value without hedge?

8.10 SUMMARY
Stock index future is one of the most popular financial derivative serving the hedging
needs of stock investors and portfolio houses. A stock index future is simply a futures contract
with the underlying asset being a stock index such as Nifty or Sensex. Stock index futures
are available today on all major stock indexes all over the world.
The value of a stock index future is not just equal to the index points. It is arrived at
after multiplying the index price by the multiplier (i.e., lot size) which is different for each
specific index futures contract. The valuation procedure of stock index future is similar to
the valuation of other futures contracts. The unique feature of a stock index futures contract
is that it ought to be cash settled, as the underlying index is physically non-deliverable. Though
stock index futures are available on a wide range of stock indices in India, all of them are
suitable for hedging only on short term basis, not exceeding 3 month duration.

8.11 KEY WORDS

Stock index Stock index futures Multiplier Portfolio hedging
8.12 SELF ASSESSMENT QUESTIONS AND PROBLEMS
1. What are stock index futures? Why were they created?
2. Discuss the distinctive features of stock index future as a financial derivative.
3. What are the contract specifications of following stock index futures contracts?
(a) Nifty futures
(b) Sensex futures
4. Explain, with a suitable example, the application of stock index futures for hedging risk
of a stock investment portfolio.

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5. The current value of Sensex is 20,500 points. Assume that the dividend yield is 3% and
the risk free rate of interest is 9%. What will be the value of futures contract with
expiry in 90 days and a lot size of 15 ?
6. On Jan. 1st 2014 an investor has a portfolio of 6 shares as given below:
Share Price/share No. of Shares Beta
P 160 800 1.05
Q 180 1800 0.35
R 200 2000 0.80
S 225 1500 0.85
T 140 2500 0.75
M 120 1200 1.20
In view of volatile stock market gripped by bearish trend, the investor plans to hedge
his portfolio investment by trading March Nifty index futures with a strike price of 6100.
Required:
1) What position would investor take in the futures market? Why?
2) Determine the portfolio beta.
3) If Nifty futures have a minimum lot size of 200 units; find the number of contracts the
investor needs to trade in order to get full hedge until March for his portfolio.
4) Calculate number of future contract the investor should trade if he desires to reduce
beta of his portfolio to 0.50.
7. Nifty future is currently trading at 6,120 points. The value of equity portfolio owned by
a mutual fund is Rs.40 million. The risk-free rate is 8% and the dividend yield on the
index is 3% and the beta of portfolio is 1.2. The fund manager plans to use futures
contract on Nifty to hedge the portfolio over the next 3 months. The lot size of futures
contract is given as 200 times. Determine how many futures contract are required to
hedge the risk. Suppose the value of Sensex after 90 days drops to 5,900 show how the
gain on index futures contract compensates the loss in the value of investment portfolio.

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8.12 REFERENCES
1. Financial Derivatives – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
2. Capital market Instruments – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
3. Risk Management – Insurance and Derivatives – By G.Kotreshwar (HPH)
4. Financial Derivatives – By Gupta (PHI)
5. Introduction to Futures and Options Markets – By John Hull (PHI)
6. Derivatives – By D.A.Dubofsky and T.W.Miller (Oxford)

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 MODULE-III
FORWARDS AND FUTURES

UNIT-9 : CALL OPTIONS BOUNDS

Structure:
9.0 Objectives
9.1 Introduction
9.2 Options’ Classification
9.2.1 On the basis of nature of contract.
9.2.2 On the basis of exercise style.
9.2.3 On the basis of place of trading.
9.3 Options Position
9.4 Option Price
9.5 Understanding Options Quotations
9.6 Intrinsic & Time Value of Options
9.7 Option Bounds - Meaning
9.8 Lower Bound of Call Prices
9.8.1 Lower Bound of European Call values of on Non-dividend Paying Stock
9.8.2 Lower Bound of European Call on Dividend Paying Stock
9.9 Upper Bounds of Call Prices (American & European)
9.10 Notes
9.11 Summary
9.12 Keywords
9.13 Self-Assessment Questions
9.14 References

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9.0 OBJECTIVES
After reading this unit, you should be able to;
• Describe intrinsic and time value of options.
• Identify classification and market quotes of options.
• Explain the concept of options bounds.
• Ascertain upper and lower bounds of call options.

9.1 INTRODUCTION
Options like futures, are also derivative instrument which gives the holder the
right to buy or sell a specified amount of underlying asset at a stipulated price (strike
price) within a specified period of time. Since options give a right to buy or sell, the
holder of the contract are not obliged to carry out the transaction in future. This is in
contrast to forwards and futures where both the parties have an obligation to perform
their commitments.
In case of options contract, there are two parties – one takes a long position, that
is, holder (buyer) of the contract and the other takes a short position, that is, the writer
(seller) of the contract. Options are generally categorized as calls and puts, where in
one gives a right to purchase and the other gives the right to sell. A trader can purchase
any of these contract based on their expectation about future price movement to construct
their trading strategies.
India joined the league of countries that trade options on exchanges in the year
2001 with introduction of Sensex options on 1st June and Nifty50 option on 4th June at
BSE and NSE respectively. Subsequently, on July 9, 2001 and November 9, 2001 both
BSE and NSE respectively added options trading in individual stocks. In the coming
section/chapters let us have a glance on basics of options, option prices, its minimum
and maximum value and few commonly used option trading strategies.

9.2 OPTIONS’ CLASSIFICATION

Options has several features, certainly more than forwards and futures making
several differentiations possible in the basic products of calls and puts. Based on several
considerations, the options can be categorized in a number of ways, such as:

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9.2.1 On the basis of Nature of Contract
♦ Call: A call option contract gives the holder the right to buy an asset by certain
date for a certain price.
♦ Put: A put option contract gives the holder the right to sell an asset by a certain
date for certain price.
9.2.2 On the basis of Exercise Style
♦ American Option: It can be exercised at any time up to the expiration date.
♦ European Option: This type of option contract can be exercised only on the
expiration date itself.
9.2.3 On the basis of Trading Place
♦ Exchange Traded Options: Contract that should be bought and sold on the specific
exchanges where the two contracting parties are not be known to each other but
instead enter into a contract on the floor/screen of an exchange.
♦ OTC Options: Contracts which are specific, customized and negotiated by two
contracting parties mutually with direct negotiations.

9.3 OPTIONS POSITION

There are two sides to every option contract. On one side is the investor/trader
who has taken the long position (i.e., has bought the options contract). On the other
side is the investor/trader who has taken a short position (i.e., has sold or written the
options contract).
There are four types of option positions that a trader can have. They are:
♦ A long position in call option contract wherein a trader holds or purchases a call
option contract from an exchange.
♦ A short position in call option contract wherein a trader writes or sells a call option
contract.
♦ A long position in put option contract wherein a trader holds or purchases a put
option contract from an exchange.
♦ A short position in put option contract wherein a trader writes or sells a put option
contract.

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 The writer of an option receives cash up front, but has potential liabilities later.
The writer’s profit or loss is the reverse of that for the purchaser of the option. Let us
see through an example about the payoffs of writer and holder of an options contract.
Mr. Shikhar purchases a call option contract from an exchanges which is written
by Mr. Rohith. The option price and exercise price specified in the European call option
contract is Rs. 6 and Rs. 280 respectively. The contract will expire on the last Thursday
of the current month. Here, Shikhar’s position on call option contract is long as he
holds the contract and Rohith’s position is short as he wrote the contract. If on the day
of expiry, the underlying asset price is Rs.250 or Rs.260 or Rs.270 or Rs.280 or Rs.290
or Rs.300, the payoffs (i.e., profit or loss) of Shikhar and Rohith’s position will be:
(Figures in Rs.)
Pay off
Stock Exercise Option
Shikhar’s Rohith’s
Price (A) Price (B) Premium (C)
Position Position
250 280 -6 -6 6
260 280 -6 -6 6
270 280 -6 -6 6
280 280 -6 -6 6
286 280 -6 0 0
290 280 -6 4 -4
300 280 -6 14 -14

On the day of expiry, if the stock price is Rs.250, Mr. Shikhar will not exercise
his right purchase instead he can purchase the same stock from the market by paying Rs.
250 instead of Rs.280/-. Here, loss to Shikhar is the premium which he paid (i.e., Rs.6)
to Rohith at the time of entering the contract. As contract is not exercised, Rohith can
keep the premium which will be his profit from the transaction. On the other hand, Shikar
will execute the contract only when stock price exceeds the exercise price as shown in
above table. The stock price level of Rs.286 will act as a break-even point where there is
no profit or no loss for the buyer and seller of the contract and it is also clearly indicated
in the table that the contract long position holder has limited loss and unlimited profit
potential and seller will have limited profit and he may bear unlimited loss.

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9.4 OPTION PRICE
A Price of an options contract refers to the price or premium that should be paid
to purchase an option contract (call or put). In contrast to forwards and futures, to purchase
an option contract it will cost a few rupees to the trader as it gives a right which he can
enjoy at the time of expiration of the contract or before the expiration of the contract.
Option bounds, in the following discussion, generally indicates the minimum or maximum
value an option can have if one intends to purchase. This is generally computed based on
the perspective of option writer who takes unlimited risk. Option price acts as a
compensation that option buyer gives to the option writer to purchase a right from the
latter by the former.

9.5 UNDERSTANDING OPTIONS QUOTATIONS

Options prices are read in the same way as that of any stock. Following screenshot
of option quotes from NSE indicates various trading terminologies used by the exchange
in quoting options metrics. The last traded price of the call was Rs.165.15. This is the
premium of Nifty50 call option as underlying asset with an exercise price of Rs.8450.00,
while the current value of the index is Rs.8484.95.

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Source: NSE, F&O Quote, as on 3rd Nov, 2016.
The expiration date of the contract is 24th November, 2016 which is the last
Thursday of the month. Generally, the equity F&O contracts expires the last Thursday of
every month in the country. Option type here is call, which is an indication that this
index option contract is call of European style of execution. At NSE, we don’t have
Nifty option contract with American style of execution, however, individual stock options
are available both the styles. This means if you purchase a call or put on Nifty50, you
cannot exercise you are right before the expiry date. You can exercise only on the day of
expiry. Apart from these data, market also quotes previous close – which is previous
day’s closing option price and high, low option prices of the current. In the above template,
the close price is ‘0’, this is because market is not yet closed at the time of taking
screen shot.
Other information pertaining to order book details, open interest (i.e., number of
contract which are not yet exercised), trading volume data, etc., are also available for
one’s perusal. The business dailies also provides information of options trading of the
previous day regularly. With this overview on option quotation, let us move on to some
of the conceptual framework of options contract, with first discussion on the intrinsic
and time value of money.

9.6 INTRINSIC & TIME VALUE OF OPTIONS

The intrinsic value of an option is defined as the amount, by which an option is in-
the-money, or the immediate exercise value of the option when the underlying position
is marked-to-market.
♦ For a call option: Intrinsic Value = Spot Price - Strike Price
Symbolically, Intrinsic Value = Max (S-X, 0)
♦ For a put option: Intrinsic Value = Strike Price - Spot Price
Symbolically, Intrinsic Value = Max (X-S, 0)
The intrinsic value of an option must be a positive number or 0. It cannot be
negative. For a call option, the strike price must be less than the price of the underlying
asset for the call to have an intrinsic value greater than 0. For a put option, the strike
price must be greater than the underlying asset price for it to have intrinsic value.

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Time Value of Options:
Time value of an option contract is the premium that an investor is willing to pay
over and above the intrinsic value of an option. It is the amount option buyers are willing
to pay for the possibility that the option may become profitable prior to expiration due
to favorable change in the price of the underlying. An option loses its time value as its
expiration date nears. At expiration an option is worth only its intrinsic value. Time value
cannot be negative.
Consider the following example of stock where in the information on option type,
stock price, exercise price and option price details have been provided.

The intrinsic and time value of above four option contracts are:

S. Option Strike Stock Premium Intrinsic Time

No. Type Price Price
1 Put 32 36 5.30 0 5.30
2 Call 50 48 4.10 0 4.10
3 Call 105 108 8.40 3 5.40
4 Put 45 41 9.70 4 5.70

9.7 OPTIONS BOUNDS - MEANING

One of the important principle while valuing options is that at any time, the value
of a call or a put cannot exceed certain limits – on the higher side as well as on the lower
side. In options literature, the maximum limit up to which an option value can go on the
higher side is commonly referred to as ‘upper bounds of an option’ and the maximum
limit below which an option value cannot fall is called the ‘lower bounds of an option’.

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 We will discuss the lower bound and upper bound of European call option contracts
in the following sections of the unit.

9.8 LOWER BOUND OF CALL PRICES

A call option gives a right to its holder/buyer to purchase an underlying asset in
future at a strike price agreed up front. As this contract provides a right, generally, a call
buyer may execute his contract if price of the underlying stock which he intends to
purchase in future exceeds the strike price of the contract as discussed earlier in section
9.3. If the underlying stock price is lower than the strike price, he will not execute the
contract because execution of the contract may result in reduction in call buyers wealth.
Hence, under any circumstances call option contract cannot have negative value because
no one can force the holder to execute his contract and intuitively, if call price is negative
it indicates that call buyer should receive cash flow at the time of purchase of contract,
which is meaningless. From, call writer\seller’s perspective, lower bound of call
represents the minimum price accepted by him. Let’s see how we can compute the lower
bound of call option contract in coming discussion.
9.8.1 Lower bound of European call values of non-dividend paying stock:
The calls with European style of execution can be exercised only on the day of
expiration and hence, the lower bound of call with European style of execution will be
equal to present value of its intrinsic value. Symbolically, the minimum price (lower
bound) of European contract acceptable by the writer of the call is :
−
= (0, − . )
−
Where, indicates the present value of the strike price.
= time to expiration.
= risk-free rate
S = underlying asset price

Let’s try an example – assume that an underlying asset value is Rs.102. One year
European option call at strike price Rs.108 is available. If the risk free rate is considered
to be 8%, the present value of 108 discounted at 8% would be
−0.08
= (0, 102 − 108. )
= (0, 102 − (108 0.92312))
= (0, 2.30)

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 = Rs.2.30/-
In this case, the value of the call cannot be less than Rs. 2.3 . If it falls to (say, Re
1) then –You can buy the call at strike 108 – you pay Re 1, You short sell the stock at 102
– You get 102. Your gain will be Rs.101 (i.e., Short sale – premium on call).
From that 101, you invest 100 in risk free bonds and get 108 at the year end. Use
that 108 to exercise the call and get back your shares. Get a profit of Rs 1, risk free –
immediately.
9.8.2 Lower bound European call on dividend paying stock:
We have seen in our previous discussion about how to compute the lower bound
of European call option contract of a stock which pays no dividend till the period of
expiration. But, when company pays a dividend within expiration period, it will have an
influence on the call price and hence we need to consider dividend factor in arriving at
minimum value of call option that pays dividend.
Following equation can be used to derive the minimum value of call option contract
with European style of execution and it pays dividend during life of the contract.

− −
= (0, − . − . )

−
Where, indicates the present value of the strike price.
= time to expiration.
= risk-free rate
S = underlying asset price
D = dividend per share
= time to dividend payment.

Let’s take an example where the stock value is at Rs.50 and three month call at
strike price Rs.40 are available. The dividend to be received after 2 months from now
later is estimated at Rs.5 per share. In this case, the value of the call cannot fall below
the share value Less (present value of dividend expected + present value of strike value)

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 − −
= (0, − . − . )

−0.08 3/12 −0.08 2/12

= (0, [50 – 20 X ]−5 )

= (0, 50 - 39.20 – 4.80)

= Rs.6.00/-
Hence, the lower bound value of a call cannot fall below Rs.6/-.
9.9 UPPER BOUNDS OF CALL PRICES
Upper bound of the call option contract indicates the maximum price a trader can
pay to purchase the contract. Let us see how we can find the upper bound of call in the
following discussion.
Upper Bounds of European Calls:
The upper bound of a European option contract depends on the stock price, as no
trader ready to pay more than the stock price itself to purchase the contract. Hence, the
maximum price is
The above relative expression indicates that the call prices cannot exceed the
underlying asset price.
We know that an American call option can be exercised at any time during the
contract period. The principle of upper bounds of American calls are the same as we saw
in upper bounds of European call values. The difference in exercisability will not make
any impact on the upper bound values. So, the upper bound value of an American call can
never rise beyond the value of the underlying stock. When the dividend is known with
certainty, the call values cannot rise beyond the spot value of the stock less present
value of the dividend.

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9.10 NOTES
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9.11 SUMMARY
An option gives a right to its holder to purchase or sell an underlying asset,
depending upon the contract which he purchases, at an agreed price which is called as
strike/exercise price in future, specifically at the end of expiration period. Options are
generally categorized as calls and puts, where in one gives a right to purchase and the
other gives the right to sell. In order to purchase an option contract a trader needs to
incur an upfront cost which is called as premium or option price. One important principle
while valuing options is that at any time, the value of a call or a put cannot exceed certain
limits – on the higher side as well as on the lower side and these limits are referred to as
upper and lower bounds of option contract respectively.
The minimum value of American call option contract cannot be negative and its
value should vary in between zero and difference between stock price and exercise price.
The upper bound value of a European call can never rise beyond the value of the underlying
stock. When the dividend is known with certainty, the call values cannot rise beyond the
spot value of the stock less present value of the dividend. The lower bound value of a
European call can never fall below the difference between stock value and the present
value of strike price. When the dividend is known with certainty, the call values cannot
fall below the spot value of the stock minus present value of the dividend minus present
value of the strike value.

9.12 KEY WORDS

♦ American Style: An option contract that can be executed any time between the
dates of purchase and its expiration.
♦ Arbitrage:The purchase of commodity or financial instrument in one market at
lower price and selling them in another market at a higher price.
♦ European Style: Contract that can be exercised only on the day of expiration.
♦ Exercise / Execute: Formal notification to implement the right under which the
buyer (holder) of an option is entitled to buy or sell the underlying asset.
♦ Strike Price or Exercise Price: The strike or exercise price of an option is the
specified/ predetermined price of the underlying asset at which the same can be
bought or sold if the option buyer exercises his right to buy/ sell on or before the
expiration day.
♦ Exercise Date: The date on which the option is actually exercised is called the
Exercise Date.

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♦ Expiration Date: The last day on which an option contract can be exercise. From
Indian equity derivatives market perspective, generally, expiration day is last
Thursday of every month.
♦ Open Interest: The total number of options contracts outstanding in the market at
any given point of time.
♦ Option Holder: is the one who buys an option, which can be a call, or a put option.
He enjoys the right to buy or sell the underlying asset at a specified price on or
before specified time.
♦ Option Premium: Premium is the price paid by the buyer to the seller to acquire
the right to buy or sell.
♦ Option Seller/ Writer: is the one who is obligated to buy (in case of put option)
or to sell (in case of call option), the underlying asset in case the buyer of the
option decides to exercise his option.

9.9 SELF-ASSESSMENT QUESTIONS

1. What are option price and option bounds?
2. European Style of options can never have negative premium. Discuss.
3. Explain the minimum value of a European Call can have.
4. What is the lower bound for the price of a 4-month call on a non-dividend paying
stock when the stock price is Rs.280, the strike price is Rs.250 and the risk free
rate of return is 8% per annum?
5. For a long call option with an exercise price of Rs.200 and an option price of
Rs.28, currently trading at Rs.190. Determine the intrinsic and time value of the
option contract.
6. A 4-month call option on a dividend paying stock is currently selling for Rs.5. the
stock price is Rs.64, the strike price is Rs.60 and a dividend of Re.1 is expected in
1 month. The risk-free rate is 12% per annum for all maturities. What opportunities
are there for an arbitrageur?
7. The price of a European call that expires in six months has a strike price of Rs.40
is available for Rs.7 in the market. The underlying stock price is Rs.34, and a
dividend of Rs.1.50 is expected in 45 days. If the risk-less rate is 5%, what is the
price of the option?

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8. What is the upper and lower bound of a call that expires after a month having an
exercise price of Rs.34, underlying asset price Rs.30 and risk-free rate of interest
is 6%?
9. Illustrate how you can arrive at the upper bound of a European Call option contract?
10. An April call option on a stock, XYZ with European style of execution, currently
priced at Rs.70 currently trades at $17. The current interest rate is 8.30% and
stock price is Rs.60. A dividend of Rs.7 is due, with the ex-dividend date being 50
days away. The time to expiration is 135 days. Find out lower bound of call that
should avoid riskless arbitrage opportunities?
11. ABC-ltd.’s stock is selling for Rs.50. ABC has decided to issue dividend of Rs.2 at
the beginning of three months from now. If the risk-free rate of interest is 10%,
then at what minimum price the following calls on the stock would sell for:
(a) A 1-month call with exercise price of Rs.45.
(b) A 2-month call with an exercise price of Rs.50.
(c) A 3-month call with an exercise price of Rs.55.

9.10 REFERENCES
♦ Chandra, P. (2011). Investment Analysis and Portfolio Management. New
Delhi: Tata McGraw Hill Education Private Limited.
♦ Damodaran, A. (2013). Investment Valuation Tools and Techniquesfor
Determining the Value of any Asset (3rd ed.). New Jersy: John Wiley & Sons.
♦ Dubofsky, D. A., & Miller, T. W. (2003). Derivatives - Valuation and Risk
Management. New York: Oxford University Press.
♦ Fischer, D. E., & Jordan, R. J. (2003). Security Analysis and Portfolio
Management (6th ed.). Delhi: Pearson education.
♦ Jarrow, R., & Turnbull, S. (2001). Derivatives Securities. Singapore: Thomson
Asia Pvt Ltd.
♦ Pandian, P. (2011). Security Analysis and Portfolio Management. New Delhi:
Vikas Publishing House Pvt Ltd.
♦ Parameswaran, S. K. (2010). Futures and Options : Concepts and Applications.
New Delhi: Tata Mcgraw Hill Education Private Limited.

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♦ Reilly, F. K., & Brown, K. C. (2011). Investment Anlysis and Portfolio
Management. Delhi: Cengage learning India Private Limited.
♦ Sridhar, A. N. (2011). Futures & Options : Equities - Trading Strategies and
Skills (4 ed.). Mumbai: Shroff Publishers and Distributors Pvt. Ltd.
♦ Srivastava, R. (2010). Derivatives and Risk Management. New Delhi: Oxford
University Press.

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UNIT-10 : AMERICAN OPTIONS

Structure :
10.0 Objectives
10.1 Introduction
10.2 Moneyness of Options
10.3 American Options - Meaning
10.4 Lower Bound of American Calls
10.5 Upper Bound of American Calls
10.6 Summary of Principles of American Options Bounds
10.7 Notes
10.9 Summary
10.10 Key words
10.11 Self-Assessment Questions
10.12 References

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10.0 OBJECTIVES

After reading this unit, you should be able to;

• Explain the concept of options bounds
• Describe the moneyness of options.
• Differentiate American option bounds from European bounds.
• Explain the principles of American option bounds.

10.1 INTRODUCTION
Remember that purchasing of a stock is completely different from purchasing of
a stock option contract. The holder of the equity options contracts do not have any of the
rights that owners of equity shares have, such as voting rights and the right to receive
bonus, dividend etc. To obtain these rights a Call option holder must exercise his contract
and take delivery of the underlying equity shares. But still, it can offer several benefits
to investors.
Options can offer an investor the flexibility one needs for countless investment
situations. An investor can create hedging position or an entirely speculative one, through
various strategies that reflect his tolerance for risk. Investors of equity stock options
will enjoy more leverage than their counterparts who invest in the underlying stock market
itself in form of greater exposure by paying a small amount as premium. Investors can
also use options in specific stocks to hedge their holding positions in the underlying
(i.e. long in the stock itself), by buying a Protective Put. Thus they will insure their
portfolio of equity stocks by paying premium.
Diverting from the benefits of options, let us see another variety of options
execution style, its upper and lower bound computation and moneyless of these contracts
in this unit.

10.2 MONEYNESS OF OPTIONS

Moneyness of options contract indicates whether exercising of options will result
in positive payoff or not. An option is said to be “at-the-money”, when the option’s
strike price is equal to the underlying asset price. This is true for both puts and calls.A
call option is said to be “in the money” when the strike price of the option is less than
the underlying asset price. For example, a Stock A” call option with strike of 3900 is
“in-the-money”, when the spot price of Stock “A” is at 4100 as the call option has a

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positive exercise value. The call option holder has the right to buy the Stock “A” at
3900, no matter by what amount the spot price exceeded the strike price. With the spot
price at 4100, selling Stock “A” at this higher price, one can make a profit.
On the other hand, a call option is out-of-the-money when the strike price is
greater than the underlying asset price. Using the earlier example of S&P BSE SENSEX
call option, if the S&P BSE SENSEX falls to 3700, the call option no longer has positive
exercise value. The call holder will not exercise the option to buy S&P BSE SENSEX®
at 3900 when the current price is at 3700 and allow his “option” right to lapse.

Moneyness CALL OPTIONS PUT OPTIONS

In-the-money Strike Price< Spot Price Strike Price > Spot Price
At-the-money Strike Price = Spot Price Strike Price = Spot Price
Out-of-the-money Strike Price > Spot Price Strike Price< Spot Price

A put option is in-the-money when the strike price of the option is greater than
the spot price of the underlying asset. For example, a Stock “A” put at strike of 4400 is
in-the-money when the spot price of Stock “A” is at 4100. When this is the case, the put
option has value because the put option holder can sell the Stock “A” at 4400, an amount
greater than the current Stock “A” of 4100. Likewise, a put option is out-of-the-money
when the strike price is less than the spot price of underlying asset. In the above example,
the buyer of Stock “A”put option won’t exercise the option when the spot is at 4800. The
put no longer has positive exercise value and therefore in this scenario, the put option
holder will allow his “option” right to lapse.
Consider another example of a hypothetical stock:

Option Strike Price Stock Price Call Option Price Classification

A Rs.160 Rs.167 Rs.13.50 In-the-money
B Rs.170 Rs.167 Rs.5.00 At-the-money

Here, the first call is in the money while the second one is out of the money,
as may be observed from the stock price and respective exercise prices.
Each exchange quotes different strike prices for a day on call option contract.
This is based on certain pre-determined proportions of In-the-money, At-the-money and
Out-of-the-money options called “Strike Intervals”. Each individual stocks will have their

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own strike intervals. Following tables depict Strike intervals of Nifty Indices and longer-
dated options.
1. The Strike scheme for all near expiry (near, mid and far months) Index Options is:

Number of strikes
Index Level Strike Interval In the money- At the money- out of the money
≤ 2000 50 8-1-8
>2001 ≤ 3000 100 6-1-6
>3000 ≤ 4000 100 8-1-8
>4000 ≤ 6000 100 12-1-12
>6000 100 16-1-16

Source: NSE
2. The Strike scheme for Nifty 50 long term Quarterly and Half Yearly expiry option
contracts is:

Number of strikers
Index Level Strike Interval In the money- At the money- out of the money
≤ 2000 100 6-1-6
>2001 ≤ 3000 100 9-1-9
>3000 ≤ 4000 100 12-1-12
>4000 ≤ 6000 100 18-1-18
>6000 100 24-1-24
Source: NSE
10.2 AMERICAN OPTIONS: MEANING
An American option is an option that can be exercised anytime during its life. It
allow option holders to exercise the option at any time prior to and including its maturity
date, thus increasing the value of the option to the holder relative to European options,
which can only be exercised at maturity. The majority of the exchange traded options
are American.
American options allow the holder to buy or sell a specified underlying asset, on
or before a predetermined expiration date. Since investors have the freedom to exercise
their American options at any point during the life of the contract, they are more valuable

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than European options, which can only be exercised at maturity. The last day to exercise
a American option on individual stock is normally on the last Thursday of a month in
which the option contract expires. Note that the name of this option style has nothing to
do with the geographic location.

10.4 LOWER BOUND OF AMERICAN CALLS

The lower bound of call generally depends on whether the contract is of American
style of execution or European style. We have already discussed about lower bound of
European Calls in the previous unit. Let us study how the bounds of American options
are different from its counterpart, the European.
As American style of option contracts can be executed any time within options’
expiration period, the minimum price acceptable to the seller cannot be less than its
intrinsic value, if call buyer intends to exercise his right. Thus the minimum value (lower
bound) of American Call can be computed as :

= (0, − )
= (0, − )
Where, indicates the strike price.
S = underlying asset price
The above expression means “Take the maximum value of the two arguments,
zero or S- X”. If the call price is lower than its intrinsic value, it would trigger an arbitrage
and due to this transaction pressure in some period of time, the price of the call will be
equal to its lower bound.
To prove this, consider the following example
Assume the Strike price of an American style call with 3 months maturity is Rs.130,
option premium attached to this contract is Rs.10 and the underlying stock price at present
is Rs.141. As the price (i.e., premium) of the contract is less than its intrinsic value (
Max (0, 141-130) , you could buy the call for Rs.10, exercise it — which would entail
buying the stock for Rs.130 — and then sell the stock for Rs.141 in the market
immediately. This arbitrage transaction would give an immediate riskless profit of Re.1
for the trader. If such kind of opportunity is found in the market at any time, all traders
may do this, which in turn drives up the option price. When the price of the call reached
Rs.11, the transaction would no longer be profitable.

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Therefore, Rs.11 is the minimum price of the above call option contract (
.
= (0, 141 − 130)

Illustration 1:
What is the lower bound of a 4-month American call option on a non-dividend
paying stock when the stock price is Rs.56, the strike price is Rs.50 and the risk free
interest rate is 9% per annum ?
As American style of option contracts can be executed any time within options’
expiration period, the minimum price acceptable to the seller cannot be less than its
intrinsic value, if call buyer intends to exercise his right. We assume here call is exercised
by the holder immediately, if that is the case, to calculate lower bound , we need to find
:
= (0, − )

= (0, 56 − 50)

=Rs.6/-

10.5 UPPER BOUND OF AMERICAN CALLS

We know that an American call option can be exercised at any time during the
contract period. The principle of upper bounds of American calls are the same as we saw
in upper bounds of European call values. The difference in exercisability will not make
any impact on the upper bound values.So, the upper bound value of an American call can
never rise beyond the value of the underlying stock. When the dividend is known with
certainty, the call values cannot rise beyond the spot value of the stock less present
value of the dividend.
Let’s assume that the call value of an option is Rs.55 and the underlying stock is
trading at Rs.50 in the spot market. In such a scenario, anybody can write the call and
sell the stock on spot, and take home the difference of 5 per share. Hence, it’s clear that
the call value at expiry cannot rise beyond the value of the underlying stock.
Now, let’s further assume that the company has announced a dividend of 5 per
share. Dividend, when paid, decreases the value of shares to that extent. Hence on expiry,
the stock will be valued at 45 (50 – 5) in the spot market and logically, the call value
cannot exceed 45 per share.

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 The gap here is associated with the observation that one can execute an American
option immediately, but the holder of a European option cannot cash in until time T,
when it will be discounted.

10.6 SUMMARY OF PRINCIPLES OF AMERICAN OPTIONS

BOUNDS
The principles of American options are summarized as follows:
1) If the stock price is zero, the American call must have a value of zero.
2) The minimum price of an American call option contract is either zero or the
difference between the underlying asset price and exercise price, whichever is
greater.
3) An American call never be worth more than its underlying asset.
4) For a stock that does not pay dividend during options maturity, dividend will not
affect the price of American call.
5) An American call can never be worth less than a European call.
6) Two American calls on the same stock having the same exercise price have to be
priced such that the one with a longer maturity is worth as much or more than the
one with shorter maturity.
7) If the underlying asset price is zero, the value of an American put must be its exercise
price.
8) The minimum value of an American put is either zero or the difference between the
exercise price and underlying asset price at start, whichever is greater.
9) The maximum value of an American put is its exercise price.
10) An American put is worth at least as much as the European put.

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10.8 NOTES
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10.9 SUMMARY
At the beginning of this unit, we started discussing about the usefulness of
option.Options can offer an investor the flexibility one needs for countless investment
situations.Investors can also use options in specific stocks to hedge their holding positions
in the underlying. Then we moved on to a new topic called Moneyness of options contract
which indicates whether exercising of options will result in positive payoff or not. It
looks at the value of an option if you were to exercise it right away. A loss would signify
the option is out of the money, while a gain would mean it’s in the money. At the
money means that you will break even upon exercising the option.A brief overview on
American options was also provided in this unit wherein we described an American option
can be exercised anytime during its life. The lower bound of the American option is
difference between stock price and strike price or zero, whichever is greater, whereas,
the upper bound value of an American call can never rise beyond the value of the underlying
stock.

10.10 KEY WORDS

♦ American Style : An American style option is the one which can be exercised by
the buyer at any time, till the expiration date, i.e. anytime between the day of
purchase of the option and the day of its expiry.
♦ At-the-Money: An option is at the money if the strike price of the contract equals
to the current market price of the underlying asset.
♦ Exercise / Execute : Formal notification to implement the right under which the
buyer (holder) of an option is entitled to buy or sell the underlying asset.
♦ Strike Price or Exercise Price : The strike or exercise price of an option is the
specified/ predetermined price of the underlying asset at which the same can be
bought or sold if the option buyer exercises his right to buy/ sell on or before the
expiration day.
♦ Exercise Date : The date on which the option is actually exercised is called the
Exercise Date.
♦ Expiration Date: The date on which the option expires is known as the Expiration
Date. On the Expiration date, either the option is exercised or it expires worthless.
♦ In-the-money: A call is in the money if the strike is less than current market price
of the underlying asset and reverse is true in case of put.

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♦ Intrinsic Value: The value of option price which is in excess of stock price over
exercise price in case of call and excess of exercise price over stock price in case
of put.
♦ Long: Option Buyer or holders’ position.
♦ Open Interest : The total number of options contracts outstanding in the market at
any given point of time.
♦ Option Price: The price or premium that should be paid to purchase an option
contract.
♦ Option seller/ writer : is the one who is obligated to buy (in case of put option)
or to sell (in case of call option), the underlying asset in case the buyer of the
option decides to exercise his option.
♦ Out-of-the-money: A call is out of the money if the strike price is greater than the
underlying asset price and vice versa in case of put option contract.
♦ Short: Option seller or writer’s position.
♦ Time Value: It is the difference between the premium of the option contract and
its intrinsic value.

10.11 SELF-ASSESSMENT QUESTIONS

1. State the underlying relationship between stock and strike prices for in-the-money
and out-of-the-money call and put options.
2. From the following data, determine for each American Options, the intrinsic and
time value.
S.No. Option Strike Price Stock Price Call Option Price
1 Put 360 320 53
2 Call 480 500 41
3 Call 1075 1050 84
4 Put 410 450 97
5 Put 196 192 08

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3. An American call on a dividend paying stock can never be exercised early. Discuss.
4. You are given below information on some options. State whether each one of these
is in-the-money, out-of-the-money or at-the-money.

S.No. Option Stock Price Strike Price

1 Call 106 110
2 Call 80 80
3 Put 224 200
4 Put 208 220
5 Put 24 30
6 Call 74 70

5. Explain the relationship between moneyness of the contract and contract’s intrinsic
value?
6. The price of an American call on a non-dividend paying stock is Rs.15. the stock
price is Rs.250, the strike is Rs.245 and the expiration period is 3 months. The
risk free interest rate is 8%. Derive upper and lower bound for the price of the
American Call?
7. How lower bounds of American calls different from its counterpart, the European?
8. Explain why American call on a dividend paying stock always worth at least as much
as its intrinsic value. Is the same true in case of European call option? Explain your
answer.
9. How option contracts are useful for a trader and investor?
10. How to arrive at maximum price of American Call? Illustrate.

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10.10 REFERENCES
♦ Chandra, P. (2011). Investment Analysis and Portfolio Management. New Delhi:
Tata McGraw Hill Education Private Limited.
♦ Damodaran, A. (2013). Investment Valuation Tools and Techniquesfor Determining
the Value of any Asset (3rd ed.). New Jersy: John Wiley & Sons.
♦ Fischer, D. E., & Jordan, R. J. (2003). Security Analysis and Portfolio Management
(6th ed.). Delhi: Pearson education.
♦ Hull, J. C. (2007). Options, Futures and Other Derivatives (6 ed.). New Delhi:
Pearson Education Inc.
♦ Jarrow, R., & Turnbull, S. (2001). Derivatives Securities. Singapore: Thomson Asia
Pvt Ltd.
♦ Pandian, P. (2011). Security Analysis and Portfolio Management. New Delhi: Vikas
Publishing House Pvt Ltd.
♦ Reilly, F. K., & Brown, K. C. (2011). Investment Anlysis and Portfolio
Management. Delhi: Cengage learning India Private Limited.
♦ Sridhar, A. N. (2011). Futures & Options : Equities - Trading Strategies and Skills
(4 ed.). Mumbai: Shroff Publishers and Distributors Pvt. Ltd.
♦ Vohra, N. D., & Bagri, B. R. (2014). Futuress and Options (2 ed.). New Delhi:
McGraw Hill Education (India) Provate Limited.

166
UNIT-11 : PUT OPTIONS BOUNDS

Structure :
11.0 Objectives
11.1 Introduction
11.2 Put Option Bounds - Meaning
11.3 Lower Bound of Put
11.3.1 Lower Bound of American Put
11.3.2 Lower Bound of European Put
11.4 Upper Bound of Put
11.5 Factors Affecting Option Price
11.6 Notes
11.7 Summary
11.8 Key words
11.9 Self-Assessment Questions
11.10 References

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11.0 OBJECTIVES
After reading this unit, you should be able to;
• Explain the concept of options bounds of put
• Describe the difference between lower bound value of American and European
options.
• Understand the determinants of option prices.

11.1 INTRODUCTION
A put option contracts are generally purchased by those traders who are long on
underlying asset and would like to sell the asset in the near future. The owner of a put
option contract has the right, but not obligation, to sell the underlying asset at a specified
strike price on or before a specified expiration day depending upon the style of execution
of the purchased contract. On the other hand seller of the put option contract has the
obligation to take delivery of the asset, if the put holder decide to exercise his option.
When a put contract is entered, the buyer of the contract should pay a sum of money to
the writer which is called as premium or option price. If the price of the asset rises
above the strike price and stays there, the put expires worthless. The put writer gets to
keep the premium as a profit, and the put buyer incurs a loss.

11.2 PUT OPTION BOUNDS - MEANING

A put option gives a right to sell the underlying asset at exercise price in future.
Therefore, the maximum value that one would pay to get the right is the exercise price,
if it is to be executed immediately. If there is still time remaining for exercise the value
of put cannot exceed its strike\exercise price in present value terms. Hence, irrespective
of the price of the underlying asset, a put options contract cannot be sold for more than
the present value of exercise price.
Let us discuss in the following section on how to arrive at minimum and maximum
value of put option that is acceptable in general.

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11.3 LOWER BOUND OF PUT
When a trader purchases a put option contract, he is entitled to a right which he
can execute at the time expiration of the contract to sell the underlying asset in future.
Upon execution the holder of the put option contract may earn unlimited profit and the
chances of loss which he may incur is limited only to the premium which he pays to the
writer of the contract. Put option writer who takes unlimited risk will get a premium
from the holder of the contract at the time of purchase of the contract. The minimum
price which is acceptable to the seller/writer of the contract in technical terms is called
as the lower bound of the put option contract. In the following explanation, let us see
how to arrive at the minimum and maximum price of put option contract with American
and European style of execution.
11.3.1 Lower Bound of American Put:
By purchasing a put with American style will provide a right to the buyer of the
contract to exercise his right to sell at any time during the trading hours till the contracts
expires.
The minimum value for an American put can be derived using following equation:

$ = (0, − )

Where, indicates the strike price.

S = underlying asset price
The above expression, that is, Max (0, X-S) means “Take the maximum value of
the two arguments, zero or E-S”
Let us consider an example wherein a put option contract on stock with an exercise
price of Rs.40 currently trading at a price of Rs.2.70. The current spot price of the stock
is Rs.37. If we assume this contract is of American style of execution then as per our
lower bound argument the option price should be:
$ = (0, 40 − 37)

= Rs.3
As the current option price (Rs.2.70) is lower than Rs.3, arbitrager will take
advantage of this scenario and they will buy put option contract with a strike price of
Rs.40 by paying Rs.2.70 and stock by paying Rs.37. This will result in a total outlay of

169
Rs.39.70 for the trader. Then, immediately they can sell the share for Rs.40 using the
put, this will give him a risk-free net gain of 30 paise. Due to similar arbitrage activities,
the option price will reach up to Rs.3.
Illustration 1:
An American put option contracts which will expire after 95 days is available in
the market for Rs.2. the underlying asset price of the option is Rs.50 and the exercise
price is Rs.45. the underlying asset will fetch a dividend of Rs.1.5 after 55 days, the risk
free rate of interest prevailing in the economy is 10%, compute the lower bound of the
contract?
Here, the option price is Rs.2, maturity time is 95 days, stock price is Rs.50 and
strike price is Rs.45. Though dividend is declared during the option period, put holder
can exercise it any time during the life of option and hence it may not affect put price.
Thus, lower bound of put will be:

$ = (0, − )
= (0,45 − 50)
=Re.0/-
11.3.2 Lower Bound of European Put
As European Put option contracts can be exercised only on the day of expiry, the
lower bound of put will be the difference between its present value of exercise price and
Spot price. If the stocks pays dividend then we need to consider present value of dividend
in expressing lower bound of put option contract. Thus, the minimum price acceptable
to the put writer will be:

$ = (0, . − − + . − )
Let us consider a three month European put with an exercise price of Rs.50. Let
the stock price be Rs.45. Let the risk free rate of return be 12% p.a. and the stock pays
no dividend over the next three months.
The lower bound for the European put is :
− −
$ = (0, . − + . )
3
−0.12
= (0, 50. 12 − 45 + 0)

= Rs.3.52/-

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 Suppose option price is Rs.3, implying that the lower bound of put is violated.
This will results in undervaluation of options and arbitrageurs will make use the
opportunity to earn risk less profit and due to which option price will rises to its lower
bound in short period of time.
Illustration-2 :
What is the lower bound for the price of a 3-month European put option contract
on a non-dividend paying stock when the stock price is Rs.55, the strike price is Rs.60
and the risk free interest rate is 6% per annum?
To compute the lower bound of the European put we need details of Stock price
and present value of exercise price. The stock price of Rs.55 which is provided in the
question. Let us compute the present value of exercise first using strike price, maturity
period and risk-free rate of interest.
−
Thus, present value of exercise = .
−0.06 3/12
60.
= 60 X 0.985125
=Rs.59.11/-
Therefore, minimum value of put is :
$ = (0, . −
− )

= Max ( 0 , 59.11 – 55)

= Rs. 4.11/-
Illustration-3 :
The price of a European put option that expires in six months has an exercise
price of Rs.40 is Rs.10. The underlying stock price is Rs.35 and a dividend of Rs.2 is
expected in 3 months. If the interest rate is 6%, then what will be the lower bound this
put?
To compute the lower bound of the put on dividend paying stock we need to use
following expression and then substitute the relevant value from the question to arrive at
lower bound.
$ = (0, . − − + . − )
6 3
−0.06 −0.06
= (0, 40. 12 − 35 + 2 . 12 )

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 = Max ( 0 , [40 X 0.97045 – 35] + 2 X 0.985125
= Max (0 , 5.79)
= Rs.5.79/-

11.4 UPPER BOUND OF PUT

Upper bound of the put option indicates the maximum price a trader can pay to
purchase the contract that gives the right to sell the underlying asset at strike price
irrespective of the price prevailing in the market. The maximum value of American put
is its strike price and European put is its strike price measured in present value terms.
Symbolically,
Upper Bound of Put American : $ ≤ and
Upper Bound of Put European : $≤ . −

Let’s take an example – the stock of APL is trading at Rs.800 right now. 1month
put options (PE) on this stock are available at a strike price of Rs.900. If we calculate
the present value of Rs.900 at 12% risk free interest rate compounded continuously,
we’ll get Rs.891 (that is, 900 X 0.99005). Logically, the upper bound price of a European
put cannot exceed that Rs.891 which is the present value of the strike. If price of the put
is above then arbitrageurs will utilize the opportunity to earn risk-less profit, which will
ensure the reestablishment of upper bound of put condition.
Now, if the dividend on stock is known, it doesn’t make any difference. The only
rule to be remembered in case of upper bound European out prices is that it cannot
exceed the present value of the strike price.Not that, in the worst case the maximum
loss that a put writer will suffer is the strike price. This loss is mitigated by investing the
present value of strike at 8% risk free investments.

11.5 FACTORS AFFECTING OPTION PRICE

In this section, we consider what happens to option prices when one of the factors
changes with all the others remaining fixed.
1) Current Stock Price:
If call option is exercised at some time in the future, the payoff from a call option
will be the amount by which stock price exceeds the strike price. Therefore call option
becomes more valuable as the stock price increases. For a put, the payoff on exercise is
the amount by which the strike exceeds the stock price and hence, put behaves in an
opposite way.

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2) Exercise Price:
If call is exercised at some time in the future, the payoff from a call option will
be the amount by which stock price exceeds the strike price. Therefore call option
becomes less valuable the strike price increases. Reverse conditions applicable to put
option, if strike price increases.
3) Time to Expiration:
Both put and call American options become more valuable as the time to expiration
increases. To see this, consider two options that differ only as far as the expiration date
is concerned. The owner of the long-life option has all the exercise opportunities open
to the owner of the short-life option and more. The long-life option must therefore
always be worth at least as much as the short-life option. European put and call options
do not necessarily become more valuable as the time to expiration increases.
4) Volatility in Stock Prices:
Roughly speaking, the volatility of a stock price is a measure of how uncertain
weare about future stock price movements.As volatility increases, the chance that the
stock will do very well or very poorly increases. The owner of a call benefits from price
increases but has limited downside risk in the event of price decreases. Therefore value
of calls increases as volatility increases. The same logic applies to put options.
5) Risk-free Rate of Interest:
If the stock price is expected to increase, an investor can choose to either buy the
stock or buy the call. Purchasing the call will cost far less than purchasing the stock.
The difference can be invested in risk-free bonds. If interest increase, the combination
of calls and risk-free bonds will be more attractive. This means that the call price will
tend to increase with increases in interest rates. However, when you sell the stock by
exercising the put, you receive certain amount of rupees. If interest rates increase, the
rupees will have a lower present value. Thus, higher interest rates make put less attractive.
6) Amount of Future Dividends:
The dividend have the effect of reducing the stock price on ex-dividend date. That
is a bad news for the value of call option and good news for the value of put option. The
value of call, therefore, be negatively related to the size of an anticipated future dividend
and vice versa in case of put option contract.

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 Summary of the effect on the price of the stock option of increasing one
variable while keeping all others fixed
European European American American
Variable
Call Put Call Put
Current stock price + - + -
Strike price - + - +
Time to expiration ? ? + +
Volatility + + + +
Risk- free rate + - + -
Amount of future
dividends - + - +

Notes:
+ indicates that an increase in the variable causes the option price to increase;
- indicates that an increase in the variable causes the option price to decrease;
? indicates that relationship is uncertain

10.8 NOTES
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11.7 SUMMARY
The owner of a put option contract has the right, but not obligation, to sell the
underlying asset at a specified strike price on or before a specified expiration day
depending upon the style of execution of the purchased contract.The minimum price
which is acceptable to the seller/writer of the contract is its lower bound and is the
difference between strike price and stock price or zero, whichever is greater in case of
American put. In case of European, one needs to consider present value of strike price
and dividend to arrive at lower bound. The maximum value of American put is its strike
price and European put is its strike price measured in present value terms. Later we
discussed about various determinants of call and put option prices to sum up this unit.

11.8 KEYWORDS
♦ American Style: An option contract that can be executed any time between the
dates of purchase and its expiration.
♦ Arbitrage: The purchase of commodity or financial instrument in one market at
lower price and selling them in another market at a higher price.
♦ European Style: Contract that can be exercised only on the day of expiration.
♦ Exercise / Execute: Formal notification to implement the right under which the
buyer (holder) of an option is entitled to buy or sell the underlying asset.
♦ Strike Price or Exercise Price: The strike or exercise price of an option is the
specified/ predetermined price of the underlying asset at which the same can be
bought or sold if the option buyer exercises his right to buy/ sell on or before the
expiration day.
♦ Exercise Date: The date on which the option is actually exercised is called the
Exercise Date.
♦ Expiration Date: The last day on which an option contract can be exercise. From
Indian equity derivatives market perspective, generally, expiration day is last
Thursday of every month.
♦ Open Interest: The total number of options contracts outstanding in the market at
any given point of time.
♦ Option Holder: is the one who buys an option, which can be a call, or a put option.
He enjoys the right to buy or sell the underlying asset at a specified price on or
before specified time.

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♦ Option Premium: Premium is the price paid by the buyer to the seller to acquire
the right to buy or sell.
♦ Option Seller/ Writer: is the one who is obligated to buy (in case of put option)
or to sell (in case of call option), the underlying asset in case the buyer of the
option decides to exercise his option.

11.9 SELF-ASSESSMENT QUESTIONS

1. How bounds computation of American style of contracts different from European
style of contracts. Elucidate.
2. A stock is selling for Rs.500. If the risk-free-rate of interest is 10% p.a., then at
what minimum price following put options of European style of execution will
have?
(a) A put with a strike of Rs.450 maturing after 1 month.
(b) A put with a strike of Rs.500 maturing after 2 months.
(c) A put with a strike of Rs.550 maturing after 3 months.
3. Explain the determinants of Option Prices?
4. Given the following data, what is the highest price of an American put?
Stock Price = Rs.485
Strike Price = Rs.450
Time to Expiration = 3 months
Risk-free Rate = 8.4% p.a.
The next ex-dividend date will be two months hence. You have established the
following probabilities for dividend amount:
Probability Dividend Amount (Rs.)
0.25 15
0.40 10
0.35 05

5. Stock price of ABC-ltd’s share is Rs.1800. if the risk free rate of interest is 6%
p.a., then at what minimum price following options on the stock of ABC, maturing
after a month would sell for:

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 (a) A call with a strike of Rs.1700.
(b) A put with a strike of Rs.1800.
(c) A call and put with a strike of Rs.1900 each.
6. How lower bounds of European put with non-dividend paying stock is different from
dividend paying stock? Illustrate.
7. What is the minimum and maximum price put option contracts? Explain.
8. A 1-month put on a non-dividend paying stock is currently selling for Rs.25. the
stock price id Rs.470, the strike price is Rs.500 and the risk-free rate of interest is
6% per annum. What opportunities are there for an arbitrageur?
9. Discuss the factors which will have varying influence on the price of call and put
option contracts.
10. A stock is selling for Rs.75. A put option with a strike of Rs.80 maturing after three
months are available on the stock. What should be the minimum price of the option
if the risk-free rate of interest is 12% p.a.? What would be the price of the same
option, if stock will fetch a dividend of Rs.3 at the end of two months?
11. Given the following data, what is the lowest price of an American put?
Stock Price = Rs.55
Strike Price = Rs.50
Time to Expiration = 3 months
Risk-free Rate = 10% p.a.
The next ex-dividend date will be two months hence. You have established the
following probabilities for dividend amount:
Probability Dividend Amount (Rs.)
0.01 1.5
0.10 1.7
0.50 1.9
0.38 2.1
0.01 2.3

8. Explain lower bounds of American & European put with illustration.

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11.10 REFERENCES
♦ Chandra, P. (2011). Investment Analysis and Portfolio Management. New Delhi:
Tata McGraw Hill Education Private Limited.
♦ Damodaran, A. (2013). Investment Valuation Tools and Techniquesfor Determining
the Value of any Asset (3rd ed.). New Jersy: John Wiley & Sons.
♦ Dubofsky, D. A., & Miller, T. W. (2003). Derivatives - Valuation and Risk
Management. New York: Oxford University Press.
♦ Fischer, D. E., & Jordan, R. J. (2003). Security Analysis and Portfolio Management
(6th ed.). Delhi: Pearson education.
♦ Hull, J. C. (2007). Options, Futures and Other Derivatives (6 ed.). New Delhi:
Pearson Education Inc.
♦ Jarrow, R., & Turnbull, S. (2001). Derivatives Securities. Singapore: Thomson Asia
Pvt Ltd.
♦ Pandian, P. (2011). Security Analysis and Portfolio Management. New Delhi: Vikas
Publishing House Pvt Ltd.
♦ Reilly, F. K., & Brown, K. C. (2011). Investment Anlysis and Portfolio Management.
Delhi: Cengage learning India Private Limited.
♦ Srivastava, R. (2010). Derivatives and Risk Management. New Delhi: Oxford
University Press.

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UNIT-12 : OPTIONS COMBINATIONS

Structure :
12.0 Objectives
12.1 Introduction
12.2 Combinations of options
12.3 Options Spreads Strategies
12.3.1 Bull Spread
12.3.2 Bear Spread
12.3.3 Butterfly Spread
12.3.4 Condor
12.4 Options Combinations Strategies
12.4.1 Straddles
12.4.2 Strangles
12.4.3 Strips
12.4.4 Straps
12.4.5 Box Spreads
12.5 Notes
12.6 Summary
12.7 Key words
12.8 Self-Assessment Questions
12.9 References

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12.0 OBJECTIVES
After reading this unit, you should be able to;
• Explain the concept of spreads and combinations
• Describe difference between various kinds of options trading/hedging strategies.
• Suggest suitable strategy for different market condition.

12.1 INTRODUCTION
Holding or writing a single option, either call or put, results in uneven gains or
losses with changes in the underlying asset prices. By making a payment of small premium
a call gives unlimited profit for the holder in a bullish market and put gives higher profit
in a declining market. Because of the non-symmetric profile of risk & reward of calls
and puts, by making a combination of these instruments we can generate a vast number
of risk return profiles to match our specific risk and return preferences. Due to this
ability to bring a trade-off between risk & reward, is one of the reasons traders continue
to trade in options.
Combination of options can be done in many ways. But, the most common and
popular blends are spreads which involve a mixture of either calls or puts and
combinations which involve a mixture of both calls and puts. These combinations or
strategies are used for trading or hedging purpose. If you combines option contracts
with the motive of managing risk, it would be called hedging but when they are combined
to assume risk, it would become speculation. Hence, it is necessary to have little bit
knowledge on these strategies under this course.

12.2 COMBINATIONS OF OPTIONS

The options literature often draws a distinction between spreads and combinations
where spreads are defined as constructed using calls or puts, but not both , while
combinations are constructed using both calls and puts, or options and the underlying
asset. While an understanding of simple calls and puts is enough to understand simple
strategies such as spreads, butterflies, condors, straddles and strangles that can help to
better define risk and even open up many more trading opportunities. Because options
prices are dependent upon the prices of their underlying securities, options can be used
in various combinations to earn profits with reduced risk, even in directionless markets.
Below is a list of the most common spreads and combinations strategies, but there are
many more—infinitely more. But this list will give you an idea of the possibilities. If

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you are contemplating these strategies, you should keep in mind the risks, which are
more complex than with simple stock options.
The most commonly used Options Spreads and Combination Strategies has been
depicted in following diagram and explained in detail in the next section.

12.3 OPTIONS SPREADS STRATEGIES

Options spreads are the basic building blocks of many options trading strategies.
A spread position is entered by buying and selling equal number of options of the same
class on the same underlying security but with different strike prices or expiration dates.
In other words, an option spread is established by buying or selling various
combinations of calls and puts, at different strike prices and/or different expiration dates
on the same underlying security. There are many possibilities of spreads, popular among
them are:
12.3.1 Bull Spread
A bull spread is used by one who is moderately bullish about underlying assets’
price movement. Since the perspective is bullish, the first position a trader will take is
long call or short put. However, as the trader does not have very aggressive view on the
price movement he will try to reduce his risk by entering in to a counter (opposite)
position. While establishing bullish spreads trader always buys lower strike price

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positions and sells higher strike price options irrespective of options type (calls or
puts).
We can broadly classify a bull spread strategy into bull call spread and bull put
strategy. Though underlying principle of these two strategies remains the same, that is,
buying contract at lower strike and selling another contract with higher strike price having
same expiration date and number of contract. The variation only in terms of type of
contract used (i.e., call or put).
Let us see an example to understand the functioning of bull spread strategy. Let
the strike price of a call option contract is Rs.100 and is available at NSE for Rs.18 and
another contract with a strike of Rs.140 available for Rs.9. Mr. Ajith has purchased first
contract and short the second one with the anticipation the price of the security will
increase in future. His payoff at the time of expiry for a possible range of stock prices
are:
Payoff of Bull Spread Strategy
(Figures in Rs.)

Stock Price Payoff from Long Call Payoff from Short Call Net Payoff
0 -18 9 -9
50 -18 9 -9
80 -18 9 -9
100 -18 9 -9
120 2 9 11
140 22 9 31
160 42 -11 31
180 62 -31 31
250 132 -101 31

If you observe the value of net payoff from bull spread, the maximum
loss is Rs.9, which is the cost strategy (i.e., Premium Received – Premium Paid) and
maximum profit is Rs.31 which is the difference between the two exercise prices minus
the net premium (i.e.,[140-100]-9). Thus, by constructing bull spread strategy a trader
can fix his profit as well as his profit to acceptable limit based on his preference.

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12.3.2 Bear Spread
A bear spread is a position where a trader has negative view on the stock. The first
position taken by the trader is a short call or long put but as he does not have a very
aggressive view he tries to reduce his exposure by adding a counter position. This spread
may be established with the help of either two call options or two put options but, while
establishing a bearish spread one must buy a higher strike price options and sell lower
strike price options.
For instance, ABC ltd.’s stock is trading at Rs.38 in June. An options trader bearish
on ABC decides to enter a bear put spread position by buying a JUL put with an exercise
price of Rs.40 for a cost of Rs.3 and sell a JUL put with a strike of Rs.35 for a cost of
Re.1 at the same time, resulting in a net debit of Rs.2 for entering this position. The
price of ABC stock subsequently drops to Rs.34 at expiration. Both puts expire in-the-
money with the JUL 40 call bought having Rs.6 in intrinsic value and the JUL 35 call
sold having Re.1 in intrinsic value. The spread would then have a net value of Rs.5 (the
difference in strike price). Deducting the debit taken when he placed the trade, his net
profit is Rs.3 (that is net value – net debit of premium). This is also his maximum possible
profit.
If the stock had rallied to Rs.42 instead, both options expire worthless, and the
options trader loses the entire debit of Rs.2 taken to enter the trade. This is also the
maximum possible loss.
12.3.3 Butterfly Spread
A butterfly requires more precision because, not only do you have to have an
opinion on direction, but also a target price. Essentially, a butterfly is a combination of
a bull spread with a bear spread using either all calls or all puts. The way a butterfly is
formed is by buying an in-the-money and an out-of-the-money call or put, and then selling
two calls or puts at the middle strike, which is your price target.To put it simple, to form
a butterfly strategy, at first
n You need to purchase a call with relatively low strike price, say X1.
n Then buy another call option with relatively high strike price, say X3.
n Sell two call options with a strike price, X2 which is half way between X1 and X3.
Suppose, if a company’s stock price is currently worth Rs.61. Consider a trader
who feels that a significant price move in the next three month is unlikely. Suppose the
market quotes of 3-month calls are as follows:

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 Strike Price (Rs.) Call Price (Rs.)
55 10
60 7
65 5

The trader could create a butterfly spread strategy by buying one call with a strike
price of Rs. 55 and another call with a strike of Rs.65 which will result in an outlay of
Rs.15, the premium paid to purchase two call options. Then he needs to write two call
option with a strike of Rs.60 on which he will receive a premium of Rs.14 (i.e., 7 X 2),
hence the cost of the butterfly spread is Rs. 1, which is a difference between premium
received and premium paid. If after 3 months the possible stock prices are (Rs.30, Rs.40,
Rs.50, Rs.55, Rs.60, Rs.65, Rs.70, Rs.80, Rs.9 or Rs.100) any of these prices, then
trader’s net payoff will be:
Payoff of Butterfly Spread Strategy
(Figures in Rs.)
Profit/loss on Profit/loss on
Stock Price Cost of the Profit/loss on
first long call second long Net Payoff
@Maturity Strategy 2 short calls
Call
30 -1 0 0 0 -1
40 -1 0 0 0 -1
50 -1 0 0 0 -1
55 -1 0 0 0 -1
60 -1 5 0 0 4
65 -1 10 0 -10 -1
70 -1 15 5 -20 -1
80 -1 25 15 -40 -1
90 -1 35 25 -60 -1
100 -1 45 35 -80 -1

When the stock price is in three months is greater than Rs.65 or less than Rs.55,
the net payoff for the trader will be Rs.-1, which is the cost of the strategy. He can earn

185
profit only when the price in future is in between Rs.55 and Rs.65 and the maximum
profit is limited to only Rs.4 in case of butterfly strategy in above example.
The butterfly spreads can also be created using put options wherein, the trader
should but put options with a low strike price and high strike price and then he need to
sell two puts with the price in between lower and higher strike price of long puts.
12.3.4 Condor
Like butterflies, Condor require you to have an opinion on direction and a price
target. Unlike butterflies, you can target a range in which you think the stock will be at
expiration. Where a butterfly requires you to sell two options at a central strike price
(which also is your price target), a condor could be profitable if the stock expires along
a range of prices because it involves selling at two different strike prices. The advantage
of a condor compared to a butterfly is it allows you to take a directional play, but it gives
you a larger range where you may do pretty well. Like a butterfly, a condor is composed
of either all calls or all puts.
Suppose, if the stock price is Rs.63, and we think the price after a month will be
somewhere between Rs.70 and Rs.75 at expiration, a condor can let us maximize profit
while limiting risk. We assume that in the market calls are quoted at a strike price of
Rs.65, Rs.70, Rs.75 and Rs.80 with a premium of Rs.12, Rs.9, Rs.6 and Rs.4 respectively.
To form a condor strategy, we can buy Rs.65 and Rs.80 calls and we need to sell
Rs.70 and Rs.75 calls. This will result in an upfront cost of Rs.1 which is difference
between premium on short calls and long calls (i.e., [9+6] – 12+4).
Profit is maximized if we expire between Rs.70-Rs.75 and our wings give us
protection if we miss our mark (i.e., Rs.70-75 range). Again, our maximum loss is the
cost of the condor, plus commissions if any.
You can by yourselves verify what will be the payoffs of condor if the stock
price at the time expiry happens to be Re.0 or Rs.40 or Rs.50 or Rs.60 or Rs.65 or
Rs.70 or Rs.75 or Rs.80 or Rs.90 or Rs.100 or Rs.1000?

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12.4 OPTIONS COMBINATIONS STRATEGIES
12.4.1 Straddles
The straddle is an unlimited profit, limited risk option trading strategy that is
employed when the options trader believes that the price of the underlying asset will
make a strong move in either direction in the near future. It can be constructed by buying
an equal number of at-the-money call and put options with the same expiration date.
If you think a stock is about to make a big move either to the upside or downside
but don’t know which way it could break, a straddle can allow you to take advantage of
that implied volatility. Typically, a long straddle involves buying an at-the-money call
and an at-the-money put, thus straddling where the stock currently is trading.
For instance, you assume that a company’s stock trading at Rs.50 and is going to
make an earnings announcement in a month period. Although you do not know whether it
is going to do well or poorly, you expect that there to be an outsized reaction to earnings,
so he initiates a straddle by buying a Rs.50 call and a Rs.50 put and the stock price may
reach to either Rs.80 or Rs.10. If it goes to Rs.80, then your put is worthless, but the
call you purchased is will save Rs.30 as you can purchase the stock at Rs.50 than Rs.8.
On the other hand, if the price goes to Rs.10, then call become worthless, but your put
offers Rs.40 more since you could sell the stock for Rs.50 than for Rs.10.
A straddle makes the most sense if you think something exceptional is going to
happen, but that implied volatility already likely is high, which would make the at-the-
money call and put fairly expensive. Anything less than a 10% move can cause a loss
because the position is so expensive to put on. Your maximum risk is right at the strike
price. If in our example the stock only moves to Rs.53 or Rs.46, you may get Rs.3 or
Rs.4 back on a position that may have cost Rs.5 or Rs.6 to initiate ( i.e., to purchase call
and put option contracts). If it works in your favor, though, the potential profit is open-
ended.
A long straddle is established by buying both a put and call on the same security
at the same strike price and with the same expiration. This investment strategy is profitable
if the stock moves substantially up or down, and is often done in anticipation of a big
movement in the stock price, but without knowing which way it will go. For instance, if
an important court case is going to be decided soon that will have a substantial impact on
the stock price, but whether it will favor or hurt the company is not known beforehand,
then the straddle would be a good investment strategy. The greatest loss for the straddle
is the premiums paid for the put and call, which will expire worthless if the stock price

187
doesn’t move enough. To be profitable, the price of the underlying asset must move
substantially before the expiration date of the options; otherwise, they will expire either
worthless or for a fraction of the premium paid. The straddle buyer can only profit if the
value of either the call or the put is greater than the cost of the premiums of both options.
A short straddle is created when one writes both a put and a call with the same
strike price and expiration date, which one would do if he believes that the stock will not
move much before the expiration of the options. If the stock price remains flat, then
both options expire worthless, allowing the straddle writer to keep both premiums.
12.4.2 Strangles
Like the straddle, a strangle is also a strategy that has limited risk and unlimited
profit potential. The difference between the two strategies is that out-of-the-
money options are purchased to construct the strangle, lowering the cost to establish
the position but at the same time, a much larger move in the price of the underlying is
required for the strategy to be profitable. A strangle is the same as straddle except that
the put has a lower strike price than the call, both of which are usually out-of-the-money
when the strangle is established. The maximum profit will be less than for an equivalent
straddle.
For the long position, a strangle profits when the price of the underlying is below
the strike price of the put or above the strike price of the call. The maximum loss will
occur if the price of the underlying is between the 2 strike prices. For the short position,
the maximum profit will be earned if the price of the underlying is between the 2 strike
prices. As with the short straddle, potential losses have no definite limit, but they will be
less than for an equivalent short straddle, depending on the strike prices chosen.
Let us reconsider our previous example of Rs. 50 stock, but in this case you buy
the 45 put and the 55 call to form a strangle strategy. The advantage is that by buying out-
of-the-money options, your initial cost is much lower, but at the same time you need to
have a bigger move in the underlying for it to be profitable. If you were able to buy both
the put and call for Rs.1 each, then stock will have to reach Rs.57 or Rs.43 just to break
even (not including any transaction cost).
You also are able to short a strangle, but the same issues apply as if you were to
short a straddle. With all of these strategies, you need to be aware of your positions
going into expiration. If a portion of your strategy is in-the-money and you do not want
to take possession, then you need to ensure you are able to exit that position before
expiration. Although these strategies allow you to balance your risk- reward profile to
your liking, you always should consider the worst-case scenario when taking on a trade.

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12.4.3 Strips
A strip position is just an extension of straddle. A straddle buyer expects the
market significant market moves but unsure about the direction of it. If market goes up,
call generates money for him and vice versa. However, if a trader believes that although
market move in either direction, there is a greater possibility of downward movement
than upward and hence, he buys two puts and one call to advantage of the down side
movement. Hence we can say that a strip is a modified, more bearish version of the
common straddle and its construction is similar to the straddle except that the ratio of
puts to calls purchased is 2:1.
Assume for instance, that the cash price of a Stock-X is Rs.200 and you are unsure
about the direction of market price movement in X, but you believe that there will be
substantial movement in prices. Moreover your belief is there will be higher chances of
fall in the price than increase and hence you decided to construct a strip strategy. In
order to form a long strip strategy, you need to purchase one call and two put option with
a strike of Rs.200 on payment of a premium of Rs.10 each, resulting to an total outflow
of Rs.30 (i.e. 1 call + 2 put premiums).
Your pay-offs under different scenarios of stock-X’s prices, at maturity are given
in following table.

Stock Price Profit/loss on Profit/loss on Net Payoff on

Premium Paid
@Maturity Call 2Puts Strip
150 -30 0 100 70
160 -30 0 80 50
170 -30 0 60 30
180 -30 0 40 10
185 -30 0 30 0
190 -30 0 20 -10
200 -30 0 0 -30
210 -30 10 0 -20
220 -30 20 0 -10
230 -30 30 0 0
240 -30 40 0 10
250 -30 50 0 20

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 The above table indicates that you will lose money between the levels of Rs.185
and 230 (break-even levels). Under strip strategy in the above example, you may end up
losing maximum of Rs.30 (i.e., option premium) no matter what the price in future.

12.4.4 Straps
The strap is a more bullish variant of the straddle. Twice the number of call options
are purchased to modify the straddle into a strap. Unlike the buyer of strip position, a
strap buyer expects the stock to move significantly in either direction with a greater
probability of an upward reaction than downward and therefore, he buys two calls and
one put to construct his strategy. A strap is a specific option contract consisting of 1 put
and 2 calls for the same stock, strike price, and expiration date.
Let us reconsider the example of Mr.A and will assume that he is expecting a
price hike than fall. His pay off of Straps for possible ranges of stock price at the time
of expiration is:

Stock Price Profit/loss on Profit/loss on Net Payoff on

Premium Paid
@Maturity 2Calls Put Strip
150 -30 0 50 20
160 -30 0 40 10
170 -30 0 30 30
180 -30 0 20 0
185 -30 0 15 -15
190 -30 0 10 -20
200 -30 0 0 -30
210 -30 20 0 -10
220 -30 40 0 10
230 -30 60 0 30
240 -30 80 0 50
250 -30 100 0 70

Under straps in the above example, Mr. A may end up losing maximum of Rs.30
(i.e., option premium) no matter what the price in future.

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12.4.5 Box Spreads
A box spread consists of a bull call spread and a bear put spread. The calls and
puts have the same expiration date. Consider two strike prices X1 and X2, such that X1<
X2. The strategy requires the investor to buy a call with an exercise price of X1 and sell
call with an exercise price of X2. It requires him to simultaneously sell a put with an
exercise price X1 and buy a put with a strike X2. The initial cash flow of cost of this
strategy will be:
-Ct,1 + Ct,2 + Pt,1 – Pt,2< 0
because Ct,1> Ct,2 and Pt,1< Pt,2.
Suppose XYZ stock is trading at Rs.45 in June, option contract size is 100 shares
and the following prices are available:
• JUL 40 put - Rs.1.50
• JUL 50 put - Rs.6
• JUL 40 call - Rs.6
• JUL 50 call - Rs.1
Buying the bull call spread involves purchasing the JUL 40 call for Rs.600 and
selling the JUL 50 call for Rs.100. The bull call spread costs: Rs.600 - Rs.100 = Rs.500
Buying the bear put spread involves purchasing the JUL 50 put for Rs.600 and
selling the JUL 40 put for Rs.150. The bear put spread costs: Rs.600 - Rs.150 = Rs.450
The total cost of the box spread is: Rs.500 + Rs.450 = Rs.950
The expiration value of the box is computed to be: (Rs.50 - Rs.40) x 100 =
Rs.1000.
Since the total cost of the box spread is less than its expiration value, a riskfree
arbitrage is possible with the long box strategy. It can be observed that the expiration
value of the box spread is indeed the difference between the strike prices of the options
involved.
If XYZ remain unchanged at Rs.45, then the JUL 40 put and the JUL 50 call expire
worthless while both the JUL 40 call and the JUL 50 put expires in-the-money with
Rs.500 intrinsic value each. So the total value of the box at expiration is: Rs.500 +
Rs.500 = Rs.1000.

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 Suppose, on expiration in July, XYZ stock rallies to Rs.50, then only the JUL 40
call expires in-the-money with Rs.1000 in intrinsic value. So the box is still worth
Rs.1000 at expiration.
What happens when XYZ stock plummets to Rs.40? A similar situation happens
but this time it is the JUL 50 put that expires in-the-money with Rs.1000 in intrinsic
value while all the other options expire worthless. Still, the box is worth Rs.1000.
As the trader had paid only Rs.950 for the entire box, his profit comes to Rs.50.
Remember that the value of a box spread will always be . If it has a
different value there is an arbitrage opportunity and this process enable the value remain
at level.

10.8 NOTES
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12.10 SUMMARY
Under this unit we discussed in detail about a variety of popular options spreads
and combinations strategies which can used for hedging as well as speculative purposes.
Options spreads are the basic building blocks of many options trading strategies. A spread
position is entered by buying and selling equal number of options of the same class on
the same underlying security but with different strike prices or expiration dates, whereas,
combinations are an option trading strategy that involves the purchase and/or sale of
both call and put options on the same asset. Option combinations are popular with
experienced traders and investors because they can be tailored to provide specific risk-
reward payoffs that suit the investor’s individual risk tolerance and preferences. This
unit also provided good overview on bull spreads, bear spreads, butterfly spreads, condors,
straddles, strangles, strips, straps and box spreads strategies.

12.11 KEY WORDS

♦ Bear Spread : a bear spread is a combination of long call/put with higher strike
and short call/put with lower strike.
♦ Box Spread : A special combination of options that result in riskless payoff in
most cases.
♦ Bull Spread : a combination of long call/put with lower strike and short call/put
with higher strike.
♦ Condor : is created by two long calls/puts at different strikes and two short calls/
puts at the different strikes that is in between the strikes of two long positions.
♦ Straddle : combination of a long/short call and a long/short put on the same asset
with same expiry.
♦ Strangle : a combination consisting of a long/short call at higher strike and a long/
short put at lower strike on the same asset with same expiry.
♦ Strips : a combination two puts and one call.
♦ Straps :a combination of two calls and a put.

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12.12 SELF-ASSESSMENT QUESTIONS
1. Compare and contrast Spreads with Combinations.
2. How would you construct a bull spread strategy using puts? Illustrate.
3. How Butterfly strategy different from Condor strategy?
4. What is straddle? When is it appropriate to use?
5. What is box spread? Explain with suitable example.
6. An investor has the following portfolio of calls on the same asset and with same
expiration of dates:
Long 1 call at a strike price of Rs.190 at a premium of Rs.10
Short 2 call at strike price of Rs.200 at premium of Rs.14 each
Long 1 call at a strike price of Rs.210 at a premium of Rs.20
Find out his payoff for various ranges of price (from Rs.150 to Rs.250 with
multiples of 10) and depict the same graphically and answer the following:
(a) The price of asset yielding maximum profit and how much?
(b) The price of asset yielding maximum loss and how much?
(c) The price of the asset yielding no profit/loss.
7. If you having bullish expectation about market, what are the strategy you can use to
take advantage of the possible opportunities in future?
8. At NSE, following were the prices of 1-month call and put on its index Nifty50 on
15th September 2016 when the Nifty was at 8500.

Exercise Price Call Option Put Option

8450 265 175
8500 225 195
8550 200 225

(a) How would you construct straddle at index value of 8500?

(b) Find out its cost, payoff, break-even point and the maximum loss.
(c) What would be the profit/loss if after 1-month the index value were (i) 8100 (ii)
8750 or (iii) 9000?

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9. “Call buyers and put writers exhibit bullish sentiments”. Do you agree? Explain.
10. Use data used in question number -8, construct following strategy and find out the
cost and payoff for 1-m future spot price of 8100, 8200, 8300, 8400, 8500, 8600,
8700, 8800 and 8900 for following strategies.
(i) Short Strangle.
(ii) Bull call Spreads
(iii) Bear put Spread.
11. Compare Strips with Straps with suitable example.
12. What trading position is created from a long strangle and a short straddle when
both have the same time to expiry? Assume that strike prices in the straddle is
halfway between the two strike prices of the strangle.
13. Currently the value of Nifty50 is at 8250 and at-the-money call and put with three
months to maturity are selling for Rs.240 and Rs.150 respectively. If an investor
believes that the market is going to remain range bound for coming three months
how can he benefit from options being traded in the market? What maximum profit
or loss can be made or incurred?

12.12 REFERENCES
♦ Chandra, P. (2011). Investment Analysis and Portfolio Management. New Delhi:
Tata McGraw Hill Education Private Limited.
♦ Damodaran, A. (2013). Investment Valuation Tools and Techniquesfor Determining
the Value of any Asset (3rd ed.). New Jersy: John Wiley & Sons.
♦ Dubofsky, D. A., & Miller, T. W. (2003). Derivatives - Valuation and Risk
Management. New York: Oxford University Press.
♦ Fischer, D. E., & Jordan, R. J. (2003). Security Analysis and Portfolio Management
(6th ed.). Delhi: Pearson education.
♦ Hull, J. C. (2007). Options, Futures and Other Derivatives (6 ed.). New Delhi:
Pearson Education Inc.
♦ Pandian, P. (2011). Security Analysis and Portfolio Management. New Delhi: Vikas
Publishing House Pvt Ltd.

196
♦ Reilly, F. K., & Brown, K. C. (2011). Investment Anlysis and Portfolio Management.
Delhi: Cengage learning India Private Limited.
♦ Sridhar, A. N. (2011). Futures & Options : Equities - Trading Strategies and Skills
(4 ed.). Mumbai: Shroff Publishers and Distributors Pvt. Ltd.
♦ Srivastava, R. (2010). Derivatives and Risk Management. New Delhi: Oxford
University Press.
♦ Vohra, N. D., & Bagri, B. R. (2014). Futuress and Options (2 ed.). New Delhi:
McGraw Hill Education (India) Provate Limited.

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 MODULE- IV
VALUATION MODELS
UNIT -13 : PRINCIPLES OF OPTIONS PRICING

Structure :
13.0 Objectives
13.1 Introduction
13.2 Factors Affecting Call Prices
13.3 Factors Affecting Put Option Prices
13.4 Maximum and Minimum Option Prices
13.5 Notes
13.6 Illustrations
13.7 Case Study
13.8 Summary
13.9 Key Words
13.10 Self Assessment Questions
13.11 References

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13.0 OBJECTIVES
After studying this units, you will be able to;
• The basic relationship between the call option premium and macro economic
and stock specific factors,
• The basic relationship between the put option premium and macro economic
and stock specific factors,
• The fundamental equations representing upper and lower bounds for call option
prices, and
• The fundamental equations representing upper and lower bounds for put option
prices .

13.1 INTRODUCTION
Option valuation is one of the most important developments in the field of finance
in the recent past. Any course in options shall be incomplete without a discussion on
pricing and valuation of these unique derivative instruments popularly traded in both
OTC markets and exchanges. The objective of this unit is to lay the foundation for
valuation of options focusing on the two important models that can be used to calculate
option prices before the option expiration date. However, before those two specific
models are presented it is important to realize that basic options value before expiration
must obey a set of pricing restrictions. The upper and lower boundary prices for call and
put options are presented. This unit begins with a brief description of factors impacting
options prices.

13.2 FACTORS AFFECTING CALL PRICES

Options have value because option buyers can exercise the option to their
advantage, should the opportunity to do so arise. A fundamental advantage of holding a
call option is that it may be possible to obtain the underlying shares more cheaply by
exercising the option than by direct share purchase. Intuitively, the price paid for the
right to exercise should therefore reflect, among other factors, the probability that the
share price will rise above the exercise price (or rise further above it, if it has already
been exceeded). This probability should, in turn, be related to the following factors.

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(i) The current share price
The higher the current share price, the greater is the probability that the share
price will increase above the exercise price, and therefore the higher the call price,
other things being equal. Ignoring market imperfections, a call whose underlying share
price is already above the exercise price must be worth at least the difference between
the two. This amount is the cash flow that will occur if the call is exercised immediately,
and is referred to as the call’s intrinsic value. However, even a call whose exercise price
is above the current price of the underlying share must be worth something. It has value
as long as there is some chance, however small, that at some point in the call’s life the
intrinsic value may become positive.
(ii) The exercise price
Clearly, the higher the exercise price, the lower is the probability that the share
price will increase above the exercise price, and therefore, the lower the call price,
other things being equal.
(iii) The term to expiry
The longer the term to expiry, the greater is the probability that the share price
will increase above the exercise price. Therefore, the longer the term to expiry, the
greater is the call price, other things being equal. To make the same point in a slightly
different way, consider two American calls which are equivalent in every respect, except
that one has a shorter term to expiry than the other. In the period before the expiry of the
shorter-term call, both calls provide the option buyer with the same rights. However, the
rights conferred by the longer-term call continue for a further period. Therefore, the
longer-term call is more valuable. The amount of the call price over and above any intrinsic
value is called the time value, since with all other factors constant it will be greater, the
longer the term to expiry. Note, however, that the term to expiry is only one factor
determining the time value. It should also be distinguished from the ‘time value of money’.
(iv) The Volatility of the Share Price
The volatility of a share is the variability of its price over time. The effect of
volatility on call price is illustrated in the following simple example. Consider a high
volatility share, H, whose current price is Rs.5, and a low volatility share, L, whose
current price is also Rs.5. Consider call options on H and L at a moment before expiry.
The exercise price of both call options is Rs.5. As explained previously, calls at expiry
are worth a positive amount if the difference between the share price and the exercise
price is positive. Otherwise they are worth zero. Suppose further that the probabilities

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of various share prices at expiry are known to be those shown in Table 1. The call on the
low-volatility share is less valuable than the call on the high-volatility share. This result
is not peculiar to this particular example and it may be shown that, other things being
equal, calls on high-volatility shares are worth more than calls on low-volatility shares.
Table 1: Probability distributions for shares H and L
Share H SharreL
___________________________________________________________________
Share Share
Price Probability Value of price Probability Value of
(Rs.) calls(Rs.) calls
_____________________________________________________________________
4.00 0.2 0 4.00 0.04 0
4.50 0.2 0 4.50 0.16 0
5.00 0.2 0 5.00 0.60 0
5.50 0.2 0.50 5.50 0.16 0.50
6.00 0.2 1.00 6.00 0.04 1.00

The expected values of the calls on shares H and L are:

E (call on H) = (0.2)(0.50) + (0.2)(1.00)
=Rs. 0.30
E (call on L) = (0.16)(0.50) + (0.04)(1.00)
= Rs. 0.12
(v) The risk-free interest rate
The buyer of a call option gets a right to buy the underlying stock on a future date
which implies deferment of payment. Because interest rates are positive, money has a
time value, so the right to defer payment is valuable. The higher the interest rate, the
more valuable is this right. Therefore, it is plausible to suggest that the higher the risk-
free interest rate, the higher is the price of a call, other things being equal.

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(vi) Expected dividends
If a company pays a dividend to its ordinary shareholders the share price will fall
on the ex-dividend date. The price of a call will decrease if the price of the underlying
share decreases. It is to be expected, therefore, that a call on a share that will go ex-
dividend before the expiry of the call is worth less than if the share either never pays
dividends or, if it does pay dividends will not reach the next ex-dividend date until after
the call has expired. In short, calls on shares that pay high dividends during the life of the
call are worth less than calls on shares that pay low dividends during the life of the call,
other things being equal.
To summarise, other things being equal, call prices should be higher and vice
versa, given:
(i) the higher current share price;
(ii) the lower the exercise price;
(iii) the longer term to expiry;
(iv) the higher volatility of the underlying share;
(v) the higher the risk-free interest rate; and
(vi) the lower expected dividend to be paid following an ex-dividend date that occurs
during the term of the call.

13.3 FACTORS AFFECTING PUT OPTION PRICES

The buyer of a put option obtains the right to sell shares at the exercise price. The
higher the exercise price, the more the buyer of the put stands to gain. For example, the
right to sell a share for Rs.100 is a more valuable right than the right to sell for only
Rs.90, other things being equal. Therefore, for put options, the higher the exercise price,
the higher is the price of the option. For call options, the opposite is true. Similarly, the
right to sell a share at a fixed price is less valuable, the higher the current share price,
other things being equal. For example, suppose that the holder of a put exercised his
right to sell a share at the exercise price of Rs.100. If the current share price is Rs. 90 ,
the holder of the put gains Rs. 10 because he has been able to sell the share for Rs.10
more than it is currently worth. If the share price had been higher – say, Rs.95 – the gain
would have been only Rs.5. Therefore higher share prices imply lower put prices, other
things being equal. For call options the opposite is true. The relationship between price
and term to expiry is straightforward in the case of american puts. Consider two american

202
puts, equivalent in all respects except that one has a longer term to expiry. Both puts
may be exercised at any time up to (and including) their respective expiry dates. Therefore,
the long-term put permits exercise, at all times permitted by the short-term put, but in
addition the long term put permits exercise after the expiry of the short-term put.
Therefore, for american puts, a longer term to expiry increases the value of the put,
other things being equal. This is also true of call options.
The buyer of a put option gains if share prices fall. Consequently, puts are
especially attractive to shareholders who fear that the share price may decrease, but who
nevertheless do not wish to sell their shares.
As with call options, higher share volatility implies a higher option price. Higher
volatility implies a greater chance of large increases and large decreases in the share
price. From the put holder’s viewpoint, share price increases are bad news, while
decreases are good news. But a put holder gains more from a share price decrease than
is lost from an increase of the same amount. So, on balance, a put holder has a favourable
view of share price volatility.
Because a put confers the right to receive a future cash inflow, it is expected that
put prices should be negatively related to interest rates. A higher interest rate reduces
the present value of whatever future cash inflow may be received. Finally, dividend
payments reduce share prices, which benefits put holders, so higher expected dividend
payments increase put prices.

13.4 MAXIMUM AND MINIMUM OPTION PRICES

To explain the models dealing with maximum and minimum possible prices of
options, it is assumed that there are some market participants for whom:
(1) There are no transactions costs
(2) All trading profits (net of trading losses) are subject to the same tax rate
(3) Borrowing and lending at the risk-free interest rate is possible
(4) No arbitrage opportunities exist
The following notations will be used:
SO = current stock price
ST = stock price at time T
K = strike price of option

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T = time of expiration of option
r = risk-free rate of interest for maturity T (continuously compounded)
CA = value of American call option
PA = value of American put option
CE = value of European call option
PE = value of European put option
An American or European call option gives the holder the right to buy one share
of a stock for a certain price. No matter what happens, the option can never be worth
more than the stock price. Hence, the stock price is an upper limit to the option price:
CA £ SO and CE £ SO
Similarly, an American or European put option gives the holder the right to sell
one share of a stock for K. No matter how low the stock price becomes, the option can
never be worth more than K. Hence,
PA £ K and PE £ K

For European put options, we know that at time T the option will not be worth
more than K. It follows that its value today cannot be more than the present value of K:
PE £ K e- r T
(1) European Calls
(Non-Dividend-Paying Stocks)
A minimum limit for the price of European call option on a non-dividend-paying stock
must be non-negative, as the worst can happen to a call is that it expires worthless. This
means that CE ³ 0, and,
CE ³ max(SO – Ke-rT , 0 ) .................(1)
Example
Consider a European call option on a non-dividend paying stock where the stock price is
Rs.140,strike price is Rs.132 and risk-free rate of interest is 10 percent per annum and
the maturity is 3 months. In this case S0 = Rs.140, K= Rs.132, r = 0.1 and T = 0.25.
S0 – Ke-rT = 140 – 132e-0.1x0.25
= Rs.11.36

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(2) European puts
(Non-Dividend Paying Stocks)
For a European put option on a non-dividend-paying stock, a lower limit for the
price must be non-negative as the worst that can happen to a put option is that it expires
worthless. This means that PE ³ O and, therefore,
PE ³ Max (Ke-rT – SO , O) ..................(2)
Example
Consider an European put option on a non-dividend-paying-stock where the stock
price is Rs.210, the time to maturity is 3 months, the risk-free rate of interest is 10
percent per annum and the strike price is Rs.225. In this case SO = Rs.210, K = Rs.225,
T = 0.25, r = 0.1 From equation (9.2), a lower limit for the option price is Ke-rT - SO , or
PE = 225-0.1x0.25 – 210
= Rs.9.44
(3) The Effect of Dividends
The price relationships discussed so far have assumed that options are on a non-
dividend-paying stock. In this section, the effect of dividends is examined. An exchange
traded stock options generally have less than a year to maturity, the dividends payable
during the life of the option can usually be predicted with reasonable accuracy. Let the
present value of the dividends during the life of option denoted by D.
On the basis of equation (1), it can be shown that the lower bound for a call option
becomes
CE ³ Max.(SO – D – Ke-rT, 0) ——(3)
Similarly, on the basis of equation (2), it can be shown that the lower bound for put
option
PE ³ Max. (D + Ke-rT – SO , 0) ———(4)
For a dividend paying stock, the put-call parity relationship is,
CE + D + Ke –rT = PE + SO ————(5)

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13.5 NOTES
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13.5 ILLUSTRATIONS
(1) What is the lower-limit for the price of a three-month European put option on
a non-dividend–paying stock when the stock price is Rs.171, the strike price is Rs.189,
and the risk-free interest rate is 10 percent per annum?
Solution:
A lower-limit for the price of a European put option on a non-dividend-paying
stock is
= (present value of strike price) – (current price)
= Ke-rT – S0
= 189-0.1x0.25 – 171
= 184 – 171
= 13

(2) What is the lower-limit for the price of a three-month European call option
on a dividend – paying stock when the stock price is Rs.710, the strike price is Rs.650,
the expected dividend in two month is Rs.5, and the risk-free interest rate is 10% per
annum?
Solution:
The lower-limit for the price of a European call option on a dividend-paying stock
is:
= (Current - (present value of - (present value
price) dividends) of strike price)
= S0 - De-rT - Ke-rT
= 710 – 5e-0.1x1/6 - 650e-0.1x0.25
= 710 - 4.9155 - 634

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13.6 CASE STUDY
Tables below sets out the call and put options prices on the stocks of RPR Ltd.
and SPS Ltd. and probability distribution for the prices of the respective stocks on
February 5, 2016.
Table : Prices of call and put options on RPR and SPS stocks on February 5, 2016.
ExpiryExercise Type of Option
Month price option price
Rs. Rs.
February - RPR 920 American-call 59.90
- SPS 460 American-call 28.60
February - RPR 980 American-call 15.80
- SPS 490 American-call 7.45
March - RPR 1000 American-call 27.70
- SPS 500 American-call 13.25
March - RPR 1020 American-call 20.00
- SPS 510 American-call 9.50
February - RPR 920 American-put 1.05
- SPS 460 American-put 0.40
February - RPR 940 American-put 1.65
- SPS 470 American-put 0.75
March - RPR 980 American-put 8.00
- SPS 490 American-put 3.85
February - RPR 1080 American-put 6.50
- SPS 540 American-put 3.10

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Table : Probability distributions of prices of RPR and SPS stocks

Share RPR Share SPS

_____________________________ ____________________________
Share Share
Price Probability price Probability
(Rs.) (Rs.)
___________________________________________________________
920 0.2 460 0.05
960 0.2 480 0.10
1000 0.2 500 0.70
1040 0.2 520 0.10
1080 0.2 540 0.05

The RPR stock is currently selling in the market for Rs.965 and SPS stock is at
Rs.475 per share.
On the basis of data presented in Tables above, prove the following conventions
about the factors impacting call and put options prices:
(1) Higher the current share price, the higher the call price.
(2) Higher the exercise price, the lower the call price.
(3) The longer the term to expiry, the greater is the call price.
(4) Calls on high-volatility shares are worth more than calls on low-volatility shares.
(5) The longer the term to expiry, the greater is the put price.

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13.8 SUMMARY
This chapter provided an overview of fundamentals of option prices. Various
factors affect price of a stock option: the current stock price, the strike price, the
expiration date, the stock price volatility, the risk-free interest rate, etc. The price of a
call generally increases as the current stock price, the time to expiration, the volatility,
and the risk-free interest rate increase. The price of a call decreases as the strike price
and expected dividend increase. The price of a put generally increase as the strike price,
the time to expiration, the volatility, and the expected dividends increase. The value of a
put decreases as the current stock price and the risk free interest rate increase.
It is possible to reach some conclusion about the values of stock options without
making any assumptions about the behaviour of stock prices. For example, the price of a
call option on a stock must always be worth less than the price of the stock itself.
Similarly, the price of a put option on a stock must always be worth less than the option’s
strike price.

13.9 KEY WORDS

Option price Volatility Upper bound Lower bound

13.10 SELF ASSESSMENT QUESTIONS

1. Explain the factors that would influence the price of a call option.
2. Explain the factors that would influence the price of a put option.
3. What is the minimum value of a call option on a share that does not pay dividends?
Why?
4. The price of an American call on a non-dividend-paying stock is Rs.4. The stock
price is Rs.31, the strike price is Rs.30, and the expiration date is in three months.
The risk-free interest rate is 8%. Derive upper and lower bounds for the price of an
American put on the same stock with the same strike price and expiration date.
5. What is the lower-limit for the price of a three-month European put option on a
non-dividend–paying stock when the stock price is Rs.171, the strike price is
Rs.189, and the risk-free interest rate is 10 percent per annum?
6. What is the lower bound for the price of a three-month European call option on a
dividend–paying stock when the stock price is Rs.710, the strike price is Rs.650,
the expected dividend in two months is Rs.5, and the risk-free interest rate is 10%
per annum?

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7. Calculate lower bound from the following data:
Stock price: Rs.300 (per share) style of option: European
Type of option : Call strike price: Rs.280
Interest rate : 8% p.a. Time to expiration: 3 months
Dividend : Nil
10. What is the lower bound for the price of a three-month European call option on a
dividend–paying stock when the stock price is Rs.710, the strike price is Rs.650,
the expected dividend in two months is Rs.5, and the risk-free interest rate is 10%
per annum?

13.10 REFERENCES
1. Financial Derivatives – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
2. Capital market Instruments – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
3. Risk Management – Insurance and Derivatives – By G.Kotreshwar (HPH)
4. Financial Derivatives – By Gupta (PHI)
5. Introduction to Futures and Options Markets – By John Hull (PHI)
6. Derivatives – By D.A.Dubofsky and T.W.Miller (Oxford)

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UNIT -14 : OPTIONS PRICING – PUT/CALL PARITY

Structure :
14.0 Objectives
14.1 Introduction
14.2 Meaning of Put - call Parity
14.3 Assumptions
14.4 Put-Call Parity
14.5 Arbitrage Opportunities
14.6 Notes
14.7 Illustration
14.8 Case Study
14.9 Summary
14.10 Key Words
14.11 Self Assessment Questions
14.12 References

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14.0 OBJECTIVES
After studying this units, you will be able to;
• Understand the basic principle of put-call parity
• Grasp the implications of put-call parity principle, and
• Clearly identify the scope for arbitrage opportunity, and
• Understand the relationship b/w put-call parity and price equilibrium.

14.1 INTRODUCTION
Option valuation is one of the most important developments in the field of finance
in the recent past. Any course in options shall be incomplete without a discussion on
pricing and valuation of these unique derivative instruments popularly traded in both
OTC markets and exchanges. There are different models used to calculate option prices
before the option expiration date. The basic assumption underlying these models is that
capital markets are perfect i.e, non-existance of arbitrage opportunities. It is important
to realize that basic options value before expiration must obey a set of pricing restrictions.
The upper and lower boundary prices for call and put options are presented. The most
important of these relationships is known as put-call parity. The objective of this unit is
to present put – call parity principle which upholds assumption of ‘no arbitrage’.

14.2 MEANING OF PUT – CALL PARITY

Put–call parity defines a relationship between the price of a European call
option and European put option, both with the identical strike price and expiry. It
establishes that a portfolio of a long call option and a short put option is equivalent to
(and hence has the same value as) a single forward contract at this strike price and expiry.
This is because if the price at expiry is above the strike price, the call will be exercised,
while if it is below, the put will be exercised, and thus in either case one unit of the asset
will be purchased for the strike price, exactly as in a forward contract. The validity of
this relationship requires that certain assumptions be satisfied. In practice transaction
costs and financing costs (leverage) makes this relationship away from reality, but in
liquid markets the relationship is close and relevant.
If the prices of the put and call options diverge so that this relationship does not
hold, an arbitrage opportunity exists, meaning that sophisticated traders can earn a
theoretically risk-free profit. Such opportunities are uncommon and short-lived
in liquid markets.

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14.3 ASSUMPTIONS
Put–call parity assumes the existence of a forward contract. In the absence of
traded forward contracts, the forward contract can be replaced by the ability to buy the
underlying asset and finance this by borrowing for fixed term (e.g., borrowing bonds),
or conversely to borrow and sell (short) the underlying asset and loan the received money
for term, in both cases yielding a self-financing portfolio. These assumptions do not
require any transactions between the initial date and expiry. The relationship thus only
holds exactly in an ideal market with unlimited liquidity. However, real world markets
may be sufficiently liquid that the relationship is close to exact, most significantly foreign
exchange markets in major currencies or major stock indices, in the absence of market
swings.

14.4 PUT– CALL PARITY

Put-call parity establishes that European call and put options values are identical.
This means that:
CE + Ke-r T = PE + SO ............(1)
It shows that the value of European call (that pays no dividend) with a certain
exercise price and exercise date is equal to the value of a European put with the same
exercise price and date. Alternatively, the price of a European call option should be
equal to the price of a put option with the same strike price and expiration date plus a
sum equal to the current price of the underlying asset minus the present value of the
option’s strike price.
CE = PE + SO - Ke-rT ............(2)
If either of these relationships is violated, arbitrageurs can make a certain profit
on a zero investment by selling the relatively overpriced option and using the proceeds
to buy the relatively underpriced option together with the appropriate related positions
in the underlying asset and debt instruments. Taken together, the latter positions create a
synthetic option which completely hedges the risk associated with the short position in
the overpriced option. For instance, if call prices are too high relative to put prices, an
arbitrageur can lock in a riskless profit by selling a call and simultaneously buying a put,
borrowing the amount equal to Ke-rT at the risk-free rate, and buying the underlying
asset.

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Example
Suppose that stock price is Rs.310, the exercise price is Rs.300 (for both call
and put options), the risk-free interest rate is 10% per annum, the price of a three-month
European call option is Rs.30, and the price of a three–month European put option is
Rs.22.5. In this case,
CE + Ke-rT = 30 + 300 e-0.1 x 3/12 = 322.26
PE + SO = 22.5 + 310 = 332.5
Portfolio consisting of PE + SO is overpriced relative to portfolio consisting of
CE + Ke-rT . This encourages arbitrage activity which involves buying the call and shorting
both the put and the stock. The strategy generates a positive cash flow of Rs. 302.5 at the
beginning.
-30 + 22.5 + 310 = 302.5
When invested at the risk-free interest rate, this grows to 302.5 e0.1 x 0.25 = Rs.310.2
in three months. If the stock price is greater than Rs.30, the call will be exercised. If it
is less than Rs.300, the put will be exercised. In either case, the investor ends up buying
one share of Rs.300. The net profit is therefore,
Rs.310.2 – Rs.300.0 = Rs.10.2
If, at the expiration date, the stock price (ST) is Rs.290, the put will be worth
Re.10 (300-290) and the call will expire worthless. If, on the other hand, at expiration
the stock price (ST) is Rs.310, the call writer will lose Rs.10(310-300), and the put will
expire worthless. In both cases, however, the investor will own the stock at expiration,
worth ST , and will have to pay K. In addition, in both cases the cash flow at expiration
will be zero. Thus, a no-arbitrate equilibrium pricing relationship requires that the initial
investment necessary to set up these riskless positions must be zero, or that
CE – PE – SO + Ke-rT = 0
Which implies that
CE = PE + SO – Ke-rT
And PE = CE + Ke-rT – SO

This shows that if SO is equal to K, the call option premium must nevertheless be
greater than the put option premium, since the strike price is discounted.

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14.5 ARBITRAGE OPPORTUNITIES
Arbitrage involves risk-less profit from market mispricing. The prices of both
call and put options in the same series have to bear a parity relationship (see section
7.4), otherwise opportunities for arbitrage will arise. Put–call parity establishes that
European call and put options values are identical. This means that
CE + Ke-rT = PE + So
It shows that the value of European call (that pays no dividends) with a certain
exercise price and exercise date is equal to the value of a European put with the same
exercise price and date. Alternatively, the price of a European call option should be
equal to the price of a put option with the same strike price and expiration dates plus a
sum equal to the current price of the underlying asset minus the present value of the
option’s strike price.
CE = PE + So – KerT
If this relationship is violated, arbitrageurs can make a profit on a zero investment
by selling the relatively overpriced option and using the proceeds to buy the relatively
underpriced option together with the appropriate related positions in the underlying asset
and debt instruments. Consider, for example, index options contracts (European) on
Oct.15, 2016 presented in Table 1.
Table 1 NIFTY option contracts on 15.10.2016
Contract Type of Contract Strike Price Premium
(European) (Rs.) (Rs.)
Oct. 2016 Call 1800 97.40
Oct. 2016 Call 1850 63.50
Oct. 2016 Call 1860 58.90
Oct. 2016 Call 1870 53.70
Oct. 2016 Put 1730 5.45
Oct. 2016 Put 1790 10.00
Oct. 2016 Put 1800 14.25
Oct. 2016 Put 1840 22.10

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 From the quotations shown on Table 1, it can be shown whether the arbitrage
opportunity available on Oct.15, 2016, when the index closed at 1888.65 and the option
contracts are expiring on Nov. 28, 2016. It is assumed that the risk-free rate is 10 percent
per annum.
For a 43 days (15+28) call option, the call price is Rs.53.70 for a strike price of
Rs.1870. In this case, for a minimum lot size of 200 contracts
Portfolio A = call price + p.v. of strike price
= 97.40(200) + [1800/(1.0118)] x 200
= 3,75,282
Portfolio B = put price + current index value
= 14.25(200) + 1888.65(200)
= 2850 + 3,77,730
= 3,80,580
Portfolio B is overpriced relative to portfolio A. The arbitrageur can buy portfolio
A and short portfolio B. This involves buying the call and shorting both the put and the
stock. The strategy generates a positive cash flow of
- 97.40(200) + 14.25(200) + 1888.15(200)
= 3,61,100
upfront. When invested at the risk-free interest rate, this grows to 3,61,100 x (1.0118)
= 3,65,361 in 43 days.
If the index value at expiration of the option is greater than Rs.1888.65, the call
will be exercised, if it is less than Rs.1888.65, the put will be exercised. In either case,
the investor ends up buying index for Rs.1800. This can be used to close out the short
position. The net profit is therefore
Rs.3,65,361 – 1800(200)
= Rs.5,361

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14.6 NOTES
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14.7 ILLUSTRATION
An European call option is currently priced at Rs.170 and has an exercise price
of Rs.1500 and a term to expiry of 3 months. The current price of the underlying share
is Rs.1490. The share does not pay dividends. The risk-free interest rate is 10 percent
per annum (continuously compounded). The price of the equivalent put option Rs.85.
show that:
(a) the price of the call option exceeds its minimum theoretical price;
(b) an arbitrage profit would be earned by simultaneously buying the put, selling
the call, buying the share and borrowing the present value of the exercise price.
Solution:
(a) put-call parity holds that
CE + Ke-rT = PE + S0
CE + Ke-rT = 170 + 1500e0.1x0.25 = 1633
PE + S0 = 85 + 1490 = 1575
As the combined value of call option price plus present value of strike price is
greater than the combined value of put price and current price of stock, the price of call
option exceeds its minimum theoretical price.
(b) An arbitrageur can short the call and buy both the put and the stock. This strategy
involves an initial investment of
Rs.1490 + 85 – 170 = 1405
When financed at the risk-free interest rate, repayment of 1405e0.1x0.25 = Rs.1440
is required at the end of three months. At the end, either call or put will be exercised.
The short call and long put option, therefore, leads to the stock being sold for Rs.1500.
Initial cash flow Rs.
Investment - 1405
Equivalent loan + 1405
Terminal cash flow
Repayment of loan - 1440
Sale of stock + 1500
Arbitrage Profit + 60

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14.8 CASE STUDY
Mr. Akhil, a post-graduate in Management with finance specialistion, is the the
manager of Bharat Funds since last 4 years. He has been providing positive returns to
the shareholders of the fund. He has mastered the art of using options when the market
was highly volatile, through covered call writing and portfolio insurance strategies. He
is convinced that better returns would not have been possible if he had not used the
options.
The Nifty index had crossed 8000 from 6000, over previous year registering an
increase of 33%. It was expected that the Indian market was likely to go up further, and
Akhil was wondering how he could use options to generate higher returns. He was not
sure whether the options were priced efficiently in the market and wanted to arbitrage, if
such an opportunity was available. He collected information on index options as of
October 2016 (as shown in tables 1 & 2 ). The risk-free rate was estimated to be 9%, and
the contract multiplier was 50. The exercise date was October 27th , 2016.
Table 1: Nifty Index Options

Exercise price Call Premium Put Premium

(INR) (INR) (INR)
8500 228.42 114.40
8400 211.51 88.50
8800 82.55 166.32
8600 181.25 146.05
9000 29.80 189.51

The major investment for Bharat Funds includes investment in the S & B stock.
There are options available on this stock, and the details are provided here.
Table 2 : S&B Options

Exercise price Call Premium Put Premium

(INR) (INR) (INR)
1850 279.42 54.40
1840 211.51 88.50
1880 182.55 146.32
1860 81.25 196.05
1900 29.80 229.51

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 Nifty Index on Oct 1 stood at 8855. S & B stock price on Oct 1 stood
at Rs 1860 ; contract size 430.
Questions
1. Identify whether there are any opportunities for arbitrage to be made in these options.
2. Do you think Mr. Akhil will be able to enhance returns to fund investors by
arbitraging ? Justify your answer.

14.9 SUMMARY
Put–call parity defines a relationship between the price of a European call
option and European put option, both with the identical strike price and expiry. It
establishes that a portfolio of a long call option and a short put option is equivalent to
(and hence has the same value as) a single forward contract at this strike price and expiry.
Put–call parity assumes the existence of a forward contract. In the absence of traded
forward contracts, the forward contract can be replaced by the ability to buy the underlying
asset and finance this by borrowing for fixed term (e.g., borrowing bonds), or conversely
to borrow and sell (short) the underlying asset and loan the received money for term, in
both cases yielding a self-financing portfolio. The relationship thus only holds exactly
in an ideal market with unlimited liquidity.

14.10 KEY WORDS

Put–call parity Portfolio Arbitrage

14.11 SELF ASSESSMENT QUESTIONS

1. What is a put-call parity? Illustrate with a suitable example.

2. An European call option is currently priced at Rs.220 and has an exercise price of
Rs.1260 and a term to expiry of 3 months. The current price of the underlying
share is Rs.1300. The share does not pay dividends. The risk-free interest rate is
10 per annum (compound). The price of the equivalent put option Rs.45. show
that:
a) The price of the call option exceeds its minimum theoretical price;
b) An arbitrage profit would be earned by simultaneously buying the put, selling
the call, buying the share and borrowing the present value of the exercise price.

221
 c) An European call option is currently priced at Rs.160 and has an exercise
price of Rs.1700 and a term to expiry of 3 months. The current price of the
underlying share is Rs.1500. The share does not pay dividends. The risk-free
interest rate is 10 per annum (compound). The price of the equivalent put
option Rs.45. Explore the arbitrage opportunity on the basis of put-call parity
principle.
3. An European call option on SS Ltd stock is currently selling at a premium of Rs.
118 and has an exercise price of Rs.1250 and a term to expiry of 3 months. The
current price of the underlying share is Rs.1310. The share does not pay dividends.
The risk-free interest rate is 7 per cent p.a (continuous compounding). The price
of the equivalent put option Rs.65. Explore the arbitrage opportunity based on put-
call parity principle.

14.10 REFERENCES
1. Financial Derivatives – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
2. Capital market Instruments – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
3. Risk Management – Insurance and Derivatives – By G.Kotreshwar (HPH)
4. Financial Derivatives – By Gupta (PHI)
5. Introduction to Futures and Options Markets – By John Hull (PHI)

6. Derivatives – By D.A.Dubofsky and T.W.Miller (Oxford)

222
UNIT - 15 : BINOMIAL MODEL

Structure :
15.0 Objectives
15.1 Introduction
15.2 A One-Step Binomial Model
15.3 Two-Step Binomial Trees
15.4 Valuation of American Options
15.5 Notes
15.6 Illustrations
15.7 Case Study
15.8 Summary
15.9 Key Words
15.10 Self Assessment Questions
15.11 References

223
15.0 OBJECTIVES
After studying this units, you will be able to;
• Understand the theory underlying Binomial option pricing model,
• Draw binomial tree,
• Apply the Binomial option pricing model to find the fair price of an option, and
• Comprehend the basic nature of a theoretical approach for option valuation.

15.1 INTRODUCTION
The two popular approaches to option valuation are binomial option pricing (BOP)
model and Black-Scholes option pricing model (BSOP). The BOP was model developed
by William sharpe, J.C. Cox, S.Ross, et all during late 1970s. It employs an approach to
option pricing based on simple algebra. Black-Scholes model (BSOP), which
revolutionized the theory of option pricing, was developed by Fischer Black and Myron
Scholes in 1973. BSOP model is based on a complex stochastic calculus which is more
difficult to comprehend by most of the business and economics students.
BOP model can be approximated to produce option values that are equivalent to
Black-Scholes prices. As such, the BOP model provides a way to understand the key
elements of modern option pricing theory without having to employ advanced methods
of calculus. Besides, BOP model can be used to compute option prices for complex
options that do not lend themselves to formalised solutions. For example, using BSOP
model, it is difficult to estimate the price of an american put option. However, if the
parameters of the binomial model can be used to estimate the prices of american puts
and other complex options to any degree of accuracy. As such, the BOP model has become
the model of choice for approximating values for many types of complex options.

15.2 A ONE–STEP BINOMIAL MODEL

Option valuation is one of the most important developments in the field of finance
in the recent past. A useful and a very popular technique for pricing a stock option involves
constructing a binomial tree. A binomial tree represents a set of different possible paths
that might be followed by the stock price over the life of the option. It is based on the
principle of risk–neutral valuation*.
Assuming no arbitrage opportunities for an investor, a simplified binomial model
can be developed to explain pricing of options. Suppose a stock price is currently Rs.100

224
and it is known that at the end of three months the stock price will be either Rs.90 or
Rs.110. The objective is to value a European call option to buy the stock for Rs.105 in
three months. This option will have one of two values at the end of three months. If the
stock price is Rs.110, the value of the option will be Rs.5; if the stock price turns out to
be Rs.90, the value of the option will be zero. The situation is illustrated in figure 1.
Fig.1: Stock price movements
Stock price=Rs.110
Option price=Rs.5

Stock price = Rs.100

Stock price=Rs.90
Option price=Rs.0
By setting up of a portfolio of the stock and the option in such a way that there is
no uncertainty about the value of the portfolio at the end of the three months, it can be
argued that the return earned on it must be equal to the risk–free interest rate. This
enables to work out the cost of setting up the portfolio and therefore the option price.
Since there are two securities (the stock and the stock option) and only two possible
outcomes, it is always possible to set up the riskless portfolio.
Consider a portfolio consisting of a long position in D shares of the stock and a
short position in one call option. It requires calculating the value of D that makes the
portfolio riskless. If the stock price moves up to Rs.110, total value of the portfolio is
given by
110 D - 5
If the stock price falls to Rs.90, the value of the portfolio is given by
90 D - 0 or 90D
The portfolio is riskless if the value of D is so chosen that the final value of the
portfolio is the same for both of the alternative stock prices. This means

225
 110 D - 5 = 90 D
or
D = 0.25

A riskless portfolio is, therefore:

Long : 0.25 shares
Short: 1 option
If the stock price moves upto Rs.110, the value of the portfolio is:
110 x 0.25 – 5 = 22.5
If the stock price falls to Rs.90, the value of the portfolio is:
90 x 0.25 = 22.5
Regardless of whether the stock price moves up or down, the value of the portfolio
is always Rs.22.5 at the end of the life of the option.
Riskless portfolio should earn a return equal to risk-free rate of interest. Suppose
that in this case the risk-free rate is 12 per cent per annum. It follows that the value of
the portfolio today must be the present value of Rs.22.5 or 22.5 e –0.12 x 0.25 = 21.84
The price of stock today is Rs.100. Supposing price of option is denoted by f, the
value of the portfolio today is, therefore,
100 x 0.25 – f
= 25 – f
It follows that
25 – f = 21.84
or
f = Rs.3.16
Suppose that the option lasts for time T and that during the life of the option the
stock price (S) can move up to a new level Su or down to Sd . If the stock price moves up
to Su , the payoff from the option is fu ; if the stock price falls to Sd , the payoff from the
option is fd .

226
 Considering a portfolio consisting of a long position in D shares and a short
position in one option, the value of D that makes the portfolio riskless can be calculated.
If there is an up movement in the stock price, the value of the portfolio at the end of the
life of the option is
Su D - fu
If there is a down movement in the stock price, this becomes
Sd D - fd
The two are equal when
Su D - fu = Sd D - fd
Or
D = f u – fd ……….(1)
Su - Sd
In this case the portfolio is riskless and must earn the risk-free interest rate.
Equation (1) shows that the ratio of the change in the option price to the change in the
stock price. The present value of the portfolio must be
[Su D - fu ] e-rT
The cost of setting up the portfolio is:
SD-f
It follows that
S D - f = [Su D - fu ] e-rT
Substituting from equation (1) for D and simplifying, the equation reduces to

f = e-rT [Pfu + (1 – P)fd] ……………(2)

Where P represents the probability. By manipulating the equation (2) , the

value of P can be derived as follows:

e- r T [ Pfu + (1 – P)fd ] = f
or 1 [ Pfu + (1 – P)fd ] = f

227
 e- r T
or 1 [ Pfu + fd - Pfd ] = f
e- r T
or [Pf (u – d) ] + fd ] = e r T f

or [Pf (u – d) ] = e r T f – fd

or Pf = e r T f – fd
u-d
or p = e r T f – fd (f -1 )
u-d
or P = e-rT – d
m-d ..………(3)
Equations (2) and (3) enable an option to be priced using a one-step binomial
model.
From the numerical example considered previously (see figure 1), u= 1.1 (110/
100), d=0.9 (90/100), r = 0.12, T=0.25, fu = 5 and fd =0. From equation (9.10),
P = e0.03 – 0.90 = 0.6523
1.10 – 0.90
and from equation (9.9),
f = e-0.03 [0.6523 x 5 + 0.3477 x 0]
= Rs.3.16
This agrees with the answer obtained earlier in this section. This means that the
option must sell for Rs.3.16. This value is independent of the probabilities associated
with the two branches. It makes no difference what the probabilities are that the investor
assigns to the two branches. Therefore, it is natural to interpret the variable P in equation
(9) as the probability of up movement and the variable 1-P is then the probability of a
down movement and the expression:
Pfu + (1-P) fd

228
is the expected payoff from the option. With this interpretation of P, equation (9) then
states that the value of the option today is its expected future value discounted at the
risk-free rate.

15.3 TWO–STEP BINOMIAL TREES

The one-step binomial tree analysis can be extended to a two-step binomial tree
such as that shown in Fig. 2.
Fig:2 : Stock prices in a two-step tree

D 121

110 B

Rs.100 A E 99

90 C

F 81
The stock price starts at 100 and in each of the two time-steps price may go up or
down by 10 per cent. It is assumed that each time-step is three months in length, the
risk-free rate is 12 per cent per annum and the strike price is Rs.105. The six node
points are identified as A, B, C, D, E and F. The objective of the analysis is to calculate
the option price at the initial nodes A, B and C. The option prices at the final nodes D, E
and F are simply the payoffs from the option. At node D the stock price is Rs.121 and
the option’s price is Rs.121 – 105 = 16, at nodes E and F the option is out of the money
and hence its value is zero.
At node C the option price is zero, since node C leads to either node E or node F
and at both of these nodes the option price is zero. The option price at node B is calculated
by using equation (2) with u = 1.1, d=0.90, r=0.12, T=0.25 so that P=0.6523.
= e-0.03 [0.6523 x 16 + 0.3477 x 0 ]
= 10.13

229
 The option price at node A depends on the option price at node B and node C. The
value of option at node B is Rs.10.13 and at node C it is zero. Equation (2), therefore,
gives the value at node A as
= e –0.03 [0.6523 x 10.13 + 0.3477 x 0]
= 6.48
These results are shown in Fig. 3
Fig.3: Stock and option prices in a two-step tree
D Suu =121
fuu=16
Su=110
fu=10.13 B
S=100
f=6.48 A E Sud =99
fud = 0
Sd =90
fd =0 C
Sdd =81
F fdd=0
By considering the situation shown in Fig.3, it can be observed that the stock
price either move up to u times its initial value or down to d times its initial value. The
notation for the value of the option is shown on the tree. For example, after two up
movements the value of the option is fuu . Assuming the risk-free interest rate is r and the
length of time step is D T years, following generalisations are possible on the basis of
application of equation 9.
fu = e-rDT [Pfuu + (1-P)fud] …………………(4)
fd = e-rDT [Pfud + (1-P)fdd] …………………(5)
f = e-rDT [Pfu + (1-P)fd] …………………(6)
The option price is equal to its expected payoff in a risk-neutral world discounted
at the risk-free interest rate. This risk-neutral valuation principle continues to hold even
when more steps are added to the tree.

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 The procedure described above for pricing a call option is equally applicable for
pricing put options of a stock whose price changes are binomial.

15.4 VALUATION OF AMERICAN OPTIONS

American options can be valued using a binomial tree. The procedure is to work
back through the tree from the end to the beginning, testing at each node to see whether
early exercise is optimal. The value of the option at the final nodes is the same as for the
European option. At earlier nodes the value of the option is the greater of
(1) The value given by equation (2); and
(2) The payoff from earlier exercise.
As an illustration consider an American put with a strike price of Rs.105 on a
stock whose current price is Rs.100. It is assumed that there are two time steps of three
months each and in each time step the stock price either moves up by a proportional
amount of 10 percent or down by a proportional amount of 10 percent. The risk-free
interest rate is 12 percent. The tree is shown in Fig. 4. At node B, equation (9) gives the
value of the option as 3.8, while the payoff from early exercise is negative (-5).
Fig. 4: Two-Step Tree for American Put Option

D 121
0

110 B
3.8

Rs.100 A E 99
7.4672 6

90
C
15.00
F 81
24

231
 As the early exercise is not optimal at node B, the value of the option at this node
is 3.8. At node C, equation (2) gives the value of the option as Rs.11.9, while the payoff
from the early exercise is 15.0. In this case early exercise is optimal and the value of the
option is Rs.15. At the initial node A the value given by equation (2) is
e-0.03 [0.6523 x 3.8 + 0.3477 x 15] = 7.4672
As the payoff from early exercise is 5.0, the value of the option is, therefore, Rs.7.4672.

15.5 NOTES
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15.6 ILLUSTRATIONS

(1)Find the value of a European call option with a strike price of Rs.21 which is
currently selling at Rs.20. Assume that there are two time steps of three months each
and in each time step the stock price either move up by a proportional amount of 10pc or
down by a proportional amount of 10 pc. Also assume that risk-free rate of interest is 12
pc.
Solution: D
24.2
3.2

22
B

A E
20 19.8
1.28 0.0

18
C
0.0
F
16.2
0.0
Payoff at node D (242-21) = Rs.3.2
Payoff at node E = (price < strike price)= 0
Payoff at node F = (price < strike price) = 0
At node C the option price = 0
(since node C leads to
either node E or node F
and at both of these nodes

234
 the option price is zero)
The value of the option at node B is given by
f = e-rT [Pfu + (1-P)fd]
The value of the risk-neutral probability, P, is given by
P = e0.12 x 0.25 - 0.9 = 0.6523
1.1 – 0.9
f = e-0.12x0.25 [0.6523x3.2 + 0.3477 x0] = 2.03
The value of the option at initial node A is given by
e-0.12x0.25 [0.6523 x 2.03 + 0.3477 x 0] = 1.28
The price of the option is Rs.1.28
(2) Find the value of an American put option with a strike price of Rs.52 which is currently
selling for Rs.50. Assume that there are two time steps of one year and in each time step
the stock price either moves up by a proportional amount of 20 pc or down by a
proportional amount of 20 pc. Also assume that the risk-free interest rate is 5 pc.

Solution:

D
B 72
60 0
1.41
E
48
A 4
50 C
5.09 40
12 F
32
20

235
 The possible final stock prices are: 72, 48 and 32. In this case fuu =0, fud = 4, and
fdd = 20.
The value of option at node B is given by
F = e-0.05x1 [0.6282x0 + 0.3718x4] = Rs.1.41
Payoff from early exercise (52-60) = -8
\ the value of option at node B = 1.41
Similarly, value of option at node C is
f = e-0.05x1 [0.6282x4 + 0.3718x20] = Rs.9.46
Payoff from the early exercise (52-40) = Rs.12.00
\ The value of option at C = Rs.12.00
The value of option at initial node A is given by
e-0.05x1 [0.6282x1.41 + 0.3718x12] = Rs. 5.09
Payoff from early exercise (52-50) =Rs.2.00
\ The value of option =Rs.5.09

15.7 CASE STUDY

Mr. Yadav is the manager of a MAX Mutual funds. His strategy is to arbitrage on
the basis of mispricing of stock option contracts traded on the NSE to boost returns. He
would like to earn profits by identifying the underpriced and overpriced options so that
he can make additional gains. He has identified the options on Nifty index, SBI, L&T and
Tata motors. On Oct 1 , the Nifty index is at Rs 6010. The Nifty index has been trading in
the range of 5600 to 6200 over the past 3 years. The contract multiplier is 250. The
standard deviation of the index is 24%. Call and put options are with an exercise of 6000
are priced at Rs 153 and Rs 340 respectively. The individual stock option details on Oct
1 are as given below:

236
 Mr. Yadav wants to know whether the call and put options are correctly priced .
The risk-free rate is estimated as 8% per annum.
Questions:
1. Identify the underpriced and overpriced options on the basis of put-call parity
SL Current standard Call Call Put Put Expiration
principle
NO price deviation option option option option
2. Identity the underpriced
strike premium strike options on the basis of BOP model
and overpriced
premium
3. Explain whetherprice price principle to be used for arbitraging.
BOP model or put-call
1 SBI 1750 SUMMARY
15.8 19% 1700 40 1700 10 26th Dec

2 L&T 800 Option

22% valuation
860 is one
90of the most
860important 26th Dec in the field of finance
100 developments
in the recent past. A useful and very popular technique for pricing a stock option involves
3 Tata 335 30% 400 24 400 23 26th Dec
constructing a binomial tree which explains relation to an important principle known as
motors
risk-neutral valuation. This principle states that it is permissible to assume that the world
is risk-neutral when valuing an option in terms of the underlying stock.
15.9 KEY WORDS
Binomial Risk neutrality probability Upside price movement Downside
price movement

237
15.10 SELF ASSESSMENT QUESTIONS
1. Explain the no-arbitrage and risk-neutral valuation approaches to valuing a European
option using a one-step binomial tree.
2. Explain the no-arbitrage and risk-neutral valuation approaches to valuing a European
option using a one-step binomial tree.
3. A stock price is currently Rs.150. It is known that at the end of one month it will be
either Rs.165 or Rs.135. The risk-free interest rate is 8 percent per annum with
continuous compounding. What is the value of a one-month European call option
with a strike price of Rs.145.
4. A stock price is currently Rs.80. It is known that at the end of six months it will be
either Rs.84 or Rs.76. The risk-free interest rate is 10 percent per annum with
continuous compounding. What is the value of a six-month European put option
with a strike price of Rs.80?
5. Draw binomial trees from the following data and show the stock prices:
Parameters European
Call option Put option
Stock price 300 300
Strike price 360 240
Time to expiration 1 year 1 year
Sub-periods Two Two
u factor 0.2 1.2
d factor 0.9 0.9

6. From the following data, calculate the value of a call option (European style):
Current price of the stock = Rs.100
Option period = 3 months
Up movement factor (u) = 1.1
Down movement factor (d) = 0.9
Exercise Price = Rs. 105

238
Risk-free interest rae = 12% p.a.
Use Binomial Option Pricing Method.

7. From the following data, calculate the value of a call option:

Style of option = European
Current price of the stock = Rs.100
Option period = 6 months
Time intervals for change at each = 3 months
Up movement factor (u) = 1.1
Down movement factor (d) = 0.9
Exercise Price = Rs. 105
Risk-free interest rate =12% p.a.
Draw a two-step binomial tree, show the stock prices at each node and

15.11 REFERENCES
1. Financial Derivatives – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
2. Capital market Instruments – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
3. Risk Management – Insurance and Derivatives – By G.Kotreshwar (HPH)
4. Financial Derivatives – By Gupta (PHI)
5. Introduction to Futures and Options Markets – By John Hull (PHI)
6. Derivatives – By D.A.Dubofsky and T.W.Miller (Oxford)

239
UNIT-16 : BLACK-SCHOLES OPTION PRICING MODEL

Structure :
16.0 Objectives
16.1 Introduction
16.2 Basis of BSOP Model
16.3 Assumptions of BSOP Model
16.4 Black-Scholes Formula
16.5 Determining Annualised Sigma
16.6 Notes
16.7 Illustrations
16.8 A Case Study
16.9 Summary
16.10 Key Words
16.11 Self Assessment Questions
16.12 References

240
16.0 OBJECTIVES
After studying this units, you will be able to;
• Understand the theory underlying Black–Scholes option pricing model,
• Comprehend th e assumptions underlying Black–Scholes option pricing model,
• Apply the Black–Scholes option pricing model to find the fair price of an option,
and
• Comprehend the superiority of Black–Scholes Model over Binomial Model.

16.1 INTRODUCTION
Black–Scholes model is a mathematical model of a financial
market containing options (derivative) investment instruments. From the model, one can
derive the Black–Scholes formula, which gives a theoretical estimate of the price
of European-style options. lt is widely used by options market participants. Many
empirical tests have shown that the Black–Scholes price is “fairly close” to the observed
prices. The Black–Scholes model was first published by Fischer Black and Myron
Scholes in their 1973 seminal paper, “The Pricing of Options and Corporate Liabilities”,
published in the Journal of Political Economy. They derived a partial differential
equation, now called the Black–Scholes equation, which estimates the price of the option
over time. The key idea behind the model is to hedge the option by buying and selling
the underlying asset in just the right way and, as a consequence, to eliminate risk. The
Black–Scholes formula has only one parameter that cannot be observed in the market:
the average future volatility of the underlying asset.

16.2 BASIS OF BSOP MODEL

Moving to two-steps of a binomial tree when valuing the option probably added
extra realism. But there is no reason to stop there. We could go on to take shorter and
shorter intervals in each of which there are only two possible changes in the value of the
stock. For example, we could divide the year into 12 subintervals of one month each.
That would give 13 possible year-end values. We could still use the binomial method to
work back from the final date to the present. Of course, it would be tedious to do such a
calculation by hand, but with a computer you can whisk through options with many periods
to run.
Since an asset can usually take on an almost limitless number of future values,
the binomial method is likely to give a more realistic and accurate measure of the option’s

241
value if we work with a large number of subperiods. But that raises an important question:
How do we pick sensible figures for the up and down changes in value? For example,
why did we pick figures of 10 percent and –10 percent when we valued the options by
using two subperiods? Fortunately there is a neat little formula that relates the up and
down changes to the standard deviation of the returns on the asset.
1 + upside change = u = esÖh
1 + downside change = d = 1/u
where
e = base for natural logarithms = 2.7183
s = standard deviation of (continuously
compounded) annual returns on asset
h = interval as a fraction of a year

When the price of a stock could either rise by 33 percent or fall by 25 percent
over one year, these figures are consistent with a figure of 28.8 percent for the standard
deviation of the annual returns:

1 + upside change (1–year interval) = u = e.288Ö1 =1.33

1 + downside change = d = 1/u = 1/1.33 =.75

To work out the equivalent upside and downside changes when we chop the year
into two 6-month intervals, we use the same formula:
1 + upside change (6-month interval) = u =e.288Ö.5 =1.226
1 + downside change = d = 1/u = 1/1.226 = .816
As the number of intervals is increased, the values that one obtains from the
binomial method should get closer and closer to the Black-Scholes value. In fact, you
can think of the Black-Scholes formula as a shortcut alternative to the binomial method
as the number of intervals gets very large. In the early 1970s, Fischer Black and Myron
Scholes made a major breakthrough in the pricing of stock options. This has had a huge
influence on the way in which market participants price and hedge options.

242
16.3 ASSUMPTIONS OF BSOP MODEL
The assumptions made by Black and Scholes when they derived their option pricing
formula were as follows:
(1) Stock price behaviour follows random walk and corresponds to the lognormal model.
(2) There are no transactions costs or taxes.
(3) All securities are perfectly divisible.
(4) There are no dividends on the stock during the life of the option.
(5) There are no riskless arbitrage opportunities.
(6) Security trading is continuous.
(7) Investors can borrow or lend at the same risk-free rate of interest.
(8) The short-term risk-free rate of interest, r, is constant.

16.4 BLACK-SCHOLES FORMULA

The Black-Scholes formulas for the prices of European calls and puts on
nondividend-paying stocks are
CE = S0 N(d1 ) – Ke –rT N(d2 ) …………………(1)
PE = Ke-rT N(-d2 ) – S0 N(-d1 ) …………………(2)

Where d1 = ln(S0 /Ke-rT) + sÖ T

sÖT 2

d2 = d1 - s Ö T
S0 , K, r and T are as previously defined.
CE = Call European
PE = Put European
s = Annualised volatility of stock returns
ln = Natural logarithm
N = is the cumulative probability distribution for a standardised normal variable*.

243
 The Black-Scholes model requires only five inputs, four of which are easily
obtainable the current price, the option’s strike price, the riskless rate of interest, and
the option’s time to expiration. The only variable that is not directly observable is the
expected volatility of the stock’s return, which is customarily estimated using historical
data. The volatility of stock’s return is computed as annualised sigma and is discussed
later.
Since the American call price, CA, equals the European call price, CE, for a
nondividend-paying stock, equation (1) also gives the price of an American call.
Unfortunately no exact analytic formula for the value of an American put on a nondividend-
paying stock has been produced.
Example
Consider the situation where the stock price three months from the expiration of
an option is Rs.245.78, the exercise price of the option is Rs.240.00, the risk-free
interest rate is 10 percent per annum, and the volatility is 20 percent per annum. This
means that S0 = 245.78, X = 240, r = 0.1, s =0.2, T = 0.25.
(1) Compute the present value of strike price
Ke-rT = 240e-0.1x0.25
= 234.07
(2) Compute d1 and d2 :
d1 = ln (S0 /Ke-rT ) + s Ö T
sÖT 2

= ln (1.05) + 0.2 Ö0.25

0.2 Ö0.25 2

= 0.5380
d2 = d1 - s Ö T

= 0.5380 - 0.2 Ö0.25

244
 = 0.4380
(3) Compute N(d1 ) and N(d2 )
N(d1 ) and N(d2 ) are the values in the cumulative standard normal distribution that
correspond to d1 = 0.5380 and d2 = 0.4380. In other words, they are the probabilities that
the the price at expiration will be 0.5380 and 0.4380 standard deviations above the mean,
(i.e.,0). That is, from normal distribution table,

N(d1 ) = 0.7045 N(-d1 ) = 0.2955

N(d2 ) = 0.6682 N(-d2 ) = 0.3318

(4) Compute the fair value of the call option:

CE (CA) = S0 N(d1) – Ke-rT N (d2)
= 245.78(0.7045) – 234.07(0.6682)
= 16.65
(5) Value of Put option
PE = Ke-rT N(-d2 ) – S0 N(-d1)
= 234.07(0.3318) – 245.78(0.2955)
= 5.03
Dividend Paying Stock
Up to now it was assumed that the stock upon which the option is written pays no
dividends. In practice, this is not always the case. Extending these results it is assumed
that the dividends paid on the stock during the life of an option can be predicted with
certainty. As traded options usually last for less than three months, this is not an
unreasonable assumption.
The model of stock price behaviour developed earlier is reasonable for a dividend-
paying stock except when it goes ex-dividend. At this point, the stock’s price goes down
by an amount reflecting the dividend paid per share. The effect of this is to reduce the
value of calls and to increase the value of puts. For tax reasons the stock price may go
down by somewhat less than the cash amount of the dividend. To take account of this, the
word dividend should be interpreted in the context of option pricing as the reduction in

245
the stock price on the ex-dividend date caused by the dividend. Thus, if a dividend of
Re.1 per share is anticipated and the share price normally goes down by 80 percent of
the dividend on the ex-dividend date, the dividend should be assumed to be Re.0.80 for
the purposes of the analysis.
(i) European Options
European options can be analysed by assuming that the stock price is the sum of
two components: a riskless component that will be used to pay the known dividends
during the life of the option and a risky component. The riskless component at any given
time is the present value of all the dividends during the life of the option discounted
from the ex-dividend dates to the present at the risk-free rate. The Black-Scholes formula
is then correct if S is put equal to the risky component. Operationally, this means that
the Black-Scholes formula can be used provided that the stock price is reduced by the
present value of all the dividends during the life of the option, the discounting being
done from the ex-dividend dates’ at the risk-free rate. A dividend is included in calculations
only if its ex-dividend date occurs during the life of the option.
Example
Consider a European call option on a stock when there is an ex-dividend date in
two months. The dividend on ex-dividend date is expected to be Rs.2.00 The current
share price is Rs.40, the exercise price is Rs.40, the stock price volatility is 30 percent
per annum, the risk-free rate of interest is 10 percent per annum, and the time to maturity
is three months. The present value of the dividends is

2e-0.1667 x 0.10 = 1.9662

The option price can, therefore, be calculated from the Black-Scholes formula
with S0=38.0338, K=40, r=0.10, s=0.3, and T=0.25.

(1) Ke-rT = 40e-0.1x0.25 = 39.01

(2) d1 = ln (38.0338/39.01) + .3Ö.25
0.3Ö.25 2

= ln (0.975) + 0.0375

246
 0.075
= -0.2998
d2 = d1 - sÖT
= -0.3748

(3) N(d1) = N(-0.2998) = 0.3821

N(d2 ) = N(-0.3748) = 0.3539

(4) CE = (38.0338)(0.3821) – (39.01)(0.3539)

= Re. 0.73
(ii) American Call Option
American call options are not exercised early when the underlying stock pays no
dividends. When dividends are paid, it is sometimes optimal to exercise at a time
immediately before the stock goes ex-dividend. The reason for this is easy to understand.
The dividend will make both the stock and the call option less valuable. If the dividend is
sufficiently large and the call option is sufficiently in-the-money, it may be worth forgoing
the remaining time value of the option in order to avoid the adverse effects of the dividend
on the stock price. In practice, call options are most likely to be exercised early
immediately before the final ex-dividend date. Here an approximate procedure suggested
by Fischer Black for valuing American calls on dividend-paying stocks is described.
(iii) Black’s Approximation
Black’s approximation involves calculating the prices of two European options:
1. An option that matures at the same time as the American option.
2. An option maturing just before the ex-dividend date occurring during the life of
the option.
The strike price, initial stock price, risk-free interest rate, and volatility are the
same as for the option under consideration. The American option price is set equal to
the higher of these two European option prices.

247
Example
Consider the situation in our previous example but suppose that the option is
American rather than European. The value of the option on the assumption that it expires
just before the ex-dividend date can be calculated using the Black-Scholes formula with
S0 =40, K=40, r=0.10, s =0.30, and T=0.1667. It is Rs.2.21. Black’s approximation
involves taking the greater of this and the value of the option when it can only be exercised
at the end of three months. From the previous example, we know that the latter is Re.0.73.
Black’s approximation, therefore, gives the value of the American call as Rs.2.21.

16.5 DETERMINING ANNUALISED SIGMA

Steps:
1. Take past data of closing price of the underlying (stock).
2. Determine daily return.
3. Calculate daily volatility or daily sigma.
4. Find annualised sigma = daily sigma *Öno. of trading days per year (i.e., 250 days)
Consider a stock’s past 10 trading days’ closing price
Trading ONGC
Day Closing Daily Return
Price
0 828.20 0
1 802.25 -3.14%
2 788.80 -1.675%
3 830.75 +5.32%
4 853.50 +2.70%
5 858.65 +0.65%
6 857.80 -0.099%
7 844.35 -1.57%
8 839.70 -0.55%
9 850.50 +1.285%
10 849.2 -0.153%
Total 2.768%

248
Daily Return = Today’s price – Yesterday’s Price *100
Yesterday’s Price
Now, Calculation of Daily Volatility or Daily Sigma (s):
_ Square of

Days Daily Return (x-X) Deviation

(%) X (x-0.2768) _

(x-X)2

1 -3.14 -3.4168 11.6745

2 -1,675 -1.9518 3.8095

3 +5.32 5.0432 25.433

4 +2.70 2.4232 5.8719

5 +0.65 0.3732 0.1393

6 -0.099 -0.3758 0.14122

7 -1.57 -1.8468 3.41067

8 -0.55 -0.8268 0.6836

9 +1.285 1.0082 1.01647

10 -0.153 -0.4298 0.18473

∑X = 2.768 ∑(x-x2)=

52.36489

_
X = åx = 2.768
N 10
_
X = 0.2768 _
Daily volatility or Daily Sigma = Ö å(x-x)2

249
 N
= Ö52.36489
10
= Ö52.36489 = 2.288 or 2.29%
Daily Sigma = 2.29%
Now, Annualized Sigma of ONGC is:
Annualized Sigma=Daily Sigma xÖ No. of trading days per year
\ Annualized Sigma = 2.29 *Ö250 days
= 2.29 * 15.8113
= 36.2076 or 36.21%
Annualized Sigma = 36.21%
This Annualized Sigma figure may differ from those annualized sigma figures
that are available on websites due to consideration of past trading day’s closing prices.

16.6 NOTES
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16.7 ILLUSTRATIONS
Illustration 1
On the basis of following information find the value of a European call option
S0 = Rs.92
K = Rs.95
T = 50 days or 50/365 (=0.137) of a year
r = 7.12%
s = 35%

Assume that the stock does not pay dividends.

Solution:
(1) Compute the present value of the strike price
Ke-rT = Rs.95e-0.0712x0.137 = Rs.94.08
(2) Compute d1 and d2 :
d1 = ln (S/Ke-rT) + sÖT
sT 2
d1 = ln (Rs.92/94.08) + (0.35)Ö.137
(0.35)Ö.137 2
= -0.1082
d2 = d1 - sÖT
= -0.1082 – 0.35)Ö.1370 = -0.2377

(3) Compute N(d1 ) and N(d2 ):

N(d1 ) = 0.4570
N(d2 ) = 0.4061

252
(4) Compute the value of the call option:
CE = (Rs.92.00) (0.4570) – (94.08)(0.4061)
= 3.83

Illustration 2
A stock is selling for Rs.330 with a strike price of Rs.340. At what price an
investor can sell put option on the stock? Assume that the T= 2 months, r = 10 percent
and s = 28%.

(1) Compute the present value of the strike price

Ke-rT = 340e-0.08x0.167
= 334.25
(2) Compact d1 = ln (330/334.25) + 0.28 Ö0.167
0.28Ö0.167 2
= -0.0547
d2 = -0.0547 – 0.1144
= -0.1691
(3) N(d1 ) = 0.4780
N(-d1 ) = 0.5220
N(d2 ) = 0.4545
N(-d2) = 0.5455
(4) Put price is
(334.25)((0.5455) – 330(0.5220)
= 10.07
He can sell the put at a maximum price of Rs.10.07.

253
16.8 CASE STUDY
On 1st July, a trader in the options market plans to write a call and put option on
the stock of NPT Limited for the month of Sep. (i.e., expiring 3 months from now). For
this purpose he has collected the following information.
a) The stock is currently selling in the market for Rs1800 each
b) The yield on treasury bills of an equivalent period is 7%
c) The volatility of the stock is 23%
d) The call option on the stock (expiring 3 months from now , strike price Rs 1900)
is currently selling in the market for Rs. 140
e) The put option on the stock (expiring 3 months from now, strike price Rs 1700)
is currently selling in the market for Rs. 65
f) The strike value of call option to be Rs.100 more than its current price and the
put option Rs.100 less than the current price.
Questions
(a) Find the fair price of call option on the basis of Black-Scholes Option Model.
(b) Should he write a call option? If so, at what price?
(c) Find the fair price of put option on the basis of Black-Scholes Option Model.
(d) Should he write a put option? If so, at what price?

16.9 SUMMARY
BSOP model is a mathematical model of a financial market containing options
(derivative) investment instruments. From the model, one can derive the Black–Scholes
formula, which gives a theoretical estimate of the price of European-style options. lt is
widely used by options market participants. Many empirical tests have shown that the
Black–Scholes price is “fairly close” to the observed prices. In fact, one can think of the
Black-Scholes formula as a shortcut alternative to the binomial method as the number
of intervals gets very large. In the early 1970s, Fischer Black and Myron Scholes made
a major breakthrough in the pricing of stock options. This has had a huge influence on
the way in which market participants price and hedge options.

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16.10 KEY WORDS
Lognormal distribution Annualised sigma Cumulative normal distribution value

16.11 SELF ASSESSMENT QUESTIONS

(1) What is the basis of BSOP Model?

(2) What are the assumptions underlying BSOP Model ?
(3) Define annualized sigma. How is it determined?
(4) What is the price of a European call option on a nondividend-paying stock when
the stock price is Rs.270, the strike price is Rs.260, the risk-free interest rate is
Rs.10 percent per annum, the volatility is 25 percent per annum, and the time to
maturity is three months?
(5) What is the price of a European put option on a nondividend-paying stock when the
stock price is Rs.80, the strike price is Rs.84, the risk-free interest rate is 5 percent
per annum, the volatility is 35 percent per annum, and the time to maturity is two
months?
(6) On 1st January, a trader in the options market plans to write a call and put option on
the stock of SST Limited for the month of March (i.e., expiring 3 months from
now). For this purpose he has collected the following information.
a) The stock is currently selling in the market for Rs.1,200 each
b) The yield on treasury bills of an equivalent period is 6.5%
c) The volatility of the stock is 30%
d) The strike value of call option to be Rs.100 more than its current price and
the put option Rs.100 less than the current price.
On the basis of Black-Scholes Option Model, determine
i) The premium at which he should write a call option
ii) The premium at which he should write a put option.

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16.12 REFERENCES
1. Financial Derivatives – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
2. Capital market Instruments – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
3. Risk Management – Insurance and Derivatives – By G.Kotreshwar (HPH)
4. Financial Derivatives – By Gupta (PHI)
5. Introduction to Futures and Options Markets – By John Hull (PHI)
6. Derivatives – By D.A.Dubofsky and T.W.Miller (Oxford)
(Footnotes)
*
A random variable has a log-normal distribution if the natural logarithm of the
variable is log-normally distributed. The Black-Scholes option pricing model assumes
that stock prices are log-normally distributed. If stock prices are normally distributed,
this would imply that it is equally likely for a stock price to move up or down. But there
are natural factors that impede price movements in the downward direction. For example,
a stock’s price cannot drop below zero. These considerations make a log-normal
distribution assumption more reasonable.

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 MODULE – V
OTHER DERIVATIVES AND RISK MANAGEMENT
UNIT - 17 : MEASURES OF RISK

Structure :
17.0 Objectives
17.1 Introduction
17.2 Delta Risk
17.3 Gamma Risk
17.4 Theta Risk
17.5 Vega Risk
17.6 RHO Risk
17.7 Case study
17.8 Summary
17.9 Key Words
17.10 Self Assessment Questions and Problems
17.11 Reference

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17.0 OBJECTIVES
This unit is so designed as to enable the reader to :
(1) Understand the concept of ‘greeks’ in the context of derivatives,
(2) Appreciate the need for greeks to hedge,
(3) Comprehend the mathematical expression of Greeks like delta, vega , etc, and
(4) Apply the Greeks for neutralizing the risk of investment in derivatives.

17.1 INTRODUCTION
The purpose of this unit is to define and measure risk in the context of derivatives
trading and portfolio of derivative investments. A trader who sells (i.e., writes) an option or
other derivative to a client in the over-the-counter market is faced with the problem of
managing its risk. If the derivative happens to be the same as one that is traded on an exchange,
the exposure can be neutralised by buying on the exchange the same derivative. But, when the
option has been tailored to the needs of a client and does not correspond to the standardised
products traded by exchanges, hedging the exposure is difficult. “Greek letters” or simply
the “Greeks” measure a different dimension of the risk in a derivative position and the aim of
the trader is to manage the Greeks so that all risks are acceptable.

17.2 DELTA RISK

As the underlying factors (such as the stock price, exchange rate, futures price, or
spot exchange rate) change, the value of the derivative asset changes as well. This exposure
is called the delta risk and is denoted by Ä. The first variable in the risk management of
options is the option delta. It is formally defined as the change in option premium expected
from a small change in the stock price. Symbolically, for a call option,

∆c = ∂c …………………(1)
∂s

where ∂c/∂s is the partial derivative of the call premium (c) with respect to the stock
price (S). Similarly, the put delta is the partial derivative of the put premium (p) with respect
to the stock price, or
ÄP = ∂P …………………………(2)

∂S

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 Delta is useful because it indicates the number of shares of stock required to match
the returns of the option. A call delta of 0.60, for instance, means it will act like 0.60 shares
of stock. If the stock price rises by Re.1, the call option will advance by 60 paise. A put delta
of –0.60 means that the put option will decline by about 60 paise if the stock rises by a rupee.
For a European option, the absolute values of the put and call deltas will sum to one. That is,

Äc +  ÄP = 1.0 ………………………(3)

This is not exactly true for an American option, but is still a reasonably accurate
estimate. If, for instance, the call delta is 0.55, a good estimate of the put delta is 0.55 – 1.0
= -0.45 irrespective of whether the option is American or European.
In the Black-Scholes OPM, determination of the call delta is a simple task: it is equal
to N(d1). For a call option,

∆c = N(d1) ……………………(4)

0 ≤ ∆c ≤ 1.0

because N(d1 ), the area under the normal curve, ranges from 0 to 100%. Similarly, for a put
option,

∆P = N(d1) - 1 ……………………(5)

-1 ≤ ∆P ≤ 0

Example
Suppose a trader has sold 100 option contracts – that is option to buy 10,000 shares
(with each contract size being 100 shares). The stock price Rs.250 and the option price is
Rs.22, and the delta ratio is 0.40.
(a) How many shares to be bought to hedge the exposure?
(b) If the stock price increases to Rs.260 or falls to Rs.240, show the results.
Solution:
(a) Trader’s exposure can be hedged 4000 shares
by buying (0.40x10,000)

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 (b) If stock price rise by Rs.10: Rs.
Gain on shares purchased + 40,000
[4000 x 10]

Loss on options written as - 40,000

Option price tend to go up by 0.4 ______
[0.4 x 10,000]
0
________
If stock price falls by Rs.10:

Gain on option written + 40,000

[0.4 x 10,000]

Loss on shares purchased

[4000 x 10] - 40,000

0
______
In example 10.1, the delta of investor’s option position is 0.4(-10,000)= -4000. In
other words, the investor losses 4000 ÄS on the short option position when the stock price
increases by ÄS . The delta of the stock is 1.0 and the long position in 4000 shares has a delta
of +4000. The delta of the trader’s overall position is, therefore, zero. The delta of the stock
position offsets the delta of the option position. A position with a delta of zero is referred to
being delta neutral as indicated by example .
Dynamic Hedging
As the value of delta keeps changing on account of market fluctuations, trader’s hedged
delta remains neutral only for a relatively short period of time. The hedge has to be adjusted
periodically. Dynamic hedging requires the hedge position to be adjusted periodically.

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Dynamic hedging can be contrasted with static hedging, where the hedge, once set up, is
never adjusted.
In the above example, if the stock price at the end of the week increases to, say,
Rs.270, resulting in increase in delta from 0.40 to 0.45. An extra 0.05 x 10,000 = 500 shares
would then have to be purchased to maintain the hedge.
Delta is closely related to Black Scholes analysis. They showed that it is possible to
set up a riskless portfolio consisting of a position in a derivative on a stock and a position in
the stock itself.

17.3 GAMMA RISK

The delta risk of a derivative securities change as the market conditions in the
underlying factors change. The rate of change of delta with respect to the price of the underlying
asset is known as gamma risk of the derivative product. This is denoted by the symbol G. It
is the second derivative of the option premium with respect to the stock price:

ΓC = ∂ ∆C
∂S

ΓP = ∂ ∆P
∂S

The ÄS of the derivative assets change constantly. The larger the G, the more dramatic
will be the movements in the Ä of the derivative asset for a given change in the market
conditions of the underlying factor.
As with the delta risk, some derivative positions will have a positive gamma risk, and
others will have a negative gamma risk. If an upward movement in the underlying factor
causes the delta (with respect to that factor) of the derivative asset to increase and a downward
movement causes the delta of the derivative asset to decrease, then such a position has a
position gamma. On the other hand, if an upward movement in underlying factor causes the
delta (with respect to that factor) of the derivative asset to decrease and a downward movement
causes the delta of the derivative asset to increase, then such a position has a negative gamma.
One use of gamma is a measure of how often option portfolios need to be adjusted as
stock prices change and time passes. Options with gammas near zero have deltas that are not
particularly sensitive to changes in the stock price, and consequently more robust. Gamma is
at a maximum when an option is at-the-money and near expiration.

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 A positive gamma comes from long option positions. A portfolio with a positive
gamma becomes more bullish as the underlying price rises (i.e., delta increases) or more
bearish as the price declines (delta declines). Negative gammas, conversely, come from
short positions. Equation (6) shows how to calculate gamma.

-0.5(d1)2
ΓC = ΓP = e ……………………(6)
So σ √π T

Where So = current stock price

ó = Annualised volatility of stock returns
T = expiry duration

17.4 THETA RISK

The rate of change in the value of a derivative asset as the time passes is known as the
theta risk of the asset and is denoted by q. Formally,

θC = ∂C
∂t

θC = ∂P
∂t

The theta of an option measures the change in the option value due to the passage of
time. It indicates the sensitivity of a call option to the time remaining until its expiration.
Mathematically, a theta is greater than zero because more time until expiration means
more option time value. Options become less valuable, ceteris paribus, as they approach
expiration day. However, because time until expiration can only get shorter, option traders
usually think of theta as a negative number. The holder of a long option position loses with
the passage of time, so holding a long call or long put means theta declines in premium due
solely to the passage of time. Conversely, the passage time is to the benefit of the option
writer, so theta is positive for a short call or short put and represents a gain to the option
writer. Equations (7) and (8) show how to calculate theta for a call and a put.

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 -0.5(d1)2
θC = - So σ e______ - rke-rT N(d2)
2√ 2πT ………(7)

-0.5(d1)2
θC = - So σ e______ + rke-rT N(d2)
2√ 2πT ………(8)

These equations determine theta per year. It is desirable to know theta per day, as this
value indicates how the option price changes with the passage of a single day and is easier to
interpret.
A theta value of –73 means that the holder will lose Rs.73 in time value over the
course of a year. This is not especially helpful information. Dividing the Rs.73 by 365 gives
about Rs.0.2, and this result is meaningful. This means that at present the option will lose
about 20 paise in time value holding it for a day. Hold it for 10 days and it will lose Rs.2.

17.5 VEGA RISK

The vega risk of a derivative, n is the rate of change in the value of the derivative with
respect to the volatility (s) of the underlying asset. It is the first partial derivative of the
Black-Scholes Model with respect to the volatility of the underlying asset.

ν = = ∂c
∂σ
ν = = ∂P
∂σ

Vega is positive for both long calls and long puts. If a vega is high in absolute terms,
the portfolio’s value is very sensitive to small changes in volatility. If vega is low, volatility
changes have relatively little impact on the value of the portfolio. For example, if an option
has a vega of 0.25, it will gain 0.25 percent in value for each percentage point increase in the
anticipated volatility of the underlying asset. Vega is the same for puts and calls and is given
by:
-0.5(d1)2

ν = So √ T e …………………(9)
√ 2π

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17.6 RHO RISK
The rho risk of a derivative measures its sensitivity with respect to the interest rate
and is denoted by r. It is the first partial derivative of the Black-Scholes Model with respect
to the risk-free interest rate and is given by:
ρC = K T e-rT N(d2 ) …………………(10)

ρρ = - K T e –rT N(-d2) ………………(11)

Rho is positive for call options and negative for put options. Unless an option has an
exceptionally long life, changes in interest rates affect the premium only modestly.

17.7 CASE STUDY

Mr. Jadav is the manager of Golden Hedge funds. He is basically a business management
post-graduate with Financial Derivative as specialization. He is keen to use financial options
contracts to design hedging strategies with the objective of improving the yield and reduce
risk. His portfolio is currently worth Rs.150 crore, of which 90% is invested in stocks. The
return on stock portfolio is highly corrected to BSE sensex (with r value being 0.92). on
august 1st, the sensex is at 27,890 and traded on BSE with an exercise price in the range of
26,500 to 28,500 with expiry on Sept. 29. The price of these options are as follows:

Exercise price(Rs.) Call Premium (Rs.) Put Premium (Rs.)

27,500 720 510
27,700 680 570
27,900 560 660
28,100 440 780
28,300 310 840
28,500 180 910

September futures on sensex are currently selling at 28,150 expiring on 29th

September. The volatility of the sensex is estimated at 23% and the risk-free rate is 6%.
Mr.Jadav is concerned about a possible downside risk and wants to hedge the value of the
portfolio.
Questions:
1. Explain the risks associated with the use of options for hedging.
2. Explain how Mr.Jadav can delta-hedge the portfolio.
3. How can portfolio be made gamma-neutral?

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 4. How can portfolio be made vega-neutral?
5. Show how to create put option synthetically in order to hedge the portfolio.

17.8 SUMMARY
The concept of risk is central to players in capital markets, particularly derivatives
market. The traders in derivatives market are faced with the problem of hedging their exposure.
Delta hedging involves creating a position with zero delta (sometimes referred to as a delta-
neutral position). The delta of a derivative changes over time. This means the position in the
underlying asset has to be frequently adjusted.
The gamma of an option is the rate of change of its delta with respect to the price of
the underlying asset. Options with gammas near zero have deltas that are not particularly
sensitive to changes in the stock price, and consequently are more robust.
Theta is a measure of the sensitivity of an option to the time remaining until its
expiration. It is greater than zero because more time until expiration means more option
time value.
Two other measures of the risk of an option position are vega and rho. The vega of an
option measures the rate of change of its value with respect to volatility. Rho measures the
rate of change of the position’s value with respect to the risk-free interest rate.

17.9 KEY WORDS

Delta risk Gamma risk Theta risk Vega risk Rho risk
17.10 SELF ASSESSMENT QUESTIONS AND PROBLEMS
1. What is meant by the delta of an option?
2. Calculate the delta of a call option given that:
T = 100 days
R = 6%
So = Rs.125
s = 0.29
3. How can a short position in 600 call options be made delta neutral when the delta of
each option is 0.5?
4. What is theta risk? How is it computed?

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5. What does theta of – 0.8 mean when time is measured in years?
6. What is meant by the gamma of an option position? How is it computed?

17.10 SUGGESTED READINGS

1. Kotreshwar, G.,” Risk Management : Insurance and Derivatives “ , HPH, B’luru.
2. Brealey R.A. and Myers S.C. “Principles of Corporate Finance” (1996) Tata McGraw
Hill.
3. Edwards F.R. and Ma C.W “Futures and Options” (1982) McGraw-Hill International
Editions.
4. Graham Peirson and others “Business FinaZnce”, (1998) Irwin/McGraw-Hill.
5. Hull J.C. “Options, Futures, & Other Derivatives” (2002) Pearson Education.
6. William H Beever & George Parker (ed.), “Risk Management”, (1995) Problems and
Solutions, McGraw Hill.

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UNIT – 18 : EURODOLLAR DERIVATIVES (FUTURES)

Structure :

18.0 Objectives
18.1 Introduction
18.2 What are Euro Dollars?
18.3 Eurodullar Futures
18.4 Hedging with Eurodullar Futures
18.5 Speculating with Eurodullar Futures
18.6 Pricing and Quotation
18.7 Forward Rate Agreements

18.8 Interest Rate Caps & Floors

18.9 Eurodollar Spreads

18.10 Case Study
18.11 Summary
18.12 Key Words
18.13 Self Assessment Questions and Problems
18.14 References

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18.0 OBJECTIVES
This unit is so designed as to enable the reader to :
• Understand the concept of ‘eurodollar’,
• Appreciate the need for eurodollar derivatives
• Comprehend the basics of eurodollar derivatives, and
• Analyse FRAs, caps , etc., based on Eurodollars.

18.1 INTRODUCTION
The name eurodollars was derived from the fact that initially dollar-denominated
deposits were largely held in European banks. At first these deposits were known
as eurobank dollars. However, U.S. dollar-denominated deposits are now held in financial
centers across the globe and referred to as eurodollars. The eurodollar futures contract was
launched in 1981 by the Chicago Mercantile Exchange (CME), marking the first cash-settled
futures contract. On expiration, the seller of cash settled futures contracts can transfer the
associated cash position rather than making a delivery of the underlying asset. Eurodollar
futures were initially traded on the upper floor of the Chicago Mercantile Exchange in its
largest pit, which accommodated as many as 1,500 traders and clerks. However, the majority
of eurodollar futures trading now takes place electronically.

18.2 WHAT ARE EURODOLLARS?

Eurodollars are time deposits denominated in U.S.dollars at banks outside the United
States, and thus are not under the jurisdiction of the Federal Reserve system of U.S.A.
Consequently, such deposits are subject to much less regulation than similar deposits within
the U.S.. The term was originally coined for U.S. dollars in European banks, but it expanded
over the years to its present definition—a U.S. dollar-denominated deposit in Hong Kong or
Tokyo or Beijing would be likewise deemed a Eurodollar deposit. The eurodollar market
traces its origins to the Cold War era of the 1950s. During this period, the Soviet Union
started to move its dollar-denominated revenue, derived from selling commodities such
as crude oil, out of U.S. banks. This was done to prevent the U.S. from being able to freeze its
assets. Since then, eurodollars have become one of the largest short-term money markets in
the world and their interest rates have emerged as a benchmark for corporate funding.
“eurodollars” as deposits were at first held mostly by European banks and financial
institutions. In the mid-1950s, Eurodollar trading and its development into a dominant world
currency began when the Soviet Union wanted better interest rates on their Eurodollars and

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convinced an Italian banking cartel to give them more interest than what could have been
earned if the dollars were deposited in the U.S. The Italian bankers then had to find customers
ready to borrow the Soviet dollars and pay above the U.S. legal interest-rate caps for their
use, and were able to do so; thus, Eurodollars began to be used increasingly in global finance.

18.3 EURODOLLAR FUTURES

The Eurodollar futures contract refers to the financial futures contract based upon
eurodollar deposits, traded at the Chicago Mercantile Exchange (CME). More specifically,
EuroDollar futures contracts are derivatives on the interest rate paid on those deposits.
Eurodollars are cash settled futures contract whose price moves in response to the interest
rate offered on US Dollar denominated deposits held in European banks.[ Eurodollar futures
are a way for companies and banks to lock in an interest rate today, for money it intends to
borrow or lend in the future. Each CME Eurodollar futures contract has a notional or “face
value” of $1,000,000, though the leverage used in futures allows one contract to be traded
with a margin of about one thousand dollars.
The London Interbank Offered Rate (LIBOR) is a benchmark for short-term interest
rates at which banks can borrow funds in the London interbank market. Eurodollar futures
are a LIBOR based derivative, reflecting the London Interbank Offered Rate for a 3-month
$1,000,000 offshore deposit. (See “An Introduction to LIBOR”)
Eurodollar futures prices are expressed numerically using 100 minus the implied 3-
month U.S. Dollar LIBOR interest rate. In this way, a eurodollar futures price of $96.00
reflects an implied settlement interest rate of 4%.
For example, if an investor buys 1 eurodollar futures contract at $96.00 and price
rises to $96.02, this corresponds to a lower implied settlement of LIBOR at 3.98%. The
buyer of the futures contract will have made $50. (1 basis point, 0.01, is equal to $25 per
contract, therefore a move of 0.02 equals a change of $50 per contract.)

18.4 HEDGING WITH EURODOLLAR FUTURES

Eurodollar futures provide an effective means for companies and banks to secure an
interest rate for money it plans to borrow or lend in the future. The Eurodollar contract is
used to hedge against yield curve changes over multiple years into the future.
For example: Suppose a company knows in September that it will need to borrow
$10 million in December to make a purchase. As each eurodollar futures contract represents
a $1,000,000 time deposit with a three month maturity, the company can hedge against an

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adverse move in interest rates during that three month period by short selling 10 December
Eurodollar futures contracts, representing the $10 million needed for the purchase.
The price of eurodollar futures reflect the anticipated London Interbank Offered Rate
(LIBOR) at the time of settlement, in this case, December. By short selling the December
contract, the company profits from upward movement in interest rates, reflected in
correspondingly lower December eurodollar futures prices.
Let’s assume that on September 1, the December eurodollar futures contract price
was exactly $95.00, implying an interest rate of 5.0%, and that at the expiry in December the
final closing price is $94.00, reflecting a higher interest rate of 6.0%. If the company had
sold 10 December Eurodollar contracts at $95.00 in September, it would have profited by
100 basis points (100 x $25 = $2,500) on 10 contracts, equaling $25,000 ($2,500 x10)
when it covered the short position.
In this way, the company was able to offset the rise in interest rates, effectively locking
in the anticipated LIBOR for December as it was reflected in the price of the December
Eurodollar contract at the time it made the short sale in September.

18.5 SPECULATING WITH EURODOLLAR FUTURES

The policy decisions of the U.S. Federal Reserve have a major impact on the price of
eurodollar futures. A change in Federal Reserve policy towards lowering or raising interest
rates can take place over a period of years. Eurodollar futures are impacted by these major
trends in monetary policy.
The high levels of liquidity along with relatively low levels of intraday volatility create
an opportunity for traders using a ‘market making’ style of trading. Traders using this non-
directional strategy place orders on the bid and offer simultaneously, attempting to capture
the spread. More sophisticated strategies such as arbitrage and spreading against other
contracts are also used by traders in the eurodollar futures market.
The TED spread is the price difference between interest rates on three-month futures
contracts for U.S. Treasuries and three-month contracts for Eurodollars with the same
expiration months. TED is an acronym using T-Bill and ED, the symbol for the eurodollar
futures contract. This spread is an indicator of credit risk; an increase or decrease in the TED
spread reflects sentiment on the default risk level of interbank loans.

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18.6 PRICING AND QUOTATION
Eurodollar futures are based on a $1 million facevalue, 3-month maturity Eurodollar
Time Deposit.They are settled in cash on the 2nd London Bank business day prior to the 3rd
Wednesday of the contract month by reference to the ICE Benchmark Administration Limited
(ICE) Interest Settlement Rate for three-month Eurodollar Interbank Time Deposits. These
contracts mature during the months of March, June, September, or December, extending
outward 10 years into the future. However, the exchange also offers “serial” contract months
in the four nearby months that do not fall into the March quarterly cycle. See Table 1 below
for contract specifications. Where once trading was largely conducted on the floor of the
exchange using traditional open outcry methods during regular daylight hours – today, trading
activity is largely conducted on the CME GlobexR electronic trading platform on nearly an
around the clock basis. These contracts are quoted in terms of the “IMM index.” The IMM
index is equal to 100 less the yield on the security. If for example, the yield equals 0.750%,
the IMM index is quoted as 99.250 (100.000 “ 0.750% = 99.250) . If the value of the futures
contract should fluctuate by one basis point (0.01%), this equates to a $25.00 movement in
the contract value. The minimum allowable price fluctuation, or “tick” size, is generally
established at one-half of one basis point, or 0.005%. Based on a $1 million face-value 90-
day instrument, this equates to $12.50. However, in the nearby expiring contract month, the
minimum price fluctuation is set at one-quarter basis point, or 0.0025%, equating to $6.25
per contract.

18.7 FORWARD RATE AGREEMENTS

The FRA is a legally binding agreement between two parties to borrow or lend at a
rate that will be applied to a notional loan or deposit of an agreed amount to be drawn, on an
agreed future date for a specified term. One of the parties is a ‘buyer’ of the FRA, the other
a ‘seller’. The buyer agrees notionally to borrow the money at the FRA rate, and the seller
agrees notionally to lend the money at the FRA rate. On the settlement date, the difference
between the agreed FRA rate and the prevailing MIBOR rate will be settled by one party to
the other in cash. Usually, one of the parties is a bank, and other a corporate organization.
The settlement date commences on some future date which needs to be specified. The
significant characteristics of an FRA are:
(a) It is an OTC product, and FRAs are quoted by many banks around the world.
(b) It is predominantly used as an inter-bank tool for hedging of short-term interest rate
risk.

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(c) Simpler to administer than futures since there is no margining requirement.
(d) The underlying principal amount is purely notional and no actual exchange takes place.
The notional principal amount (NPA) is used for calculation of settlement amount to be
exchanged between parties. The difference between the agreed FRA rate and the ruling
market rate (MIBOR) will be cash-settled by the parties.
(e) Most liquid and frequently traded FRAs are for 3 to 6 months.
(f) FRAs are available for periods extending to 2 years.
(g) It is like insurance. The bank will guarantee (or insure) a rate of interest for a transaction
which starts on a future date.
(h) FRAs are flexible. If the FRA is no longer required, a reversing contract may be transacted
to close out the position.
(i) FRAs involve zero cost. There are no costs incurred by the hedger.
Many leading banks around the world quote and trade FRAs and the market is liquid.
The bid-ask spreads are usually quite low – as small as 3 to 4 basis points. For a 6x12 FRA
(Borrowing for 6 months, beginning six months from now), a bank may be willing to borrow
at a rate of 5.05% for a 6-month period, 6 months hence, and lend at a rate of 5.08%; this is
a spread of 3 basis points.
a) The settlement date which is also known as the delivery date of the forward contract, is
given by t1.
b) The end of exposure period, also known as the end of the forward period, given by t2.
c) The length of the loan period is t2 - t1, which is the length of time for which the money
is borrowed.
d) The payment is made on the settlement date, t1, which is the start of the loan period
e) The forward rate according to the FRA is known and is denoted as Fr.
f) On t1 the spot interest rate – denoted by r is ascertained on the basis of MIBOR or any
other benchmark rate for the same period, i,e t2 –t1.
g) Since Fr and r are calculated in annual terms, the rates are converted to the rates
applicable for the loan period. For example, if the r is 6% and the Fr is 8%, the difference
is 2% on an annual basis, if the loan period is six months; the rate for six-month period
is 1%.

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h) The difference in interest rate, which is (r-Fr), is multiplied by the principal to find the
amount of interest differential. This amount is discounted at the spot rate as indicated
by the following formula.

P ∆ (r, Fr) [D/B]

Settlement amount =

1 + [ r x ( D / B) ]

Where,
P = principal amount
“ = (r, Fr) = interest rate differential.
D = no of days in the loan period
B = No of days in the year (360/365 as specified in the FRA)
Example
NDH bank sells a 2x5 FRA with a principal amount of INR 15 million at an Fr of 8%
.The reference rate on the FRA is the MIBOR, and the cost of the loan is MIBOR + 100. On
the settlement date, which is two months ahead, the MIBOR is 6.4 % and the r is MIBOR +
100. A year is specified to have 360 days. What will be the settlement payment?
(1) Calculate the difference between Fr and r.
Fr =8%
r = 7.4 %[MIBOR +100 , or 6.4% + 1% =7.4%]
Fr – r = 0.6%
(Fr - r) (D/B) = 0.15% OR 0.0015
(2)
Settlement amount = P “ (r, Fr) [D/B]
1 + [ r x ( D / B)]

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Settlement amount = 15,000,000 x 0.0015
1 + [0.074x90/360]
= 22500
1.0185
= 22,091
In this example, NDH bank will receive INR 22,091 as the settlement amount.

18.8 INTEREST RATE CAPS & FLOORS

An interest rate cap is a derivative in which the buyer receives payments at the end of
each period in which the interest rate exceeds the agreed strike price. An example of a cap
would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%.
They are most frequently taken out for periods of between 2 and 5 years, although this can
vary considerably. Since the strike price reflects the maximum interest rate payable by the
purchaser of the cap, it is frequently a whole number integer, for example 5% or 7%. By
comparison the underlying index for a cap is frequently a LIBOR rate, or a national interest
rate. The extent of the cap is known as its notional profile and can change over the lifetime of
a cap, for example, to reflect amounts borrowed under an amortizing loan. The purchase
price of a cap is a one-off cost and is known as the premium. The purchaser of a cap will
continue to benefit from any fall in interest rates below the strike price, which makes the cap
a popular means of hedging a floating rate loan. The interest rate cap can be analyzed as a
series of European call options, known as caplets, which exist for each period the cap
agreement is in existence. Unlike other types of option, it is generally not necessary for the
purchaser of a cap to notify the seller in order to exercise it, as this will happen automatically
if the interest rate exceeds the strike price. Each caplet is settled in cash at the end of the
period to which it relates. In mathematical terms, a caplet payoff on a rate L struck at K is : N
* a{\displaystyle N\cdot \alpha \max(L-K,0)} max(L – K , 0)
where N is the notional value exchanged and {\displaystyle \alpha } a is the day
count fraction corresponding to the period to which L applies. For example, suppose you
own a caplet on the six month USD LIBOR rate with an expiry of 1 Sept. 2016 struck at 2.5%
with a notional of 1 million dollars. Then if the USD LIBOR rate sets at 3% on 1 Sept. you
receive
$ 1M * 0.5.max ( 0.03-0.025,0) = $ 2500
Customarily the payment is made at the end of the rate period, in this case on 1 August.

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An interest rate floor is a series of European put options or floorlets on a
specified reference rate, usually LIBOR. The buyer of the floor receives money if on the
maturity of any of the floorlets, the reference rate is below the agreed strike price of the
floor. An interest rate collar is the simultaneous purchase of an interest rate cap and sale
of an interest rate floor on the same index for the same maturity and notional principal
amount.
♦ The cap rate is set above the floor rate.
♦ The objective of the buyer of a collar is to protect against rising interest rates (while
agreeing to give up some of the benefit from lower interest rates).
♦ The purchase of the cap protects against rising rates while the sale of the floor generates
premium income.
♦ A collar creates a band within which the buyer’s effective interest rate fluctuates
A reverse interest rate collar is the simultaneous purchase of buying an interest
rate floor and simultaneously selling an interest rate cap.
♦ The objective is to protect the bank from falling interest rates.
♦ The buyer selects the index rate and matches the maturity and notional principal amounts
for the floor and cap.
♦ Buyers can construct zero cost reverse collars when it is possible to find floor and cap
rates with the same premiums that provide an acceptable band.

18.9 EURODOLLAR SPREADS

It is Known as the TED spread. TED spread is the difference between the interest
rates on interbank loans and on short-term U.S. government debt (“T-bills”). TED is
an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract.
Initially, the TED spread was the difference between the interest rates for three-month U.S.
Treasuries contracts and the three-month Eurodollars contract as represented by the London
Interbank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchangedropped
T-bill futures after the 1987 crash,[1] the TED spread is now calculated as the difference
between the three-month LIBOR and the three-month T-bill interest rate.
TED spread = (3-month LIBOR) - ( 3-month T-bill int. rate)
The size of the spread is usually denominated in basis points (bps). For example, if
the T-bill rate is 5.10% and ED trades at 5.50%, the TED spread is 40 bps. The TED spread

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fluctuates over time but generally has remained within the range of 10 and 50 bps (0.1% and
0.5%) except in times of financial crisis. A rising TED spread often presages a downturn in
the U.S. stock market, as it indicates that liquidity is being withdrawn.
Treasury/Eurodollar (TED) spreads have been studied and traded since 1981
concurrent with the introduction of Eurodollar futures. Spreads were originally constructed
with use of CME ( Chicago Mercantile Exchange) 90-day Treasury bill futures vs. CME 90-
day Eurodollar futures contracts. As such, the spread was a very direct measure of marketplace
perception of the credit risk implied by a private investment (in Eurodollars) vs. the so-
called “risk-free rate” implied by a Treasury bill. The popularity of the TED spread was
enhanced by various credit events affecting the marketplace over the years like Continental
Illinois Bank crisis of 1984, the savings and loan failures and subsequent bailout of the early
1980s. While CME’s T-bill futures contract has fallen into disuse as the popularity of
Eurodollar futures has transcended all other domestic short-term interest rate contracts, the
TED lives on as a popular device for trading credit risks. The TED is sometimes referred to
as a “swap spread” or a spread between interest rate swap (IRS) rates and a riskfree government
rate. Noting the close relationship between IRSs and Eurodollar futures as a pricing mechanism
and hedging tool, one may readily substitute Eurodollar futures as a proxy for a swap. Thus,
TED spreads are often constructed with the use of Eurodollar futures vs. cash Treasury notes.
Or, one may facilitate the trade with use of 2-year, 5-year, 10-year Treasury note futures as
traded on the Chicago Board of Trade (CBOT) vs. Eurodollar futures. All yields are not
going to be uniform. The yield quoted on a money market instrument such as LIBOR is
calculated using somewhat different assumptions than the yield quoted on a TED spreads or
Treasury vs. Eurodollar spreads have been traded in a variety of forms over the years. A TED
spread does reflect credit quality. Yields quoted on money market instruments such as
Eurodollars are not strictly comparable to yields quoted on coupon bearing items such as
Treasury notes. Fixed income traders need be careful to assure that they are comparing
“oranges with oranges.” Yields associated with Eurodollar or LIBOR quotes are known as
money market yields (MMY). Eurodollars are so-called “add-on” instruments where one
invests the stated face value and received the original investment plus interest at term. Thus,
one’s interest may be calculated as a simple function of the face value (FV), rate (r) and days
to maturity (D) :
Interest = FV [r x (D/360)]
Example: If one were to purchase a $1 million face value unit of 270- day Euros with
MMY(Money Market Yield) =3.00%, one would receive the original $1 million face value
(FV) investment plus interest (i) of $7,833 at the conclusion of 94 days. Interest = $1,000,000

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[0.03 x (270/360)] = $22,500. The MMYs suffer from the mistaken assumption that there
are but 360 days in a year . As such, MMYs are not completely comparable to the bond
equivalent yield (BEY) quoted on Treasury notes that imply periodic coupon payments. The
following adjustment may be made to render the two quotes comparable :
BEY = MMY x (365/360)
where BEY= bond equivalent yield
Example: Assume an investor has a 90-day money market instrument yielding 3.00%.
The BEY of the instrument is 3.0417% which slightly exceeds the MMY.

18.10 CASE STUDY

Victoria (India) Ltd. is a foreign subsidiary engaged in the business of Pearls and
Diamonds. On January 2, the company plans to borrow $ 10 million and Rs.10 crores in
March for three months. HSB Bank agrees to provide required funds at 1 pc above whatever
the 3-month LIBOR on March 20 for dollar loan, and 1 pc above whatever the 3-month
MIBOR on March 20 for rupee loan.
The management of the firm is concerned that in the interim the LIBOR and MIBOR
may rise causing increase in borrowing cost.
On January 2, the March Eurodollar futures price is 91.72, and the implied 3-month
Eurodollar rate is 8.28 pc. The 3-month LIBOR on January 2 is 8.375.
The 3-month benchmark MIBOR rate (ask) is 8.1 pc on January 2 .
MIBOR Rates (%)
Duration Bid Ask
1 month 7.80 8.30
2 months 7.90 8.30
3 months 8.00 8.10
6 months 7.75 7.80
12 months 7.63 7.65

The 3-3 FRA is being quoted by the Bank of Baroda at 7.70 – 7.80 pc.

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Discussion Questions:
(1) What strategy the management of the firm should put in place to protect itself against
possible rise in LIBOR?
(2) What strategy the management of the firm should put in place to protect itself against
possible rise in MIBOR?
(3) If it can lock in the 3-month Eurodollar futures rate of 8.28 pc on January 2, what will
be its guaranteed dollar borrowing cost?
(4) If it can lock in the 3-month FRA rate of 7.80 pc on January 2, what will be its guaranteed
rupee borrowing cost?
(5) If the 3-month LIBOR rises to 9.00 pc by March 20 (March futures are $ 91),
demonstrate how the dollar borrowing cost will still be equal to the amount computed
in part (3) above.
(6) If the 3-month MIBOR rises to 8.25 pc on March 20, demonstrate how the rupee
borrowing cost will still be equal to the amount computed in part (4) above.

18.11 SUMMARY
Eurodollars are time deposits denominated in U.S.dollars at banks outside the United
States, and thus are not under the jurisdiction of the Federal Reserve system of U.S.A.
Consequently, such deposits are subject to much less regulation than similar deposits within
the U.S.. The term was originally coined for U.S. dollars in European banks, but it expanded
over the years to its present definition—a U.S. dollar-denominated deposit in Hong Kong or
Tokyo or Beijing would be likewise deemed a Eurodollar deposit. The eurodollar market
traces its origins to the Cold War era of the 1950s.
The Eurodollar futures contract refers to the financial futures contract based upon
eurodollar deposits, traded at the Chicago Mercantile Exchange (CME). More specifically,
EuroDollar futures contracts are derivatives on the interest rate paid on those deposits.
Eurodollar futures provide an effective means for companies and banks to secure an interest
rate for money it plans to borrow or lend in the future. The Eurodollar contract is used
to hedge against yield curve changes over multiple years into the future. The FRA is a legally
binding agreement between two parties to borrow or lend at a rate that will be applied to a
notional loan or deposit of an agreed amount to be drawn, on an agreed future date for a
specified term. An interest rate cap is a derivative in which the buyer receives payments at
the end of each period in which the interest rate exceeds the agreed strike price. An interest
rate floor is a series of European put options or floorlets on a specified reference rate,

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usually LIBOR. A reverse interest rate collar is the simultaneous purchase of buying an
interest rate floor and simultaneously selling an interest rate cap. TED spread is the difference
between the interest rates on interbank loans and on short-term U.S. government debt (“T-
bills”).

18.12 KEY WORDS

Eorodollar Eurodollar futures FRAs Caps Floors Collars Eorodollar spreads
18.13 SELF ASSESSMENT QUESTIONS AND PROBLEMS
1. What do you mean by ‘Eurodollar’? why did Eurodollars evolved?
2. Define an Eurodollar futures contract. What are its salient features?
3. How Eurodollars are useful for hedging? Explain with an example.
4. Briefly explain the pricing mechanism of Eurodollar futures.
5. What are forward rates? Explain, with a suitable example, the procedure for determining
forward rates.
6. Discuss the mechanics of trading FRAs
7. What are interest rate caps?
8. What do you mean by interest rate floors and collars?

18.14 REFERENCES
1 Labuszewski J. W., “ Undersatanding Eurodollar futures” @ www : cmegroup.com
2. Financial Derivatives – by Dr. G. Kotreshwar (Chandana Publications, Mysuru)
3. Capital market Instruments – by Dr. G. Kotreshwar (Chandana Publications, Mysuru)
4. Risk Management – Insurance and Derivatives – By G.Kotreshwar (HPH)
5. Financial Derivatives – By Gupta (PHI)
6. Introduction to Futures and Options Markets – By John Hull (PHI)
7. Derivatives – By D.A.Dubofsky and T.W.Miller (Oxford)

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UNIT – 19 : ACCOUNTING ISSUES IN DERIVATIVES

Structure :
19.0 Objectives
19.1 Introduction
19.2 ‘Fair Value’Accounting
19.3 Accounting for Derivative Instruments
19.4 Accounting Practice
19.5 Accounting Treatment of Derivatives in India
19.6 Case Study
19.7 Summary
19.8 Key Words
19.9 Self Assessment Questions and Problems
19.10 References

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19.0 OBJECTIVES
This unit is so designed as to enable the reader to :
• Understand the basics of accounting for derivatives,
• Grasp the concept of hedge accounting,
• Comprehend the derivative accounting practices , and
• Analyse accounting standards applied for derivative accounting in India.

19.2 INTRODUCTION
The trading volume in financial derivatives has increased tremendously over the last
three decades. But the accounting framework has not kept pace with the growth and complexity
of these instruments. It is still in the process of evolution. Though some accounting standards
have been framed by various accounting bodies on the basis of International Accounting
Standards (IAS) 39, but still there is no uniform standard accounting practice for derivative
instruments as a whole. International Accounting Standards Board (IASB) has an on going
project to revise IAS 39. This chapter focuses on the current version of accounting treatment
of derivative deals, followed by brief note on accounting for derivatives in India.

19.3 ‘FAIR VALUE’ ACCOUNTING

Conventional accounting principles do not specifically describe the accounting
treatment of derivative financial instruments and their risk reducing effects of a hedge. For
example, as per accounting convention of conservatism or prudence, inventory is to be valued
at the lower of cost or market value (net realizable value). A firm may hold inventory of a
particular material (say raw coffee) and the price of the raw coffee might have fallen in the
market. Assume that the firm has simultaneously have hedged against the fall in price by
selling raw coffee in the futures market in a particular exchange. In conventional accounting
the unrealized loss on such raw coffee will have to be reflected in terms of lower stock
valuation in both profit and loss account as well as in balance sheet of the firm. As a result,
the profit figure of the company will be lesser. On the other hand, the gain (unrealized) on
futures transaction on raw coffee will not be shown, because as per above accounting
convention, the unrealized gain cannot be shown. Hence, in these circumstances, the
conventional accounting may not show the fair financial position of the firm.
The big change that accounting standards on financial instruments bring about is clearly
the fair value accounting, also called mark-to-market accounting, is taking over the age-old

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historical cost accounting. ‘Mark-to-market’ is a stock market term; ‘fair value’ is more
preferable. Assets are stated at their historical cost under conventional accounting. Gain or
loss cannot be booked until they are actually realized. However it is generally felt that
historical costs are less relevant than prevailing values. There is a general consensus that
fair values provide more current and relevant information.

19.4 ACCOUNTING FOR DERIVATIVE INSTRUMENTS

In the regular course of business operations, organizations are exposed to market
risks such as interest rate risk, foreign exchange risk, commodity price risk, etc., that give
rise to income volatility. As a result, organizations often will take some action to mitigate or
economically hedge against such exposures using derivative financial instruments. In addition,
some organizations may enter into derivative contracts for speculative or trading purposes.
Under current Indian and International accounting standards, an entity is required to
measure derivative instruments at fair value, or mark-to-market (MTM), with changes in fair
value or MTM to be recognized through the income statement.
(1) Hedge Accounting
Hedge accounting means designating a hedging instrument, normally a derivative, as
an offset to changes in the fair value or cash flows of a hedged item. Non-derivative financial
instruments may be used as hedging instruments only in respect of foreign exchange risk. A
hedged item can be an asset, liability, firm commitment or forecast future transaction that is
exposed to a risk of change in value or changes in future cash flows. Hedge accounting
attempts to match the off-setting effects of the fair value changes in hedged items and hedging
instruments and recognize them in net profit or loss at the same time.
The normal rules for financial instruments call for all derivatives to be carried at fair
value with gains and losses in the income statement. Hedge accounting allows departures
from the normal recognition rules in order to reflect the economics of hedging relationships
in reporting performance. An entity using hedge accounting can alter the timing of recognition
of gains and losses from fair value changes in hedged items and hedging instruments and
avoid the significant volatility that might arise if the gains and losses were recognized in the
income statement under normal accounting rules. There are three types of hedge accounting
recognized by IFRS; fair value hedges, cash flow hedges and hedges of the net investment
in a foreign entity.

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(2) Criteria for Hedge Accounting
Hedge accounting is an exception to the usual rules for financial instruments. There
are strict criteria that must be met before accounting can be used. The requirements are:
a) The hedged item and the hedging instrument are specifically identified.
b) The hedging relationship is formally documented – at the outset.
c) The documentation of the hedged relationship must identify the hedged risk and how
effectiveness of the hedge will be assessed.
d) At the inception of the hedge, it must be expected to be highly effective; that is, the
gains and losses on the hedged item and the hedging instrument should almost fully
offset over the life of the hedge.
e) Effectiveness of the hedge must be tested regularly throughout the life of the hedge.
Retrospective effectiveness should fall within a range of 80% to 125%.
f) One to one designation is normally required between a single external asset, liability or
forecast transaction and a single external derivative instrument.
g) Hedges of forecast transactions are allowed if the forecast transaction is ‘highly
probable’.
(3) Hedged Items
Hedge accounting can be applied to qualifying hedged items. A hedged item must
create an exposure to risk that could affect the income statement, currently or in future
periods. The usual types of risks that are hedged include foreign currency risk, interest rate
risk, equity price risk, commodity price risk and credit risk. Portfolio hedging, that is hedging
the open position arising from a number of similar hedged items, is difficult to achieve.
Any financial asset or liability which creates exposure to risk can be hedged item,
with two specific exclusions. Held-to-maturity investments cannot be hedged items for
interest rate risk nor can investments in subsidiaries or associates that are consolidated or
measured using the equity method. However, the net investment in a foreign entity can be
hedged. Some examples of risks that can be hedged are:
a) Foreign currency monetary items (risk or changes in foreign exchange rate).
b) Fixed interest debt security classified as available for sale (risk of changes in interest
rates or credit risk).
c) Highly probable forecast sale or purchase in a foreign currency.
d) Originated loans (risk of changes in interest rates).

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 An exposure to general business risks cannot be hedged, nor can risk of obsolescence
of computer equipment or risk of unseasonable weather because these risks cannot be reliably
measured. For similar reasons, a commitment to acquire another entity in a business
combination cannot be a hedged item, other than for foreign exchange risk.
(4) Qualifying for Hedge Accounting
There are three basic requirements that must be satisfied in order for hedge accounting
to be applied to any eligible hedge relationship: (1) Documentation, (2) Assessment of
Effectiveness and (3) Measurement of Ineffectiveness
Formal documentation of the hedge relationship needs to exist at the date of designation
those details:
a) The entity’s risk management objective and strategy for undertaking the hedge;
b) The nature of the risk being hedged
c) Clear identification of the hedged item and hedging derivative including the key terms;
and
d) The methods through which the effectiveness of the relationship will be assessed on
both a prospective and retrospective basis, and how any ineffectiveness will be measured.
A critical requirement before one can apply hedge accounting is the analysis that
supports the assessment of hedge effectiveness by analyzing the relationship between the
changes in fair value or cash flows of the hedging derivative instrument versus those of the
hedged item. At the inception of each hedge, an organization is required to demonstrate that
the hedge is expected to be highly effective throughout the designated term in achieving
offsetting changes in the fair value or cash flows attributable to the hedge risk through a
prospective test. At each subsequent period , the prospective test should be rerun to
demonstrate that the relationship is still expected to be highly effective for the remainder of
the term of the hedge. At each period end, a retrospective test also has to be conducted to
demonstrate that the hedge has been highly effective since inception of the hedge. Hedge
accounting must be discontinued prospectively from the current assessment date should
there be a failure of the prospective test, or discontinued prospectively from the previous
assessment date should there be a failure of the retrospective test.
When applying hedge accounting an entity is also required to measure any
ineffectiveness that may exist in the relationship (that is, the extent to which the change in
the fair value or cash flows of the derivative instrument does not offset the change in fair
value or cash flows of the hedged item). For a cash flow hedge ineffectiveness is currently

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recognized in profit or loss only when there is an over hedge and accordingly entities require
processes and information to calculate the ineffectiveness accurately and in the appropriate
instances. For a fair value hedge, ineffectiveness is naturally recognized in profit or loss as
it is simply the extent to which a perfect offset does not exist and can occur in an over hedge
or under hedge situation.

19.5 ACCOUNTING PRACTICE

International Accounting Standards get modified and rewritten very frequently. For
instance, IASB seeks to replace IAS 39 by IFRS 9 in three phases. The first phase was
completed with the issue of the portion of IFRS 9 which deals with the classification and
measurement of financial assets and financial liabilities. The second and third phase are in
the area of Impairment and Hedge Accounting, the supplementary document of these was
published in Jan. 2011 and the comment period closed on 1st April 2011.
Any derivative instrument used as a trading transaction should be recorded in accounting
records on marked-to-market basis. It means that it has to be valued at market value, and
resultant capital gains or losses must be taken into the profit and loss account for the current
period as part of earnings. In other words, not only realized gains and losses but also unrealized
gains and losses will be accounted for at the end of each accounting period. The treatment
of specific hedge transaction in accounting records should be the same as the treatment used
for the underlying asset. For example, if the underlying asset is valued at cost then the hedge
too will be at the cost. Further, if the underlying asset will affect profit or loss for more than
one year, the effect of the hedge should be spread over a matching number of accounting
years. If the underlying asset is marked-to-market, the same treatment should be with the
hedge.
If the underlying asset in a specific hedge transaction is carried at lower of cost or
market value, the market value should include the market value (i.e. net open or loss) on the
hedge instrument. The market value of the asset and the hedge are aggregated and treated as
one composite market value. Then this composite market value is compared with the cost
(book value) and the lower of the two is adopted. This valuation process has explained by an
example.
Example
A jewelery design company holds stock of 14 kilos of gold bars with a book value of
42 lakhs at the rate of Rs.3000 per gram. Its accounting year ends on December 31. It
hedges the same by selling January gold futures contract. It wants to know the correct stock
valuation for balance sheet purposes in each of the following scenarios:

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1. Sale of futures at Rs.2700 per gram, market price on balance sheet date is Rs.2600 per
gram.
2. Sale of futures at Rs.3200 per gram, market price on balance sheet date is Rs.2600 per
gram.
3. Sale of futures at Rs.3200 per gram, market price on balance sheet date is Rs.3300 per
gram.
. Rs. in lakh
. Scenario
I II III
1. Book value 420 420 420
2. Market value 364 364 462
+ (-) Gain (loss) on futures contract 141 842 -143
Composite Market value 378 448 448
3. Balance Sheet value 378 420 420
[lower of (1) ad (2)]
Notes:
1. (Rs.2700/gm – Rs.2600/gm) x 14000 gms = Rs. 14 lakhs gain
2. (Rs.3200/gm – Rs.2600/gm) x 14000 gms = Rs. 84 lakhs gain
3. (Rs.3300/gm – Rs.3200/gm) x 14000 gms = Rs.14 lakhs loss

19.6 ACCOUNTING TREATMENT OF DERIVATIVES IN INDIA

The Institute of Chartered Accountants of India (ICAI), 2006 issued, a new draft
accounting standard for recognition and measurement of financial instruments. It has also
modified its earlier draft standard on presentation of financial instruments. The Code came
at a time when corporate organisations had undertaken a large number of currency and interest
rate swaps to reduce their liability on loans. But the firms often abstain from disclosing
these off-balance sheet items. In the proposed rule, these derivative positions will not only
have to be disclosed, but also provided for, depending on the nature of the transaction.
The standards cover all financial instruments including various derivatives, equity,
debt, preference capital, bonds, convertible debentures and their combinations that corporate
design for specific needs. The standards will also make it easier for investors to find the net

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worth of a company without making complex calculations. The idea is to infuse transparency
and enable a clearer picture of a company’s financial health and. The standard on recognition
and measurement of these instruments (AS 30) is based on the International Accounting
Standard (IAS) 39.
AS 30 requires that all derivatives are accounted for on the balance sheet at fair value,
irrespective of whether they are used as part of a hedging relationship. Changes in fair value
are recognized in the statement of profit and loss unless the contract is part of an effective
cash flow or net investment hedging relationship. As the definition of a derivative is so
broad, many contracts are likely to be with in its ambit, and therefore will have to be accounted
for at fair value.
(1) Definition of Derivative
According to Para 8 of AS 30, A derivative is a financial instrument or other contract
within the scope of this Standard with all three of the following characteristics:
(a) Its value changes in response to the change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or
credit index or other variable provided in the case of a non-financial variable that the
variable is not specific to a party to the contract (sometimes called the ‘underlying’)
(b) It requires no initial net investment or an initial net investment that is smaller than
would be required for other types of contracts that would be expected to have a similar
response to changes in market factors and
(c) It is settled at a future date.
(2) Hedge Accounting
Hedge accounting is a method of presentation that may be voluntarily applied to hedging
transactions. The objective of hedge accounting is to ensure that the gain or loss on the
hedging instrument is recognized in the statement of profit and loss in the same period when
the item that is being hedged affects profit or loss. In other words, applying hedge accounting
results in the ‘matched’ timing of recognition of gains and losses in the statement of profit
and loss. Where an entity is perfectly hedged, the gains and losses on the hedging instrument
and the hedged item perfectly offset in the statement of profit and loss in the same period.
AS 30 allows an entity to apply hedge accounting if an entity specifically designates
the hedging instrument and the hedged item at inception of the hedge accounting relationship.
Generally, there are two ways in which hedge accounting achieves the matching of gains and
losses on the hedging instrument and the hedged item.

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a) Changes in the fair value of the hedging instrument are recognized in the statement of
profit and loss at the same time that a recognized asset and liability that is being hedged
is adjusted for movements in the hedged risk and that adjustment is also recognized in
the statement of profit and loss in the same period. This is referred to as a fair value
hedge because it is the exposure to changes in the fair value of the hedged item due to
the designated risk that is being hedged ; or
b) Changes in the fair value of the hedging instrument are recognized initially in equity
and ‘recycled’ into the statement of profit and loss when the hedged item affects profit
or loss. This is known as a cash flow hedge because it is the exposure to the variability
in future cash flow that is being hedged.
A third and final category of hedge accounting is hedging a net investment in a foreign
operation. This is accounted for similarly to cash flow hedges.
When an entity wishes to apply hedge accounting, it must formally document in writing
its intention to apply hedge accounting prospectively. Hedge accounting cannot be applied
retrospectively. Additionally, hedge accounting must be consistent with the entity’s
established risk management strategy for that hedge relationship. The hedge documentation
must identify the hedging instrument, the hedged item or transaction, the nature or the risk
being hedged and specify how the ‘effectiveness’ of the hedge relationship will be assessed
and ineffectiveness measured.
AS 30 does not mandate the use of hedge accounting. Hedge accounting is voluntary.
If an entity does not wish to use hedge accounting it does not need to designate and document
its hedging relationships.
Definitions of hedge accounting
AS 30 recognises three types of hedge accounting depending on the nature of the risk
exposure:
(a) Fair value hedge: Fair value hedge is a hedge of the exposure to changes in fair value of
a recognized asset or liability or an unrecognized firm commitment, or an identified
portion of such an asset, liability or firm commitment, that is attributable to a particular
risk and could affect profit or loss.
The following assets and liabilities are commonly fair value hedged:
(i) Fixed rate liabilities like loans;
(ii) Fixed rate assets like investments in bonds;

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 (iii) Investments in equity securities; and
(iv) Firm commitments to buy/sell non-financial items at a fixed price
A firm commitment is a binding agreement for the exchange of a specified quantity
of resources at a specified price on a specified future date or dates.
(b) Cash flow hedge: Cash flow hedge is a hedge of the exposure to variability in cash
flows that (i) is attributable to a particular risk associated with a recognized asset or
liability (such as all or some future interest payments on variable rate debt ) or a highly
probable forecast transaction and (ii) could affect profit or loss.
Common assets and liabilities and forecast transactions that are cash flow hedged include:
(i) Variable rate liabilities like loans;
(ii) Variable rate assets like investments in bonds;
(iii) Highly probable future issuance of fixed rate debt;
(iv) Forecast reinvestment of interest and principal received on fixed rate assets; and
(v) Highly probable forecast sales and purchases
An example of a cash flow hedge is a hedge of variable rate debt with a floating to
fixed interest rate swap. The cash flow hedge reduces future variability of interest cash
flows on the debt.
(c) Hedge of a net investment in a foreign operation (‘net investment hedge’): A hedging
relationship qualifies for hedge accounting under AS 30 if, and only if, all of the
following conditions are met.
(i) At the inception of the hedge there is formal designation and documentation of the
hedging relationship and the entity’s risk management objective and strategy for
undertaking the hedge. The documentation should include identification of the hedging
instrument, the hedged item or transaction, the nature of the risk being hedged and how
the entity will assess the hedging instrument’s effectiveness in offsetting the exposure
to changes in the hedged item’s fair value or cash flows attributable to the hedged risk.
(ii) The hedge is expected to be highly effective in achieving offsetting changes in fair
value or cash flows attributable to the hedged risk, consistently with the originally
documented risk management strategy for that particular hedging relationship.
(iii) For cash flow hedges, a forecast transaction that is the subject of the hedge must be
highly probable and must present an exposure to variations in cash flows that could
ultimately affect profit or loss.

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(iv) The effectiveness of the hedge can be reliably measured, i.e., the fair value or cash
flows of the hedged item that are attributable to the hedged risk and the fair value of the
hedging instrument can be reliably measured.
(v) The hedge is assessed on an ongoing basis and determined actually to have been highly
effective throughout the financial reporting periods for which the hedge was designated.
Forwards and Options: A forward contract is basically a contractual arrangement in which
one party buys and other party sells designated currency at a forward rate mutually agreed
upon the date of contract for delivery at designated future date. Accordingly, ‘An enterprise
may enter into a forward contract or other financial instrument that is in substance a forward
exchange contract to establish the amount of reporting currency required or available at
settlement date of a transaction. The difference between the forward rate and the exchange
rate at the date of transaction should be recognized as income or expense over the life of the
contract, excect in respect of liabilities incurred for acquiring fixed assets, in which case,
such difference should be adjusted in carrying amount of the respective fixed assets.
(3) Embedded Derivatives
AS 30 describes embedded derivative as a component of a hybrid (combined)
instrument that also includes a non-derivative host contract – with the effect that some of the
cash flows of the combined instrument vary in a way similar to a stand-alone derivative. An
embedded derivative causes some or all of the cash flows that otherwise would be required
by the contract to be modified according to a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or
credit index, or other variable, provided in the case of a non-financial variable that the variable
is not specific to a party to the contract.
The hybrid contract is the entire contract, within which there may be an embedded
derivative. The host contract is the main body of the contract, excluding the embedded
derivative. Company X holds a bond which is convertible into the equity shares of company
Y. The hybrid contract is the convertible bond; the host contract is the bond asset, and the
embedded derivative is the conversion option.
A derivative that is attached to a financial instrument but is contractually transferable
independently of that instrument, or has a different counterparty from that instrument, is not
an embedded derivative, but a separate financial instrument.
An embedded derivative should be separated from the host contract and accounted
for as a derivative under this Standard if, and only if:

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(a) The economic characteristics and risks of the embedded derivative are not closely
related to the economic characteristics and risks of the host contract (see Appendix A
paragraphs A50 and A53 of AS 30);
(b) A separate instrument with the same terms as the embedded derivative would meet the
definition of a derivative; and
(c) The hybrid (combined) instrument is not measured at fair value with changes in fair
value recognized in the statement of profit and loss (i.e., a derivative that is embedded
in a financial asset or financial liability at fair value through profit or loss is not separated)
If an embedded derivative is separated, the host contract should be accounted for
under this Standard if it is a financial instrument, and in accordance with other appropriate
Standards if it is not a financial instrument. This Standard does not address whether an
embedded derivative should be presented separately on the face of the financial statements.
Notwithstanding paragraph 10 of AS 30, if a contract contains one or more embedded
derivatives, an entity may designate the entire hybrid (combined) contract as a financial asset
or financial liability at fair value through profit or loss unless:
(a) The embedded derivative(s) does not significantly modify the cash flows that otherwise
would be required by the contract: or
(b) It is clear with little or no analysis when a similar hybrid (combined) instrument is first
considered that separation of the embedded derivative(s) is prohibited, such as a
prepayment option embedded in a loan that permits the holder to prepay the loan for
approximately its amortised cost.
Example
At the beginning of year 1, an enterprise issued 20,000 convertible debentures with
face value Rs.100 per debenture at par. The debentures have six-year term. The interest at
annual rate of 9% is paid half-yearly. The bondholders have an option to convert half of the
face value of debentures into 2 ordinary shares at the end of year 3. The bondholders not
exercising the conversion option will be repaid at par to the extent of Rs.50 per debenture at
the end of year 3. The non-convertible portion will be repaid at 10% premium at the end of
year 6. At the time of issue, the prevailing market interest rate for similar debt without
conversion option was 10%. Compute value of embedded derivative.

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Solution
Half – year Cash Flow DF1 PV2
Rs. 000 (5%) Rs.000
1-6 90 5.076 456.84
7 – 12 45 3.787 170.41
12 1,100 0.557 612.70
Value of host (liability component) 1,239.95
Value of embedded derivative 760.05
(Equity component)
Issue proceeds 2,000.00
1. Discount factor
2. Present Values
The ICAI issued a reminder in Feb. 2008 that companies should endeavour to follow
as quickly as possible the Accounting Standard (AS) 30: Financial Instruments: Recognition
and Measurement. AS 30 prescribes detailed rules to account for derivatives in balance
sheets. The clarification issued also ruled that companies not yet ready to comply with AS
30 must, in the interim, “ mark-to-market (MTM) all outstanding derivative contracts on the
balance sheet date”. This is to be done as per AS 1: Disclosure of Accounting Policies,
which requires companies to reveal in balance sheets known losses or liabilities they might
suffer later. AS 1, which is binding on companies, is rooted in the conservative accounting
style of prudence and seeks to keep stakeholders informed of the financial risks to companies
even before the threats play out fully.

19.7 CASE STUDY

MNP Tyres Ltd. is a leading tyres company with more than 50% of sales representing
exports to Dubai. The company is extensively making use of derivatives contracts for the
purpose of hedging its exposure to various risks, mainly exchange risk and price risk of
rubber. The specific derivatives contracts the company has taken during current financial
year ending on 31.03.14 are:

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(1) Forward currency contract in Australian dollar (A$) maturing in April to guard against
the possible depreciation of Dinar amounting to A$ 4 million to be received from a
dealer in Dubai.
(2) Forward contract in Eurocurrency maturing in May to guard against possible appreciation
of Euro currency. The company has taken this contract to meet its commitment
regarding Eurobonds amounting to • 5 million maturing in May.
(3) The company has also taken long position in May rubber futures market as insurance
against the possible rise in market price of rubber.
Questions:
1. Does forward contract in A$ to hedge against depreciation of Dinar comes under the
purview of IAS 39 as a derivative?
2. Does the forward contract in Euro currency come under the purview of IAS 39 as a
derivative?
3. Is the rubber futures contract covered under IAS 39 as derivative?
4. Is there any possibility that definition of derivative under IAS 39 is likely to be different
from the definition of derivative under FASB 133 in each of the above situations?
5. Explain the deficiencies of conventional accounting in reflecting true value of its assets
and liabilities in view of fluctuations in the currency market as well as rubber market.
6. Is hedge accounting mandatory in each of the above situations?
7.. Write a note on the accounting entries of the above derivative transactions.
8. What problems are generally encountered in accounting for derivatives?

19.8 SUMMARY
The accounting treatment of derivatives is still in the process of evolution. Various
accounting bodies, both at national and international level, particularly IASB, are busy
developing suitable standards for fair valuation of complex derivative instruments.
Under Indian and International Accounting Standards, business firms are required to
measure a derivative instrument at fair value, or mark-to-market (MTM) with changes in fair
value or MTM to be recognized through the income statement.

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 Hedge accounting provides for eliminating mismatch between the derivative instrument
which is measured at fair value, and the underlying asset which is typically valued a cost or an
amortised cost basis, through one of three ways: (1) ‘fair value hedge’ (2) ‘cash flow hedge’
and (3) ‘net investment hedge’.
AS 30, AS 31 and AS 32 are Indian accounting standards that correspond respectively
to IAS 39, IAS 32 and IFRS 7. The ICAI has issued a reminder in Feb. 2008 that companies
should endeavour to follow as quickly as possible the accounting standard (AS 30). AS 30
prescribes detailed rules to account for derivatives in balance sheets and it mandates the
companies to carry the unrealized MTM gains to profit and loss statements. The new norms
are a codification of the best international practices.

19.9 KEY WORDS

Hedge accg Fair value hedge Cash flow hedge Investment hedge

19.10 SELF ASSESSMENT QUESTIONS AND PROBLEMS

1. Define the following terms:
a) Fair value accounting
b) Financial instrument
c) Derivative
d) Embedded derivative
2. What do you mean by hedge accounting? Discuss the important guiding standards on
which the hedge accounting is done.
3. Define fair value hedge. When it is used?
4. Define cash flow hedge. When it is used?
5. Discuss the classification of financial instruments for accounting purposes.
6. What are the various issues relating to derivative financial instruments with respect to
accounting?
7. Discuss the progress of accounting standards for derivatives in India.

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19.11 REFERENCES
1. Financial Derivatives – by Dr. G. Kotreshwar ( Chandana Publications, Mysuru)
2. Risk Management – Insurance and Derivatives – By G.Kotreshwar (HPH)
3. Financial Derivatives – By Gupta (PHI)
4. Introduction to Futures and Options Markets – By John Hull (PHI)
5. Derivatives – By D.A.Dubofsky and T.W.Miller (Oxford)

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UNIT – 20 : OTHER (WEATHER) DERIVATIVES

Structure :
20.0 Objectives
20.1 Introduction
20.2 Energy Derivative
20.3 Catastrophe Derivatives (Bonds)
20.4 Carbon Credit Derivatives
20.5 Case Study
20.6 Summary
20.7 Key Words
20.8 Self Assessment Questions
20.9 References

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20.0 Objectives
On reading this unit the learner should be able to :
• Understand the concept of Alternative Risk Transfer (ART) ,
• Grasp the basic features of energy derivatives,
• Comprehend the emergence of catastrophe derivatives , and
• Understand the scope and importance of carbon derivatives.

20.1 INTRODUCTION
Alternative Risk Transfer (ART) is a new concept that describes a range of solutions
other than traditional insurance and reinsurance that can assist companies in the financial
management of their businesses . The ART market is the “combined risk management
marketplace for innovative insurance and capital market solutions”, while Alternative Risk
Transfer is “a product, channel or solution that transfers risk exposures between the insurance
and capital markets to achieve stated risk management goals”. As a result, ART is used to
absorb the effects of a hard market or to manage complex risk exposures which are often
uninsurable in the traditional insurance market. This unit introduces innovations in the capital
market through ART instruments for managing weather related risks i,e ; energy, catastrophe
and carbon risks.

20.2 ENERGY DERIVATIVE

An energy derivative is a derivative contract based on (derived from) an underlying
energy asset, such as natural gas, crude oil, or electricity. Energy derivatives are exotic
derivatives and include exchange-traded contracts such as futures and options, and over-the-
counter (i.e., privately negotiated) derivatives such as forwards, swaps and options. Major
players in the energy derivative markets include major trading houses, oil companies, utilities,
and financial institutions.
Electricity derivatives are the popular energy derivatives traded today – both in
organised and unorganized markets. Electricity spot prices are volatile due to the unique
physical attributes of electricity such as non-storability, uncertain and inelastic demand and
a steep supply function. Uncontrolled exposure to market price risks could lead to devastating
consequences. For this reason market participants find the importance and necessity of risk
management practices in competitive electricity market. Hedging of risk by a corporation
should in principle be motivated by the goal of maximizing firm’s value. Hedging achieves

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value enhancement by reducing the likelihood of financial distress and its ensuing costs. On
the supply side, managing risk associated with long-term investment in generation and
transmission requires methods and tools for planning under uncertainty and for asset valuation.
The plainest forms of electricity derivatives are forwards, futures and swaps. Being
traded either on the exchanges or over the counters, these power contracts play the primary
roles in offering future price discovery and price certainty to power generators .
Electricity forwards:
Electricity forward contracts represent the obligation to buy or sell a fixed amount of
electricity at a pre-specified contract price, known as the forward price, at certain time in
the future (called maturity or expiration time). In other words, electricity forwards are custom
tailored supply contracts between a buyer and a seller, where the buyer is obligated to take
power and the seller is obligated to supply. Electricity forwards differ from other financial
and commodity forward contracts in that the underlying electricity is a different commodity
at different times. The settlement price is usually calculated based on the average price of
electricity over the delivery period at the maturity time T. Consider a forward contract for
the on-peak electricity on day T. “On-peak electricity” refers to the electricity delivered
over the daily peak-period, traditionally defined by the industry as 06:00 - 22:00. The daily
“off-peak” period is the remaining hours of the day. In this case, the settlement price is
obtained by averaging the 16 hourly prices from 06:00 to 22:00 on day T. Based on the
delivery period during a day, electricity forwards can be categorized as forwards on on-peak
electricity, off-peak electricity, or “around-the-clock” (24 hours per day) 6 electricity. As
almost all electricity derivatives have such categorization based on the delivery time of a
day, we will not repeat this point. Generators such as independent power producers (IPPs)
are the natural sellers (or, shortside) of electricity forwards while utility companies often
appear as the buyers (or, long-side). The maturity of an electricity forward contract ranges
from hours to years although contracts with maturity beyond two years are not liquidly traded.
Some electricity forwards are purely financial contracts, which are settled through financial
payments based on certain market price index at maturity, while the rest are physical contracts
as they are settled through physical delivery of underlying electricity. Electricity forwards
with short maturity like one hour or one day are often physical contracts, traded in the physical
electricity markets. Those with maturity of weeks or months can be either physical contracts
or financial contracts and they are mostly traded through brokers or directly among market
participants (namely, traded in the OTC markets). Electricity forward contracts are the primary
instruments used in electricity price risk management.

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Electricity futures:
First traded on the NYMEX in March 1996, electricity futures are highly standardized
in contract specifications, trading locations, transaction requirements, and settlement
procedures. The most notable difference between the specifications of electricity futures
and those of forwards is the quantity of power to be delivered. The delivery quantity specified
in electricity futures contracts is often significantly smaller than that in forward contracts.
Electricity futures are exclusively traded on the organized exchanges while electricity
forwards are usually traded over-the-counter in the form of bilateral transactions. This fact
makes the futures prices more reflective of higher market consensus and transparency than
the forward prices. The majority of electricity futures contracts are settled by financial
payments rather than physical delivery, which lower the transaction costs. In addition, credit
risks and monitoring costs in trading futures are much lower than those in trading forwards
since exchanges implement strict margin requirements to ensure financial performance of
all trading parties. The OTC transactions are vulnerable to financial non-performance due to
counterparty defaults. The fact that the gains and losses of electricity futures are paid out
daily on mark-to -market basis, as opposed to being cumulated and paid out in a lump sum at
maturity time, as in trading forwards, also reduces the credit risks in futures trading. In
summary, as compared to electricity forwards, the advantages of electricity futures lie in
market consensus, price transparency, trading liquidity, and reduced transaction and monitoring
costs while the limitations stem from the various basis risks associated with the rigidity in
futures specification and the limited transaction quantities specified in the contracts.
Electricity swaps:
Electricity swaps are financial contracts that enable their holders to pay a fixed price
for underlying electricity, regardless of the floating electricity price, or vise versa, over the
contracted time period. They are typically established for a fixed quantity of power referenced
to a variable spot price at either a generator’s or a consumer’s location. Electricity swaps are
widely used in providing short- to medium-term price certainty up to a couple of years. They
can be viewed as a strip of electricity forwards with multiple settlement dates and identical
forward price for each settlement. These swaps are effective financial instruments for hedging
the basis risk on the price difference between power prices at two different physical locations.
Electricity options:
An electricity option is a contract wherein the holder has a right to buy or sell a
specified quantum of electricity at a specified rate on some future date.The emergence of
the electricity wholesale markets and the dissemination of option pricing and risk management
techniques have created electricity options not only based on the underlying price attribute

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(as in the case with plain vanilla electricity call and put options), but also other attributes like
volume, delivery location and timing, quality, and fuel type. Basically, a counterpart of each
financial option can be created in the domain of electricity options by replacing the underlying
of a financial option with electricity.

20.3 CATASTROPHE DERIVATIVES (BONDS)

Catastrophe bonds (or cat bonds ) are also known as Act of God bonds . Cat bonds
came into existence due to the lack of capacity in the catastrophe reinsurance market. Although
the catastrophe bond market is still relatively small compared with the traditional insurance
and reinsurance markets, it is expected to continue to grow and exert an important check and
balance upon pricing and underwriting practices in traditional insurance and reinsurance
markets. Catastrophe bonds have become an increasingly important part of the loss financing
market for insurance corporations. Cat bonds were first launched in 1994. Over 85% of
these catastrophe-linked securities are sold in the US.
The catastrophe bonds are so structured that if a pre-specified event such as a hurricane
occurs prior to the maturity of the bonds, then investors risk losing accrued interest and/or
the principal value of the bonds. Specifically, a catastrophe bond offering is made through a
special purpose reinsurer (SPR), an issuance vehicle that may be an insurance or a reinsurance
company. The SPR provides reinsurance to a sponsoring insurance or reinsurance company
and sells in particular notes to investors, passes the proceeds to the trustee for further
reinvestment, and provides an indemnity contract to the issuing company. The return generated
through reinvestment and the premium payment from the issuing company form the investor
coupon that becomes due and payable on a periodic basis. The invested proceeds held in the
trust account are used to repay principal at maturity. If a pre-specified catastrophic event
occurs the trustee withholds interest and/or principal payments temporarily or permanently.
Principal that otherwise would be returned to the investors is then used to fund the SPR’s
payments to the insurer. The investor’s reward for taking catastrophe risk is a relatively high
interest rate paid by the bonds. Since the issuing company will be exposed to losses on its
underlying catastrophe risk but will not longer need to provide payments to investors, it has
effectively used the capital markets investor base to hedge its risk. Catastrophe bonds serve
an extremely useful role in their overall approach to manage natural catastrophe risk exposures
and are therefore a constitute a basic ART instrument.They help to raise more equity capital
by selling more company stock, they limit risks through the underwriting and asset
management process, and they allow a reinsurance company to transfer a portion of its natural
catastrophe exposures to the capital markets rather than retaining the exposure on its books

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of business or retroceding the risks to other reinsurers. Cat bonds have a moderating effect
on reinsurance . Furthermore, these have emerged as a distinct asset class since cat bonds
have presumably low or zero correlation with other currently traded assets and are therefore
a promising instrument for portfolio management .
Investments in catastrophe risk indeed are proven to over-perform domestic bonds
and returns on catastrophe bonds are proven to be less volatile than either stocks or bonds.
However,catastrophe bonds are struggling with significantly high costs, especially compared
to the costs of buying traditional reinsurance coverage. One of the costs associated with
catastrophe bonds are the interest costs that insurers must pay to compensate investors for
purchasing securities that involve a substantial risk of loss of principal. Administrative and
transaction costs are cited as another reason for the relatively high costs associated with
catastrophe bonds. Transaction costs include underwriting fees charged by investment banks,
fees charged by modeling firms to develop models to predict the frequency and severity of
the event that is covered by the security, fees charged by the rating agencies to assign a rating
to the securities, and legal fees associated with preparing the provisions of the security and
preparing disclosures for investors. Indeed, catastrophe bonds may be cost-competitive with
traditional reinsurance for high-severity and low-probability risks, for retrocessional
coverage, and for larger-sized transactions. Therefore it can be concluded that cat bond
constitute a mixed bag.
Cat Bonds in India
GIC Re, the sole Indian reinsurer, has sought government’s permission in 2014 for
issuing cat bonds. GIC Re is attempting to establish itself as a bigger player in the
international reinsurance business. It has been underwriting many global events in the past.
For the company, it is a natural progression to launch what is popularly known as ‘cat bonds’.
The ‘cat bond’ market size is more than $20 billion. The bonds, popular in the US, are generally
priced 200 basis points above the 10-year US treasury yield. The price offered on ‘cat bonds’
is higher than corporate bonds as they carry junk status and investors run the risk of losing
their entire sum. GIC will raise funds for a particular catastrophic risk like either earthquake
or a tsunami or a cyclone with the condition that if the event happens, there will be no payout
of interest or principal. But if the event does not happen, investors will get a higher yield than
in other top-rated bonds. GIC saw a claim of Rs2,000 crore in Uttarakhand floods. It has not
announced last fiscal’s result. In 2012-13, it had posted a profit of Rs2,345 crore against a
loss of Rs2,469 crore in the previous year. GIC will be the first company to issue ‘cat bonds’
in India and is likely to benchmark them against the 10-year government securities. According
to the Swiss Re Cat Bond Price Return Index, ‘cat bonds’ have returned 9.09 per cent in the

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nine months till September last. Large global reinsurance companies like Swiss Re sell ‘cat
bonds’ to reinsure against catastrophes. Also, companies package various catastrophic risks
and some even design products based on specific perils like storm, earthquake and flood.

20.4 CARBON CREDIT DERIVATIVES

A carbon credit is a generic term for any tradable certificate or permit representing
the right to emit one tonne of carbon dioxide or the mass of another greenhouse gas with
a carbon dioxide equivalent (tCO2e) equivalent to one tonne of carbon dioxide. Carbon credits
and carbon markets are a component of national and international attempts to mitigate the
growth in concentrations of greenhouse gases (GHGs). One carbon credit is equal to one
tonne of carbon dioxide, or in some markets, carbon dioxide equivalent gases. Carbon trading
is an application of an emissions trading approach. Greenhouse gas emissions are capped
and then markets are used to allocate the emissions among the group of regulated sources.
The goal is to allow market mechanisms to drive industrial and commercial processes
in the direction of low emissions or less carbon intensive approaches than those used when
there is no cost to emitting carbon dioxide and other GHGs into the atmosphere. Since GHG
mitigation projects generate credits, this approach can be used to finance carbon reduction
schemes between trading partners and around the world.
Carbon Credits Trading or Emission Trading refers to trading in Greenhouse gas
emission certificates within the legal framework. It is a market-based scheme for
environmental improvement that allows parties to buy and sell permits for emissions or
credits for reductions. Emissions trading allow established emission goals to be met in the
most cost-effective way by letting the market determine the lowest-cost pollution abatement
opportunities. Under such schemes, the environmental regulator first determines the total
acceptable emissions and then divides this total into tradable units (often referred to as credits
or permits). These units are then allocated to scheme participants with dual purpose while
allowing the flexibility to meet their emission targets according to their own strategy.
Participants who emit pollutants must obtain sufficient tradable units to compensate for
their emissions Participants who reduce emissions may have surplus units that they can sell
to others, who find emission reduction more expensive or difficult . Emissions trading schemes
were first developed in the 1960s and 1970s in the United States, motivated partly by
dissatisfaction with the cost of the regulatory approaches to pollution control, they were
first used to price, with a view to reduce nitrogen and sulphur oxides (NOx and SOx) emissions
in the United States electricity industry. The Kyoto Protocol is an amendment to the
international treaty of United Nations Framework Convention on Climate Changes (UNFCCC)

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which is a legally binding agreement under which more than 169 industrialized countries
have agreed to reduce greenhouse gas emissions to a level of 5.4% by 2012 keeping 1990 as
the base. The objective of the protocol is the “stabilization of greenhouse gas concentrations
in the atmosphere at a level that would prevent dangerous anthropogenic interference with
the climate system. Under this protocol, about 38 industrialized countries and the European
Union forms a part of Annex-1 list, the remaining are part of Non–Annex 1 list of countries.
Carbon Market is the outcome of the Kyoto Protocol for controlling greenhouse gas
emissions. Green house gases are emitted mainly by burning oil, gas, and coal that are resulting
in perilous climate change. Each carbon credit represents one ton of carbon dioxide either
removed from the atmosphere or saved from being emitted. Countries buy and sell green
house gas emission in the form of “Units” and “Credits”. Credits issued for emission
reductions or removals achieved by a project under the clean development mechanism (CDM)
involving certification requirements. The certification requirements are as follows: Base
line to be drawn up – a scenario in which one provides supporting evidence about the emission
of greenhouse gases till 2012 without investment and compare this baseline with lower
emission that will be achieved through investment. A validation or certification organization,
acting as an independent third party validates the baseline. This organization works according
to the “Accreditation Guidelines for the Validation and Verification of Joint Implementation
(JI) projects” or according to the guidelines of the UNFCCC Executive Board accreditation
Panel for Clean Development Mechanism (CDM) projects. The host country’s government
must provide approval for the transaction in carbon credits through a Letter of Approval.
However, even if there is an MoU with the country in which one wants to invest, this letter
has to be obtained from the country’s government.
Simple transactions account only for a very small percentage of the carbon market
today. The carbon market has moved away from its beginnings, where carbon trading was
about a simple trade between two parties: one needing a permit or offset credit for compliance,
and the other having one to spare. At financial conferences, carbon is now being marketed as
a new asset class for investors such as pension funds. The carbon market has grown into a
‘matured’ market.As a consequence, the nature of the trading has changed significantly.
Market for Carbon Credits
Both OTC traders and organised exchanges trade in carbon derivatives such as carbon
forwards (OTC), carbon futures (exchanges) or carbon swaps. They can also both trade in
offset credits or emission permits directly. In 2009, 53 per cent of all European Union
Emission Trading System (EUETS) trading took place over the counter, while the remaining

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47 per cent was made on exchanges. Some 85 per cent of exchange trades were made through
the European Climate Exchange (ECX) in 2009. Other active exchanges include Bluenext,
the Chicago Climate Exchange (CCX), Climex, EEX, EXAA, Green Exchange, GME/PEX,
MCX and Norpool. In the OTC offset market, purchases are typically arranged through an
Emission Reduction Purchase Agreements (ERPA). These can take a variety of forms, but
usually stipulate the price of the reductions, the volumes expected, and delivery schedule.
Most trading in CDM carbon offset credits occurs on the OTC markets (71 per cent by value
or US$ 7.1 billion in 2008). Trading in secondary offset credits (i.e. credits generally
purchased from a financial institution or other entity that has previously purchased the credits
directly from the carbon project owner) more than doubled between the first three quarters
of 2007 (US$ 4 billion) and the same period in 2008 (US$ 10 billion). The primary CDM
offset market, where offset credits are purchased directly from project developers, by contrast,
decreased by more than half from 2008 to 2009 (see table below). The secondary market for
offset credits has continued to grow exponentially.
Options represent a small but growing percentage of carbon market activity, although
there may be OTC trading of options not reported. A market for options on CDM offset
credits started to emerge in the second half of 2008, with hedging, profit-taking, raising cash
and arbitrage (the simultaneous purchase and sale of an asset in order to profit from price
differences on different markets or in different forms) as the main drivers. In 2009, $
91.1million worth of options for CDM offset credits were traded against $ 67.8 million in
2008, a rise of 34 per cent.The first full year of options trading in EUETS allowances was
2009. Continuing global financial uncertainty and reduced access to cheap lending are cited
as additional factors for the continued growth of options trading in ETS permits; options can
provide a source of financing when other alternative financing is not available or more
expensive. This is another example of how EUETS permits become an asset with a value
beyond the original objective of the asset: companies covered by the EUETS, and who received
free allowances, thereby gain an extra financial advantage over other industry sectors like
the renewable energy or energy efficiency industries that do not have these alternative ways
of accessing capital.
Innovations in Carbon Market
The carbon market is expanding, powered by innovation. In November 2008, Credit
Suisse, in a joint venture with EcoSecurities, was the first bank to launch a ‘carbon structured
product’. It bundled together carbon credits from 25 different offset projects that were at
various stages of CDM approval, were located in three countries, and had been developed by
five project developers. The package of project credits was then split into three tranches

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representing different risk levels. This arrangement allows investors to choose the level of
risk they would like to take on. Although the Credit Suisse deal was relatively small, future
deals could become bigger and more complex, bundling carbon credits from many more
projects of mixed types and origins, perhaps combined with agreements to swap more risky
carbon credits for safer assets such as EUETS allowances as ‘insurance’ against ‘junk’ carbon.
By diluting (or hiding) risk, this bundling would help make dubious offset projects more
acceptable to buyers. The World Bank’s Prototype Carbon Fund (PCF) has already performed
a similar service, by bundling controversial projects such as the Plantar tree plantation project
in Brazil together with less controversial projects. The problem is that it is just as difficult to
analyse the quality of the individual underlying carbon offset projects as it was to analyse the
quality of the US sub-prime mortgages whose ‘bundling’ in structured financial products
nearly brought down the world economy. Trading in complicated carbon derivatives poses a
threat to economic as well as climatic stability. In another development reflecting the
expanding economic role and exchangeability of carbon commodities, in September 2009
companies covered by the EUETS began moving toward using their surplus European Union
Allowances (EUAs) as collateral when trading oil. ICE Clear Europe for example, the clearing-
house for the Intercontinental Exchange (ICE), has started to accept both EUETS allowances
and CDM offset credits as partial payment of margin fees in the trade of energy contracts.
Carbon Offsets
The World Resources Institute defines a carbon offset as “a unit of carbon dioxide-
equivalent (CO2e) that is reduced, avoided, or sequestered to compensate for emissions
occurring elsewhere”. The Collins English Dictionary defines a carbon offset as “a
compensatory measure made by an individual or company for carbon emissions, usually
through sponsoring activities or projects which increase carbon dioxide absorption, such as
tree planting”. Offsets are typically achieved through financial support of projects that reduce
the emission of greenhouse gases in the short- or long-term. The most common project type
is renewable energy, such as wind farms, biomass energy, or hydroelectric dams. Others
include energy efficiency projects, the destruction of industrial pollutants or agricultural
byproducts, destruction of landfill methane, and forestry projects.[11] Some of the most popular
carbon offset projects from a corporate perspective are energy efficiency and wind turbine
projects.
Sources of carbon offsets :
The CDM identifies over 200 types of projects suitable for generating carbon offsets,
which are grouped into broad categories like renewable energy, afforestation, etc. Renewable
energy offsets commonly include wind power, solar power, hydroelectric power and biofuel.

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Some of these offsets are used to reduce the cost differential between renewable and
conventional energy production, increasing the commercial viability of a choice to use
renewable energy sources.
Indian Scenario
India now has two Commodity exchanges trading in Carbon Credits. With the initiative
of Multi Commodity Exchange (MCX), India’s largest commodity exchange,of launching
futures trading in carbon credits, it has become Asia’s first-ever commodity exchange and
among the select few along with the Chicago Climate Exchange (CCE) and the European
Climate Exchange to offer trades in carbon credits. The Indian exchange also expects its tie-
up with CCX which will enable Indian firms to get better prices for their carbon credits and
better integrate the Indian market with the global markets to foster best practices in emissions
trading. From April 2008 National Commodity and Derivatives Exchange (NCDEX) also has
started futures contract in Carbon Trading for delivery in December 2008.The Indian
government has not fixed any norms nor has it made it compulsory to reduce carbon emissions
to a certain level. So, buyers of carbon credit, who are actually financial investors, anticipate
an increase in the demand of carbon credits by 2009, 2010 or 2012 which will result in huge
profits. So investors are willing to buy now to sell later. There is a huge requirement of
carbon credits in Europe before 2012. Only those Indian companies that meet the UNFCCC
norms and take up new technologies will be entitled to sell carbon credits. There are
parameters set and detailed audit is done before you get the entitlement to sell the credit.
This means that Indian Companies can now get a better trading platform and price for CERs
generated. Carbon Credits projects requires huge capital investment. Realizing the importance
of carbon credits in India, The World Bank has entered into an agreement with Infrastructure
Development Finance Company (IDFC), wherein IDFC will handle carbon finance operations
in the country for various carbon finance facilities. The agreement initially earmarks a $10-
million aid in World Bank-managed carbon finance to IDFC-financed projects that meet all
the required eligibility and due diligence standards. IDBI has set up a dedicated Carbon Credit
desk, which provides all the services in the area of Clean Development Mechanism/Carbon
Credit (CDM). In order to achieve this objective, IDBI has entered into formal arrangements
with multi-lateral agencies and buyers of carbon credits like IFC, Washington, KfW, Germany
and Sumitomo Corporation, Japan and reputed domestic technical experts like MITCON.
HDFC Bank has signed an agreement with Cantor CO2E India Pvt. Ltd. and MITCON
Consultancy Services Limited (MITCON) for providing carbon credit services. As part of
the agreement, HDFC Bank will work with the two companies on awareness building,
identifying and registering Clean Development Mechanism (CDM) and facilitating the buy
or sell of carbon credits in the global market.

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20.5 CASE STUDY
Carbon offset schemes allow individuals and companies to invest in environmental
projects around the world in order to balance out their own carbon footprints. The projects
are usually based in developing countries and most commonly are designed to reduce future
emissions. This might involve rolling out clean energy technologies or purchasing and ripping
up carbon credits from an emissions trading scheme. Other schemes work by soaking up
CO2 directly from the air through the planting of trees.
Some people and organisations offset their entire carbon footprint while others aim
to neutralise the impact of a specific activity, such as taking a flight. To do this, the
holidaymaker or business person visits an offset website, uses the online tools to calculate
the emissions of their trip, and then pays the offset company to reduce emissions elsewhere
in the world by the same amount – thus making the flight “carbon neutral”.
Offset schemes vary widely in terms of the cost, though a fairly typical fee would be
around £8/$12 for each tonne of CO2 offset. At this price, a typical British family would pay
around £45 to neutralise a year’s worth of gas and electricity use, while a return flight from
London to San Francisco would clock in at around £20 per ticket.
Increasingly, many products are also available with carbon neutrality included as part
of the price. These range from books about environmental topics through to high-emission
cars (new Land Rovers include offsets for the production of the vehicle and the first 45,000
miles of use).
Over the past decade, carbon offsetting has become increasingly popular, but it has
also become – for a mixed reasons – increasingly controversial.Traditionally, much of the
criticism of offsetting relates to the planting of trees. Some of these concerns are valid, but
in truth most of the best-known carbon offset schemes have long-since switched from tree
planting to clean-energy projects – anything from distributing efficient cooking stoves through
to capturing methane gas at landfill sites. Energy-based projects such as these are designed
to make quicker and more permanent savings than planting trees, and, as a bonus, to offer
social benefits. Efficient cooking stoves, for instance, can help poor families save money on
fuel and improve their household air quality – a very real benefit in many developing countries.
Even in the case of energy-based schemes, however, many people argue that offsetting is
unhelpful – or even counterproductive – in the fight against climate change. For example,
writer George Monbiot famously compared carbon offsets with the ancient Catholic Church’s
practice of selling indulgences: absolution from sins and reduced time in purgatory in return
for financial donations to the church. Just as indulgences allowed the rich to feel better

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about sinful behaviour without actually changing their ways, carbon offsets allow us to “buy
complacency, political apathy and self-satisfaction”, Monbiot claimed. “Our guilty
consciences appeased, we continue to fill up our SUVs and fly round the world without the
least concern about our impact on the planet … it’s like pushing the food around on your
plate to create the impression that you have eaten it.
Questions
1. Do Carbon offset schemes help present or future generation?
2. What is the range of products available for achieving carbon neutrality?
3. Is the whole concept of offsetting a scam?
4. “ A carbon offset scheme just allows companies to indulge and feel better about sinful
behaviour without actually changing their ways” . Do you agree ?

20.6 SUMMARY
Innovations in the capital market through ART instruments for managing weather related
risks i,e ; energy, catastrophe and carbon risks has opened a new chapter in risk management.
An energy derivative is a derivative contract based on (derived from) an underlying energy
asset, such as natural gas, crude oil, or electricity. Energy derivatives are exotic derivatives and
include exchange-traded contracts such as futures and options, and over-the-counter (i.e.,
privately negotiated) derivatives such as forwards, swaps and options. Major players in the
energy derivative markets include major trading houses, oil companies, utilities, and financial
institutions.
Catastrophe bonds (or cat bonds ) are also known as Act of God bonds . Cat bonds
came into existence due to the lack of capacity in the catastrophe reinsurance market. Although
the catastrophe bond market is still relatively small compared with the traditional insurance
and reinsurance markets, it is expected to continue to grow and exert an important check and
balance upon pricing and underwriting practices in traditional insurance and reinsurance
markets. Catastrophe bonds have become an increasingly important part of the loss financing
market for insurance corporations. Cat bonds were first launched in 1994. Over 85% of
these catastrophe-linked securities are sold in the US.
A carbon credit is a generic term for any tradable certificate or permit representing
the right to emit one tonne of carbon dioxide or the mass of another greenhouse gas with
a carbon dioxide equivalent (tCO2e) equivalent to one tonne of carbon dioxide. Carbon credits
and carbon markets are a component of national and international attempts to mitigate the

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growth in concentrations of greenhouse gases (GHGs). One carbon credit is equal to one
tonne of carbon dioxide, or in some markets, carbon dioxide equivalent gases. Carbon trading
is an application of an emissions trading approach. Greenhouse gas emissions are capped
and then markets are used to allocate the emissions among the group of regulated sources.

20.7 KEY WORDS

Alternative Risk Transfer (ART) Energy derivative Catastrophe bonds Carbon
creditsCarbon offsets
20.8 SELF ASSESSMENT QUESTIONS
1. Define the concept of ‘alternative risk transfer’.
2. What are energy derivatives? Why are they needed?
3. Briefly explain the evolution of electricity derivatives.
4. What are the different types of electricity derivatives traded?
5. What are cat bonds?
6. Discuss the merits and limitations of cat bonds.
7. What is the status of cat bonds in India ?
8. Define the concept of ‘carbon credit’.
9. Discuss the market for carbon credits.
10. What are carbon offsets?

20.9 REFERENCES
1. “The ART of Risk Management: Alternative Risk Transfer, Capital Structure, and the
Convergence of Insurance and Capital Markets” 1st Edition, by Christopher L. Culp ,
Wiley(Finance).
2. “Alternative Risk Transfer : Integrated Risk management Through insurance, Ri-insurance
and the Capital markets” by Eric banks, Wiley, 2004.
3. “Alternative Risk Transfer” in Risk management by C.L . Culp, Springer, 2008.
4. ‘Cat Bonds” at website : < insurancelinked.com >

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